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ANNAMALAI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION

M.B.A. Human Resource Management

M.B.A. Marketing Management
M.B.A. Financial Management
First Year

FINANCIAL MANAGEMENT
LESSONS : 1 – 24

Copyright Reserved
(For Private Circulation Only)
 1

M.B.A. HUMAN RESOURCE MANAGEMENT

M.B.A. MARKETING MANAGEMENT
M.B.A. FINANCIAL MANAGEMENT
FIRST YEAR

FINANCIAL MANAGEMENT
EDITORIAL BOARD
Members
Dr. R. Rajendran
Dean
Faculty of Arts
Annamalai University
Annamalainagar.
Dr. A. Rajamohan
Dr. C. Samudhrarajakumar Professor and Head
Professor and Head Management Wing, D.D.E.
Department of Business Administration Annamalai University
Annamalai University Annamalainagar.
Annamalainagar.

Internals
Dr. D. Senthil Dr. S. Jambulingam
Assistant Professor Assistant Professor
Management Wing Management Wing
D.D.E.
D.D.E.
Annamalai University
Annamalai University
Annamalainagar.
Annamalainagar.
Externals
Dr. R. Thenmozhi Dr. Jayapal
Professor and Head Professor and Head
Department of Management Studies Department of Bank Management
University of Madras Alagappa University
Chennai. Karaikudi.
Lesson Writers
Units: I – III Units: IV – VI
Dr. V. Sachithanantham Dr. D. Ayubkhan
Associate Professor Associate Professor
Management Wing Department of Commerce
D.D.E Quaide Milleth College for Men
Annamalai University
Chennai.
Annamalainagar.
 i

M.B.A. HUMAN RESOURCE MANAGEMENT

M.B.A. MARKETING MANAGEMENT
M.B.A. FINANCIAL MANAGEMENT
FIRST YEAR
FINANCIAL MANAGEMENT
SYLLABUS
UNIT – I
Finance functions – nature and scope – evolution of finance function – its new
role in the contemporary scenario – goals of finance function – maximising vs
satisfying – profit vs weath vs welfare – agency relationship and cost – risk – return
trade off – concept of time value of money – future value and present value and the
basic valuation model
UNIT – II
Source of short term financing – the management of working capital – meaning
of working capital – working capital alternative definition – financing mix – basic
approaches – hedging approach – the conservative approach –trade off between the
two – aggressive approach – management of cash – importance of cash and
liquidity- motives for holding cash – objectives of cash management-cash balance
deciding factors – cash management strategies – determination of cash cycle – cash
turnover – minimum operating cash – strcting the account receivables – combined
operation of management strategies - working capital control – working capital gap
– banking policy – receivables management – objectives – cost benefit credit policies
– credit terms – collection policies – inventory management - objectives of inventory
– inventory management techniques – cost benefit – other short term source of
finance
UNIT – III
Sources of long term finance – nature of term financing – common stock –
preferred stock – debt financing – secured and unsecured debts – repurchase of
shares – right issue procedure – underwriting shares – pricing the right issues –
dilution of market price rights – market price share – listing – rising of the term
loans and other source of finance – issue of bonus share and its procedure
UNIT – IV
Dividend policy decision – internal financing – dividend retained earnings –
relevance and irrelevalance of dividend MM hypothesis – walter’s model of cost of
retained earnings – dividend practices – factors affecting dividend policy – dividend
payout ratio - stock dividends and stock splits.
UNIT – V
Cost of capital and capital structure – cost of specific source of capital – cost of
retained earnings – measurement of overall cost of common stock – cost of preferred
stock – capital structure –traditional and modern approach –Leverages – types-
measurement of leverages – effect of profit –analysing alternative financing plans -
valuation of shares – concept of concern value – asset approach to valuation
approach.
UNIT – VI
Merger, aquatation and restructuring - reasons for merger -mechanics of
merger - cost benefit of merger - terms of merger - take over -jointventure -
managing and acquations - restructuring -portfolio-financial management of sick
units - definations-causes-symptoms-prediction-review of sick units.
Economic value added (EVA) - concept of EVA - calculatory EVA - adjustments
for calculations of EVA superiortity of EVA.
 ii

M.B.A. HUMAN RESOURCE MANAGEMENT

M.B.A. MARKETING MANAGEMENT
M.B.A. FINANCIAL MANAGEMENT
FIRST YEAR

FINANCIAL MANAGEMENT

CONTENT
Lesson Title Page No.
No.
1 Overview of Financial Management 1
2 The Time Value of Money 26
3 Short term Financing 35
4 Working Capital Management 44
5 Management of Cash 92
6 Receivables Management 107
7 Inventory Management 121
8 Long Term Financing 142
9 Equity And Preference Shares 154
10 Debentures and Bonds 174
11 Listing and Underwriting of Securities 191
12 Retained Earnings 205
13 Dividned and Dividend Policy 224
14 Theories of Dividend 238
15 Dividend Policy and Dividend Pay-out Ratio 255
16 Cost of Capital 270
17 Computation of Cost of Capital 275
18 Capital Stucture 292
19 Theories of Capital Structure 300
20 Leverage 319
21 Corporate Restructuring: Mergers Amalgamations 332
and Acquistions
22 Financial Management of Sick Units 346
23 Economic Value Added 358
24 Value of Shares 371
 1

LESSON – 1

OVERVIEW OF FINANCIAL MANAGEMENT

1.1 INTRODUCTION
The term financial management can be defined as the management of flow of
funds in a firm and it deals with the financial decision making of the firm. It
encompasses the procurement of the funds in the most, economic and prudent
manner and employment of these funds in the most optimum way to maximize the
return for the owner. Since raising of funds and their best utilization is the key to
the success of any business organization, the financial management as a functional
area has got a place of prime relevance, it is concerned with overall managerial
decision making in general and with the management of economic resources in
particular. All business decisions have financial implications and therefore financial
management is inevitably related to almost every aspect of business operations,
Evolution of trance as 8 disciplines, and the scope of finance functions are
discussed in this unit. In addition the relationship between financial management
and other functional areas and the organization of finance functions are also dealt
with.
1.2 OBJECTIVES
After Completing this Lesson you should be able to
 Explain finance as a discipline.
 Define the term financial Management.
 Distinguish between profit maximization and wealth maximization.
 Discuss the decisions in financial management.
 List out the functions of finance manager.
 Describe the risk return trade off.
1.3 CONTENT
1.3.1 Evolution of finance as discipline
1.3.2 Definition and Meaning of Financial Management
1.3.3 Goals of Financial Management
1.3.4 Decisions of financial Management
1.3.5 Finance Manager function
1.3.6 Risk return trade off
Financial Management as a Branch of Management
Of all the branches of management, financial management is of the highest
importance. The primary purpose of a business firm is to produce and distribute
goods and services to the society in which it exists. We need finance for the
production of the goods and services as well as their distribution. The efficiency of
production, personnel and marketing operations is directly influenced by the
manner in which the finance function of the enterprise is performed by the finance
 2

personnel. Thus it may be stated that all the functions or activities of the business
depends on how best all these functions can be co-ordinated.
A tree keeps itself green and growing as long as its roots sap the life juice from
the soil and distribute the same among the branches and leaves. The activities of
an organization also keep going smoothly as long as finance flows through its veins.
Any and every business will ultimately be reflected through its finance the mirror
and also the barometer of the enterprise functions.
Finance and Other Functional Areas of Management
Financial Management and Research and Development: The Research and
Development manager has to justify the money spent of research by coming up with
new products and process which would help to reduce costs and increase revenue.
If the Research and Development department is like a bottomless pit only
swallowing more and more money but not giving any positive results in return, then
the management would have no choice but to close it. No commercial entity runs a
Research and Development department for conducting infructuous basic research.
For instance, until 5 years ago, 80% of the Research and Development efforts of
Bush India, the 45-year old consumer electronics company, well known for its
audio systems, were in TVs and only 20% was in audio. But the fact that a 15-year
stint in the TV market starting form 1981 when the company shifted its interest
from the audio line to TV manufacture, led the company’s decline to near oblivion,
pausing the once-famous. Bush brand name to near anonymity, called for a change
in production and re-orientation of Research and Development strategy. The
company has also identified and shut down some of its non-productive divisions
and trimmed its workforce. At the beginning of 1992. Bush had 872 employees, by
the ends this was cut down to 550. The company had to further cut it down to 450
by the end of 1993.
Financial Management and Materials Management: Likewise the materials
manager should be aware the inventory of different items in stores is nothing but
money in the shape of inventory. He should make efforts to reduce inventory so
that the funds release could be put to more productive use. At the same time, he
should also ensure that inventory of materials does not reach such a low level as to
interrupt the production process. He has to achieve the right balance between too
much about which you will read more in the lessons on Working Capital
Management. The in an organization are reflected in the financial statements in
rupees.
Financial Management and Production Management: In any manufacturing
firm, the Production Manger controls a major part of the investment in the form of
equipment, materials and men. He should so organize his department that the
equipments under his control are used most productively, the inventory of time and
work stoppages are minimized. If the Production Manager can achieve this, he
would be holding the cost of the output under control and thereby help in
 3

maximizing profits. He has to appreciate the fact that whereas the price at which
the output can be sold is largely determined by factors external to the firm like
competition, government regulations, etc., the cost of production is more amenable
to his control. Similarly, he would have to make decisions regarding make or buy,
buy or lease etc., for which he has to evaluate the financial implications before
arriving at a decision.
Financial Management and Marketing Management: Marketing is one of the
most important areas on which the success or failure of the firm depends to a very
great extent. The philosophy and approach to the pricing policy are critical
elements in the company’s marketing effort, image and sales level. Determination of
the appropriate price for the firm’s products is importance both to the marketing
and the financial managers and, therefore, should be a joint decision of both. The
marketing manager provides information as to how different prices will affect the
demand for the company’s products in the market and the firm’s competitive
position while the finance manager can supply information about costs, change in
costs at different level of production and the profit margins required to carry on the
business. Thus, the finance manager contributes substantially towards formulation
of the pricing policies of the firm.
Financial Management and Personnel Management: The recruitment, training
and placement of staff are the responsibility of the Personnel Department. However,
all this requires finances and, therefore, the decisions regarding these aspects
cannot be taken by the Personnel Department in an isolation of the Finance
Department.
Thus, it will be seen that the financial management is closely linked with all
other areas of management. As a matter of fact, the financial manager has a grasp
over all areas of the firm because of his key position. Moreover, the attitude of the
firm towards other management areas is largely governed by its financial position. A
firm facing a critical financial position will devise its recruitment, production and
marketing strategies keeping the overall financial position in view. While a firm
having a comfortable financial position may give flexibility to the other management
functions, such as, personnel, materials, purchase, production, marketing and
other polices.
Evolutionary Change in the Concept of Finance
The word “finance” has been interpreted differently by different authorities.
More significantly, the concept of finance has changed markedly from time to time.
For the convenience of analysis different view points of finance have been
categorized into three major groups.
Finance Means cash only
Starting from the early part of the present century, finance was described to
mean cash only. The emphasis under this approach is only liquidity and financing
of the firm. Since nearly every business transaction involves cash, directly or
 4

indirectly, finance is concerned with everything that takes place in the conduct of
the business. However, it must be noted that this meaning of finance is too broad to
be meaningful.
Finance is raising of Funds
The second grouping, also called the ‘traditional approach’, is concerned with
raising funds used in an enterprise. It covers; (a) instruments, institutions,
practices through which funds are raised and (b) the legal and accounting
relationships between a company and its sources of funds, including the
redistribution of income and assets among these sources. This concept of finance
is, of course, broader than the first as it is concerned with raising of funds.
Finance, during the forties through the early fifties, was dominated by this
traditional approach. However, it could not last for long because of some
shortcomings. First, this approach emphasized the perspective of an outsider
lender. It only analysed the firm and did not emphasis decision-making within the
firm. Second, this approach laid heavy emphasis on areas of external sources of
long-term finance. However, short-term finance i.e., working capital is equally
important. Third, the function of efficient employment of resources was totally
ignored.
Finance is raising and Utilization of Funds
The third grouping is called the integrated approach or ‘Modern Approach’.
According to this approach, the concept of finance is concerned not only with the
optimum way of raising of funds but also their proper utilization too in time and
low cost in a manner that each rupee is made to work at its optimum without
endangering the financial solvency of the firm. This approach to finance is
concerned with (a) determining the total amount of funds required in the firm,
(b) allocating these funds efficiently to the various assets, (c) obtaining the best mix
of financing-type and amount of corporate securities, (d) use of financial tools to
ensure proper and efficient use of funds
1.3.1 Evolution of Finance as a Discipline
To begin the study of financial management what is needed is to address to
two central issues First, what is financial management and what is the role of
finance manager? Second, what is financial decision making and what is the goal of
financial management?
Finance has emerged as a distinct area of study during second half of the
twentieth century. But even before that some direct or indirect references to finance
function were made on a casual basis. The evolution of finance function and the
changes in its scope appeared due to two factors, namely,
1. The continuous growth and diversity in business, and
2. The gradual appearance of new financial analytical tools.
Financial Management is concerned with the planning and controlling of the
firm’s financial resources. It was a branch of Economics till 1890. Later on it was
developed into a separate subject. Since thirty years, the importance of Financial
 5

Management is increasing day by day. In the early part of 20th century,

technological innovation and industrialization created a need for more funds. This
promoted the study of finance to emphasize liquidity and financing of the firm.
Philippatos points out that, Financial Management is concerned with the
managerial decisions that result in the acquisition and financing of long-term and
short-term assets for the firm.
In the middle of Fifties, capital budgeting along with the Discounted Cash flow
techniques to find out the present value became important. Development of
portfolio theory was a major event in 1960's. In the 1970's Black and Scholes
developed the option pricing model for the relative valuation of financial claims. In
the 1980's, risk and uncertainties were considered in the valuation of the firm. Role
of personal taxation for dividends, and corporate taxation vis-a-vis, high inflation
increased the importance for study of Financial Management as a separate subject.
The modern phase of the evolution of finance function can be summarized as
follows:
i) The scope has widened to include the optimum utilization of funds
through analytical decision making.
ii) The finance function is now viewed from the point of view of the insiders
i.e., those who are taking decisions in the firm.
iii) The knowledge of the securities, financial markets and institutions is also
necessary and the scope of finance manager's function has expanded
beyond being nearly descriptive into analytical in nature.
Thus, the perusal of the evolution of finance function over the last fifty years
points out that the finance has emerged as relatively a new field of study and a
separate management function. As of today, the finance function has developed as
decision oriented and includes among its analytical tools, the quantitative and
computer techniques. In view of the increasing complex problems and opportunities
being faced by corporate financial managers, the finance function is making rapid
strides in its development process. The subject matter of finance function is stiff
developing and many new theories as well as refinement to existing theories may be
in the offing.
1.3.2 Definition and Meaning of Financial Management
In general, finance may be defined as the provision of money at the time it is
wanted. However, as a management function it has a special meaning. Finance
function may be defined as the procurement of funds and their effective utilization.
Some of the authoritative definitions are as follows.
According to Ezra Solomon, “Financial Management is concerned with the
efficient use of an important economic resource, namely, Capital Funds.”
In the words of Howard and Upton, “Finance maybe defined as that
administrative area or set of administrative functions in an organization which
 6

relate with the arrangement of cash and credit so that the organization may have
the means to carry out its objectives as satisfactorily as possible.”
Phillippatus has given a more elaborate definition of the term financial
management. According to him “Financial Management is concerned with the
managerial decisions that result in the acquisition and financing of long-term and
short-term credits for the firm. As such it deals with the situations that require
selection of specific assets (or combination of assets), the selection of specific
liability (or combination of liabilities) as well as the problem of size and growth of an
enterprise. The analysis of these decisions is based on the expected inflows and
outflows of funds and their effects upon managerial objectives.”
“Financial management is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for efficient
operation.” by Joseph & Massie
“Financial management is an area of financial decision making, harmonizing
individual motives and enterprise goals” by Weston and Brigham
“Financial management is the area of business management devoted to a
judicious use of capital and a careful selection of sources of capital in order to
enable a business firm to move in the direction of reaching its goals" by J.F.
Bradlery
Financial Management may also be defined as ‘planning, organizing, direction
and control of financial resources with the objectives of ensuring optimum
utilization of such resources and providing, insurance against losses through
financial deadlock.’ This definition clearly explains four broad elements viz.,
planning, organizing, direction and control. The details under these elements are as
follows.
a) Ascertainment of need
Planning
b) Determination of sources

c) Collection of funds
Organising
d) Allocation of funds

e) Communication of planned objective Direction

f ) Monit oring of f unds a (t hrough ' f inancial

discipline' in respect of funds utilisation)
g) Know ing performance actuals
h) J udging perf ormanc e against norms,
standards, targets etc.
i) Taking correct iv e act ion w hich in t urn
inv olv es remov al of snags as w ell as
revision of targets
 7

While the functions under planning and organizing are mostly of ‘discrete’
nature (undertaken from time to time and very often independently), those under
control area are ‘continuous’ in nature. All the principles, steps and weapons of
managerial control are applicable in proper control of financial resources and their
utilization. Hence, it is rightly said by Howard and Upton that financial
management is an application of general managerial principles to the area of
financial decision making viz. Funds requirement decision. Investment decision,
financing decision and Dividend decision. Hunt, William and Donaldson have
rightly called it as ‘Resource Management.’
Financial management is intimately interwoven into the fabric of management
itself. Not only is this because the results of managements’ actions are expressed in
financial terms, but also principally because the central role of financial
management is concerned with the same objectives as those of management itself
and with the way in which the resources of the business are employed and how it is
financed. Because it is about making profits and profits will be determined by the
way in which the resources of the business in terms of people, physical resources,
capital, and any other specific talents are organized.
Financial management is concerned with identifying sources of profit and the
factors which affects profit. That is to say with operating activities in the way in
which the assets are used, and form a longer term point of view, the process of
allocating funds to use within the business. In these activities, financial managers
form part of a management team applying their specialist advice and processing
and marshalling the data upon which decisions are based.
1.3.3 Goals of Financial Management
1.3.3.1 Specific Objective
1. Profit Maximisation: Earning profits by a corporate or a company is a social
obligation. Profit is the only means through which an efficiency of organisation can
be measured.
As the business units are exploiting the resources of the country namely, land,
labour, capital and resources, has an obligation to make use of these resources to
achieve profits. It is an economic obligation to cover the cost of funds and offer
surplus funds to expansion and growth. Accumulated profits reduce the risks of an
enterprise. It should serve as the base for all types of decisions. Profit maximization
achieved by an organisation is regarded as a primary measure of its success. The
survival of the firm depends upon its ability to earn profits. Though the profit
maximization has many features different people expressed different opinions to
consider this as main goal of a company.

TABLE- 1 Profit Maximization Favour and Against
Points in favour of profit
maximization
1. Profit is a barometer through
which the performance of a
business unit can be measured.
2. Profit ensures maximum welfare
to the share-holders, employees
and prompt payment to creditors
of a company.
3 Profit maximization increases the
confidence of management in
expansion and diversification
programmes of a company.
4. Profit maximisation attracts the
investors *o invest their savings
in securities.
5. Profit indicates the efficient use
of -funds for different
requirements
8
Point against profit maximization
1. Profit is a not a clear term. Is it
accounting profit? Economic Profit?
Profit before tax? After tax? Net
profit? Gross profit or earnings per
share?
2. It encourages corrupt practices to
increase the profits.
3. Profit maximization does not
consider the element of risks.
4. It does not consider the impact of
time value of money.
5. The true and fair picture of the
organisation is not reflected through
profit maximization.
6. Profit maximization attracts throat
competition
7. Huge amount of profit attracts
government intervention.
8. Some of the industries would like to
attain 'Industry leadership. They do
not bother about the increase in cost
and getting a low profit with huge
market share.
9. A huge profit invites problems from
workers. They demand high salary
and fringe benefits
10. The modern concept of marketing
does hot encourage profit
maximization. A huge profit
ultimately disturbs the morale of the
customers. He feels exploited by the
company.
11. Profit maximization is a narrow
concept, later it affects the long-term
liquidity of a company
12. Estimating the exact amount of
profit of a company under the
changing world is and difficult and
impracticable task.
 9

From the above points it is clear that firms always would like to have normal
profits and Profit maximization in only an illusion But the companies do earn the
profits to pay dividends to shareholders, to meet the obligation of creditors, to offer
fair amount of wages and salaries by maintaining high quality of products.
Through this, the image of the company will go up. The image offers high
returns to the equity shareholders in the stock market, resulting in capital
appreciation to the owners in. course of time, which is called “Wealth
Maximisation”.
1.3.3.2 Wealth Maximisation
The concept of ‘Wealth Maximisation’ refers to the gradual growth of the value
of assets of the firm in terms of benefits it can produce. Any financial action can be
judged in terms of the benefits it produces less cost of action. The wealth
maximization attained by a company is reflected in the market value of shares. In
other words, it is nothing but the process of creating wealth of an organisation. This
maximizes the wealth of shareholders.
Wealth maximization is the net present value of a financial decision. Net
present value will be equal to the gross present value of the benefits of that action
minus the amount invested to receive such benefits. (NPV = GPV of benefits -
investments). The gross present value I ascertained by discounting or capitalizing
its benefits at a rate, which reflects their timing and uncertainty. Any financial
action results in positive NPV, creates wealth to the organisation. If the NPV is
negative, it reduces the existing wealth of the shareholders. The total cash inflow of
the organisation must always be more than the cash outflows. The surplus inflow of
cash indicates the size of wealth, which was added to the total value of the assets.
When earnings per share (EPS) and profit after taxes are considered as indicators of
welfare of shareholders, they clearly exhibit that 'profit' cannot take care of the
welfare of shareholders. An earnings of profits is uncertain and it is exposed to the
risk. A new financial action may bring down the ‘economic welfare’ of owners, in
spite of the increase in profits?
Significance of Wealth Maximisation
The company, although it cares more for economic welfare of the shareholders,
it cannot forget the others who directly or indirectly contribute effectively for the
overall development of the company, namely, Lenders or Creditors, Workers or
Employees, Public or Society and Management. In this backdrop, let us examine
the relevance of wealth maximization.
 10

Fig. 1 Business Concern Relationship

Creditors: The creditors or lenders to a corporate enterprise refer to financial

institutions, commercial banks, private money lenders, debentures, and trade
creditors. The company has to meet their obligation of paying interest and principal
on the due dates. Though they are creditors, they are also interested in the well
being of the company. The earnings of the company assure prompt recovery of their
investment. This helps in improving their confidence in industrial financing. It is
through which a country can accelerate the economic growth. In addition to this,
the business entity will also have an opportunity to earn 'good name' and can
increase their ‘Liquidity’.
Workers: Workers/Employees are the backbone of the industry. They are the
main contributors to the growth and success of an industry. It is the basic
obligation of the company to keep the workers in good humour and harmony. This
is achieved only when a company pays fair salary and provides good working
condition with appropriate welfare measures. Otherwise, with the strong union
movement, it is highly difficult task for a company to carry out their operation. In
the absence of these welfare measures, the union may disturb the normal
operations of the enterprise by demanding more wages and other benefits. Hence a
company must have a long-term vision of 'building good relationship' with the
employees. This would help the company to earn good name in the long run.
Society/Public: A business concern is an important socio-economic organ of a
country. Economy permits the business unit to exploit all natural resources
available in the country, in exchange of this; society/economy demands welfare
facilities to the public. Government expects to increase the standard of living of the
people. The earnings of the company must have an obligation to fulfill the basic
requirement of the common man. This helps a corporate enterprise to gain good
 11

reputation and creditworthiness. Hence it has to care for the society and
consumers. Consumers are to be given good quality product with fair prices. It has
to care for society by participating directly or indirectly in its social actions namely,
sponsoring social programmes, free medical camps, free educational programmes
etc. To achieve this, a business unit must have to strike a balance between social
responsibility and profit maximization. Although the society’s needs are to be taken
care of by the company, it cannot forget the welfare of the owners, who are the
actual instruments in promoting economic welfare of the owners, who are the
actual instruments in promoting economic welfare of the society. Relevance of
“Wealth Maximisation” to the firm lies in its healthy relationship with the society.
Management: The total success of a business entity mainly depends on the
decisions of the management. The contribution of finance manager to this is
substantial. He has to make and guide the management in taking ‘right decision at
the right time’. He has to have maximum control over the movement of funds and
deploy the funds in the profitable avenues to reach maximum profits. They have to
show their competence in allowing a company to grow in all directions, create
confidence in the minds of equity shareholders.
From the forgoing discussion, it may be observed that the wealth maximization
is the ulterior motive of any firm. It cannot ignore the welfare of the organs or
associates who collectively contribute for the wealth maximization. Thus wealth
maximization takes place after satisfying these organs (lenders, workers,
management and society).
Advantages of Wealth Maximisation
1. Wealth maximization is a clear term. Here, the present value of cash flows is
taken into consideration. The net effect of investment and benefits can be measured
clearly, (quantitatively)
2. It considers the concept of time value of money. The present values of cash
inflows and outflows help the management to achieve the overall objective of a
company.
3. The concept of wealth maximization is universally accepted, because, it
takes care of interest of financial institution, owners, employees and society at
large.
4. Wealth maximization guides the management in framing consistent strong
dividend policy to reach maximum returns to the equity holders.
5. The concept of wealth maximization considers the impact of risk factor,
while calculating the NPV at a particular discount rate, adjustment is being made
to cover the risk that is associated with the investments?!
CRITICISMS OF WEALTH MAXIMISATION
The concept of wealth maximization is being criticized on the following grounds:
The objective of wealth maximization is not descriptive. The concept of
increasing the wealth of the stockholders differs from one entity to another
 12

business entity. It also leads to confusion and misinterpretation of financial policy

because different yardsticks may be used by different interest in a company. While
history indicates that even the earliest businessmen were expected to conform to
certain ethical standards of trade, the twentieth century has confronted the
businessman with a more demanding so economic environment and a less clearly
defined set of standard for a social nr conduct of business.
Other Objectives
1. Balanced Asser Structure: The subject of financial management must have
a goal of maintaining balanced asset structure of company. The size of fixed assets
is to be decided scientifically. The size of current assets must permit the company
to exploit the investments on fixed assets. Therefore balances between fixed assets
and current assets have to be maintained.
2. Liquidity: The Liquidity objective of a company will exploit the long-term
vision of a company. If a firm is 'Liquid', it is an indication of positive growth. The
application of management of cash flows yielded in increasing the company's
capacity to meet short-term as well as long-term obligation of the company.
3. Judicious Planning of Funds: The concept of wealth or profit maximization
is achieved only when a company reduces its cost. Cost here not only refers to the
overall cost of operations but also the cost of funds. The weighted average cost of
different sources of funds must be minimum. With the proper blend, of Debt of
Equity mix, short term or current liabilities are to be planned consciously, so that
the cost incurred on this should not become a burden to the organisation.
4. Efficiency: "Innovate or Perish" is the slogan of this century. If a company is
innovative/efficient, it can be run successfully in its future periods. The threat of
competition alarmed the businessman to be made creative and efficient. Hence it is
the obligation of a finance manager to be vigilant in increasing the efficiency level of
a company.
5. Financial Discipline: As in the recent past, country has witnessed different
types of scandals, corporate financial indiscipline, misuse of funds. Hence it has
become an obligatory responsibility of a company to have finances discipline
through various techniques of financial management viz., budgeting, fund flow and
cash flow statement, performance budget' analysis etc. Financial Management
1.3.4 Decision of Financial Management
The question of ‘scope of finance function’ determines the decisions or
functions to be carried out by the financial manager in pursuit of achieving the
objective of wealth maximization. The various functions of the financial manager
relate to the estimation of financial requirements, investment of funds in long-term
the various sources of finance, decision regarding retention of earnings and
distribution of dividend, and administering proper financial controls. In the
following discussion, these decisions have been categorized into two broad
groupings.
 13

1. Long-term financial decisions

(a) investment decision (capital allocation for fixed and current assets).
(b) Financing decision (capital sourcing), and
(c) dividend decision
2. Short-term financial decisions: (Working Capital Management)
(i) Cash, (ii) Investment (marketable securities), (iii) Receivable, and (iv) Inventory.
A brief Description of these Financial Decisions is Given Below
1.3.4.1 Long-Term Financial Decisions
The long term financial decisions pursued by the financial manager have
significant long term effects on the value of the firm. The results of these decisions
are not confined to a few months but extend over several years and these decisions
are mostly irreversible. It is, therefore, necessary that before committing the scarce
resources of the firm a careful exercise is done with regard to the likely costs and
benefits of the various decisions.
Investment Decision: Investment decision (also known as Capital-budgeting
decision) is concerned with the allocation of given amount of capital of fixed assets
of the business. The important characteristic of fixed assets is that their benefits
are realized in the future (generally after one year). Thus, capital-budgeting decision
adds to the total fixed assets of the concern by selecting and investing in new
investments. It must be properly understood at this stage that because the future
benefits are not known with certainty, investment proposals necessarily involve
risk. Consequently, they must whole. Obviously, the management will select
investments adding something to the value of the firm. The criteria of judging the
profitability of projects is the difference between the cost of the investment
proposals and its expected earnings. The important methods employed to judge the
profitability of the investment proposals and it expected earnings. The important
methods employed to judge the profitability of the investment proposals are: (a)
Payback method, (b) Average rate of return method, (c) Internal-rate of return
method, and (d) Net present value method. A careful employment of these methods
helps in determining the contribution of investment projects to owners’ wealth.
Financing Decision: Financing decision (also known as Capital Structure
Decision) is intimately tied with the investment decision. To undertake investment
decision the firm needs proper finance. The solution to the question of raising
finance is solved by financing decision. There are number of sources from which
funds can be raised. The most important sources of financing are equity capital and
debt capital. The central task before the financial manager is to determine the
proportion of equity capital and debt capital. He must endeavour to obtain that
financing mix or optimal capital structure for the firm where overall cost of capital
is the minimum or the value of the firm is maximum. In taking this decision, the
financial manager must bear in mind the likely effects on shareholders and the
firm. The use of debt capital, for instance, affects the return and risk of the
 14

shareholders. The return on equity will not only increase, but also the risk. A
proper balance will have to be struck between return value per share will be
maximized and firm’s capital structure would be optimum. Once the financial
manger is able to determine the best combination of debt and equity, he must raise
the appropriate amount through best available sources.

Capital
Budgeting
Decisions Return

Capital
Structure
Decisions
Market
Value
Dividend of the Firm
Decisions

Working
Capital Risk
Decisons

Fig. 2 Decisions, Return, Risk, and Market Value

Dividend Decision: The next crucial financial decision is the dividend decision.
This decision is the basis of dividends payment policy, reserves policy, etc. The
dividends are generally paid as some percentage of earnings on the paid-up capital.
However, the policy pursued by management concerning dividends payment is
generally stable in character. Stable dividends policy implies the payment of same
earnings percentage with only small variations depending upon the pattern of
earnings. The stable dividends policy among other things increases the market
value of the share. The amount of undistributed profits is called ‘retained earnings.’
In other words, dividends payout ratio determines the amount of earnings retained
in the firm. The amount of earnings of profit to be kept undistributed with the firm
must be evaluated in the light of the objective of maximizing shareholders’ wealth.
1.3.4.2 Short-Term Financial Decision
The job of the financial manger is not just limited to the long-term financial
decisions, but also extends to the short-term financial decisions aiming at
safeguarding the firm against illiquidity or insolvency. Surveys indicate that the
largest portion of a financial manager’s time is devoted to the day to day internal
operations of the firm; this may be appropriately subsumed under the heading
Working Capital management. Working capital management requires the
understanding and proper appreciation of its two concepts-gross and net working
 15

capital. Gross working capital refers to the firm’s investment in current assets such
as cash, short-term securities, debtors, bills receivable and inventories. Current
assets have the distinctive characteristics of being convertible into cash within as
accounting year. 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 trade
creditors, bills payable, bank overdraft and outstanding expenses. For the financial
manger both these concepts of gross and net working capital are relevant.
Investment in current assets affects firm’s profitability, liquidity and solvency.
In order to ensure the neither insufficient nor unnecessary funds are invested in
current assets, the financial manger should develop sound techniques of managing
current assets. He should estimate firm’s working capital needs and make sure that
funds would be made available when needed.
Investment Decisions
Allocation and Rationing the Resources
Risk Vs. Return  Framing (Fixed & Current) Risk Vs. Return
Assets Management polices

External Financing  Forecasting and controllig Internal Financing

Debt/Equity Ratios cash flow s, requirements etc. Debt/Equity Ratios

Financing Decisions Dividend Decisions

Planning for a Balanced Determination of the Quantum

Capital Structure & Timing of Dividend Payment

 Deciding upon  Determining the

requirements and allocation of net
sources of new profits
external financing  Checking the
 Carrying on financial
negotiations for new performance etc.
outside financing
etc.

Cost of Capital
Debt/Equity Ratios Payout Ratios
Core in the Framew ork of
Financial Management Decison Making
 Financing Decisions
 Investment Decisions
 Dividend Decisions

Fig:3 Relationship between Finance Functions

The cost of capital acts as the core in the framework for financial management
decision-making. It has a two-way effect on the investment, financing and dividend
decisions. It influences and is in turn influenced by them. The cost of capital leads
to the acceptance or rejection of projects, as it is the cut-off criterion in investment
decisions. In turn, the profitability of projects raises or lowers the cost of capital.
 16

The financing decisions affect the cost of capital because it is the weighted average
of the cost of capital, in turn, influences the financing decisions. The dividend
decisions try to meet the expectations of the investors raise or lower the cost of
capital. The following figure explains the components of finance functions and their
interrelation.
Figure-4 Finance Function
Finance Functions
 
Executive Functions Incidental Functions
a) Financial forecasting a) Cash receipts and payments
b) Investment Policy b) Custody of valuable papers
c) Dividend Policy c) Keeping mechanical details of financing
d) Cash flows and requirements d) Record keeping and reporting
e) Deciding upon borrowing e) Cash planning
policy
f) Negotiations for new outside f) Credit management
financing
g) Checking upon financial and
performance

Financial Controls: The long-term and short-term decisions, together,

determine the value of the firm to its shareholders. In order to maximize this value,
the firm should strive for optimal combination of these decisions. In an endeavour
to make decisions, the financial manager makes use of certain tools in the analysis,
planning and control activities of the firm. Some of such important tools are

a) Financial Accounting Statements g) Operating Budgeting and

Budgetary
b) Analysis of Financial Ratios h) Costing and Cost Control
Statement
c) Funds Flow Analysis and Cash flow i) Variance Analysis Reports,
Analysis
d) Financial Forecasting, j) Cost-Volume-Profit Analysis,
e) Analysis of Operating and Financial k) Profitability Index,
Leverage,
f) Capital Expenditure Budgeting, l) Financial Reports,

Organisation for Finance Function: Almost anything in the financial realm falls
within such a committee’s realm, including questions of financing, budgets,
expenditures, dividend policy, and future plans. Such is the power of financial
committee that in most cases their recommendations are approved as a matter of
course by the full board of directors. On the operational level, the financial
 17

management team may be headed up by a financial Vice-President. This is recent

development, the financial Vice-President answers directly to the president. Serving
under him are a treasurer and a controller. An illustrative organization chart of
finance function of management in a large organization is given below:

Board of Directors

President

Vice-President Vice-President Vice-President Vice-President Vice-President

Purchase Purchase Production Finance Personnal

Controller Treasurer

Fig. 5 Organization Chart of Finance Functions of Management

The above chart shows that the Vice-President (Finance) exercises his
functions through his two deputies known as: 1. Controller – concerned with
internal matters, 2. Treasurer – basically handles external financial matters.
Vice President
Finance

 
Controller Treasurer
1. Planning and Control 1. Provision of Finance
2. Reporting and Interpreting 2. Investor Relations
3. Tax Administration 3. Short-term Financing
4. Government Reporting 4. Banking and Custody
5. Protection of Assets 5. Credit and Collections
6. Economic Appraisal 6. Investments
7. Insurance
Fig. 5 Functions of Controller and Treasurer

The controller is concerned with the management and control of the firm’s
assets. His duties include providing information for formulating the accounting and
financial policies, preparation of financial reports, direction of internal auditing,
budgeting, inventory control, taxes, etc. While the treasurer is mainly concerned
with management of the firm’s funds, his duties include the following.
 18

Forecasting the financial needs; administering the flow of cash; managing

credit; floating securities; maintaining relations with financial institutions and
protecting funds and securities.
A brief description of the functions of the Controller and the Treasurer, as
given by the Controllers Institute of America, is given below.
Functions of Controller
1. Planning and Control: To establish, coordinate and administer, as part of
management, a plan for the control of operations. This plan would provide to the
extent required in the business, profit planning, programmes for capital investing
and for financing, sales forecasts and expense budgets.
2. Reporting and Interpreting: To compare actual performance with operating
plans and standards, and to report and interpret the results of operations to all
levels of management and to the owners of business. To consult with the
management about the financial implications of its actions.
3. Tax Administration: To establish and administer tax policies and procedures.
4. Government Reporting: To supervise or co-ordinate the preparation of report
to government agencies.
5. Protection of Assets: To ensure protection of business assets through
internal control, internal auditing and assuring proper insurance coverage.
6. Economic Appraisal: To appraise economic and social forces and government
influences and interpret their effect upon business.
Functions of Treasurer
1. Provision of Finance: To establish and execute programmes for the provision
of the finance required by the business, including negotiating its procurement and
maintaining the required financial arrangements.
2. Investor Relations: To establish and maintain adequate market for the
company’s securities and to maintain adequate contact with the investment
community.
3. Short-term Financing: To maintain adequate sources for the company’s
current borrowings from the money market.
4. Banking and Custody: To maintain banking arrangements, to receive, have
custody of and disburse the company’s moneys and securities and to be
responsible for the financial assets of real estate transactions.
5. Credit and Collections: To direct the granting of credit and the collection of
accounts receivables of the company.
6. Investments: To invest the company’s funds as required and to establish
and coordinate policies
7. Insurance: To provide insurance coverage as may be required.
Another way of looking at these functions is this:
 19

The controller function generally concentrates on the asset side of the balance
sheet, while the treasurer function concentrates on the claims side i.e., identifying
the best sources of finance to utilize in the business and timing the acquisition of
funds.
Controller’s and Treasurer’s Functions in the Indian Context
The terms ‘controller’ and ‘treasurer’ are essentially sued in U.S.A. However,
this pattern is not popular in India. Some companies do use the term ‘Controller’
for the official who performs the functions of the chief accountant or the
management accountant. However in most cases, in case of Indian companies, the
term ‘General Manager (Finance) or Chief Finance Manager is more popular. Some
of the functions of the Controller and the Treasurer such as government reporting,
insurance coverage, etc., are taken care of by the Secretary of the company. The
function of the treasurer of maintaining relations with its investors is also not
much relevant in the Indian context since by and large Indian investors/
shareholders are indifferent towards attending the general meetings. The finance
manager in Indian companies is mainly concerned with the management of the
firm’s financial resources. His duties are not compounded with other duties
generally in large companies. It is a healthy sign since the management of finances
is an important business activity requiring extraordinary skill and attention. He has
to ensure that the scarce financial resources are put to the optimum use keeping in
view various constraints. It is, therefore, necessary that the finance manager
devotes his full time attention and energies only in raising and utilizing the
financial resources of the firm.
Routine Duties of Financial Manager
Apart from the three broad functions of financial management mentioned
above, the financial manager has to perform certain routine or recurring function.
These are stated below:
i) Keeping track of actual and projected cash outflows and making adequate
provision in time for any shortfall that may arise.
ii) Managing of cash centrally and supplying the needs of various divisions
and departments without keeping idle cash at many points.
iii) Negotiations and relations with banks and other financial institutions.
iv) Investment of funds available and free a short period.
v) Keeping track of stock exchange prices in general and prices of the
company’s shares in particular.
vi) Maintenance of liaison with production and sales departments for seeing
that working capital position in not upset because of inventories, book
debts, etc.
vii) Keeping management informed of the financial implication of various
developments in and around the company
 20

Non-Routine Duties
The non-recurring duties of the financial executive may involve preparation of
financial plan at the time of company promotion, expansion diversification,
readjustments in times of liquidity crisis, valuation of the enterprise at the time of
acquisition and merger thereof, etc.
Today’s financial manager has to deal with a variety of developments that
affect the firm’s liquidity and profitability, including:
a) High financial cost identified with risk-bearing investments in a capital-
intensive environment;
b) Diversification by firms in to differing businesses, markets, and product
lines;
c) High rates of inflation that significantly affect planning and forecasting the
firms operations;
d) Emphasis on growth, with its requirements for new sources of funds and
improved uses of existing funds;
e) High rates of change in technology, with an accompanying need for
expenditures on research and development;
f) Speedy dissemination of information, employing high speed computers and
nationwide and worldwide networks for transmitting financial and
operating data.
Social Responsibility of Financial Manager
Another point that deserves consideration is social responsibility: should
businesses operate strictly in the stockholders’ best interest, or are firms also partly
responsible for the welfare of society at large? In tackling this question, consider
first the firms whose rates of return on investment are close to normal, that is,
close to the average for all firms. If such companies attempt to be socially
responsible, thereby increasing their costs over what they otherwise would have
been, and if the other business in the industry do not follow suit, then the socially
oriented firms will probably be forced to abandon their efforts. Thus, any socially
responsible acts that raise costs will be difficult, if not impossible, in industries
subject to keen competition.
What about firms with profits above normal levels – can they not devote
resources to social projects? Undoubtedly they can many large, successful firms do
engage in community projects, employee benefit programmes, and the like to a
greater degree than would appear to be called for by pure profit or wealth
maximization. Still, publicly owned firms are constrained in such actions by capital
market factors. Suppose a saver who has funds to invest is considering two
alternative firms. One firm devotes a substantial part of its resources to social
actions, while the other concentrates on profits and stock prices. Most investors are
likely to shun the socially oriented firm, which will put it to a disadvantage in the
capital market. After all, why should the stockholders of one corporation subsidies
 21

society to a greater extent than stockholders of the businesses? Thus, even highly
profitable firms (unless they are closely held rather than publicly owned) are
generally constrained against taking unilateral cost-increasing social action.
Does all this mean that firms should not exercise social responsibility? Not at
all-it simply means that most cost-increasing actions may have to be put on a
mandatory rather than a voluntary basis, at least initially, to insure that the
burden of such action falls uniformly across all businesses. Thus, fair hiring
practices, minority training programmes, product safety, pollution abatement,
antitrust actions, and are more likely to be effective if realistic rules are established
initially and enforced by government agencies It is critical that industry and
government cooperate in establishing the rules of corporate behavior and that firms
follow the spirit as well as the letter of the law in their actions. Thus, the rules of
the game become constraints, and firms should strive to maximize stock prices
subject to these constraints.
FINANCE MANAGER
Finance manager is a person who heads the department of finance. He forms
important activities in connection with each of the general functions of
management. He groups activities in such a way that areas of responsibility and
accountability are clearly defined. His focus is on profitability of the firm. The profit
centre is a technique by which activities are decentralised for the development of
strategic control point. The determination of the nature and extent of staffing is
aided by financial budget programme. Planning involves heavy reliance on financial
tools and analysis. Control requires the use of the techniques of financial ratios and
standards. Briefly, an informed and enlightened use of financial information is
necessary for the purpose of co-coordinating the activities of an enterprise. Every
business, irrespective of its size, should, therefore, have a financial manager who
has to take key decisions on the allocation and use of money by various
departments. Specifically, the finance manager should anticipate financial needs;
acquire financial resources and allocate funds to various departments of the
business. If the financial manager handles each of these tasks well, his firm is on
the road to good financial health. Since the financial manager is an integral part of
the top management, he should shape his decisions and recommendations to
contribute to the overall progress of the business. It is his primary objective, to
maximize the value of the firm to its stockholders.
1.3.5 Functions of Finance Manager
The following are some of the important functions of the finance manager.
 He should anticipate and estimate the total financial requirements of the
firm (Preparing sound financial plan).
 He has to select the right sources of funds at right time and at right cost.
 [Balancing the own capital (EQUITY) and borrowed capital (DEBT) for the
best advantage of the firm.]
 22

 He has to allocate the available funds in the profitable avenues. [Judicious

Fund Allocation]
 He has, to maintain liquidity position of the firm at the peak. [Synchronizing
the finance inflow and outflow for better liquidity].
 He should analyzes financial performance and plan for its growth.
[Continuous financial appraisal activity]
 He has to administrate the activities of working capital management.
 He has to protect the interest of creditors, shareholders and the employees.
 He has to concentrate more on fulfilling the social obligation of a business
unit
1.3.6 Risk Return Trade-off
The financial derision of the firm are interrelated and jointly affect the market
value of its shares by influencing return and risk of the firm The relationship
between return and risk can be simply expressed as follows
Return = Risk free rate + Risk premium
Risk-free rate is a compensation for time and risk premium is a compensation
for risk. Higher the risk of an action, higher will be the required return on that
action. A proper balance between return and risk should be maintained to
maximize the market value of a firm's shares. Such balance is called risk-return
trade - off and every financial decision involves this trade-off- The interrelation
between market value, financial decisions and risk-return trade-off is depicted in
figure 1 .2. It also gives an overview of the functions of financial management.
Figure 6
An Overview of Financial Management
 23

The financial manager in a bid to maximize owners’ wealth, should strive to

maximize returns in relation to the given risk should seek of actions that avoid
unnecessary risks To ensure maximum return, funds flowing in and firm should be
constantly monitored to assure that they are safeguarded and properly utilized.
1.4 REVISION POINTS
Financial Decisions : Refer to decisions concerning financial
matters of a business concern.
Investment Decisions : Refer to assets mix or utilization of funds.
Financing Decisions : Refer to capital structure or optimal financing
mix.
Dividend Policy Decisions : Decide about allocation of business earnings.
1.5 INTEXT QUESTIONS
1. What do you mean by profit Maximisation?
2. What do you mean by wealth maximiasation?
3. What do you mean by executive function?
4. What do you mean by routine Function?
5. What do you mean by Liquidity?
6. What do you mean by profitability?
1.6 SUMMARY
Financial management is concerned with the Planning and controlling of the
firm’s financial resources. The finance functions can be divided into three board
categories (1) Investment decisions, (2) Financing decisions and (3) Dividend
decision. In other words, the firm decides how much to invest in short-term and the
required funds. In making these decisions the financial management should aim at
increasing the value of the shareholders stock in the firm. The operative objective of
financial management implies maximization of market price of share.
The financial management provides oxygen to the life of a firm by providing
uninterrupted flow of funds throughout the firm and thus helps achieving the
ultimate objectives of the firm. The finance function is related to management,
wherever and whenever a policy decision
1.7 TERMINAL EXERCISE
1. ………….…………… means earning profits by a corporate or a company is a
social obligation.
2. ………………………….. refers to the gradual growth of the value of assets of
the firm in terms of benefits it can produce.
3. …………………………… is concerned with the allocation of given amount of
capital of fixed assets of the business.
4. …………………………… is intimately tied with the investment decision.
 24

1.8 SUPPLEMENTARY MATERIAL

1. www.csb.uncw.edu
2. www.unilorin.edu.ng
3. https://drhemantyadav.files.wordpress.com/
4. www.accfile.com
1.9 ASSIGNMENTS
1. What role finance managers play in a modern firm?
2. Draw a typical Organization Chart highlighting the finance function of a
company.
3. An optimal combination of decisions relating to investment, financing and
dividends will maximize the value of the firm to its shareholder. Examine.
4. “Financial management is more than procurement” -What do you think
are the responsibilities of a Finance Manager?
5. How the financial decision making risk-return trade off?
6. “Finance is the oil of wheel, marrow of bones and spirit of trade, commerce
and industry” – Elucidate.
7. Discuss the role and significance of financial management in the
functional areas of modern management.
8. Some of the early concerns of financial management are related to
preservation of capital, maintenance of liquidity and reorganization. Do
you think these topics are still important in our current unpredictable
economic environment?
9. Who discharges the finance function and what are his specific
responsibilities?
10. Contrast profit maximization and value maximization as criteria for
financial management decisions in practice.
11. Why is it inappropriate to seek profit maximization as the goals of
financial decision making? How do you justify the adoption of present
value maximization as an apt substitute for it?
12. “The operative objective of financial management is to maximize wealth or
net present worth” – Ezra Solomon. Explain the statement and explain the
finance function performed by a Finance Manager to achieve this goal.
13. Explain the scope of finance function and suggest an organizational
structure that you consider suitable for an effective financial control of a
large manufacturing concern.
14. Discuss the respective of ‘Treasurer’ and ‘Controller’ I the financial set-up
of a large corporations. Out of these two finance officers who is more
important in the modern contest and why?
 25

15. As a Financial Manager of a company, how would you reconcile between

financial goals and social objectives of the concern?
1.10 SUGGESTED READINGS
1. Maheswari S.N., “Financial Management Principles and Practices” Sultan
Chand & Sons, New Delhi (2010).
2. Antony Robert. N and Reece, James.S. “Management Accounting
Principles” Tata Mc Graw Hill (2004).
3. Sawalia Bihari Verma, Financial Management, Excel Books.
4. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi,
Tata McGraw Hill Co.
5. Hampton, J. J. :Financial Decision Making, New Delhi, Prentice Hall of
India.
6. Pandey, I. M. :Financial Management, New Delhi, Vikas Publishing House.
7. Van Horne, James C: Financial Management and Policy, New Delhi,
Prentice Hall of India.
1.11 LEARNING ACTIVITIES
You have been appointed as a finance manager. Now it is your responsibility to
design the function of financial management in your organization. Suggest the role
of finance manger and design the best financial management.
1.12 KEYWORDS
Profit Maximisation, Wealth Maxisimation, Liquidity, Profitability, Dividend,
Routine Function, Executive Function, Finance Manager.



.
 26

LESSON – 2

TIME VALUE & MONEY

2.1 INTRODUCTION
Money has a time value because of the following reasons:
i) Individuals generally prefer current consumption;
ii) An investor can profitably employ a rupee received today to give him a
higher value to be received tomorrow or after a certain period;
iii) In an inflationary economy the money received today has more purchasing
power than money to be received in future.
Thus, the fundamental principle behind the concept of “time value of money”
is that a sum of money received today is worth more than if the same is received
after sometime. A corollary to this concept is also the concept that money received
in future is less valuable than what it is today. For example, if an individual is
given an alternative either to receive Rs. 10,000 now or after six months; he will
prefer Rs. 10,000 at present. This may be because he may invest this money and
earn some interest on it or because he may need money for current consumption or
because he is in a position to purchase more goods with this money than what he is
going to get for the same amount after six months.
Time value of money or time preference for money is one of the central ideas in
finance. Individuals as well as business organizations frequently encounter the
situations involving cash receipts or disbursements over several periods of time.
When this happens time value of money becomes important and some time vital
consideration in decision making. This will be clear with the following examples.
Example 1: A gives a loan of Rs. 10,000 to for a period of one year. The market
rate of interest is 10% p.a. Thus, at the end of a year A will get Rs. 11,000 for the
initial loan of Rs. 10,000 given by him to B. In other words, the amount of Rs.
10,000 today at 10% interest is equivalent to Rs. 11,000 to be received after a year).
2.2 OBJECTIVES
After completing this Lesson you must be able to
 Explain the meaning for time value of money
 List out the Valuation concept
 Describe the reasons for time preference for money
 Explain the Concept of Value
2.3 CONTENT
2.3.1 Reasons for time Preference for money
2.3.2 Concepts of Value
2.3.3 Valuation concepts
 27

2.3.1 Reasons for Time preference for money

Normally people prefer to receive money today is more than its value received
after some time because of the following reasons.
i) Uncertainty and loss
Anything may happen in future. Either for an individual or for an organization
there may a chance of not getting the cash inflow and hence they will like to receive
money immediately because future is always uncertain and involves huge risk.
ii) To satisfy present needs
In economics point of view, people in actual life prefer to use their money for
satisfying present needs than future needs. For the purpose of purchasing clothes,
television, car and luxurious articles for their present sophisticated life. They feel
present needs are considered more urgent as compared to future needs.
iii) Investment opportunities
Money has time value. As more investment opportunities are available to
invest money received immediately than the future. For example Mr. Lai receives
Rs. 40,000 today. But immediately he can invest either in banks or in shares. It can
earn some interest or appreciation. In reality he gets an interest of 12%. Actually at
the end of the first year he will have the value of Rs. 44,800. Therefore it is the
opportunities for the investor to receive Rs. 40,000 at present as it will enhance
into Rs. 44,800 at end of the year. If he invests in shares to some times it may be
doubled. So without investment, any investor it is difficult to enhance their
earnings.
2.3.2 Concepts of Value
The term value has been used in different meanings. It differs with its
purposes. The various concepts of value are given below.
(i) Book value: The term book value of the assets means value recorded in the
books or balance sheet of a firm which is prepared according to accounting
concept. Fixed assets' are shown in the balance sheet at cost less depreciation.
Current cost are recorded at cost price or market price whichever is less. Intangible
assets are recorded at cost less amortization. Liabilities are shown at their
outstanding values. Book value per share is calculated by the share holders' equity
by the total number of shares outstanding.
(ii) Market value: The term market value is the value of asset or the security
bought or sold in the market at the current market rate or present value.
(iii) Liquidation value: The term liquidation means winding up of business.
Whenever the firm decides to wind up their business it will sell its assets, After
discontinue the business the amount which will be realized from the sale of assets
is known as liquidation value. Liquidation value is calculated only on the winding
up of the firm.
(iv) Replacement value: Generally, assets are shown at historical cost basis in
the balance sheet. Replacement value indicates the amount required for replacing
 28

their existing assets to its present condition. In actual sense there are certain
difficulties for the computation of replacement value. For example there may be
some difficulties to ascertain the present value of similar assets used by the firm.
And also it ignores value of intangible assets.
(v) Going concern value: According to the going concern concept it is assumed
that the business will continue for a very long period of time. Simply the business is
not discontinued. Going concern value is the price which a firm could realize if it is
sold as running the business. Generally the going concern value will be always
higher than the liquidation value. Valuation refers to the process that links risk and
return to determine the value of an asset.
(vi) Bonds or debenture valuation: In order to raise long term funds the
government, public sector and private sector companies may issue the securities
known as bonds.
2.3.3 Valuation Concepts
The above discussion establishes that there is a preference of having money at
present than at a future point of time. This automatically means: that a person will
have to pay in future more for a rupee received today; and a person may accept less
for a rupee to be received in future. There are two different concepts:
1. Compound Value Concept.
2. Present Value Concept.
Each of these concepts are being explained in detail in the following pages.
Compound Value Concept
In case of this concept, the interest earned on the initial principal becomes a
part of principal at the end of the compounding period. For example, if Rs. 100 is
invested at 10% compound interest for two years, the return for first year will be Rs
10 and for the second year interest will received on Rs. 110 (Le. 100 + 10). The total
amount due at the end of second year will become Rs. 121 (i.e. 100 + 10 + 11). This
can be understood better with the following illustration:
Illustration 1: Rs. 1.000 is invested at 10% compounded annually for three
years. Calculate the compounded value after three years.
Solution
Amount at the end of 1st year will be:
1,000 + (1,000 x .10) =Rs. 1,100
or1,000 x (1.10) =Rs. 1,100
Amount at the end of 2nd year will be:
1,0.00-+(l.l00 x.10) =Rs.1,210
or1.100x (1.10) =Rs. 1,210
Amount at the end of 3rd year will be:
 29

1,210+ (1,210 x.10) =Rs. 1,331

or1,210 x (1.10) =Rs. 1,331
This compounding procedure will continue for an indefinite time period.
Compounding of Interest over ‘n’ Years
The return from an investment are generally spread over a number of years. In
the Illustration 2.1 given above, the interest has been compounded only for three
years. However, if one is required to calculate interest for five-six-years, the method
given in the Illustration 2.1 would become tedious. The general equation used to
calculate the compounded value after 'n' years is given below:
A = P( 1 + i)n
Where:
A = Amount at the end of period 'n'
P = Principal at the beginning of the period
i = Interest rate
n = Number of years.
Using above formula, for example, we get the same result.
A = P(l +i)n
1,331 = 1,000 (1+.10)3
Computation by this formula can also become very time consuming if the
number of years become large, say 10, 15 or more. In such cases to save upon the
computational efforts, compound value tables can be used. The table gives the
compounded value of Re. 1, after 'n' years for a wide range of combination of i and n.
For instance, in the above example, as per Table 3, the compound value of Rs.
1,000 will amount to : l.000x 1.331 =Rs. 1.331
Multiple Compounding Periods
Interest can be compounded, even more that once in a year. For calculating
the multiple compounded value, above logic can be extended. For instance, in case
of semi-annual compounding, interest is paid twice a year but at half the annual
rate. For the purpose of calculation, semi-annual compounding implies that there
are two periods of six months. Similarly in case of quarterly compounding interest
rate effectively is I/ 4th of the annual rate and there are four quarter years.
In general the formula to calculate the compounded value is:
A = P(l +i/m)mxn
Where
A = Amount after a period
m = number of times per year compounding is made
P = Amount in the beginning of period
 30

i = interest rate
n = number of years for which compounding is to be done.
The-term compounded value is also referred to as terminal value i.e. value at
the end of a period.
Illustration 2: Calculate the compound value when Rs. 1,000 is invested for 3
years and the interest on it is compounded at 10% p.a. semi-annually.
Solution
The general formula is
A = P(l + i/m)mxn
Substituting the value we get
2x3
 10 
A  1,0001  
 2 
1,340

Alternatively, we can look to Table 3. The compound value of Re. 1, at 5%

interest at the end of 6 years is Rs. 1.340. Hence, the value of Rs. 1,000 will be:
1,000 x 1.340 = Rs. 1,340.
Future Value of Series of Cash Flows
The transactions in real life are not limited to one. An investor investing money
in installments may wish to know the value of his saving after n years.
Illustration 3: Mr. Investor invests Rs. 5,00 Rs. 1,000 and Rs. 2,000 at the end
of each year. Calculate the compound value, at the end of 3 years compounded
annually when interest is charged at 10% per annum.
STATEMENT OF THE COMPOUND VALUE
No. of years Compounding Future value (Amount
End of Amt.
compounded interest factor Deposited x Compound
the year Deposited
@ 10% (from table 3) interest factor)
1 500 2 1.210 605
2 1,000 1 1.000 1,100
3 2,000 0 0 1.000 2,000
Amount at the end of third year……… 3,705
Notes:
1. The compound interest table gives the value of Re. 1, when compounded at
the rate Y (same as T in the general formula) for 'n' years.
2. Re. 1 deposited for two years at compounded rate of 10% will yield
Rs. 1,210. Similarly, Rs. 500 will yield 1.210 x 500 = Rs. 605. Same logic
holds goods for other deposit of Rs. 1,000 for one year. Rs. 2,000 will not
earn any interest.
 31

Compounding Annuities
Compound Value Annuity Table assumes an annuity payment of Rs. 1 for 'n'
years at an interest rate of T. It gives the compound value when Re. 1 is invested
every year for 'n' years at 7 rate of interest. Annuity Table gives the compound value
of an annuity immediately after the last payment is made. In other words it gives
the compound value of an annuity at the point where the last installment is paid.
This effectively means that annuity involving A: number of payments will occur over
a period of x-l number of years. This will be clear from the following illustration.
Illustration 4: Find the compounded value of annuity when three equal yearly
payments of Rs. 2,000 are deposited into an account that yields 7% compound
interest.
Solution: We know that the annuity table gives the compound value
immediately after 3rd installment. So, the 3rd installment will be compounded for
'nil' years. 2nd Installment will be compounded for 1 year and 1st installment will
be compounded for 2 years.
The annuity Table gives the compound value as 3.215 when Re. 1 is paid every
year for 3 years at 7%. Thus, the compounded value of annuity of Rs.2,000 is:
= Rs. 2,000 x (3.215) = 6,43o
Present Value or Discounting Concept
The present value concept is exact opposite of the compounding technique
concept. In case of compounding we calculate the future value of a sum of money or
series of payments, while in case of Present Value Concept, we estimate the present
worth of a future payment/installment or series of payments adjusted for the time
value of money.
The basis of Present Value approach is that opportunity cost exists for money
lying idle. That is to say, that interest can be earned on the money. This return is
termed as 'discounting rate'. Given a positive rate of interest, the present value of
future rupee will always be lower. The technique for finding the present value is
termed as ‘discounting’.
Present Value after 'n' Years
From the above discussions it is obvious that value of Re. 1 received after a
time period, is less that its present worth. Therefore, an investor would like to part
away with a sum that is less than Re. T to get Re. 1 after a time period. To calculate
the amount that he is willing to part away with, the following formula can be used:
A
Pv 
(1  i)n
Here Pv = Principal amount the investor is willing to forego at present
i = interest rate
A = Amount at the end of the period n
n = number of years
 32

Note: This is reverse of the compounding formula.

With this formula, we can directly calculate the amount; any depositor would
be willing to accept at present, with a time preference rate or discount rate of x %.
Let us take an example.
If Mr. Depositor expects to get Rs. 1,000 after one year at the rate of 10 %, the
amount he will have to forego at present can be calculated as follows:
Similarly, the present value of an amount of inflow at the end of 'n' years can
be computed!
Present Value of an Annuity
In the above case there was a mixed stream of cash inflows. An individual or
depositor may receive only constant returns over a number of years. For example
returns on debentures /fixed deposits etc., is fixed in its nature. This implies that
the cash flows are equal in amount. To find out the present value of annuity either
we can find the' present value of each cash flow or use the annuity table. The
annuity table gives the present value for an annuity of Re. 1 for interest rate Y over
number of years ‘n’.
Illustration 5: Calculate the Present Value of Annuity of Rs.500 received
annually for four years, when discounting factor is 10%.

Year 1 Cash Flows 2 Present Value Factor 3 Present Value (2 x 4 3)

1 500 0.909 454.50
2 500 0.827 413.50
3 500 0.751 375.50
4 500 0.683 341.50
3.170 1 585.00

This basically means add up the Present Value Factors and multiply with Rs.
500, Le., 3.170 x 500 = Rs. 1,585.00.
Formula for calculation of the present value of an annuity can be derived from
the formula for calculating the Present Value of a series of cash flows.

A A
Pv  1  2  .......... ....  An
(1  i)I (1  i)I (1  i)n
1/4
 1 1 1 1 
 A    .......... .......... .....  
 (1  i)1 (1  i)2 (1  i)3 n
(1  i) 

 n 1 
 A  
t  1 (1  i)n 
 
 33

Where:
PVAn = Present value of ‘n’ annuity’
A = Value of single installment
i = Rate of interest.
However, as stated earlier a more practical method of computing the present
value would be to the annual installment with the present value factor. The formula
would then be as follows:
PVAn = A x ADF
where ADF denotes Annuity Discount Factor.
The PVAn in the above example can be calculated as:
500 x 3.170 = Rs. 1,585
Present Value of a Perpetual Annuity
A person, may like to find out the present value of his investment in case, he is
going to get a constant return year after year. An annuity of this kind which goes on
for ever is called a perpetuity. A practical example is the way in which scholarships
are given to the students in schools/colleges. An individual invests a certain sum of
money, on which a constant interest is received year after year. This return is given
in the form of award, to students achieving academic excellence. This type of
annuity continues forever.
The present value of a perpetuity of an amount A can be ascertained by simply
dividing A by interest rate as discount i, symbolically represented as A/i.
Illustration 6: Mr. Principal wishes to institute a scholarship of Rs. 500 for an
outstanding student every year. He wants to know the present value of investment
which would yield Rs. 500 in perpetuity, discounted at 10%.
Solution: The present value can be simply calculated by dividing Rs. 500 by
.10 that gives us Rs. 5,000. This is quite convincing since an initial sum of Rs.
5,000 would if invested at a rate of 10% would provide a constant return of Rs. 500
for ever without any loss of initial capital.
2.4 REVISION POINTS
Annuity: Refers to a uniform cash flows or a series of equal annual payment for
a specified period
Time value: Value of money received today is more than value of same amount
received after a certain period.
2.5 INTEXT QUESTIONS
1. What is the concept of time value of money?
2. List out the techniques of time value of money?
3. State the reasons for time preference for money.
4. Write short notes: (i) Annuity (ii) Discount rate (iii) Annuity due and (iv)
Effective Interest rate.
 34

2.6 SUMMARY
The more important objective of financial management is to maximize the
shareholders Wealth or maximize the value of the shares in the market. In order to
achieve this objective there is a need to develop valuation model. In other words the
investors from their opinion above the firm on the basis of information about these
decisions while taking these decisions the finance manager must keep the time
factor in mind i.e., (i) when interest on funds raised will have to be paid ;(ii) When
return in investment will be received and (iii) whether it will be received on
consistent basis. All this requires that the finance manager knows about the
various valuation concept Compound value concept, annuity concept, present value
concept etc. All there concept are basically based on their fact that the money has a
time value.
2.7 TERMINAL EXERCISE
1. …………………………of the assets means value recorded in the books or
balance sheet of a firm which is prepared according to accounting concept.
2. ………………….is the value of asset or the security bought or sold in the
market at the current market rate or present value.
3. …………………… is exact opposite of the compounding technique concept
2.8 SUPPLEMENTARY MATERIAL
1. http://educ.jmu.edu/
2. http://faculty.kfupm.edu.sa/
3. www.finance professor.com
2.9 ASSIGNMENTS
1. Explain the different methods of valuing the firms
2. Eplain the signifance of of time value of money.?
2.10 SUGGESTED READINGS
1. Reeta manthur, Indian Financial System, Jain Book Agency. New Delhi
2. Machiraju , Indian Financial System, Jain Book Agency, New Delhi.
3. Vasant Desai, Indian Financial System and development, Sulthan Chand .
2.11 LEARNING ACTIVITIES
What is the present value of an income stream which provides rs.2000 a year
for the first five years and Rs.3000 a year forever therafter, if the discount rate is 10
percent?
2.12 KEYWORDS
Book Value, Market Value, Liquidation Value, Replacement Value, Going
concern Value, Compund Value Concept, Present Value concept.
 35

LESSON - 3

SHORT TERM FINANCING

3.1 INTRODUCTION
Integrative approach explains that short-term financing problem involves
interplay of the following variables:
 Profitability;
 Liquidity preference; and
 Risk attitude of management.
The cost of current liabilities is normally less than that of long-term liabilities
and return on current assets lower than that on long-term investment. Minimal
holding of current assets and maximal holding of current liabilities in preference to
long-term liabilities would maximize current profit. But this would involve a
dangerous risk of technical insolvency from potential deficiencies of liquid funds.
The problem of short-term financing is, therefore, two-fold.
(a) Given the imposing variation, how much portion of current requirement of
funds may be allowed to be financed by short-term financing means based on
management's risk profile; and
(b) Given the appropriate level of short-term financing, what would be the
optimum mix of alternative means of short-term financing? The world of
uncertainty and risk association with maturity composition of debts have to be kept
in view.
3.2 OBJECTIVES
After completing this lesson you must be able to explain short term financing
 Explain short term financing
 Discuss the measures to maintain short term financing
 Enumerate the characteristics & short term financing
 Explain the sources of short-term financing
3.3 CONTENT
3.3.1 Measures to maintain short-term financing
3.3.2 Characterization of short term financing
3.3.3 Nature of credit
3.3.4 Sources of short - term finance
3.3.5 Advantages and disadvantage of short term financing
3.3.1 Measures to Maintain Short –Term Financing
(i) Elimination of non-current items from Working Capital: An insight into the
historical records of the company reveals the existence of some items in both
current assets and current liabilities. Though by natural classification or as per
requirements of companies Act, they have to be grouped under current assets or
 36

current liabilities, in reality these items may assume non-current character over
years. In current assets by search into the sundry debtors and inventory, one may
get disillusioned from such hidden non-current elements. Similarly, in current
liabilities management may declare allowable limit of turnover cycle and chances
for matching current assets with current liabilities.
(ii) Short-term Finance Requirement: The organization’s long-term investment
plan based on management's objectives should be broken down into short-term
operating plans. This short-term operating plans determine the quantum of finance
required for short-term horizon.)
(iii) Self-generation of Funds: Projected forecast of cash should show self-
generation of funds to meet the operating plan. Residual of the projected cash flow
would represent the final period-to-period requirement of finance calling for a
financing package-which is the focal point.
(iv) Management of Current Assets: It is ordinarily assumed that various items
of current assets are efficiently managed. But it would be necessary to know the
optimal turnover and mix of current assets, after taking into consideration that:
(a) Cash and marketable securities give a return lower than other items of
current assets.
(b) Autonomous cash inflows/outflows are a result of the company's
established policy and involve no decision variables. This means that the company
has an established policy with regard to the discharge of the bills of various
creditors and Credit grants to customers are matched according to the credits from
suppliers of goods and services.
(c) There has to be a definite policy of eliminating minimizing the use of
working capital for meeting long-term needs, i.e., acquisition of non-current assets.
(d) Within the organisation there must be information consciousness and
system orientation.
If the above measures are adopted, it would be possible to get a clear picture of
the objectives long-term plan, short-term operating plan, liquidity preference, risk
attitudes, etc.
3.3.2 Characteristics of Short-Term Financing
(i) Short-term finance tends to be-less expensive than long-term finance. The
principal supplier of the short-term variety is the banking system and its overdrafts
and loans have the additional advantages of being available quickly and
inexpensively.
(ii) Short-term financing embraces the borrowing or lending funds for a short
period of time, say one year or less.
(iii) There is a common tendency for greater use of short-term financing among
small concerns and lesser use among large concerns is prevalent in practically all
types of business. This is probably accounted for by the fact that small-sized
 37

business finds it quite difficult to raise long-term funds resulting on account of

lower average credit standing and relative impermanence of many small units.
(iv) Short-term finance deals with the commercial bank, trade credit, and other
sources of funds that have to be repaid within a year or less. Trade credit is the
privilege extended by suppliers to their customers of delaying payment of goods
purchased, .sometimes for a period of a month or more.
(v) Short-term financing is associated largely with paying for those business
assets that charge constantly in form and that are used up or consumed in the
course of operations. Such assets are also called “current assets” or “working
assets”.
(vi) Customers may sometimes provide short-term funds by making advances
on contracts. They, in essence, make a pre-payment on goods before receiving
delivery. Customers might advance funds, if the order is large enough to require the
manufacture to tie up in raw materials or goods in process more funds than what
the latter can afford.
3.3.3 Nature of Credit
Of all the banking concepts, that of credit is probably the most elusive. It is
commonly said that a man “has credit” - a bank “extends credit” or “Credit is based
upon the three” “C” s - of capital, character and capacity”. Nothing in any of these
notions tells us anything about what credit is or what the function of credit is in
simple business parlance, credit involves merely getting something now and paying
for it later. It is synonymous with borrowing. The essential element in credit
operations always is postponement of payment for something that has been
received. It is important to bear in mind that the thing loaned (on credit) may be
either commodities or funds. Goods sold on time involve credit. Such merchandise
may be paid for by a return of goods in kind; though under modern conditions the
obligation is usually settled by money payments. There are various types of kinds of
credit operations that exist in the modern world these are:
(i) Public Credit: By public credit is meant the borrowing operations of
Governments, whether national, state or local. In a broad way, it is in contrast to
private credit of all kinds. Public credit may be used either for long term or short
term financial requirements.
(ii) Capital Credit: By capital credit, or industrial credit is meant the credit
used by manufacturing and producing corporations in procuring the necessary
permanent capital required for their operations.
(ii) Mercantile Credit: Mercantile credit is the term applied to the borrowing
operations of jobbers, wholesalers, commission merchants, and retailers, in
connection with the movement of goods from first producer to ultimate consumer.
(iii) Individual or Personal Credit: It obviously takes its name from the fact that
it is connected with individuals rather than with public or private corporations
Individuals borrow money from acquaintances and from financial institutions for, a
 38

wide variety of purposes, and, more important, they purchase consumptive goods
on time from retail stores.
(v) Banking Credit: It relates to the process by means of which banking
institutions are enabled to attract funds of depositors and to make loans and create
obligations, payable on demand, which are not backed by a matching cash reserve.
(vi) Investment Credit: It is used in connection with the development of
business enterprises such as railroads, factories, workshops, stores, farms, mines,
etc. The funds borrowed are used mainly for the creation of "Fixed" or durable
forms of capital goods; hence the term “fixed capital”,
(vii) Commercial Credit: It is employed in financing the production,
manufacture and marketing of goods in furnishing working capital. In contrast with
investment, credit, the borrower is usually in a position to repay his loan in a very
short period of time.
(viii) Consumptive Credit: It involves the granting of loans or the selling of
goods on time to individuals who use the money or the goods received for the
purpose of satisfying consumptive wants!"?
3.3.4 Sources of Short-Term Financing
1. Trade Credit
Trade creditors in the narrowest sense are manufacturers, wholesalers, other
suppliers of merchandise, materials or suppliers, that is, tangible goods, that are
sold to other business establishments on the basis of deferred payment. In a
broader sense trade creditors include those firms rendering services to other
concerns. Credit is extended by these firms in an Endeavour to increase their sales
or because of custom that has been built up over time. Such credit is not a cash
loan but results from a sale of goods or services which need not be paid for until
some time after the sale takes place. Trade creditors are the most important single
source of short-term credit.
2. Bank Credit
Commercial banks are a major source of finance to industries and commerce.
Banks have introduced many innovative schemes for the disbursements of
credit. The schemes of village adoption, agricultural development branches and
equity fund for small units are representative of such schemes. They have moved in
the direction of bridging certain difficulties or gaps in their policies such as giving
too little credit to agriculture, small industries, etc. Banks in India provides mainly
short-term credit for financing working capital needs, although they have of late
started attending to term loan requirements in a small measure. Term credit is
mainly extended by development and financing institutions also called as
development banks”.
Cash credit and overdrafts are the running accounts from which the borrower
can withdraw funds as and when needed after the credit limit is sanctioned by the
bank. Cash credit is given against the security of commodity stocks, whereas
 39

overdrafts are allowed on personal or joint current accounts. Interest is charged on

the outstanding account borrowed and not on the credit limit sanctioned.
Purchasing and discounting of bills is another method of financing credit for banks.
It is popularly known as bill finance.
The drawbacks of the cash credit system of lending are:
(a) A bank has no control over the level of advances in the cash credit
accounts. No notice is required for drawing under limits that may remain unutilized
for long periods;
(b) A bank is not in any position to foresee demand for credit. This hampers its
credit planning; and
(c) The cost of the operations of the system to the banker, on account of the
attendant uncertainties, is high because whatever chances the banker may take in
overselling credit, there is a limit for overselling.
Under loan arrangement the total amount of loan is credited by the bank and
interest is payable on the entire amount sanctioned as loan. The overdraft
arrangement is a system which permits the party to overdraw current account with
his bank up to a stipulated limit. Interest is charged on the actual amount
withdrawn. Cash credit facility is allowed against pledge or hypothecation of goods
or by providing alternative securities in conformity with the term of advance.
3. Bank Financing of Accounts Receivable
A commercial was one of the latest developments in the financing of accounts
receivable.
Of the many developments since 1933 which influenced commercial banks to
begin this method of financing, the following must be noted.
a) Difficulty in getting goods commercial loans of conventional character;
b) Chronic surplus loan able funds;
c) Declining interest rates on other earning assets, particularly Government
bends;
d) Growing respectability of this type of financing because of the success and
relatively high profits of the agencies specializing in it; and
e) Increased safety because of improved legal position, thereby establishing
the validity of the lender's lien on assigned account.
4. Factoring
Factoring is defined as an agreement in which receivables arising out of sale of
goods or services are sold to the ‘factor’ as a result of which the title to the goods/
service represented by the said receivables passes on to the factor. Henceforth, the
factor becomes responsible for all credit control, sales accounting and debt
collection from the buyer(s). In a full service factoring concept (without recourse
facility), if any of the debtors fails to pay the dues as a result of his financial
inability/insolvency/ bankruptcy, the factor has to absorb the losses”.
 40

Features of Factoring
1. Client can get 80% of the invoice amount from the factor after the factoring
agreement.
2. Client shifts his responsibility of credit collection from the customers.
3. The responsibility of maintaining credit sales ledger vests with the factor.
4. The client will have easy access to know the details of credit sales.
5. The financial position of the client can be strengthened as factoring supply
easy cash. This helps the company to provide funds for working capital.
6. The remaining balance of 20% of invoice amount will be paid by the factor
at the time of realisation of assigned invoice.
7. Client has to pay service charges in addition to the interest on funded
amount to the factor.
8. Factoring allows client to spend more time on planning for his business, as
the time to be spent on credit collection is looked after by factor.
9. Factor many at times offers the services of consultancy in areas of
production, finance and marketing.
Pricing of Factoring Services
Pricing of factoring service mainly depends on two factors/aspects:
1. Administrative Aspect: The activities relating to sales ledger maintenance,
credit collection, and protection against bad debts are charged at 0.5-2.5% on the
turnover.
2. Interest or Discount Charges: Interest or discount charges are levied on the
client for providing instant cash up 80% on the invoice value. The base for charging
interest would be the interest rate of bankers.
Types of Factoring
Factors influencing the type of factoring service:
The type of factoring services available in India and rest of world is varied.
There is no uniform system prevailing in the factoring arrangements. The selection
of the type of factoring service mainly depends on the nature of the client's
business, volume of business and the cost that can be charged on the service. In
addition to these three, factor must also have to consider the safety and security for
his funds as well as the services.
However, in the general global practice, the following package of factoring
services are offered:
1. Full Service Factoring: This method is one of the most popular factoring
service practiced in India. Under this system, factor provides finance, maintains
sales ledger, undertakes credit collection, offers protection against bad debts and
offer consultancy services. In the event of bad debts, if the factoring agreement has
been made as “Factoring with recourse”, the obligation to repay the dues vests with
 41

clients. In case of “Factoring with non-Recourse” factors has to absorb the loss of
bad debts. Even under ‘factoring with recourse’ if the size of bad debts and other
monetary loss is huge. It is the ultimate responsibility of the client to make good
the loss to the factor. In other words, factoring without recourse will automatically
be converted into Factoring with Recourse.
2. Factoring with Recourse or With Recourse Factoring: Under this method, the
client is not given protection against the bad debts. In the normal factoring
arrangements 90 days credit collection period will be allowed to customer to pay his
dues. If the customer fails to pay his dues within this allotted time, it becomes the
responsibility of the client to pay the remaining balance of the amount to factor.
Otherwise, factor can charge “Refactoring Charges” on the dues of the customers.
In addition to finance, factor offers the services of maintaining sales ledger
accounts and offer consultancy services to the clients.
3. Maturity Factoring: Under this method, factor offers only services relating to
maintenance of sales ledger account, asset management, credit control including
collection of debts, debt protection and will not provide finance. Therefore, it is also
called as ‘Collection Factoring.
4. Invoice Factoring: Under this system, invoices are sold to a factor as opposed
to the system previously mentioned where actual goods are sold. The scheme in
practice commences with an agreement made with the business desiring funds. The
method is not inflexible and may be adjusted to particular requirements. The
business list the invoices it wishes to sell, stating the anticipated settlement dates.
5. Bulk Factoring: Under this method, the total agreed bunch of invoices of the
client will be considered for providing 80% finance to client. However, the
arrangement of this will be made known to the debtors. Hence, the responsibility of
maintaining sales ledger, collection of credit and the risks of bad debts vests with
client himself.
6. Agency Factoring: This is a unique type of factoring arrangement in which
the risks and responsibility of clients and factors are clearly defined. Client takes
the responsibility of maintaining the sales ledger administration and collection of
debts from the customers.
7. Undisclosed Factoring: Under this method, instead of making a sale direct to
the customer, on arrival of the time for delivery goods are sold to a factor for cash
who then appoints the business as its agent to collect the debt outstanding. A
cheque is received on delivery of the goods and the customers collects the debt on
behalf of the factor, but the factor has no recourse to the business in the event of a
bad debt arising.
3.6 ADVANTAGES AND DISADVANTAGES OF SHORT-TERM FINANCING
Advantages
Easier to Obtain: For most firms it is easier to secure short-term funds than
long-term funds, because creditors advancing funds for a few weeks or months
 42

generally assume less risk than on longer loans. There is less chance of substantial
change in the credit standing of the borrower occurring before maturity because of
a change in his competitive position or because of a change in general economic
conditions. Most of the employees of business firms are paid weekly or monthly. An
employee who is paid every two weeks is, in effect, extending credit to his employer
for an amount which averages one week's wages. Moreover, short-term credit is
obtained automatically, since in the ordinary course of business, expenses
accumulate for a period before they actually become due and require repayment.
Such accumulating but unpaid amounts appear as accruals under current
liabilities.
Cost: Short-term financing may be obtained at lower cost than long-term
financing. By cost is meant interest plus any service charges or other costs on an
annual basis paid by the borrower in connection with the credit.
Flexibility: Short-term financing is more flexible than long-term financing.
Flexibility refers to the ability of the business to secure funds as and when they are
needed and repay them as soon as the need vanishes.
Disadvantages
Frequent Maturities: The greatest hazard of short-term liabilities is the frequent
maturity of principal. Debts must be paid at maturity, or else the business may be
closed by creditors.
High Cost: The second possible disadvantages of short-term finance is that it
may be very costly, as the rate of interest may be high. On account of credit risk,
collateral protection, general economic outlook and size of loan, the rate of interest
demanded by lenders may be high.
Widely Fluctuating: Total asset debt of a business fluctuate over the year and
over the business cycle. The extent of the fluctuation depends on the nature of the
business conducted. A cannery or coal business has large seasonal fluctuations
and a heavy machinery manufacturer or building contractor would have large
cyclical variations. Within enterprises with personal asset fluctuations it is the
current assets rather than the fixed assets that show practically all the variation.
Inventory will have to be increased just prior to the busy season.
3.4 REVISION POINTS
Trade credit: Credit extended by the suppliers of goods in normal course of
business.
Bank Credit: Commercial banks grant short-term finance to business.
Bills discounting: Banks also advance money by discounting bills of exchange,
promissory notes and hundies.
Factoring : An arrangement between a factor and his client which includes
finance, maintenance of accounts, collection of debt and protection against credit
risk.
 43

3.5 INTEXT QUESTIONS

1. What do you understanding by short-term finance?
2. State the purposes served by Short-term finance?
3. Explain the different sources of short-term finance?
4. What is trade credit? Explain its merits and demerits
5. Write short-term bank credit.
6. State the merits and demerits of bills discounting.
3.6 SUMMARY
After establishment of the firm, funds are required to meet its day to day
expenses. For example, raw materials must be purchased at regular intervals,
workers must be paid wages regularly. Thus there is a continuous necessity of
liquid cash to be available for meeting these expenses. For financing such
requirements, short-term funds are needed. The availability of short-term funds is
essential. Inadequacy of short-term funds may lead to closure of firm.
3.7 TERMINAL EXERCISE
1. Term credit is mainly extended by development and financing institutions
also called as………………………………..
2. ……………………………………defined as an agreement in which receivables
arising out of sale of goods or services are sold to the ‘factor’ as a result of
which the title to the goods/ service represented by the said receivables
passes on to the factor.
3.9 SUPPLEMENTARY MATERIAL
1. https://es.scribd.com/doc/
2. www.first-hand.info/sheet/
3.9 ASSIGNMENTS
1. Explain the advantages and disadvantages of short-term financing
2. Explain the various sources of short term financing.
3.10 SUGGESTED READINGS
 Jain, Khan, Financial Management: Text, Problems and Cases 7th Edition,
Tata McGraw Hill Publishers.
 Sheeba Kapil Financial Management Pearson Publishers
3.11 LEARNING ACTIVITIES
Suggest the best short term financing with suitable examples
3.12 KEYWORDS
Trade Credit, Bank Credit, Factoring, Bills Discounting.


 44

LESSON – 4

WORKING CAPITAL MANAGEMENT

4.1 INTRODUCTION
The term working capital refers to current assets which may be defined as
“those which are convertible info cash or equivalents within a period of one year,
and those which are required to meet day to day operations. The fixed assets as
well as the current assets, both require investment of funds. So, the management of
working capital and of fixed assets, apparently, seem to involve same types of
considerations but it is not so. The management of working capital involves
different concepts and methodology than the techniques used in fixed assets
management. The reason for this difference is obvious. The very basics of fixed
assets decision process i,e., the capital budgeting and the working capital decision
process are different.
The need for working capital management arises from two considerations.
First, existence of working capital is imperative in any firm. The fixed assets which
usually require a large chunk of total funds, can be used at an optimum level only
if supported by sufficient working capital, and Second, the working capital involves
investment of funds of the firm. If the working capital level is not properly
maintained and managed, then it may result in unnecessary blocking of scarce
resources of the firm.
Thus, the working capital management may be defined as the management of
firm’s sources and uses of worker capital in order to maximize the wealth of the
shareholders. The proper working capital management requires both the medium
term planning (say up to three years) and also the immediate adaptations to
changes arising due to fluctuations in operating levels of the firm.
4.2 OBJECTIVES
After completing this lesson you should be able to
 Explain the various concepts of working capital
 Discuss the constituents of working capital
 List out the various types of working capital
 Examine the Sources of working capital
 Discuses the approaches for determining financial mix
4.3 CONTENT
4.3.1 Concepts of Working Capital
4.3.2 Constituents of working Capital
4.3.3 Classification of Working Capital
4.3.4 Assessment of working Capital
4.3.5 Problems of Inadequacy of working capital
4.3.6 Reason for Inadequacy of Working Capital
 45

4.3.7 Excessive working capital

4.3.8 Principles of Working capital Management
4.3.9 Steps involved in Effective Management of Working Capital
4.3.10 Sources for Working Capital Finance
4.3.11 Working Capital Forecasting Technique
4.3.12 Working capital Financing policy
4.3.1 Concepts of Working Capital
Working capital may be defined in two ways, either as the total of current
assets or as the difference between the total of current assets and total of current
liabilities. Like, most other financial terms the concept of working capital is used in
different connotations by different writers. Thus, there emerged the following two
concepts of working capital.
i) Gross concept of working capital
ii) Net concept of working capital
Gross Concept
No special distinction is made between the terms total current assets and
working capital by authors like Mehta, Archer, Bogen, Mead and Baker. According
to them working capital is nothing but the total of current assets for the following
reasons:
i) Profits are earned with the help of the assets which are partly fixed and
partly current. To a certain degree, similarity can be observed in fixed and
current assets in that both are partly borrowed and yield profit over and
above the interest costs. Logic then demands that current assets should be
taken to mean the working capital of the company.
ii) With every increase in funds, the gross working capital will increase.
iii) The 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 came,
Thus, the gross working capital refers to the firms investment in all the
current assets taken together. Current assets are the liquid assets of the firm and
are convertible into cash within a period of one year.
For example, if a firm has a cash balance of Rs,2,50,000, debtors Rs.70,000,
and inventory of raw material and finished goods has been assessed at
Rs.1,50.000, then the gross working capital of the firm is Rs. 4,70,000 ( Rs.
2,50,000 + Rs. 70,000+ Rs. 150,000)
Net Concept
Contrary to the aforesaid point of view, writers like Smith, Guthmann and
Dongall. Howard and Gross, consider working capital as the mere difference
between current assets and current liabilities. According to Keith V. Smith, a
 46

broader view of working capital would also include current liabilities. The current
liabilities includes all types of liabilities which will mature for payment within a
period of one year e.g., bank overdraft, trade creditors, outstanding expenses,
provision for taxation, proposed dividend, etc. Thus, working capital management
involves the managing of individual current liabilities and the managing of all inter-
relationships that link current assets with current liabilities and other balance
sheet accounts. The net concept is advocated for the following reasons:
i) In the long-run what matters is the surplus of current assets over current
liabilities.
ii) It is this concept which helps creditors and investors to judge the financial
soundness of the enterprise.
iii) Can always be relied upon to meet the contingencies (the excess of current
assets over current liabilities).
iv) Helps to find out the correct financial position of companies having the
same amount of current assets.
The net working capital may either be positive or negative. If the total current
assets are more than total current liabilities, then the difference is known as
positive net working capital, otherwise the difference is known as negative net
working capital.
4.3.2 Constituents of Working capital
No matter how, we define working capital, we should know what constitutes
current assets and current liabilities. Refer Balance Sheet of any company for this
purpose.
Current Assets: The following listed are the companies as current assets:
1. Inventories: (a) Raw materials and packing materials, (b) Work-in progress,
(c) Finished/Traded Goods and (d) Stores, Spares and fuel.
2. Sundry Debtors: (a) Debts outstanding for a period exceeding six months, (b)
Other debts.
3. Cash and Bank Balances: (a) With Scheduled Banks (i) in Current accounts,
(ii) in Deposit accounts; (b) with others, (i) in Current accounts.
4. Loans and Advances: (a) Secured Advances; (b) Unsecured (considered good),
(i) Advances recoverable in cash or kind for value to be received, (ii) Deposits,
(iii) Balances with customs and excise authorities.
Current Liabilities: The following items are included under this category,
1. Sundry Creditors
2. Unclaimed dividend warrants
3. Unclaimed debenture interest warrants
4. Short term loans and advances
5. Provision for taxation
 47

6. Proposed dividend I
4.3.3 Classification of Working Capital
Generally speaking, the amount of funds required for operating needs varies
from time to time in every business. But a certain amount of assets in the form of
working capital are always required, if a business has to carry out its functions
efficiently and without a break. These two types of requirements –permanent and
variable are the basis for a convenient classification of working capital
Figure-1 Types of working capital.
Working Capital

Permanent Temporary
(or Fixed) (or Variable/Fluctuating)

Regular Reserve margin Seasonal Special

(or cushion)

1. Permanent or Fixed Working Capital

As is apparent from the adjective ‘permanent’ it is that part of the capital
which is permanently locked up in the circulation of current assets and in keeping
it moving. For example, every manufacturing concern has to maintain stock of raw
materials, works-in-progress (work-in-process), finished products loose tools and
spare parts. It also requires money for the payment of wages and salaries
throughout the year.
The permanent or fixed working capital can again be subdivided into (i)
Regular Working Capital and (ii) Reserve Margin or Cushion Working Capital. It is
the minimum amount of liquid capital needed to keep up the circulation of the
capital from cash to inventories to receivables and back again to cash. This would
include a sufficient cash balance in the bank to discount all bills, maintain an
adequate supply of raw materials for processing, carry to discount all bills,
maintain an adequate supply of raw materials for processing, carry a sufficient
stock of finished goods to give prompt delivery and effect the lowest manufacturing
costs, and enough cash to carry the necessary accounts receivables for the type of
business engaged in Reserve margin or cushion working capital is the excess over
the need for regular working capital that should be provided for contingencies that
arise at unstated periods. The contingencies included (a) raising prices, which may
make it necessary to have more money to carry inventories and receivables, or may
make it advisable to increase inventories; (b) business depressions, which may raise
the amount of cash required to ride out usually stagnant periods; (c) strikes, fires
and unexpectedly severe competition, which use up extra supplies of cash; and (d)
special operations, such as experiments with new products or with new method of
 48

distribution, war contracts, contractors to supply new businesses, and the like,
which can be undertaken only if sufficient funds are available, and which in many
cases mean the survival of a business.
2. Variable Working Capital
The variable working capital changes with the volume of business. It may be
sub-divided into (i) Seasonal and (ii) Special Working Capital. In many lines of
business (e.g., Gur or sugar and Fur industry operations are highly seasonal and as
a result, working capital requirements vary greatly during the year. The capital
required to meet the seasonal needs of industry is termed as Seasonal Working
Capital. On the other hand, Special Working Capital is that part of the variable
working capital which is required for financing special operations, such as the
inauguration of extensive marketing campaigns, experiments with new products or
with new methods of distribution, carrying put of special jobs and similar to the
operations that are outside the usual business of buying, fabricating and selling.
This distinction between permanent and variable working capital is of great
significance particularly in arranging the finance for an enterprise. Regular or fixed
working capital should be raised in the same way as fixed capital is procured,
through a permanent investment of the owner or through long-term borrowing. As
business expands, this regular capital will necessarily expand. If the cash returning
from sales includes a large enough profit to take care of expanding operations and
growing inventories, the necessary additional working capital may be provided by
the earned surplus of the business. Variable needs can, however, be financed out of
short-term borrowings from the Bank or from public in the form of deposits.
The position with regard to the ‘fixed working capital’ and ‘variable working
capital’ can be shown with the help of the following figures:

Y
Variable working
capital
Amount

Fixed Working Capital

O Period X

Fig. 2 Steady Firm’s Working Capital Requirement

 49

From the above figure it should not be presumed that permanent working
capital shall remain fixed throughout the life of the concern. As the size of the
business grows, permanent working capital too is bound to grow. The position can
be depicted with the help of the following figure:

Y
Variable working
capital
Amount

al
Capit
kin g
ed Wor
Fix

O Period X

Fig. 3 Growth Firm’s Working Capital Requirement

So unlike a static concern, the fixed working capital of a growing concern will
increase with the growth in its size.
Elements of Working Capital
(i) Cash: Management of cash is very important fro firm’s point of view. There
must be balance between the twin objectives of liquidity and cost while managing
cash. There must be adequate cash to meet the requirements of all segments of the
organization. Excess cash may be costly to meet the requirements of all segments of
the organization. Excess cash may be costly for the concern as it will increase the
cost in terms of interest. Less cash may also be harmful to the concern as it will not
be able to meet the liabilities as the appropriate time. Thus the requirements of the
cash must be estimated properly either by preparing cash flow statements or cash
budgets. This will help the management to invest the idle funds remuneratively and
shortages, if any, may be met timely by making different arrangements. Therefore,
it is necessary that every segment of the organisation must have adequate cash in
order to meet the requirements of that segment without having surplus balances.
Cash management is highly centralized whereby cash inflows and outflows are
centrally controlled but in multi-divisional companies it may be possible to
decentralize cash requirements so that every company may have cash for its
requirements.
 50

(ii) Marketable (Temporary) Investments: Firms hold temporary investments for

surplus cash flows arising either during seasonal operations or out of sale of long
term securities. In most cases the securities are held primarily for precautionary
purposes-most firms prefer to rely on bank credit to meet temporary transactions or
speculative needs, but to hold some liquid assets to guard against a possible
shortage of bank credit. The cash forecast may indicate whether excess cash
available is temporary or not. If it is found that excess liquidity will be temporary,
the cash should then be invested in marketable but temporary in vestments. It
should be remembered that even if a substantial part of idle cash is invested even
though for a short period, the interest earned thereon is significant.
(iii) Receivables: Management of receivables involves a trade off between the
gains due to additional sales on account of liberal credit facilities and additional
cost of recovering those debts. If liberal credit facilities are given to the customers,
sales will definitely increase. But on the other hand bad debts, collection expenses
and interest charge will increase. Similarly if the credit policy is strict, the sales
will be less and customers may go to the competitors where liberal credit facilities
are available. This will result in loss of profit because of less sales but there will be
saving because of less bad debts, collection and interest charges. Management of
debtors also covers analysis of the risks associated with advancing credit to a
particular customer. Follow up of debtors and credit collections are the remaining
aspects of receivables management.
(iv) Inventories: Inventories include all investments in raw materials, work-in-
progress, stores, spare parts and finished goods; they constitute an important part
of the current assets. The purchase of inventory involves in vestment which must
be properly controlled. There are many issues of inventory management which
must be taken into consideration as fixation of minimum and maximum level,
deciding the issue of pricing policy, setting up the procedures for receipts and
inspection, determining the economic ordering quantity, providing proper storage
facilities, keeping control on obsolescence and setting up an effective information
system with reference to inventories. Inventory management requires the attention
of stores manager, production manager and financial manager. There must be
adequate inventories in order to avoid the disadvantages of both inadequate and
excessive inventories.
(v) Creditors: Management of creditors is very important aspect of working
capital. If the payment of creditors is delayed there is a possibility of saving of some
interest but it can be very costly because it will spoil the goodwill of the concern in
the market, As far as possible, the credit manager should try to get the liberal
credit terms so that payment may be made at the stipulated time.
4.3.4 Assessment of Working Capital Requirements
The following factors are considered for a proper assessment of the quantum of
working capital requirements:
 51

(i) The Production Cycle: There is bound to be time span in raw materials input
in manufacturing process and the resultant output as finished product. To sustain
such production activities the requirement of investment in the form of working
capital is obvious. The lesser the production cycle (or the operating cycle) the lesser
will be the requirements of working capital. There are enterprises due to their
nature of business will have shorter cycle than others. Further, even within the
same group of industries, the more the application of technological advances in, will
result in shortening the operating cycle. In this context the choice of product
requiring shorter or greater operating cycle will have a direct impact on the working
capital requirements. This is factor of paramount importance irrespective of
whether a new industry is venturing production of the first time or an on-going
business. Hence it can be said that the time span for each stage of the process of
manufacture if geared to improve upon will lead to better efficiency and utilisation
of working capital.
(ii) Work-in-Process: A close attention is to be given to the accumulation of
work-in-progress or work-in-process. Unless the sequences of production process
leading to conversion into finished product is kept under close observation to
achieve better production and productivity, more and more working capital funds
will be tied up. In this context, proper production planning and control is vital.
(iii) Terms of Credit from Suppliers of Materials and Services: The more the
terms of credit is favourable i.e., the more the time allowed by the creditor’s to pay
them, the lesser will be the requirement of working capital. Hence, the aspect in
working capital management. In this process the impact of the requirement of
finance is shared by the creditors for goods and services.
(iv) Realisation from sundry Debtors: The lesser the time span between selling
the product and the realisation the more will be the quicker inflow of cash. This, in
turn, will reduce the finance required for working capital purposes. A realistic credit
control will reduce locking up of finance in the form of sundry debtors. The impact
of better realisation will not only help in reducing the working capital fund
requirement but also can boost up the finance needed for other operational needs.
The important factors in credit control will be: (a) volume of credit sales desired; (b)
terms of sales and (c) collection policy.
(v) Control on Inventories: The decision to maintain appropriate minimum
inventories either in the form of raw material, stores materials, work-in-process or
finished products is an important factor in controlling finance locked up. The better
the control on inventories the lesser will be the requirements of working capital.
The following vital factors involved in inventory management are to be considered
for an effective inventory control: (a) volume of sales, (b) seasonal variation in sales,
(c) selling ‘off the shelf’, (d) stocking to gay from higher price under inflationary
conditions, (e) the operating cycle, i.e., the time interval between manufacturing,
selling and realization, and (f) safety or buffer stock. A minimum policy levels of
 52

stock may have to be maintained to seize the opportunity of selling when there is
spark in demand for the product.
(vi) Liquidity Versus Profitability: The management dilemma as to the optimal
balancing between liquidity (and solvency) and the profitability is another factor of
great importance on the determination of the level of working capital requirement.
In other words, the level of liquidity and the profitability to be maintained according
to the goals of financial management.
(vii) Competitive Conditions: The whole question of cash inflow depends as to
the quickness in selling the products and the realisation thereof. In this context,
the nature of business and the product will be the two important contributory
factor as to the policy on the quantum of working capital requirements.
(viii) Inflation and the Price Level Changes: In an inflationary trend, the impact
on working capital is that more finance is needed for the same volume of activity
i.e., one has to pay more price for the purchase of same quantity of materials or
services to be obtained; such raising impact of prices can be fully or partly
compensated by increasing the selling price of the product. All business may not be
in a position to do so due to their nature of product, competitive market or
Government’s regulatory price.
(ix) Seasonal Fluctuation and Market Share of Product: There are products
which are mostly in demand in certain periods of the year. In other words, there
may not be any sale or only a fraction of the total sale in off-season due to seasonal
nature of demand for the product. There may be shifting of demand due to better
substitute of the product available. This means the company affected by this
economics, attempts to plan diversification to sustain profit, expansion and growth
of the business. In certain businesses, demands for products are of seasonal in
nature and for certain businesses, the raw materials buying have to be done during
certain seasonal timings. Naturally the working capital requirement will be more in
certain periods than in others.
(x) Management Policy on Profits, Retained Profit, Tax Planning and Dividend
Policy: The adequacy of profit will lead to strengthen the financial position of the
business through cash generation which will be ploughed back as internal source
of financing. Tax planning is an integral part of working capital planning. It is not
only the question of quantum of cash availability for tax payment at the appropriate
time but also through tax planning the impact of tax payable can be reduced.
Dividend Policy considers the percentage of dividend to be paid to the shareholders
as interim and / or final dividend. There must be cash available at the appropriate
time after the dividend is declared. This way the dividend payment is connected
with working capital management.
(xi) Terms of Agreement: It refers to the terms and conditions of agreement to
repay loans taken from bankers and financial institutions and acceptance of ‘fixed
deposits’ from public. The question of fund arrangement whether for working
 53

capital needs or to long term loans is to be decided after taking into account the
repayment ability? The cash flow projection will have to be made accordingly.
(xii) Cash (Flow) Budget: In order to meet certain cash contingencies it may be
necessary to have liquidity in form of marketable securities as cash reservoir. This
extra cash reserve may remain as an idle fund. This type of cash reserve is
necessary to meet emergency disbursements.
(xiii) Overall Financial and Operational Efficiency: A professionally managed
company always applies appropriate tools and techniques to achieve efficiency and
utilization of working capital fund. Adequacy of assessment and control of business
will lead to improve the ‘working capital turnover’. Management also will have to
keep itself abreast of the environmental, technological and other changes affecting
the business so that an effective and efficient financial management can play a vital
role in reducing the problems of working capital management.
(Xiv) Urgency of Cash: In order to avoid product becoming obsolete or to under-
cut the competitors to hold the market share or in case of emergency for cash
funds, it may be necessary to sell out products at a cheaper rate or at a discount or
allowing cash rebate for early realization from sundry debtors (customers). This
situation may boost up the cash availability. However, this sort of critical situation
should be avoided as this results in reducing profit.
(xv) Importance of Labour Mechanisation: Capital intensive industries, i.e.,
mechanized and automated industries, will require lower working capital, while
labour intensive industries such as small scale and cottage industries will require
larger working capital.
(xvi) Proportion of Raw Material to Total Costs: If the raw materials are costly,
the firm may require larger working capital while if raw materials are cheaper and
constitute a small part of the total cost of production, lower working capital is
required.
(xvii) Seasonal Variation: During the busy season, a business requires larger
working capital while during the slack season a company requires ‘lower working
capital. In sugar industry the season is November to June, while in the woolen
industry the season is during the winter. Usually the seasonal or variable needs of
working capital are financed by temporary borrowing.
(xviii) Banking Connections: If the corporation has good banking connections
and bank credit facilities, it may have minimum margin of regular working capital
over current liabilities. But in the absence of the availability of bank finance, it
should have relatively larger among of net working capital.
(xix) Growth and Expansion: For normal rate of expansion in the volume of
business, one may have greater proportion of retained profits to provide for more
working capital, but fast growing concerns require larger amount of working
capital. A plan of working capital should be formulated with an eye to the future as
well as present needs of a corporation.
 54

4.3.5 Problem of Inadequacy of Working Capital

In case of inadequacy of working capital, a business may have to face the
following problems:
i) Production Facilities: It may not be possible to have the full utilization of the
production facilities to the optimum level due to the inability of buying
sufficient raw material and/or major renovation of the plant and
machinery.
ii) Raw Material Purchases: Advantage of buying at cash discount or on
favourable terms may not be possible due to paucity of funds.
iii) Credit Rating: When financial, crisis continues, the credit worthiness of the
company may be lost, resulting in poor credit rating.
iv) Seizing Business Opportunities: In case of boom for the products and for
the business, the company may not be in a position to produce more to
earn ‘opportunity profit’ as there may be inadequacy of finished products
availability.
v) Proper Maintenance of Plant and Machinery: If the business is on financial
crisis, adequate sums may not be available for regular repair and
maintenance, renovation or modernization of plant to boost up production
and to reduce per unit cost.
vi) Dividend Policy: In the absence of fund availability it may not be possible to
maintain a steady dividend policy. Under such financial constraint,
whatever surplus is available will be kept in general reserve account to
strengthen the financial soundness of the business.
vii) Reduced Selling: Due to the constraint in working capital, the company
may not be in a position to increase credit sales to boost up the sales
revenue.
viii) Loan Arrangement: Due to the emergency for working capital the company
may have to pay higher rate of interest for arranging either short-term or
long-term loans.
ix) Liquidity versus Profitability: The lower liquidity position may also result in
lower profitability.
x) Liquidation of the Business: If the liquidity position continues to remain
weak, the business may run into liquidation.
To remedy the situation of working capital crisis, the following steps are
required:
a) An appraisal and review is to be conducted to minimize the operating
cycle.
b) Adequate credit control measures are to be adopted for early and prompt
realization forms the debtors.
 55

c) Proper planning and control of cash management through cash flow

forecasting.
d) Whether more credit periods can be obtained for buying is to be explored.
4.3.6 Reasons for Inadequacy of Working Capital
Inadequacy or shortage of working capital may arise for various reasons, of
which, the main reasons are the following:
i) Operating Losses: This may arise when the cost of production and other
related costs are more than the sales revenue, reduction in sales, falling
prices, increased depreciation, etc. It is obvious that a company facing
losses will not have any ‘cash generation’ to sustain its on-going business.
ii) Extraordinary Losses: There may be exceptional losses due to fall in price
of finished product stocks, government action, obsolescence or otherwise.
The effect of such a loss will be a reduction in current assets or increase in
current liabilities without any corresponding favourable change in the
working capital composition.
iii) Expansion of Business: The company during the profitable years might
have invested substantially in fixed capital assets, increased production
and increased credit sales to make the sales volume grow rapidly. Against
those activities, the pitfalls of over-trading may show its ugly face
subsequently. That is why a balancing judgement between investment,
liquidity and profitability is to be drawn and projected to save the business
falling into financial crisis. Thus the continuity and growth of the business
may be jeopardized. Along with the increased sales there may be increase
in inventories and higher sundry debtors. Such excessive build-up of
inventories and receivables may amount to alarming figures.
iv) Payment of Dividend and Interest: The Payment of interest for borrowings
will have to be made as per terms of agreement. Similarly, the payment of
dividend may have to be arranged to keep up the business prestige to the
public and to the shareholders. There may be profit to declare dividend
but there may not be adequate cash to disburse dividend. In case of
insufficient funds to meet the aforesaid liabilities, the mobilizing of funds
will be necessary.
4.3.7 Excessive Working Capital
The following are the major disadvantages of having or holding excessive
working capital
i) Overtrading: A time many come when overtrading will engulf the financial
soundness of the business.
ii) Excessive Inventories: The inventories holding may become excessive
under the influence of excessive funds availability.
iii) Liquidity Versus Profitability: The situation of liquidity and the profitability
may be misbalanced.
 56

iv) Inefficient Operation: Availability of excessive production facilities may

result in higher production but sales may not be anticipated to match
goods produced.
v) Lower Return on Capital Employed: There may be reduced profit in relation
to total capital employed resulting in lower rate of return on capital
employed.
vi) Increased Fixed Capital Expenditure: As enough fund is available there
may be boost–up in acquiring plant and machinery to enhance production
facilities. In case there is not enough sales potentiality with adequate
margin of profit such fixed investment may not be worthwhile for fund
employment.
4.3.8 Principles of Working Capital Management
1. Principle of Risk Variation: If working capital is varied relative to sales, the
amount of risk that a firm assumes is also varied and the opportunity for gain or
loss is increased.
This principle implies that a definite relation exists between the degree of risk
that management assumes and the rat of return. That is, the more risk that a firm
assumes, the greater is the opportunity for gain or loss. It should be noted that
while the gain resulting from each decrease in working capital is measurable, the
losses that may occur cannot be measured. It is believed that while the potential
loss, the exactly opposite occurs if management continues to decrease working
capital that is to say, potential losses are small at first for each decrease in working
capital but increase sharply if it continues to be reduced. It should be the goal of
management to find that point of level of Working Capital at which the incremental
loss associated with a decrease in Working Capital investment becomes greater
than the incremental gain associated with that investment. Since most of the
managers do not know what the future holds, they tend to maintain an investment
in working capital that exceeds the ideal level. It is this excess that concerns since
the size of the investment determines firm’s rate of return o investment. The
obvious conclusion is that managers should determine whether they operate in
business that react favourably to changes in working capital levels, if not, the gains
realize may not be adequate in comparison to the risk that must be assumed when
working capital investment is decreased.
2. Principle of Equity Position: Capital should be invested in each components
of working capita as long as the equity position of the firm in creases.
It follows from the above that the management is faced with the problem of
determining the ideal ‘level’ of working capital. The concept that each rupee
invested in fixed or variable working capital should contribute to the net worth of
the firm should serve as a basis for such a principle.
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3. Principle of Cost of Capital: The type of capital used to finance working

capital directly affects the amount of risk that a firm assumes as well as the
opportunity for gain or loss and cost of capital.
Whereas the first principle dealt with the risk associated with the amount of
working capital employed in relation to sales, the third principle is concerned with
the risk resulting from the type of capital used to finance current assets. It has
been observed that return to equity capital increases directly with the amount of
risk assumed by management. This is true but only to a certain point. When
excessive risk is assumed, a firm’s opportunity for loss will eventually over-shadow
its opportunity for gain, and at this point return to equity is threatened. When this
occurs, the firm stands to suffer losses. Unlike rate of return, cost of capital moves
inversely with risk; that is, as additional risk capital is employed by management,
cost of capital declines. This relationship prevails until the firm’s optimum capital
structure is achieved; thereafter, the cost of capital increases.
4. Principle of Maturity of Payment: A company should make every effort to
relate maturities of payment to its flow of internally generated funds. There should
be the least disparity between the maturities of a firm’s short-term debt
instruments and its flow of internally generated funds because a greater risk is
generated with greater disparity. A margin of safety should, however, be provided
fro short term debt payments.
5. Principle of Negotiation: The risk is not only associated with the amount of
debt used relative to equity, it is also related to the nature of the contracts
negotiated by the borrower.
Some of the clauses of the contracts such as restrictive clause and dates of
maturity directly affect a firm’s operation: Lenders of short term funds are
particularly conscious of this problem and they ask for cash flow statements.
Lenders realize that a firm’s ability to repay short-term loan directly related to cash
flow and not to earnings and, therefore, a firm should make every effort to tie
maturities to its flow of internally generate funds. This concept serves as the basis
for the final hypothesis of this presentation. Specifically, it may be stated as follows:
“The greater the disparity between the maturities of firm’s short term debt
instrument and its flow of internally generated funds, the greater the risk, and vice-
versa”. One can see that it is possible for a firm to face insolvency or
embarrassment even though it might be making a profit. It is extremely difficult to
predict accurately a firm’s cash flow in an economy such as ours. Therefore, a
margin of safety should be included in every short term debt contract; that is,
adequate time should be allowed between the time the funds are generated and the
date of maturity.
4.3.9 Steps Involved in Efficient Management of Working Capital
1. Proper financial set up with appropriate authority and responsibility.
2. Coordination between the following functional areas in the organization:
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3. Production Planning and Control

4. Sales Credit Control
5. Materials Management
6. optimal utilization of fixed plant and machinery together with other
facilities. Sale of uneconomical fixed assets.
7. Acquiring plant and machinery to augment production.
8. Financial planning and control for achieving increased profitability to have
adequate ‘cash generation’ and ‘plough back’ of profits so that there is
adequate internal source of finance.
9. Proper cash management through projection of cash flow and source and
application of funds flow statement.
10. Establishing appropriate Information and Reporting System.
4.3.10 Sources for Working Capital Finance
One of the important tasks of the finance manager is to select an assortment
of appropriate sources to finance the current assets. A business firm has various
sources to meet its financial requirements. Normally, the current assets are
supported by a combination of long-term and short-term sources of financing. In
selecting a particular source a firm has to consider the merits and demerits of each
source in the context of prevailing constraints.
The following is a snapshot of various sources of working capital available to a
concern:
Sources of Working Capital

Long Term Sources Medium & Short Term Sources

(a) sale of shares
(b) sale of debentures
Internal (a) trade credit
(c) retained earnings
(a) depreciation (b) bank credit
(d) sale of idle fixed assets
(b) reserves and (c) public deposits
provisions (d)customers'advance
(c) inter-corporate (e) factoring
loans and (f) comercial paper
deposits (g) term loans

Fig. 4 sources of working capital

The long term working capital can be conveniently financed by (a) owners’
equity e.g. shares and retained earnings, (b) preferred equity, (c) lenders’ equity e.g.,
debentures, and (d) fixed assets reduction e.g., sale of assets, depreciation on fixed
assets etc. This capital can be preferably obtained from owners’ equity as they do
not carry with them any fixed charges in the form of interest or dividend and so do
not throw any burden on the company.
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Intermediate working capital funds are ordinarily raised for a period varying
form 3 to 5 years through loans which are repayable in instalments e.g. term-loans
from the commercial banks or from finance corporations. Short term working
capital funds can be obtained for financing day-to-day business requirements
through trade credit, bank credit, discounting bills and factoring of account
receivables. Factoring is a method of financing through account receivable under
which a business firm sells its accounts to financial institution, called the factor.
Sources of short-term finance: In choosing a source of short term financing, the
finance manager is concerned with the following five aspects of each financing
arrangement.
(i) Cost: Generally the finance manager will seek to minimize the cost of
financing, which usually can be expressed as an annual interest rate. Therefore,
the financing source with the lowest interest rate will be chosen. However, there are
other factors which may be important in particular situations.
(ii) Impact on credit rating: Use of some sources may affect the firm’s credit
rating more than use of others. A poor credit rating limits the availability, and
increases the cost of additional financing.
(iii) Reliability: Some sources are more reliable than others in that funds are
more likely to be available when they are needed.
(iv) Restrictions: Some creditors are more apt to impose restrictions o the firm
than others. Restrictions might include rupee limits on dividends, management
salaries, and capital expenditures.
(v) Flexibility: Some sources are more flexible than others in that the firm can
increase or decrease the amount of funds provided very easily.
All these factors must usually be considered before making the decision as to
the sources of financing.
Trade Credit
Trade credit represents credit granted by manufacturers, wholesalers, etc., as
an incident of sale. The usual duration of credit is 30 to 90 days. It is granted to the
company on ‘open account’, without any security except that of the goodwill and
financial standing of purchaser. No interest is expressly charged for this, only the
price is a little higher than the cash price.
The use of trade credit depends upon the buyer’s need for it and the
willingness of the supplier to extend it. The willingness of a supplier to grant credit
depends upon (i) the financial resources of the supplier; (ii) his eagerness to dispose
of his stock; (iii) degree of competition in the market; (iv) the credit worthiness of
the firm; (v) nature of the product; (vi) size of discount offered; (vii) the degree of risk
associated with customers.
The length of the credit period depends upon: (a) Customer’s marketing period
(b) nature of the product (long credit for new; seasonal goods and short credit on
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perishable goods and low-margin goods) and (c) customer location (long distance
evidencing the amount that he owes to the seller.
Cost of Trade Credit: The trade credit as a source of financing is not without
cost. The cost of trade credit is clearly determined by its terms. However, the terms
of trade credit vary industry to industry and from company to company. However,
regardless of the industry, the two factors that must be considered while analyzing
the terms and the cost of trade credit are: (i) the length of time the purchaser of
goods has before the bill must be paid and (ii) the discount, if any that is offered for
prompt payment. For instance, a concern purchases goods worth Rs.10,000/- on
terms Rs.10,000/2/10, net 30 days. It means if the payment is made within ten
days the firm will be entitled for 2% cash rebate; otherwise the payment is to be
made within 30 days I full. If the concern wants to use Rs.9,800/- for 20 days at a
cost of Rs.200/- and then its actual cost works to 2.04%.
Advantages of Trade Credit
Trade credit, as a form of short term financing has the following advantages:
i) Ready Availability: There is no need to arrange financing formally.
ii) Flexible Means of Financing: Trade credit is a more flexible means of
financing. The firm does not have to sign a Promissory Note, pledge
collateral, or adhere to a strict payment schedule on the Note.
iii) Economic Means of Financing: Generally during periods of tight money
large firms obtain credit more easily than small firms do. However, trade
credit as a source of financing is still more easily accessible by small firms
even during the periods of tight money.
Customers Advances
Depending upon the competitive condition of the market and customs of trade,
a company can meet its short-term requirements at least partly through
customer/dealers advances. Such advances represent part of the price and carry no
interest. The period of such credit will depend upon the time taken to deliver the
goods. This type of finance is available only to those firms which can dictate terms
to their customers since their product is in great demand as compared to the
products of the other competitive firms.
COMMERCIAL BANK: BILL DISCOUNTING AND CASH CREDIT
Bank credit is the primary institutional source for working capital finance.
Banks offer both unsecured as well as secured loans to business firms. At one time
banks confined their lending policies to such loans only. Banks, now, provide a
variety of business loans, tailored to the specific needs of the borrowers, still, short
term loans are an important source of business financing such as seasonal build
ups in accounts receivable, and inventories. The different forms in which unsecured
and secured short-term loans may be extended are discounting of bills of exchange,
overdraft, cash credit, loans and advances. Banks provide credit or the basis of the
security. A loan may either be secured by tangible assets or by personal security.
 61

Tangible assets may be charged as security by any one of the following modes, viz.,
lien, pledge, hypothecation, mortgage, charge, etc.
Discounting and Purchase of Bills: Under the Bill Market scheme, the Reserve
Bank of India envisages the progressive use of bills as an instrument of credit as
against the current practice of using the widely prevalent cash credit arrangement
for financing working capital. To popularize the scheme, the discount rates are fixed
at lower rates than those of cash credit, the difference being about 1 to 1.5 per
cent.
Cash Credits: Banks in India normally make loans and advances in three
forms viz., cash credits, overdrafts and loans. Cash credit is an arrangement by
which a banker allows the customer to borrow money upto a certain limit (called
cash credit limit) against some tangible security or on the basis of a promissory –
not signed and fixes the limit annually or quarterly after taking into account several
material levels, etc. The banker keeps adequate cash balances so as to meet the
customer’s demand as and when demand arises. Once the cash credit arrangement
is made, the customer need not take the whole advance at once but may draw out
or utilize the bank credit at any time without keeping a credit balance. Further, the
borrower can put back any surplus amount which he may find with him for the
time being. The bank can also withdraw the credit at any time in case the financial
position of the borrower goes down. Generally the borrower is charged interest on
the actual amount utilized by him and for the period of actual utilization only;
interest is charged by the bank on daily debit balance.
Overdrafts: When a customer having a current account requires a temporary
financial accommodation, he is allowed to overdraw (to draw more than his credit
balance) his current account up to an agreed limit. Overdraft accounts can either
be secured or unsecured, usually, security is insisted upon for an overdraft
accounts can either be secured or unsecured, usually, security is insisted upon for
an overdraft arrangement. The customer is allowed to withdraw the amount by
cheques as and when he needs it and repay it by means of deposits of actual
utilization. This is more advantageous to the customer-borrower in the sense that
the interest is charged only on the amount drawn by him. But the banker is
comparatively at a disadvantage because he has to keep himself in readiness with
the full amount of the overdraft and he can charge interest on the amount actually
drawn. An overdraft, is different from a cash credit in that the former is supposed
to be for a comparatively short time whereas the letter is not so.
Loans: When an advance to a customer is made in a lump sum against
security or otherwise, without liberty to him of repaying, with a view to making a
subsequent withdrawal it is called a loan. The entire loan amount is paid to the
borrower in cash or is credited to his current account and interest is charged on
the full amount of the loan form quarterly rests from the date of sanction. Where
the loan is repayable in instalments the interest is charged only on the reduced
balance. A loan once repaid in instalments the interest is charged only on the
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reduced balance. A loan once repaid in full or in part cannot be withdrawn again by
the borrower, unless the banker grants a fresh loan which will be treated as a
separate transaction. In this respect a loan account differs from a cash credit or an
overdraft account. A banker prefers to make an advance in the form of a loan
because he can charge interest on the entire amount of the loan sanctioned or
disbursed and secondly, loan account involves a smaller operating cost than
overdraft or cash credit because in the latter case there is continuity and
magnitude of operation.
Critical Evaluation of Bank Finance
Bank credit offers the following advantages to the borrowing companies
i) Timely Assistance: Banks assist the borrowing companies by providing
timely assistance to meet the working capital requirements. A company can
usually rely upon the bank for amounts of loan upto an agreed limit
sanctioned by bank in advance.
ii) Flexibility: Bank assistance is flexible to the company. The accommodation
can easily be got extended and may be used when it is urgently needed. It
helps the company in maintaining good will in the market. Also, if the
amount of loan or a part of it is no more required it can be repaid and
interest on it be saved.
iii) Economy: Bank assistance entails the payment of only interest and does
not involve the kind of costs which are to be incurred in the issue of
securities such as commission on underwriting etc. Moreover, the rate of
interest is not very high. The interest is payable only for the period the loan
remains unpaid. Thus it reduces the cost of borrowings.
iv) No Interference with Company Management: The loan provided by the bank
is simply a loan and no string is attached to it. Generally banks do not
interfere with the management of the borrowing companies, till bank is
assured of the repayment of loans.
v) Secrecy: This is by far the greatest advantage of bank finance. Any
information supplied to bank regarding financial position of the borrowing
company is not made public in any way by the bank.
Drawback of Bank Finance: Bank accommodation and loans suffer from the
following drawbacks:
i) Burden of Mortgage or Hypothecation: The stock of raw material, finished
or semifinished goods are tobe kept in a godowns under bank control and
can be used only with the permission of bank or after paying the amount
of loan.
ii) Short-Duration of Assistance: Banks provide only shot-term assistance
generally for the period less than a year and its renewal or extension is
quite uncertain depending upon the discretion of bank’s authorities.
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iii) Cumbersome Terms: Banks grant assistance generally, to the extent of 50

to 75% of the cost of security pledged or hypothecated, thus having a
margin of 25% to 50%. In addition, banks press the borrowing companies
to have the goods in their godowns. Minimum interest is paid on a certain
specific amount whether it is drawn or not and repayment of loan is
strictly enforced as per the agreement entered into between the company
and the bank. Thus, the terms of borrowings are too harsh. It also
increases the cost of new borrowings and of the production.

REGULATION OF BANK CREDIT SINCE 1965

During the last 25 years the availability of bank credit to industry has been
the subject matter of regulation and control with a view to ensure equitable
distribution of bank credit to various sectors of the economy as per planning
priorities. The following are of special significance in this respect: (i) Credit
Authorisation Scheme, 1965, (ii) Dehejia Committee, 1969, (iii) Tandon Committee
Report, 1975, (iv) Chore Committee Report, 1979, (v) Marathe Committee 1,1992,
and (vi) Nayak Committee.
Credit Authorisation Scheme: The Credit Authorisation Scheme (CAS) was
introduced by the Reserve Bank of India in November 1965 as a measure to
regulate bank credit in accordance with plan priorities i.e., purpose-oriented. Under
this Scheme, the scheduled commercial banks are required to obtain Reserve
Bank’s prior authorization before granting fish credit limits (including commercial
bill discounts and term-loans) of Rs.1 crore or more to any single party or any limit
that would take the total limits enjoyed by such party from the banking system as a
whole to Rs.1 crore or more on secured or unsecured basis. If the existing credit
limits exceed Rs.1 crore such prior authorization is also required for grant of any
further credit facilities.
New procedures for Quicker Release of Funds under CAS, based on Marathe
Committee 1982: The Reserve Bank of India (RBI) has issued guidelines under
which banks can release funds to their borrowers up to 50 per cent of the
additional limits under the modified Credit Authorisation Scheme (CAS) which
come into force form April 1, 1984 without waiting for prior authorization from the
RBI subject to the five requirements.
The five requirements under this “Fast Track Procedure” are:
1. Reasonableness of the estimates and projections of production, sales,
current assets, etc, given by the client.
2. Proper classification of current assets and liabilities.
3. Maintenance of minimum current ratio of 1.33:1
4. Prompt submission of quarterly operating statements also annual
accounts by borrowers, and
5. Regular annual review of the credit facilities by the banks.
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The proposals should be certified by an authorized senior officer of the bank

regarding the fulfillment of these requirements.
All proposals seeking the benefit of the Fast Track Procedure simultaneously
go through the normal process of scrutiny by the RBI. If it is found that the credit
limits sanctioned by the commercial banks are not need-based or were excessive,
corrective action will be taken. In such cases the RBI may stipulate that until
further notice, credit proposals from these borrowers should be referred to it for its
prior authorization.
With effect from April 1, 1984, banks may grant facilities on an ad hoc basis
for a period not exceeding three months to ay of CAS borrowers under exceptional
circumstances upto 25 per cent of the existing packing credit limit or 10 per cent of
the existing working capital limit subject to an overall ceiling of Rs.75 lakhs against
Rs.50 lakhs now. Prior authorization from the RBI will not be necessary for letters
of credit (L.C.) facilities subject to the following conditions. Banks should not open
letters of credit for amounts out of proportion to the borrowers’ genuine needs and
without ensuring that the borrowers have made adequate arrangement for retiring
the bills received under the letters of credit out of their own resources or from the
existing borrowing arrangements.
Tandon Committee Recommendations
The Reserve Bank of India (RBI) constituted in July 1974 a study group t
frame guidelines for follow-up of bank credit under the chairmanship of
P.L.Tandon. The report submitted by the committee in August 1975 is popularly
referred to as the Tandon Committee Report.
The recommendations of this committee are given below:
1. Norms for Inventory and Receivables
The Committee has come out with a set of norms that represent the maximum
levels for holding inventory and receivables in each of 15 major industries, covering
about 50 per cent of industrial advances of banks. As norms cannot be rigid,
deviations from norms can be permitted under extenuating circumstances such as
bunched receipt of raw materials including imports power-cuts, strikes, transport
bottlenecks etc., for usually short periods. Once normalcy is restored, the norms
should become applicable. The norms should be applied to all industrial borrowers
with aggregate limits from the banking system in excess of Rs. 10 lakhs and extend
to smaller borrowers progressively.
2. Approach to Lending
1. As a lender the bank should only supplement the borrower’s resources in
carrying a reasonable level of current assets in relation to his production
requirements.
2. The difference between total current assets and current liabilities other
than bank borrowing is carrying a reasonable level of current assets in
relation to his production requirements.
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3. Three alternative methods have been suggested fro calculating the

maximum permissible bank borrowing. The methods will progressively
reduce the maximum permissible bank borrowing. These three methods
are explained by means of a numerical example which indicates the
projected financial position as at the end of the next year.
Method1: Under this method, 75% of the ‘working capital gap’ may be provided
by banks and the customer should provide the balance 25% from long-term funds
like owned funds or term-loans.
Method 2: According to this method, the borrower should be required to
provide by banks and the customer should provide the balance 25% from long-term
funds like owned funds or term-loans.
Method 3: This method is similar to Method 2, but it further requires that even
out of the gross current assets, the ‘core current assets’ should be determined and
separately funded from long-term resources. The Committee did not lay down any
mode for the determination of the ‘core current assets’ and left it to the lending
banks to find out method for such determination.
The Committee recommended that if in any borrower’s case, the limit under
the particular method in its case had been exceeded, the excess should be
converted into a funded debt and liquidated within an agreed period. It was also
suggested that the change over should be gradual, viz., a borrower may first be
brought into the base provided under Method 1, and then he should be carried
towards Method 2, and thereafter to Method 3. In fact, till now, Method 3 has not
been applied.
Example: Let us try to apply these methods to a company which has the
following current assets and current liabilities position.

(In
lakhs)
Current Liabilities Rs. Current Liabilities Rs.
Creditors for purchases 150 Raw Material 400
Other Current Liabilities 50 Work-in-process 75
Bank borrowings including bill 500 Finished goods 200
discounted
Other current assets 25
Receivable including discounted 100
bills
Total Current Liabilities 700 Total Current Assets 800

The current assets have been worked out on the basis of suggested norms or
past practices, whichever is lower.
Computation of maximum permissible borrowings
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(In lakhs)
Method 1 Rs. Method 2 Rs. Method 3 Rs.
Total current assets 800 Total current assets 800 Total current assets 800
Less: Current 200 Less: 25% above from 200 Less: ‘core’ 120
Liabilities long-term sources Current Assets 680
other than bank
Working capital gap 600 Working capital gap 600 (assume) 170
Less: 25% of above 150 Less: current 200 25% of above from 510
from long-term liabilities other than long-term sources
sources bank borrowings Less: Current liabilities 200
other
Maximum bank 450 Maximum bank 400 than bank borrowings
borrowing per-missible borrowing per- Maximum bank
missible borrowing 310
per-missible
Actual borrowing 500 Actual borrowing 500 Actual borrowing 500
Excess borrowing 50 Excess borrowing 50 Excess borrowing 50

3. Reporting System Regarding Bank Credit: The Committee suggested the in

order that the lending bank could follow up the position of a borrower, certain
periodical statements (in addition to the audited Balance Sheet) should be
submitted by the borrower to the lending bank, e.g.
i) Quarterly Profit & Loss Account
ii) Quarterly Statement of Current Assets & Current Liabilities
iii) Quarterly Funds Flow Statement
iv) Half-yearly Proforma Balance Sheet and Profit and Loss Account
v) Monthly Stock Statements in a revised form
The Committee suggested that the above information system should be
introduced initially with borrowers whose limits aggregated rupees one crore and
above within a period of 6 months, and then progressively extended to borrowers
with limits of rupees fifty lakhs and above, and then to borrowers with credit limits
of rupees ten lakhs and above. According to the committee, the banker should be
guided by the borrowers’ total operations and not merely by the value of the current
assets. The credit that should be allowed must be entirely need-based and the
borrower’s requirement should be planned in advance with the assistance of the
banker. A financial analysis of the borrower’s operating results along with inter-firm
comparison should be carried out by the banker so that the efficiency and
performance of the borrower can be judged, and a time-bound programme can be
laid down as corrective measure.
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4. Inter-firm Studies: To facilitate inter-firm and industry-wise comparisons for

assessing efficiency, it would be of advantage if companies in the same industry
could be grouped under three or four categories, say, according to size of sales and
the group-wise financial ratios compiled by the RBI for furnishing to banks.
5. Classification of Borrowers: For the purpose of better control, there should
be a system of borrower classification in each bank. This will facilitate easy
identification of the borrowers whose affairs require to be watched with more than
ordinary care and will also provide a rational base for the purposes of fixing rates of
interest for the respective borrowers.
6. Bank Credit for Trade: While financing trade, banks should keep in view,
among other things, the extent of owned funds of the borrower in relation to the
credit limits granted, the annual turnover, possible diversion to other units or uses
and how much is being ploughed back from profit into the business. They should
avoid financing of goods which have already been obtained on credit.
7. Norms for Capital Structure: In discussing the norms for capital structure we
have to keep in mind both the relationship long-term debt to equity and total
outside liabilities to equity. Where a companies long-term debt/net worth and
outside liabilities, net worth ratios are worse than the medians, the banker should
try to persuade the borrower to strengthen his equity base as early as possible.
8. The committee favoured the retention of the basic elements of the existing
system because (i) it provides more flexibility to borrowers, (ii) it is cheaper to
borrowers, and (iii) it leaves abundant discretion and judgement to the bankers
operate in a realistic manner given daily developments. Central to existing system is
the cash credit arrangements with its three elements of annual credit limits,
drawing accounts and drawing power based on security stipulations.
9. The committee also suggested that within the over-all eligibility, a part of
the borrower’s requirements should be met by the banker by way of a bills limit
apart from the loan or other cash credit arrangements. This however, should be
only a sort of interim arrangement.
In most cases, the bankers apply Method 1 Advocated by the Committee for
determining the maximum limit of borrowals to be allowed to a borrower. In some
cases only, Method 2 is applied, while Method 3 has not yet been applied in any
case. The Committee’s Report has been subsequently modified to some extent by
the Chore Committee Report of 1979.
Chore Committee
The RBI constituted in April 1979 a six-member working group under the
chairmanship of K.B. Chore, Chief Officer, Department of Banking Operation and
Development RBI to review mainly the system of cash credit and credit
management policy by banks.
Recommendations: The highlights of the Chore Committee report as considered
by the RBI are as follows:
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1. Enhancement on Borrower’s Contribution: The net surplus cash generation of

an established industrial unit should be utilised partly at least for reducing
borrowing for working capital purpose. In assessing the maximum permissible bank
finance, banks should adopt the second method of lending recommended by the
Tandon Committee, according to which, the borrower’s contribution from owned
funds and term finance to meet the working capital requirement should be equal to
at least 25 per cent of the total current assets. In cases where the borrowers may
not be in a position to comply with this requirement immediately, the excess
borrowing should be segregated and treated as Working Capital Term Loan (WCTL)
which could be made repayable in half-yearly instalments within a definite period
which should not exceed five years in any case. The WCTL should carry a rate of
interest which should, in no case, be less than the rate sanctioned for the relative
cash credit limit and banks may in their discretion, with a view to encouraging an
early liquidation of the WCTL, charge a higher rate of interest, not exceeding the
ceiling. Provisions should be made for charging of penal rate of interest in the even
of any default in the timely repayment of WCTL.
2. Lending System: The existing system of three types of lending (cash credit,
loans and bills) should continue but wherever possible the use of cash credit
should be supplemented by loans and bills. However, there should be scrutiny of
the operations of the Cash Credit accounts by at least reviewing large working
capital limits once in a year. The discipline relating to the submission of quarterly
statements to be obtained from the borrowers under the information system is also
to be strictly enforced in respect of all borrowers having working capita limits of
Rs.50 lakhs and over from the banking system.
3. Bifurcation of Cash Credit: The RBI’s earlier instructions to banks to
bifurcate the cash credit accounts (as recommended by the Tandon Committee) in
demand loan for corporation and fluctuating cash credit component and t maintain
a differential interest rate between these two components are withdrawn. In cases
where the cash credit accounts have already been bifurcated, steps should be taken
to abolish the differential interest rates with immediate effects.
4. Separate Limits for Peak Level and Normal Non-peak Level Period: Banks
should appraise and fix separate limits for the ‘normal non-peak level’ as also for
the ‘peak level’ credit requirements for all borrowers in excess of Rs.10 lakhs
indicating the relevant periods.
5. Drawals of Fund to be Regulated Through Quarterly Statement: Within the
sanctioned limits for peak and non-peak periods, the borrower should indicate in
advance his need for funds during the quarter. Excess of under-utilisation against
this operative limit beyond tolerance of 10 per cent should be deemed tobe an
irregularity and appropriate corrective action should be taken.
6. Ad hoc or Temporary Limits: Borrowers should be discouraged from
frequently seeking ad hoc or temporary limits in excess of sanctioned limits to meet
 69

unforeseen contingencies. Additional interest of 1 per cent per annum should

normally be charged for such limits.
7. Encouragement for Bill Finance: Advances against book debts should be
converted to bills wherever possible and at least 50 per cent of the cash credit limit
utilized for financing purchase of raw material inventory should also be changed to
this bill system.
The RBI tentatively accepted a few major recommendations of Chore
Committee on cash-credit system for reshaping and reforming the existing system
and asked the commercial banks to submit their opinion on the feasibility of
implementing the recommendations and their possible future impact.
The Chore Committee’s recommendations will pre-empt all internal accruals
towards augmenting working capital, leaving nothing for modernisation and
expansion.
COMMERCIAL PAPERS
Commercial Papers (CPs) are short-term use promissory notes with a fixed
maturity period, issue mostly by the leading, reputed well-established, large
corporations who have a very high credit rating. If can be issued by body corporate
whether financial companies or non-financial companies. Hence, it is also referred
to as Corporate Paper.
Features of a Commercial Paper
i) They are unsecured and backed only by the credit standing of the issuing
company.
ii) They are negotiable by endorsement and delivery like pro-notes and hence
are highly flexible instruments.
iii) Since Commercial Papers are issue by companies with good credit-rating,
they are regarded as safe and liquid instruments. In India, as per the RBI
guidelines, any private or public sector company can issue Commercial
Papers provided (a) its minimum tangible net worth (paid up share capital
plus reserves and surplus) is equal to Rs.4 crores and it has a minimum
current ratio of 1.33:1 as per the latest audited balance sheet, (b) it enjoys
a working capital limit of Rs.4 crores or more, (c) it is listed on one or more
of the stock exchanges, and (d) it obtains every 6 months an excellent
credit rating (p1or A1) from a rating agency approved by RBI like CRISIL,
ICRA, CARE, etc.
iv) Commercial Papers are normally issued at a discount and are in large
denominations.
v) Issues of Commercial Papers may be made through banks, merchant
banks, dealers, brokers, open market, or through direct placement through
lenders or investors.
vi) Commercial Papers normally have buy-back facility; the issuers of dealers
can buy back Commercial Papers if needed.
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vii) The maturity period of Commercial Papers may vary from 3 to 6 months.
viii) The minimum denomination of a Commercial Paper issues and
underwriting of the issue is not mandatory.
ix) The minimum size of a commercial paper issue is Rs. 25 lakhs.
Commercial Papers are mostly used to finance current transactions of a
company and to meet its seasonal needs for funds. They are rarely used to finance
the fixed assets or the permanent portion of working capital. The rise and
popularity of Commercial Papers in other countries like USA, UK, France, Canada
and Australia, has been a matter of spontaneous response by the large companies
to the limitations and difficulties they experienced in obtaining funds from banks.
Commercial Papers in India
The introduction of Commercial Papers in India is a result of the suggestions
of the Working Group (known as Vaghul Committee) on Money Market in 1987.
Subsequently, in 1989, the RBI announced its decision to introduce a scheme by
which certain categories of borrowers could issue Commercial Papers in the Indian
Money Market. This was followed by RBI Guidelines on issue of Commercial Papers
in January 1990, further revised in April 1991. These guidelines apply to all Non-
Banking Finance and Non-Finance Companies.
Some recent issues of Commercial Papers by Indian Companies and their
CRISIL Ratings are shown below

Size of Issue
Company CRISIL Rating
(Rs. Crores)
1. Cadbury India Limited 7.5 Pl +
2. Century Textiles and Industries 10 Pl +
Limited
3. CIPLA Limited 10 Pl+
4. National Thermal Power Corporation 50 Pl+
Limited (NTPC)
5. Special Steels Limited 15 Pl
6. Ashok Leyland Finance Limited 15 Pl+
7. Bajaj Auto Finance Limited 8 Pl+

Source: CRISIL Rating Scan, April 1993.

Note: P1: Highest Safety – This rating indicates that the degree of safety
regarding timely payment on the instrument is very strong.
CRISIL may apply ‘+’ (plus) or ‘-‘ (minus) signs for ratings to reflect comparative
standings within categories.
 71

INTER-CORPORATE DEPOSITS
A deposit made by one company with another, normally for a period up to six
months, is referred to as an inter-corporate deposit. Such deposits are of three
types.
Call Deposits: In theory, a call deposit is withdrawable by the lender on giving
a day’s notice. In practice, however, the lender has to wait for at least three days.
The interest rate on such deposits may be around 14 per cent per annum.
Three Months Deposits: More popular in practice, these deposits are taken by
borrowers to tide over a short-term cash inadequacy that may be caused by one or
more of the following factors: disruption, dividend payment, and unplanned capital
expenditure. The interest rate on such deposits is around 16 per cent annum.
Six-month Deposits: Normally, lending companies do not extend deposits
beyond this time-frame. Such deposits, usually made with first-class borrowers,
carry an interest rate of around 18 per cent per annum.
Growth of Inter-Corporate Deposit Market: Traditionally, some prosperous
companies in the fold of big business houses such as Birlas and Goenkas carried
substantial liquid funds meant primarily to exploit investment opportunities in the
form of corporate acquisitions and takeovers. Until such opportunities arose, the
liquid funds were deposited with other companies with an understanding that they
would be withdrawn at short notice. From the early seventies (more particularly
from 1973), the inter-corporate deposit market grew significantly I the wake of the
following development.
(i) Substantial excise duty provisions made by the companies every since the
Bombay High Court made a ruling that excise duty was not payable on post-
manufacturing expenses.
(ii) Curbs on working capital financing imposed by the Reserve Bank of India
after the first oil shock of 1973.
(iii) Imposition of restrictions on acceptance of public deposits (this was
perhaps caused largely by the failure of W.G. Forge and Company Limited).
(iv) Burgeoning liquidity of scooter companies (little Bajaj, Honda etc.) and, of
late, of car companies (like Maruti Udhyog), which have received massive booking
deposits from their customers.
Characteristics of the Inter-Corporate Deposit Market
Lack of Regulation: While section 58A the Companies Act, 1956, specifies
borrowing limits for inter-corporate loans of a long-term nature, inter-corporate
deposits of a short-term nature are virtually exempt fro any legal regulation. The
lack of legal hassles and bureaucratic red tape makes an inter-corporate deposit
transaction very convenient. In a business environment otherwise charactersied by
a plethora of rules and regulations, the evolution of the inter-corporate deposit
market is an example of the ability of the corporate sector to organize itself in a
reasonably orderly manner.
 72

Secrecy: Te inter-corporate deposit market is shrouded in secrecy. Brokers

regard their lists of borrowers and lenders as guarded secrets. Tightlipped and
circumspect they are some what reluctant to talk about their business. Such
disclosures, they apprehend, would result in unwelcome competition and
undercutting of rates.
Importance of Personal Contacts: Brokers and lenders argue that they are
guided by a reasonably objective analysis of the financial situation of the borrowers.
However, the truth is that lending decisions in the inter-corporate deposit markets
are based on personal contacts and market information which may lack reliability.
PUBLIC DEPOSITS
Public deposits constitute an important source of industrial finance in some of
the Indian industries, particularly in sugar, cotton textiles, engineering, chemicals,
and electricity concerns. Although public deposits are principally a form of short-
term finance, but have since long been utilized to provide long and medium term
finance by cotton mills of Bombay, Ahmedabad and Sholapur and tea gardens of
Bengal and Assam. The system is a legacy from the old past when the banking
system had not developed adequately and the money was kept for safe custody with
the mahajans. In Bombay and Ahmedabad the men who established the mill
companies were either merchants or shroffs in whom the public had confidence,
and hence their savings were entrusted to them. These deposits are received from (i)
the public, (ii) the shareholders and (iii) the employees of the mills.
Popularity of Public Deposits: Hardly a day passes with a big advertisement in
the news papers issued by one company or the other inviting deposits from the
pubic. Their major selling point is the attractive rate of interest they offer. When the
banks are giving just 12 per cent, some of these companies offer even up to 15 to
24 per cent. Over a period of three years this difference in the rate of interest can
mean a lot, especially when compounded.
Merits: Given below is a brief of plus points of fixed deposits with companies:
1. Returns: The interest has tobe paid irrespective of the level of profits of a
company. It has to be paid even if a company incurs loss in a particular
year This is in sharp contrast with dividend on shares, which becomes
payable only if there are profits and even then only if the directors
recommend such a payment.
2. Frequent Payments: Many companies offer interest payments on half-
yearly, quarterly, or even on monthly basis. One can expect frequent
returns, instead of just once or twice in a year.
3. Regularity: If the company’s management is honest and efficient, it is quite
likely that the interest payments will be regular, and that the principal
sum will be returned on the due date.
 73

4. No Fluctuations: The principal sum is not subject to any fluctuations

unlike the market prices of shares. One can be sure of the value of one’s
investments.
5. Preference Over Shareholders: In case the company goes into liquidation,
the fixed deposit holder enjoys preference over the shareholders, for both
the principal and the interest as unsecured creditor of the company.
6. Tax Deduction at Source: Income tax will not be deducted at source up to
an interest income of Rs. 10,000 at one time, or during one year for one
deposit holder (on sums exceeding Rs.10,000/- tax is deducted t source at
the rate of 10%). So far, so good. Many brokers advertise and circulate
literature enumerating the merits of fixed deposits. But all these merits
are subject to a major qualification provided the company is financially
sound. Now, turn to the other side of the story.
There are many risks associated with fixed deposits with companies:
1. Lack of Security: Fixed deposits are absolutely unsecured. If a company
becomes insolvent there is no chance that a fixed deposit holder may get anything
back. It is no consolation that the shareholders are also going to lose in such a
case. The Central Government or the Reserve Bank of India does not come to the
rescue of the deposit-holder. The broker who might have lured the innocent
investors to invest in that company will not even, perhaps acknowledge his letters
of complaints. The investor can do one thing to write off the investment as bad
debt.
2. No Protection: There are many tales of woe even when a company does not
become insolvent several companies neither pay interest nor return the principal.
Therefore, for very understandable reasons, they do not even reply registered
letters. There is no statutory authority on earth t whom one, as a small investor,
can go for any effective remedy; The Company Law Board or the Registrar of
Companies cannot, and do not, generally, come to one’s rescue
4.11 Working capital Forecasting Techniques
Working capital requirements can be determined mainly in three ways: Per
cent-of-sales method, Regression analysis method, and The working capital cycle
method.
(1) Per cent-of-Sales Method: It is a traditional and simple method of
determining the volume of working capital and its components, sales being a
dominant factor. In this method, working capital is determined as a per cent of
forecasted sales. It is decided on the basis of past observations. If over the year,
relationship between sales and working capital is found to be stable, then this
relationship may be taken as a standard for the determination of working capital in
future also. This relationship between sales and working capital and its various
components may be expressed in three ways: (i) as number of days’ of sales, (ii) as
turnover, and (iii) as percentage of sales.
 74

The per cent-of-sales method of determining working capital is simple and

easy to understand and is useful in forecasting of working capital requirements,
particularly I the short-term. However, the greatest drawback of this method is the
assumption of linear relationship between sales and working capital. Therefore, this
method cannot be recommended for universal application. It may be found suitable
by individual companies in specific situations.
(2) Regression Analysis Method: As stated earlier the regression analysis
method is a very useful statistical technique of forecasting. In the sphere of working
capital management it helps in making projection after establishing the average
relationship in the past years between sales and working capital (current) and its
various components. The analysis can be carried out through the graphic
portrayals (scatter diagrams) or through mathematical formula.
The relationship between sales and working capital or various components
may be simple and direct indicating complete linearity between the two or may be
complex in differing degree involving simple linear regressions or simple
curveilinear regression, and multiple regressions situations.
This method, with a range of techniques suitable for simple as well as complex
situations, is an undisputed refinement on traditional approaches of forecasting
and determining working capital requirements. It is particularly suitable for long
term forecasting.
(3) The Working Capital Cycle Method: The working capital cycle refers to the
period that a business enterprise takes in converting cash back into cash.
As an example, a manufacturing firm uses cash to acquire inventory of
materials that is converted into semifinished goods and then into finished goods
and then into finished goods. When finished goods are disposed of to customers on
credit, accounts receivable are generated. When cash is collected from customers,
we again have cash. At this stage one operating cycle is completed. Thus a circle
from cash-to-cash is called the working capital cycle. This concept is also be termed
as “pipe Line Theory” as popularly known.
Cash

Inventory of
raw materials

Accounts
receivable

Semi-finished
goods

Inventory
of finished goods

Fig. 5 Working Capital Cycle

 75

Thus we see that an working capital, generally, has the following four distinct
stages:
1. The raw materials and stores inventory stage;
2. The semi-finished goods or work-in-progress stage;
3. The finished goods inventory stage; and
4. The accounts receivable or book debts stage.
Each of the above working capital cycle stage is expressed in terms of number
of days of relevant activity and requires a level of investment to support it. The sum
total of these stage-wise investments will be the total amount of working capital of
the firm.
A series of such operating cycle recur one after another and chain continues
till the end of the operating period. In this way the entire operating period has a
number of operating cycles. It is important to note that the velocity or speed of this
cycle should not slacken at any stage; otherwise the normal duration of the cycle
will be lengthened, resulting in an increased need for working fund. The faster the
speed of the operating cycle, shorter will be its duration and larger will be the
number of total operating cycles in a year (operating period) which n turn would be
instrumental in giving the maximum level of turnover with comparatively lower level
of working fund.
The four steps involved in this method are (i) computing the duration of the
operating cycle. (ii) calculating the number of operating cycles in the operating
period, (iii) estimating the total amount of annual operating expenses, and (iv)
ascertaining the total working capital requirements. Each step is discussed with
some detail in the following paragraphs.
(i) Duration of Operating Cycle: The duration is computed in days by adding
together the average storage period of raw materials, works-in-progress, finished
goods and the average collection period and then deducting from the total the
average payment period. The formula to express the framework of the operating
cycle is:
O=(R+W+F+D)-C
Where: O = Duration of operating cycle
R = Raw material average storage period
W = Average period of work-in-progress
F = Finished goods average storage period
D = Debtors collection period
C = Creditors payment period
The average inventory, trade creditors, work-in-progress, finished goods and
book debts can be computed by adding the opening and closing balances at the end
of the year in the respective accounts and dividing the same by two. The average
 76

per day figures can be obtained by dividing the concerned annual figures by 365 or
the number of days in the given period.
(ii) Number of Operating Cycle in Operating Period: This is found out by
dividing the total number of days in the operating period by number of days in the
operating cycle as shown below:
P
N
O
Where: N = Number of operating cycle in operating period
P = Number of days in the operating period
O = Duration of operating cycle (in days)
Suppose the operating period is one year (365 days) and the duration of
operating cycle is 73 days then the number of operating cycles in the operating
period will be:
365
N  5 cycles
73

(iii) Total amount of Annual Operating Expenses: These expenses include

purchase of raw materials, direct labour costs and the overhead costs-calculated on
the basis of average storage period of raw materials and the time-lag involved in the
payment of various items of expenses. The aggregate of such separate average
amounts will represent the annual operating expenses.
(iv) Estimating the Working Capital Requirement: This is calculated by dividing
the total annual operating expenses by the number of operating cycles in the
operating period as shown below:
E
R
N
Where: R = Requirement of Working Capital (Estimated)
E = Annual Operating Expenses
N = Number of Operating cycles in the operating period
The amount of working capital thus estimated is increased by a fixed
percentage so as to provide for contingencies and the aggregate figure gives the
total estimate of working capital requirements. The operational cycle method of
determining working capital requirements gives only an average figure. The
fluctuations in the intervening period due to seasonal or other factors and their
impact on the working capital requirements cannot be judged in this method. To
identify these impacts, continuous short-run detailed forecasting and budget
exercises are necessary.
Working Capital Requirements can be determined mainly in three ways – They
are Per cent–of Sales Method, Regression analysis method, and working capital
cycle method.
 77

Percent–of sales method – Simple method, – Sales being dominant Factor –

Based on Past Observations – Expressed in three ways as number of days’ of sales,
turnover and as percentage of sales.
Regression Analysis method – a very useful statistical technique of forecasting
– It is carried out through the graphic portrayals (or) through mathematical
formula.
The working capital cycle method – Thus a circle from cash – back – to- cash is
called the working capital cycle – Termed as “Pipe Line Theory” as popularly known
– The Working Capital Cycle has four stages.
The four steps involved in this method are duration of operating cycle, Number
of operating cycle in operating period, total amount of annual operating expenses,
estimating the working capital requirement.
4.3.12 Working capital Financing policy
The current assets financing plan may be readily related to the broader issue
of the financing plan for all the firms’ assets. The firm has a wide variety of
financing policies it may choose, and the fact that short-term financing usually is
less costly but involves more risk than long-term financing plays an important part
in describing the degree of aggressiveness or conservatism of the firm’s financing
policy.
In comparing financing plans we should distinguish between three different
kinds of financing: (i) Permanent source of financing, (ii) temporary source of
financing and (iii) the spontaneous short-term financing. A firm’s investment is
namely financed by the some of its spontaneous, temporary and permanent sources
of financing.
(i) A permanent investment in an asset is one that the firm expects to hold for
period longer than one year. Permanent investments are made in the firm’s
minimum level of current assets as well as in its fixed assets. Permanent sources of
financing include intermediate and long-term debt, preference share and equity
share.
(ii) Temporary investments are comprised of the firm’s investments in current
assets, which will be liquidated and not replaced within the current year. For
example, a seasonal increase in the level of inventory is a temporary investment as
the holding up in inventories will be eliminated when it is no longer needed.
Temporary source of financing is a current liability. Thus, temporary financing
consists of the various sources of short-term debt including secured and unsecured
bank loans, commercial paper, factoring of accounts receivables, and public
deposits.
(iii) Besides permanent and temporary sources of financing, there also exist
spontaneous sources. Spontaneous sources consist of the trade credit and other
accounts payable that arise spontaneously in the firm’s day-to-day operations.
Examples include wages and salaries payable, accrued interest, and accrued taxes.
These expenses generally arise direct conjunction with the firm’s ongoing
 78

operations, they are referred to as spontaneous. Popular example of a spontaneous

source of financing involves the use of trade credit. As the firm acquires materials
for its inventories, credit is often made available spontaneously or on demand by
the firm’s suppliers. Trade credit appears on the firm’s balance sheet as accounts
payable. The size of the accounts payable balance varies directly with the firm’s
purchases of inventory items, which in turn are related to the firm’s anticipated
sales. Thus, a part of the financing needs by the firm is spontaneously provided by
its use of trade credit.
The long term working capital can be conveniently financed by (a) owners
equity e.g. shares and retained earnings, (b) lender’s equity e.g., debentures, and (c)
fixed assets reduction e.g., sale of assets, depreciation of fixed assets etc. This
capital can be preferably obtained from owners’ equity as they do not carry with
them any fixed charges in the form of interest or dividend and so do not throw any
burden on the company. Intermediate working capital funds are ordinarily raised
for a period varying from 3 to 5 years through loans which are repayable in
installments e.g., working capital term-loans form the commercial banks or from
finance corporations.
Matching (or Moderate) Approach
Matching approach is also called Hedging principle. It involves matching the
cash flow generating characteristics of a firm’s assets with the maturity of the
source of financing used. The rational for matching is that since the purpose of
financing is to pay for assets, when the asset is expected to be relinquished so
should the financing be relinquished. Obtaining the needed funds from a long-term
source (longer than one year) would mean that the firm would still have the funds
after the inventories have been sold. In this case the firm would have “excess”
liquidity, which results in an overall lowering of firm profits. Similarly arranging
finance for shorter periods that the assets require is also costly in that there will be
extra transaction costs involved in continually arranging new short-term financing.
Also, there is always the risk that new financing cannot be obtained in times of
economic difficulty.
The firm’s permanent in vestment in assets is financed by the use of either
permanent source of financing (intermediate-and long-term debt, preference shares,
and equity shares) or spontaneous source (trade credit and other accounts
payable,) its temporary investment in assets is financed with temporary (short-term
debt) and/or spontaneous sources of financing. Note the matching approach has
been modified to state: Asset needs of the firm, not financed by spontaneous
sources, should be financed in accordance with the rule: Permanent asset
investments financed with permanent sources and temporary investments financed
with temporary sources.
Since total assets must always equal to the sum of spontaneous, temporary,
and permanent sources of financing, the hedging approach provides the financial
manager with the basis for determining the sources of financing to use at any point
in time.
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Aggressive Approach
The firm’s financing plan is said to be aggressive if the firm uses more short-
term negotiated financing than is needed under a matching approach. The firm is
no longer financing all its permanent assets with long-term financing. Such plans
are said to be aggressive because they involve a relatively heavy use of (riskier)
short-term financing. The more short-term financing used relative to long-term
financing, the more aggressive is the financing plan. Some firms are even financing
part of their long-term assets with short-term debt, which would be a highly
aggressive plan.
Conservative Approach
Conservative financing plans are those plans that use more long-term
financing than is needed under a matching approach. The firm is financing a
portion of its temporary current assets requirements with long-term financing. Also,
in periods when the firm has no temporary current assets the firm has excess
(unneeded) financing available that will be invested in marketable securities. These
plans are called conservative because they involve relatively heavy use of (less risky)
long-term financing.
Comparison of Conservative, Heading and Aggressive Approaches: These
approaches to working capital financing can be compared on the basis of (a) cost
considerations, (b) profitability considerations, and (c) risk considerations
(probability of technical insolvency). This following statement gives a comparative
evaluation.

Comparative Evaluation of Financing Approaches

Financing
Cost Risk Return of Profitability
Approaches or Plan
Conservative High Low Low
Hedging Moderate Moderate Moderate
Aggressive Low High High
Balanced Policy
Because of the impracticalities in implementing the matching policy and the
extreme nature of the other two policies, most financial managers opt for a
compromise position. Such a position is the balanced policy. As its name implies,
management adopting this policy balances the trade-off between risk and
profitability in a manner consistent with its attitude toward bearing risk. The long-
term financing is used to support permanent current assets and part of the
temporary current assets. Thus short-term credit is used to cover the remaining
working capital needs during seasonal peaks. This implies that as any seasonal
borrowings are repaid, surplus funds are invested in marketable securities.
This policy has the desirable attribute of providing a margin of safety not
found in the other policies. If temporary needs for current assets exceed
management’s expectations, the firm will still be able to use unused short-term
 80

lines of credit to fund them. Similarly, if the contraction of current assets is less
than expected, short-term loan payments can still be met, but less surplus cash
will be available for investment in marketable securities. In contrast to the other
working capital policies, a balanced policy will demand more management time and
effort. Under the policy, the financial manager will not only have to arrange and
maintain short-term sources of financing but must be prepared to manage the
investment of excess funds.
The Appropriate Working Capital Policy
The analysis so far has offered insights into the risk-profitability trade-off
inherent in a variety of different policies. Just as there is no optimal capital
structure that all firms should adopt, there is no one optimal working capital policy
that all firms should employ. Which particular policy is chosen by a firm will
depend on the uncertainty regarding the magnitude and timing of cash flows
associated with sales; the greater this uncertainty, the higher the level of working
capital necessary. In addition, the cash conversion cycle will influence a firm’s
working policy; the longer the time required to convert current assets into cash, the
greater the risk of illiquidity. Finally, in practice, the more risk adverse
management is the greater will be the net working capital position. The
management of working capital is an ongoing responsibility that involves many
interrelated and simultaneous decisions about the level and financing of current
assets. The considerations and general guidelines offered in this lesson should be
useful in establishing an overall net working capital policy.
Illustration
Problem 1: Prepare an estimate of working capital requirement from the
following (information of a trading concern:
a) Projected annual sales 1,00,000 units.
b) Selling price Rs. 8 per unit.
c) Percentage net profit on sales 25.
d) Average credit period allowed to customers - 8 weeks.
e) Average credit period allowed to suppliers - 4 weeks.
f) Average stock holding in terms of sales requirement -12 weeks.
g) Allow 10% for contingences. (MC1M - April 96)
Solution
Step 1 : Classify the given information into current assets and current
liabilities.
 81

Step 2 : Calculate the cost of sales to find out the components of current
assets. This is being done by excluding the percentage of profit
out of sales.
 82

Statement showing the details of calculating working capital

Current Assets
Rs.
8 92,308
Debtors: 6,00,000 x
52
12 1,38,462
Stock : 6,00,000 x
52 2,30,770
Less: Current Liabilities:
4 46,154
Creditors:6,00,000 x
52
Net working capital 1,84,462
Add: 10% Contingencies 18,462
Working capital required 2,03,078
Working Note
Cost of sales  Sales - Profit
25
 8,00,000- x8,00,000
100
 8,00,000- 2,00,000  6,00,000
Assumptions - 1. Calculation of debtors and creditors are being done by considering
Illustration - 1
The following data have been extracted from the financial records of Prabhakar
enterprises Limited:
Raw Materials Rs.8 per unit, Direct Labour, Rs. 4 per unit, and Overheads
Rs.80,000/-
Additional Information
1. The company sells annually 25,000 units @ Rs.20 per unit. All the goods
produced are sold in the market.
2. The average storage period for raw materials is 40 days and for finished
goods it is 18 days.
3. The suppliers give 60 days credit facility to the firm for purchases. The firm
also sells goods on 60 days credit to its customers.
4. The duration of the production cycle is 15 days and raw material is issued
at the beginning of each production cycle.
5. 25% of the average working capital is kept as cash for contingencies.
On the basis of the above information, estimate the total working capital
requirements of the firm under Operating Cycle Method.
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Solution
Duration of Operating Cycle Days
i) Materials storage period 40
ii) Production cycle period 15
iii) Finished goods storage period 18
iv) Average collection period 60
133
Less: Average payment period 60
Duration of Operating Cycle 73

Number of Operating Cycles in a Year: Total Number of Days in a year divided

by Duration of Operating Cycle = 365 =5 Cycles in a year.
73

Total Annual Operating Expenses

i) Raw Material 25,000 × 8 2,00,000
ii) Direct Labour 25,000 × 4 1,00,000
iii) Overheads 80,000
Total Operating Expenses for the year 3,80,000

Estimating Working Capital Requirements:

Total AnnualOperating Expenses 3,80,000

=   Rs.76,000
Number of Operating Cyclesin the year 5
Add: 25% of the above by cash (for contingencies 19,000
Total Working Capital Requirement 95,000
Illustration – 2
M/s Senthil Industries Ltd., are engaged in large scale retailing. From the
following information, you are required to forecast their working capital
requirements of this concern.

Projected annual sales ` Rs. 65 lakhs

Percentage of Net Profit on cost of sales 25%
Average credit allowed to Debtors 10 weeks
Average Credit allowed by Creditors 4 weeks
Average stock carrying (in terms of sales requirement) 8 weeks
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Solution
Statement of Working Capital Requirements
Selling Price Cost Price
Basis Basis
Current Assets: (Rs. in lakhs) (Rs. in
lakhs)
Stock Rs.1.00 lakh × 8 weeks 08.00 08.00
Debtors–At cost equivalent Rs.1.00 lakh×10 =10.00 12.50 10.00
lakh
Profit Rs. 13 × 10=2.50 lakh
52

20.50 18.00
Less: Current Liabilities
Creditors Rs. 1.00 lakh×4 weeks 04.00 04.00
Working Capital Computed 16.50 14.00
Add: 10% for contingencies 01.65 01.40
Net Working Capital Required 18.15 15.40

Per annum Rs.

Projected annual sales 65 lakhs
Net Profit 20% on Sales or 25% on cost of sales 13 lakhs
Cost of sales (65-13) = Sales – Profit 52 lakhs
Cost of sales per week (52 weeks in a year) 1.00 lakhs

Note: It has been assumed that the creditors include those for both goods and
expenses and that all such creditors allow one month credit on average.
Interpretation of Results: The amount of working capital fund above is to be
interpreted as the amount to be blocked up in inventory, debtors (minus creditors)
at any time during the period (year) in view, in order that the anticipated activity
(sales primarily) can go on smoothly. The amount is not for a period of time but at
any point of time. It represents the maximum (or the highest) quantum of locking
up at any time during the period.
Illustration - 3
Ramaraj Brothers Private Limited sells goods on a gross profit of 25%.
Depreciation is taken into account as part of cost of production. The following are
the annual figures given to you:
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Rs.
Sales (two months credit) 18,00,000
Materials consumed (one month’s credit) 4,50,000
Wages paid (one month lag in payment) 3,60,000
Cash manufacturing expenses (one month lag in payment 4,80,000
Administration expenses (one month lag in payment ) 1,20,000
Sales promotion expenses (paid quarterly in advance) 60,000
Income tax payable in 4 installments of which one lies in the next 1,50,000
year

The company keeps one month’s stock each of raw materials and finished
goods. It also keeps Rs.1,00,000 in cash. You are required to estimate the working
capital requirements of the company on cash basis assuming 15% safety margin.
Solutions
Statement of Working Capital Requirements
A. Current Assets: Rs.
Debtors (cash of goods sold, i.e., 14,70,000×2/12) 2,45,000
Prepaid sales expenses 15,000
Inventories:
Raw Materials (4,50,000/12) 37,500
Finished Goods (12,90,000/12) 1.07,500
Cash-in-hand 1,00,000
5,05,000
B. Current Liabilities:
Sundry creditors (4,50,000/12) 37,500
Outstanding Manufacturing expenses (4,80,000/12) 40,000
Outstanding administration expenses (1,20,000/12) 10,000
Provision for taxation (1,50,000/12) 37,500
Outstanding wages (3,60,000/12) 30,000
1,55,000
Working Capital [(A)-(B)] 3,50,000
Add: 15% for contingencies 52,500
Total Working Capital required 4,02,500
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Working Notes
1. Total Manufacturing Expenses
Rs. Rs.
Sales 18,00,000
Less: Gross Profit 25% of sales 4,50,000
Total Cost 13,50,000
Less: Cost of Materials 4,50,000
Wages 3,60,000 8,10,000
Manufacturing Expenses 5,40,000
2. Depreciation
Rs. Rs.
Total Manufacturing Expenses 5,40,000
Less: Cash Manufacturing Expenses 4,80,000
Depreciation 60,000
3. Total Cash Cost
Total Manufacturing Expenses 13,50,000
Less: Depreciation 60,000
12,90,000
Add: Administration Expenses 1,20,000
Sales Promotion Expenses 60,000
Total Cash Cost 14,70,000
e cost of sales.
Illustration: 1
Following is the summary of Balance Sheets of a firm under the three
approaches:

Policy
Conservative Hedging Aggressive
Liabilities
Current Liabilities: 5,000 15,000 25,000
Long-term loan 25,000 15,000 5,000
Equity 50,000 50,000 50,000
Total 80,000 80,000 80,000
Assets
Current Assets:
(a) Permanent Requirement 20,000 20,000 20,000
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(b) Seasonal Requirement 15,000 15,000 15,000

45,000 45,000 45,000
Total 80,000 80,000 80,000
Additional Information
1. The firm earns, on an average, approximately 6% on investments in
current assets and 18% on investments in fixed assets.
2. Average cost of current liabilities is 5% and average cost of long-term funds
in 12%.
Compute the costs and returns under any three different approaches, and
comment on the policies.
Solutions
1. Computation of Costs under Conservative, Matching & Aggressive Approaches.

Hedging
Conservative Aggressive
(matching)
Rs. Rs. Rs.
Cost of Current Liabilities 5% on 5,000= 750 15,000= 750 25,000=1,250
Cost of long term funds 12% 75,000=9,000 65,000=7,800 55,000=6,600
Total Cost 9,250 8,550 7,850
2. Computation of Returns under the three Approaches

Conservative Hedging Aggressive

Rs. Rs. Rs.
Return Current Assets 6% on 35,000=2,100 35,000= 2,100 35,000=2,100
Return of Fixed Assets 18% 45,000=8,100 45,000=8,100 45,000=8,100
Total Return 10,200 10,200 10,200
Less: Cost of Financing (9,250) (8,550) (7,850)
Net Return 950 1,650 2,350
3. Measurement of (a) Liquidity (b) Risk of Commercial Insolvency i.e., illiquidity
under the three approaches.

Conservative Hedging (matching) Aggressive

Rs. Rs. Rs.
(a) Net Working 35,000 – 35,000 – 35,000 –
Capital 5,000=30,000 15,000=20,000 25,000=10,000
(CA – CL)
(b) Current Ratio 35,000 =7:1 35,000 =2.33:1 35,000 =1.4:1
5,000 15,000 25,000
(CA: CL)
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Comments
1. Cost of financing is highest being Rs.9,250/- in conservative approach, and
lowest (Rs.7,850/-) in aggressive approach (the total funds being the same,
i.e., Rs.80,000/-).
2. Return on investment (net) is lowest in conservative approach being
Rs.950/- and highest in aggressive approach being Rs.2,350/-.
3. Risk is measured by the amount of net working capital. The larger the net
working capital, the lesser will be the degree of technical insolvency or the
lesser will be the inability to meet obligations on maturity dates. In other
words, larger net working capital means less risk. The net working capital
is comparatively larger in conservative approach and therefore, the degree
of risk is low. The net working capital is comparatively lower in aggressive
approach, and therefore, the degree of risk is high.
Risk is also measured by the degree of liquidity. The larger the degree of
liquidity, the lesser will be the degree of risk. One of the measurements of degree of
liquidity is current ratio; it is also known as ‘Working Capital Ratio: This ratio
signifies the firm’s ability to meet its current obligations. The larger the ratio, the
greater the liquidity, and the lesser the risk. In conservative approach, current ratio
is the highest being 7:1, and in aggressive approach, this ratio is lowest being 1.4:1
Therefore, there is low risk in conservative approach.
The aforementioned analysis leads to the following conclusions:
i) In conservative approach, cost is high, risk is low, and return is low.
ii) In aggressive approach, cost is low, risk is high, and return is high.
iii) Hedging approach has moderate cost, risk and return. It aims at trade-off
between profitability and risk.
4.4 REVISION POINTS
Working capital : The total of current assets or as the
difference between current assets and
current liabilities.
Current assets : The total of inventories, debtors, loans and
advanced, cash and marketable securities.
Current liabilities : The sum of sundry creditors, unclaimed
dividends short term loans, bank credit and
various types of provisions.
Permanent working capital : Minimum level of investment in current
assets required for production.
Variable working capital : Working capital which takes care of
fluctuations in business activity
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4.5 INTEXT QUESTIONS

1. Distinguish between gross working capital and net working capital?
2. What is meant by working capital?
3. Discuss the significance of working capital in a firm
4. Explain the two concepts of working capital
5. Explain the different source of working capital
6. Explain the different types of working capital.
4.6 SUMMARY
This unit has aimed at providing a conceptual understanding of the issues
involved in working capital. Thus, it started with the discussion on definition and
explain the concept of working capital. This unit has attempted to highlight, what
constitutes working capital to enhance the understanding of the readers.
Permanent and variable working capital are the two forms of working capital.
4.7 TERMINAL EXERCISE
1. ……………..is the difference between current assets and current liabilities.
2. ……………………is the amount of funds invested in the various components
of current assets.
3. .……………………..is called as the maturity of source of funds should match
the nature of assets to be financed .
4. ………………….approach is less risky, but more costly as compared to the
hedging approach.
5. ……………………….Refers to the period that a business enterprise takes in
converting cash back into cash.
6. …………………represents credit granted by manufactures,wholesalers,etc.,
as an incident of sale.
4.8 SUPPLEMENTARY MATERIAL
1. wps.prenhall.com/wps/media/objects/13070/13384693/
2. faculty.business.utsa.edu/kfairchild/classes/
3. icaiknowledgegateway.org
4.9 ASSIGNMENTS
1. Evaluate the following statement: “A firm can reduce its risk of illiquidity
with higher current-asset investments, but the return on capital goes
down.”
2. What are the risk-return trades-offs involved in choosing a mix of short-
and long-term financing?
3. There are four different policies that managers must consider in designing
their working capital policy. Explain the salient features of each policy.
what are the advantages and disadvantages of each such policy?
 90

4. Discuss the importance of working capital for a manufacturing concern.

5. Explain the various determinants of working capital of a concern.
6. What are the advantages of having ample working capital funds?
7. Differentiate between fixed working capital and variable working capital.
8. What are the different principles of working capital management?
9. Summaries the causes for and changes in working capital of a firm.
4.10 SUGGESTED READINGS
 Eugene F. Brigham, Joel F. Houston Fundamentals of Financial
Management Cengage Learning
 Srivastava Financial Management and Policy, Himalaya Publishers
 Anil Mishra, Ragul Srivastava, Financial Management Oxford Publishers.
 Agarwal, N.K. : Working Capital Management; New Delhi, Sterling
Publication (P) Ltd.,
 Khan, M.Y. and Jain, P.K. : Financial Management; New Delhi, Tata
McGraw Hill Co.,
 Ramamoorthy, V.E.: Working Capital Management: Madras, Institute for
Financial Management and Research.
4.11 LEARNING ACTIVITIES
Practical problems
The Board of Directors of Guru Nanak Engineering Company Private Ltd.,
requests you to prepare a statement showing the Working Capital Requirements
Forecast for a level of activity of 1,56,000 units of production.
The Following information is available for you calculation

A. Per Units
Rs.
Raw Materials 90
Direct Labour 40
Over Heads 75
205
Profits 60
Selling Price per unit 265
B. Raw materials are in stock on average one month
Materials are in process, on average two weeks
Finished goods are in stock, on average one month
Credit allowed by suppliers one month
Time lag in payment from debtors 2 months
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Lag in payment of wages 11/2 weeks

Lag in payment of overheads is one month

20% of the output is sold against cash. Cash in hand and at Bank is expected
to be Rs.60,000/-. It is to be assumed that production is carried on evenly
throughout the year, wages and overheads accrue similarly and a time period of 4
weeks is equivalent to a month.
[Ans: Working Capital Required Rs.74,13,000/-]
Notes: (i) Since wages and overheads accrue evenly on average, half the wages
and over head would be included in working progress. Alternatively if it is assumed
that the direct labour and overhead are introduced at the beginning, full wages and
overhead would be included.
1. A Performa cost sheet of a company provides the following particulars:
Elements of Cost
Raw Materials 40%
Labour 10%
Overheads 30%
The following further particulars are available:
(a) Raw materials are to remain in stores on an average 6 weeks.
(b) Processing time is 4 weeks.
(c) Finished goods are required to be in stock on average period of 8 weeks
(d) Credit period allowed to debtors, on average 10 weeks.
(e) Lag in payment of wages 4 weeks
(f) Credit period allowed by creditors 4 weeks
(g) Selling price is Rs.50 per unit
You are required to prepare an estimate of working capital requirements
adding 10% margin for contingencies for a level of activity of 1,30,000 units of
production.
[Ans: Working Capital Required – Rs.25,25,000/-]
2. From the following information extracted from the books of manufacturing
concern, compute the operating cycle in days –
Period covered: 365 days
Average period of credit allowed by suppliers 16 days.

Average total of debtors outstanding 4,80,000

Raw-Material Consumption 44,00,000
Total Production Cost 1,00,00,000
Sales for the year 1,60,00,000
 92

Value of average stock maintained –

Raw Materials 3,20,000

Work-in-Progress 3,50,000
Finished goods 2,60,000
[Ans: Total period of operating cycle 44 days]
3. The management of Jayant Electrical Ltd., is faced with various alternatives
for managing its current assets. The company is producing 1,00,000 units of
electrical heaters. This is its maximum installed capacity. Its selling price per unit
is Rs.50/-. The entire output is sold in the market. Fixed assets of the company are
valued at Rs.20 lakhs.
The company earns 10% on sales before interest and taxes. The management
is faced with three alternatives about the size of investment in current assets.
(i) to operate with current assets of Rs. 20 lakhs, or
(ii) to operate with current assets of Rs. 15 lakhs, or
(iii) to operate with current assets of Rs. 10 lakhs,
You are required to show the effect of the above three alternative current
assets management policies on the degree of profitability of the company.
[Ans: (i) Conservative Policy (ii) Moderate Policy (iii) Aggressive Policy]
3. (a) Total investments:
In Fixed Assets Rs.1,20,000
In Current Assets 80,000 2,00,000
(b) Earning (EBIT) is 35%
(c) Debt – ratio is 60%
(d) Rs.80,000/- being (40% assets) financed by the equity shareholder, i.e.,
long-term sources.
(e) Cost of short-term debt and long-term debt is 14% and 16% respectively.
(f) Assume Income-tax @ 50%
As a result of the financing policy, ascertain the return on equity shares.
[Ans: Return on equity is highest in aggressive policy]
4.12 KEYWORDS
Fixed working capital , Variable Working Capital, Working Capital Gap,Gross
working Capital, Net Working Capital,working capital Cycle, Percent of Sales
Method,Coservative Approach, Hedging Approach,Aggressive Approach.

 93

LESSON – 5

MANAGEMENT OF CASH
5.1 INTRODUCTION
Cash is basic input to start a business unit, Cash in initially invested in fixed
assets like plant and machinery, which enable the firm to produce products and
generate cash by selling them. Cash is also required and invested in working
capital. Investments in working capital are required because firms have to store
certain quantity of raw materials and finished goods and provide credit terms to the
customers. The cash invested in raw materials at the beginning of working capital
cycle goes through several stages (work-in-progress, finished goods and sundry
debtors) and gets released at the end of cycle to the fund fresh investment needs of
raw materials. The firm needs additional cash during its life wherever it needs to
buy more fixed assets, increase the level of operations and any change in working
capital cycle such as extending credit period to the customers. In other words, the
demand for cash is affected by several factors and some of them are within the
control of the managers and others are outside the control of the managers. Cash
management thus, in a broader sense is managing the entire business.
The objective of cash management is to balance the cost associated with
holding cash and benefits derived out of holding the cash. The objective 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.
The term ‘cash’ under cash management thus refers to both cash and credit
balance in the bank and short-term investments in marketable securities.
Cash means and includes actual cash (in hand and at bank). Cash is like
blood stream in the human body gives vitality and strength to a business
enterprise. The steady and healthy circulation of cash throughout the entire
business operation is the basis of business solvency.
Nature of Cash: Cash is the common purchasing power or medium or
exchange. Cash forms the method of collecting revenues and paying various costs
and expenses of the business. As such, it forms the mot important component of
working capital. Not only that, it largely upholds, under given conditions, the
quantum of other ingredients of working capital viz., inventories and debtors, that
may be needed for a given scale and type of operation. Approximately 1.5 to 2 per
cent of the average industrial firms’ assets are held in the form of cash. However,
cash balances vary widely not only among industries but also among the firms
within a given industry, depending on the individual firm’s specific conditions and
on their owner’s and managers’ aversion to risk.
Cash as a Liquid Asset: Cash is the most liquid asset that a business owns.
Liquidity refers to commonly accepted medium for acquiring the things, discharging
the liabilities, etc. The main preoccupation of a businessman should be cash, which
are the starting point and the finishing point. It is the sole asset at the
commencement and the termination of a business. It should be remembered that a
want of cash is more likely to cause the demise of a business than any single factor.
 94

Credit standing of the firm with sufficient stock as cash is the strengthened. A
strong credit position of the firm helps it to secure from banks and other sources
form banks and other sources generous amount of loans on softer terms and to
procure the supplies on easy terms.
Cash as a Sterile Asset: Cash itself is a barren or sterile asset and in nature
until and unless human beings apply their head and hand. That is cash itself can
to earn any profit or interest or yield unless, it is invested in the form of near-cash
or non-cash assets.
Cash as a Working Asset: While cash is a factor contributing to the liquidity
position of the enterprise, fixed assets are real producer of earnings; on planning it
would be the objective of management to maintain in each asset group the
appropriate amount of resources to easy but on efficient production and to meet the
requirements of the future. Should an excess cash balance be discovered, it would
be non-working asset and should be employed elsewhere to produce some income.
Cash as a Strange Asset: A form seeks to receive it in the shortest possible
time but to hold as little as possible. It is more efficient to maintain good credit
sources than to hold extra cash or low interest bearing market instruments against
unexpected use. Clearly, it is preferable, whenever possible to hold income-earning
marketable investment in lieu of cash and to use short-term borrowing to meet
peak seasonal needs.
5.2 OBJECTIVES
After Completing this Lesson you must be able to
 Outline the role of cash in the operation of business
 Explain different motives behind holding cash
 Discuss the objectives of cash management
 Prepare cash budget.
 Explain cash management Holders
5.3 CONTENT
5.3.1 Motives of holding cash
5.3.2 Objectives of cash management
5.3.3 Cash Management – Basic problems
5.3.4 Cash Management – Planning Aspects
5.3.5 Cash Management Holders
Issues in Cash Management
In a business enterprise, ultimately, a transaction results in either an outflow
or an inflow of cash. Its shortage may degenerate a firm into a state of technical
insolvency and even to liquidation. Though idle cash is sterile, its retention is not
without cost. Holding of cash balance has an implicit cost in the firm of opportunity
 95

cost. It varies directly with the quantity of cash held. The higher the amount of idle
cash, the greater is the cost of holding it in the form of loss of interest which could
have been earned either by investing it in some interest bearing securities or by
reducing the burden of interest charges by paying off the past loans, especially in
the present era of ever increasing cost of borrowing. Hence, a finance manager has
to adhere to the five ‘R’s of financial management. Viz (i) the right quality of finance
for liquidity considerations; (ii) the right quantity whether owned or borrowed; (iii)
the right time to preserve solvency, (iv) the right source; and (v) the right cost of
capital the organisation can afford to pay.
In order to resolve the uncertainty about cash flow prediction, lack of
synchronization between cash receipts and payments, the organization should
develop some strategies for cash management. The organization should evolve
strategies regarding the following areas and facets of cash management.
i) Determining the organisation’s objective of keeping cash
ii) Cash planning and forecasting
iii) Determination of optimum level of cash balance in the company
iv) Controlling flow of cash by maximizing the availability of cash i.e.,
economizing cash by accelerating inflows or decelerating cash outflows.
v) Financing of cash shortage and cost of running out of cash
vi) Investing idle or surplus cash
5.3.1 Motives of Holding Cash
According to John Maynard Keynes, the famous economist, there are three
motives that both individuals and businessmen hold cash. They are (i) The
transaction motive, (ii) the precautionary motive and (iii) the speculative motive. Yet
another motive which has been added as the fourth one by the modern writers on
financial management is compensation motive thus, there are altogether four
primary motives for maintaining cash balances.
The basic question is why firms hold cash. Some of the reasons for holding
cash are listed below.
i) Transaction Motive: Money is required to settle customers' bills, pay salary
and wages to workers, pay duties and taxes, etc. Some cash balance is to be
maintained to complete these transactions The amount to be maintained for the
transaction motive depends or. the ..ash inflows and outflows. Often, firm prepare a
cash budget by incorporating the estimates of inflows and outflows to know
whether the cash balance would be adequate to meet the transactions.
ii) Precautionary or Hedging Motive: The transaction motive takes into account
the routine cash needs c the firm. It is also based on the assumption that inflows
are as per estimation. However, the future cash needs for transaction purposes are
uncertain. The uncertainty arises on account of sudden increase in expenditure or
delay in cash collection or inability to source the materials and other supplies on
 96

credit basis. The firm has to protect itself from such contingencies by holding
additional cash. This is called as precautionary motive of holding cash balance.
iii) Speculative Motive : if the firm intends to exploit the opportunities that may
arise in the future suddenly, it has to keep some cash balance. This is particularly
relevant, where the prices of material fluctuate widely in different periods and the
firm's success depends on it's ability to source the material at the right time.
iv) Managing uneven supply and demand for cash: Firms generally experience
some seasonality in sales, which leads to exceeds cash flows in certain period of the
year. This is not permanent surplus and cash is required at different points of time.
One possible solution to address this mismatch of cash flows is to pay off bank
loans whenever there is excess cash and negotiate fresh loan to meet the
subsequent demands. Since firms are exposed to some amount of uncertainty in
getting the loan proposal sanctioned in time, the surplus cash is retained and
invested in short-term securities.
In a competitive environment, firms also felt the desire of holding cash to get
flexibility in meeting competition. For instance, when a competitor suddenly resort
to massive advertisement and other product promotion, it forces other firms to
increase advertisement cost or some other sales promotion activities.
v) Compensation Motive: Commercial banks require that in every current
account, there should always be a minimum cash balance. This amount remains as
a permanent balance with the bank so long as the current account is operative.
This minimum balance is generally not allowed by the bank to be used for
transaction purposes and therefore, it becomes a sort of investment by the firm in
the bank. In order to avail the convenience of current account the minimum cash
balance must be maintained by the firm and this provides the compensation motive
for holding cash.
5.3.2 Objectives of Cash Management
There are two basic objectives of cash management:
1. To meet the cash disbursement needs as per the payment schedule
2. To minimize the amount locked up as cash balances.
As a matter of fact both the objectives are mutually contradictory and
therefore, it is a challenging task for the finance manager to reconcile them and to
have the best in this process.
1. Meeting cash disbursement
The first basic objective of cash management is to meet the payments
schedule. In other words, the firm should have sufficient cash to meet the various
requirements of the firm at different periods of times. The business has to make
payment for purchase of raw materials, wage, taxes, purchase of plant, etc. The
business activity may come to a grinding halt if the payment schedule is not
maintained. Cash has, therefore, been aptly described as the “oil to lubricate the
ever-turning wheels of the business, without it the process grinds to a stop”.
 97

2. Minimizing funds locked up as cash balances

The second basic objective of cash management is to minimize the amount
locked up as cash balances. In the process of minimizing the cash balances, the
Finance Manager is confronted with to conflicting aspects. A higher cash balance
ensures proper payment with all its advantages. But this will result in a large
balance of cash remaining idle. Low level of cash balance may result in failure of
the firm to meet the payment schedule. The finance manager should, therefore, try-
to have an optimum amount of cash balance, keeping the above facts in view.
5.3.3 Cash Management - Basic Problems
Cash management involves the following four basic problems:
1. Controlling levels of cash;
2. Controlling inflows of cash;
3. Controlling outflows of cash; and
4. Optimum investment of surplus cash.
Controlling Level of Cash
One of the basic objectives of cash management is to minimize the level of cast
balance with the firm This objective is sought to be achieved by means of the
following:
i) Preparing Cash Budget : Cash budget or cash forecast is the most significant
device for planning and controlling the use of cash. It Involves a projection of future
cash receipts and cash disbursements of the firm over various intervals of time. It
reveals to the financial manager the timings and amount of expected cash inflows
and outflows over a period. With this information, he is better able to determine the
future cash needs of the firm, plan for the financing of these needs and exercise
control over the cash and liquidity of the firm.
ii) Providing for unpredictable discrepancies: Cash budget as explained above
predicts discrepancies between cash inflows and outflows on the basis of normal
business activities. It does not take into account discrepancies between cash
inflows and outflows on account of unforeseen circumstances such as strikes,
short-term recession, floods, etc. A certain minimum amount of cash balance has
therefore, to be fixed on the basis of past experience”
iii) Consideration of short costs. The term short cost refers to the cost incurred
as a result of cash. Such cost may take any of the following forms.
a) The failure of the firm to meet its obligations in time may result in legal
action by the firm's creditors against the firm. This, cost in terms of fall in
the firm's reputation besides financial costs incurred in defending the suit:
b) Borrowing may have to be resorted to at high rates of interest. The firm
may also be required to pay penalties, etc., to banks for not meeting the
obligations in time”)
iv) Availability of other sources of funds: A firm can avoid holding unnecessary
large balance of cash for contingencies in case it has to pay a slightly higher rate of
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interest than that on a long-term debt. But considerable saving in interest costs will
be effected because such interest will have to be paid only for shorter period.
Controlling Inflows of cash
Speedier collection of cash can be made possible by adoption of the following
techniques
i) Concentration Banking : Concentration banking is a system of decentralizing
collections of accounts receivable in case of large firms having their business
spread over a large area. According to this system, a large number of collection
centres are established by the firm in different areas selected on geographical basis.
The firm opens its bank accounts in local banks of different areas where it has its
collection centres. The collection centres are required to collect cheques from their
customers and deposit them in the local bank account.
ii) Lock-Box System : Lock-box system is a further step in speeding up
collection of cash. In case of concentration banking cheques are received by
collection centres who, after processing deposit them in the local bank accounts.
Thus, there is time gap between actual receipt of cheques by a collection centre and
its actual depositing in the local bank account. Lock-Box system has been devised
to eliminate delay on account of this time gap. According to this system, the firm
hires a post-office box and instructs its customers to mail their remittances to the
box. The firm’s local bank is given the authority to pick the remittances directly
from the post-office box. – The bank picks up the mail several times a the cheques
in the firm’s account. Standing instructions are given to the local bank to transfer
funds to the Head Office Bank when they exceed a particular limit.
iii) Electronic Funds Transfer and Anywhere Banking: The advent of banking
technology and the spread of internet facilities has changed the face of corporate
cash management The more towards paperless economy reduces many of the
difficulties in dealing with cheques/ drafts. It should be clear from the prior
discussion that the time necessary for transmittal of cash from one firm to another
revolves largely around the passing from one hand to another of a piece of paper,
i.e., the cheque, if we can eliminate this paper there will be a major saving in the
time and cost.
Control over Cash Outflows
An effective control over cash outflows or disbursements also helps a firm In
conserving cash and reducing financial requirements. However, there is a basic
difference between the underlying objective of Exercising control over cash inflows
and cash outflows. In case of the former, the objective is the maximum acceleration
of collector*case of latter, it is to slow down the disbursements as much as possible.
The combination of fast collections and slow disbursements will result in maximum
availability of funds.
A firm can advantageously control, outflows of cash if the following
considerations kept in view.
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i) Centralized system of disbursements should be followed as compared to

decentralized system in case of collections. All payments should be made from a
single control account. This will result in delay in presentment of cheques for
payment by parties who are away from the place of control account;
ii) Payments should be made on the due dates, neither before nor after. The
firm should neither lose cash discount nor its prestige on account of delay in
payments. In other words, the firm should pay within the terms offered by the
suppliers;
iii) The firm may use the technique of “playing float” for maximizing the
availability of funds. The term float, refers to the period taken from one stage to
another in the cash collection process. It can be the following types:-
a) Billing Float: It refers to the between the making of a formal invoice by the
seller for the goods sold and, the invoice to the purchaser;
b) Capital Float: It refers to the time which elapses between by the post office
or other messenger from the buyer till it is actually delivered to the seller;
c) Cheque Processing Float: It refers to the time required for the Seller to sort,
record and deposit the cheque after it has been received by him;
d) Bank Processing Float: This refers to the time period which elapses
between deposit of the cheque with the banker and final credit of funds by
the banker to the seller's account.
5.3.4 Cash Management - Planning Aspects
In order to maintain an optimum cash balance, what is required is (i) a
complete and accurate forecast of net cash flows over the planning horizon and (ii)
perfect synchronization of cash receipts and disbursements. Thus, implementation
of an efficient cash management system starts with the preparation of a plan of
firm's operations for a period in future. This plan will help in preparation of a
statement of receipts and disbursements expected at different point of time of that
period, it w-' r -able the management to pin point the timing of excessive cash or
shortage of cash This will also help to find out whether there is any expected
surplus cash still unutilized or shortage of cash which is yet to be arranged for. In
order to take care of all these considerations, the firm should prepare a cash
budget.
A cash budget is a summary of movement of cash during a particular period.
There are three methods of preparation of cash budget. These are
i) Adjusted Net Income,
ii) Pro-forma Balance Sheet, and
iii) Cash Receipts and Disbursements.
i) Adjusted Net Income Method : requires that a pro-forma income statement
should be prepared for each desired interim period of the budget period. The net
income figures for each period are then adjusted to a cash basis by deleting the
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transactions that are affecting the income statements but not the cash balance or
the items which affect the one without affecting the other. This adjusted figure is
taken as cash profit (Joss) during that period. This can be taken as net increase or
decrease in cash balance during that period
ii) Pro-forma Balance Sheet Method: requires the preparation of as many pro-
forma balance sheets as there are interim periods in the cash budget. Each item of
the balance sheet except cash is projected for each period, and the cash balance is
ascertained in accordance wit the accounting equation i.e. Total Assets = Total
Liabilities + Capital. The balancing figure of the preformed balance sheet is taken as
the cash balance.
iii) Receipts and Payments Method of Cash Budget: Cash budget, under this
method, is a statement projecting the cash inflows and outflows (receipts and
disbursements) of the firm over various interim periods of the budget period. For
each period, the expected inflows are put against the expected outflows to find out
if there is going to be any surplus or deficiency in a particular period. Surplus, if
any, during a particular period may be carried forward to the next period or steps
may be taken to make short term investments of this surplus.
Table 1
Pro-forma Cash Budget Monthly Cash Budget for the year 2001

Particulars January February --- November December

Opening Cash Balance --- --- --- --- ---
Cash Inflows --- --- --- --- ---
Cash Sales --- --- --- --- ---
Collection from Debtors --- --- --- --- ---
Loans and Borrowings --- --- --- --- ---
Subsidy --- --- --- --- ---
Other Incomes --- --- --- --- ---
Total Cash Available (A) --- --- --- --- ---
Cash Outflows:
Cash outflows: --- --- --- --- ---
Payment to Creditors --- --- --- --- ---
Wages and Salaries --- --- --- --- ---
Other expenses --- --- --- --- ---
Fixed assets purchase --- --- --- --- ---
Investments --- --- --- --- ---
Repayment of debts Interest --- --- --- --- ---
and Taxes
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Dividend Payment --- --- --- --- ---

Total Payments (B) --- --- --- --- ---
Closing Balance (A - B) --- --- --- --- ---
+ Funds required --- --- --- --- ---
– Excess cash to be invested --- --- --- --- ---
5.3.5 Cash Management Models
Every business enterprise will have to take sound decisions regarding the
optimum cash balance it should possess. Several factors influence the holding of
optimum cash balance in an enterprise. The factors that decide the safety level of
cash holdings are:
 Average Daily Cash Outflows during peak days and normal days (ADCO)
and
 Required Days of Cash holdings (RDC) (i.e., number of days the cash is
required to meet the cash demand).
Safety level of cash holdings will be normally decided by multiplying ADCO by
RDC.
Certain models have been developed to manage the cash. These models assist
determining the optimum cash to be held by the enterprise. The models are:
 Baumol Model
 Miller-orr Model
 Orgler's Model
These models are developed to give a scientific approach to cash management
However these models are only guidelines and need not necessarily be adopted.
1. Baumol Model
W.J. Baumol designed a model in 1952 (The Transaction Demand for cash: .
Inventory Theoretic Approach Quarterly Journal of economics-1952) to throw light
holding optimum cash. This model deals with the cost of holding cash in an
enterprise The model suggests that the amount of cash held should be such that
costs of hold them should be at minimum. “Costs” here refers to two types of costs,
(i) Opportunity cost of cash and (ii) Cost of converting the securities into cash.
Opportunity cost of cash means the amount that cash would have earned has been
invested in readily marketable securities rather than keeping it idle. Some cal
“Carrying cost”.
Conversion cost includes the brokerage, etc., incurred at the time of convert
securities into cost.
Opportunity cost and Conversion costs move in opposite directions. If
opportunity cost increases the conversion cost comes down. They together meet
point and that point is the minimum cost point and will decide the optimum
balance an entity can hold.
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The following formula may be adopted to determine the cash balance.

Optimum Cash[OC]  2CP x FCT

OC or CC
Where OC = Optimum cash to be held.
CP= Cash payment for the given period (Monthly or p.a.)
FCT= Fixed cost per transaction.
OC= Opportunity cost of each rupee held or conversion cost.
Let us take an illustration
Cash demand in as month Rs.1 lakh
Rate of interest of securities 10% p.a.
Cost per transaction (fixed) Rs. 50
Optimum Cash[OC]  2CP x FCT  2x1Lx50  10,00,00,000  Rs.10.000
OC or CC 0.1 0.1
2. Miller - Orr Model
This model was developed in 1966 by Miller, and Orr. D. [A model of the
demand for money in firms-quarterly Journal of Economics Lxx-Aug.-1966]. The
model is an improvement over the Boumel model. Boumel model assumes that cash
payments are fixed and steady. The variation in cash payments (increase due to
expansion and decrease due to reduction in investments) are not considered. Miller-
Orr model fixes the maximum and minimum limits or upper and lower limits of the
cash balances. The optimum balance lies in between upper and lower limits.
When the cash balance reaches the upper limit, it indicates that difference
between upper limit and optimum balance can be invested in readily in marketable
securities. Similarly, when cash balance reaches the lower limit it indicates the
securities be converted into cash to reach the optimum balance level.
The developers of this model have given a formula to assess the optimum level
of cash. It is as follows:
3. Orgler's Model
The model developed by Orgler’s, Y.E., relating cash management is based on
"Linear Programming". This model is an integration of three vital segments, viz., (I)
deciding a planning premise (ii) Recognize and pick-up the supporting and related
components to take decisions regarding cash holdings. (These components may be
(I) conversion of securities into cash and vice-a-versa (ii) payment schedule (Hi)
cash position etc.) (Hi) preparing a strategy for cash management.
Model assumes that any revenue generated is immediately reinvested and any
expense incurred is immediately financed.
Illustration 1
The following information is available in respect of a firm:
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a) On an average accounts receivable are collected after 80 days; inventories

have an average of 100 days and accounts payable are paid approximately
60 days after they arise.
b) The firm spends a total of Rs.1,81,200/- annually at a constant rate.
c) It can earn 8% on investments.
Calculate: (i) the firm’s cash cycle and cash turnover assuming 360 days in a
year: (ii) minimum amounts of cash to be maintained to meet payments as they
become due; (iii) savings by reducing the average age of inventories to 70 days.
Solution
(i) Cash cycle: 80 days + 100 – 60 = 120 days
Cash Turnover = 360 divided by 120 days = 3 times
Total operatingannualoutaly
(ii) Minimum operating cash=
Cash turnover
= Rs.1,81,20,000 /3= Rs. 60,40,000

(iii) Savings by reducing the average age of inventory to 70 days

New Cash cycle = 120 days – 10 = 110 days
360
New Cash Turnover = = 3.2727 times
110
Rs.1,81,20,000
New Minimum operating cash =
3.2727
= Rs.55,36,713

Reduction in investments = (Rs.60,40,000 – 55,36,713)

= Rs. 5,03,287

Savings = 8% on Rs.5,03,287 = Rs. 40,263.

Illustration – 2
A firm uses a continuous billing system that results in an average daily receipt
of Rs.40,000.000 it is contemplating the institution of concentration banking,
instead of the current system of centralized billing and collection. It is estimated
that such a system would reduce the collection period of accounts receivable by 2
days. Concentration banking would cost Rs.75,000/- annually and 8% can be
earned by the firm on its investments. It is also found that a lock-box system could
reduce its overall collection time by four days and could cost annually Rs,1,20,000/-.
i) How much cash would be released with the concentration banking
system?
ii) How much money can be saved due to reduction in the collection period
by 2 days? Should the firm institute the concentration banking system?
iii) How much cash would be freed by lock-box system?
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iv) How much can be saved with lock-box?

v) Between concentration banking and lock-box system which is better?
Solution
i) Cash released by the concentration banking system
ii) =Rs.40,00,00× 2 days = Rs.80,00,000
iii) Savings=8% ×Rs.80,00,000=Rs.6,40,000. The firm should institute the
concentration banking system. It costs only Rs.75,000 while the savings
expected are Rs.6,40,000. Net savings = 6,40,000-75,000=5,65,000.
iv) Cash released by the lock-box system
v) =Rs.40,00,000 × 4 days = Rs.1,60,00,000
vi) Savings in lock-box system: 8% on Rs.1,60,00,000 = Rs. 12,80,000.
vii) Lock-box system is better. Its net savings Rs.11,60,000/- (Rs.12,80,000 –
Rs.1,20,000) are higher than that of concentration banking.
viii) Net savings = 12,80,000 – 1,20,000 = Rs.11,60,000
ix) Difference net savings = 11,60,000 = 5,65,000=5,95,000
5.4 REVISION POINTS
1. Cash management : Refers to optimizing the benefits and
costs associated with holding cash.
2. Transaction motive : Cash balance required to meet the
expenses towards day to day operations
of a business

3. Precautionary motive : Cash balances required to take care of

the contingencies that arise due to
unplanned activity.

4. Speculative motive : Cash balances kept by a business unit

to take advantage of increasing prices of
raw materials, services, etc.

5. Short cost : The cost incurred as a result of shortage

of cash.

6. Concentration banking : Is a system of decentralizing collections

of accounts receivable in case of large
firms having their business spread over
a large area.

7. Float : The period taken from one stage to

another in the cash collection process.

8. Safety level for cash : Minimum cash balance that the firm
must keep to avoid risk or cost of
running out of funds.
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5.5 INTEXT QUESTIONS

1. What are the objectives of cash management?
2. What are the factors affecting the cash needs of a firm?
3. Explain the nature of cash and state the scope and objectives of cash
management.
4. Discuss the methods accelerating cash inflows and decelerating cash
inflows of a company.
5. Describe how a lock-box arrangement may be used to accelerate cash flow.
What costs are involved with the use of a lock-box?
6. Discuss the management problems involved in planning and control of
cash explain the main tools of cash planning and control.
7. What is a firm’s ‘cash cycle’? How are the each cycle and cash turnover of a
firm related?
8. What should a firm’s objectives with respect to its cash cycle and cash
turnover be?
5.6 SUMMARY
Availability of cash is crucial for the operation of business. However, cash is
the least productive asset of the firm and thus managers take every effort to
minimize cash holding. Despite the least productive nature of the assets, firms hold
large cash. There are several motives behind holding cash. Cash is required to
settle dues of the firm. Since cash inflows are uncertain and outflows are certain,
firms keep additional cash. Cash kept for these two purposes are called transaction
motive and precautionary motive respect. Cash is also kept to overcome the
mismatch of inflows and outflows. There are several methods of forecasting cash
flows and often different methods are employed to forecast individual cash flow
items. Cash forecasting is converted into cash budgets and cash budget is broken
into quarterly, monthly and weekly cash budgets. Budgets are prepared to
understand whether cash inflows and outflows match with each other and if not, to
know the period in which the mismatch arises. Managers plan to deal with such
mismatches by initiating faction in advance.
5.7 TERMINAL EXERCISE
1. ………………….forms the method of collecting revenues and paying various
costs and expenses of the business.
2. …………………… is the most significant device for planning and controlling
the use of cash.
3. …………………. is a system of decentralizing collections of accounts
receivable in case of large firms having their business spread over a large
area.
4. ………………….. system is a further step in speeding up collection of cash.
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5.8 SUPPLEMENTARY MATERIAL

1. www.ateneonline.it/ross/
2. www.willamette.edu
3. www.hkiaat.org
5.9 ASSIGNMENTS
1. “Efficient cash management will aim al maximizing the availability of cash
inflows by decentralizing collections and decelerating cash outflows by
centralizing the disbursements” ? Discuss.
2. Since cash does not earn can we still call it a working asset? Why? What
are the principal motives for holding cash? How do they relate to cash as
working assets? Discuss the inventory approach to cash management.
3. Enumerate the factors that influence the size of cash holdings of company.
Discuss the inventory approach to cash management.
5.10 SUGGESTED READINGS
1. Vyuptakesh Sharan Fundamentals of Financial Management, Dorling
publishers
2. Lawrence J Gitman Principles of Managerial Finance Pearson
3. Sheeba Kapil Financial Management Pearson Publishers
5.11 LEARNING ACTIVITIES
1. A firm purchases raw-materials on credit of 30 days. All the sales of the
firm are made on credit basis and the credit term allowed to its customers
is 60 days. However in actual practice the average age of the, firm’s
Accounts Payables is 35 days and that of Accounts Receivables is 70 days.
The average age of the firm’s inventory (that is the time-lag between the
purchase of raw-materials and the sale of finished goods) is 40 days.
From the above data calculate (i) The firm’s cash-cycle and (ii) The firm’s
cash turnover.
2. A group of new customers with 10% risk of non-payment desires to
establish business connections with you this group would require one and
a half month of credit and is likely t increase your sales by Rs.60,000 p.a.
Production, administrative and selling expenses amount to 80% of sales.
You are required to pay income-tax @ 50%. Should you accept the offer if
the required rate of return is 40% (after-tax)?
[Ans: Return 50% this is higher than desired rate of return of 40% and
hence the offer should be accepted.]
3. A Company’s present credit sales amount of Rs.50 lakhs. Its variable cost
ratio is 60% of sales and fixed costs amount to Rs.10 lakhs per annum.
The company proposes to relax its present credit policy of 1 month to either
2 months or 3 months, as the case may be. The following In formations are
also available:
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Present
Policy1 Policy 2
Policy
Average age of debtors increase in sales
percentage of bad debts
1 months 2months 3months
– 20% 30%
1.0 2.5 5.0

If the company requires a return on investment of 20% before tax, evaluate the
proposals.
[Ans: Policy 1 is more profitable as it gives surplus of Rs.2,13,333/- after
meeting the required return on investment at 20% before tax.]
4. Prepare cash budget for the period of July-December 2001 from the
following information
i) The estimated sales and expenses are as follows:
(Figures in Rs. lacs)

Particulars June July Aug. Sept. Oct. Nov. Doc.

Sales 35 40 40 50 60 60 65
Purchases 14 16 17 20 20 25 28
Wages and salaries 12 14 14 18 18 20 22
Expenses 5 6 6 6 7 7 6
Interest received 2 -- -- 2 -- -- 2
Sale of Fixed assets -- -- 20 -- -- -- --
ii) 20% of the sales are made on cash and balance on credit. 50% of the
debtors are collected in the month of sales and the remaining in the next month.
iii) The time lag in payment of purchases and expenses is 1 month, however,
wages and salaries are paid fortnightly with a time lag of 15 days.
iv) I he company keeps a minimum cash balance of Rs.5 lacs. The cash
balance in excess of Rs.7 lac is invested in Government Securities in multiple of
Rs.1 lac Short-falls in cash balance are made good by borrowing from banks. The
interest received as well as paid is to be ignored.
5.12 KEYWORDS
Transaction Motive, Speculation Motive, Precaution Motive, Compensation
Motive.


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LESSON – 6

RECEIVABLES MANAGEMENT
6.1 INTRODUCTION
“Buy now, pay latter” philosophy is increasingly gaining importance in the way
of Irving of the Indian Families. In other words, consumer credit has become a
major selling factor. When consumer expect credit, business units in turn expect
credit form their suppliers to match their investment in credit extended to
consumers. If you ask a practising manager why her/his firm offers credit for the
purchases, the manager is likely to be perplexed. The use of credit for the
purchases, the manager is likely to be perplexed. The use of credit in the purchase
of goods and services is so common that it is taken for granted. The granting of
credit from one business firm to another, for purchase of goods and services
popularly known as trade credit, has been part of the business scene for several
years. Trade credit provided the major means of obtaining debt financing by
businesses before the existence of banks. Though commercial banks provide a
significant part of requirements for working capital, trade credit continues to be a
major sources of funds for firms and accounts receivables that result from granting
trade credit are major investment for the firm.
6.2 OBJECTIVES
After completing this Lesson you must be able to
 Highlight the importance of offering credit in the operation of business
 List out the decisions covering credit policy, credit in the operation of
business
 Discuss the different credit evaluation process and credit granting
decisions
 Explain the needs for effective collection efforts and incentives such as
cash discount
 Street the importance if monitoring and control of receivables.
6.3 CONTENT
6.3.1 Credit Policy
6.3.2 Credit Eligibility
6.3.3 Credit Evaluation
6.3.4 Control of Receivables
6.3.5 Cost of Receivable
6.3.6 Evaluation of Credit Policies
Objective of Credit Management
The main objective of credit management can be enumerated as follows:
a) Increase the volume of credit sales to the optimum level in relation to the
credit period.
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b) To what extent the debtors volume to be in relation to the overall financial

soundness of the firm.
c) To have business volume to optimal level so that the point of overtrading
and under-trading will not occur.
d) Balancing of liquidity versus profitability in the context of trade off between
credit volume of sales and the time span for realization from credit
customers.
e) Control over cost of investment in sundry debtors and the cost of
collection.
f) At what level the price fixation to be done taking into account the cash
discount, trade discount etc.
g) To decide the price factor and the credit factor in relation to the
competitors business.
h) To take into account the external factors such as mercantile business
conventions, effect of inflation, seasonal factors government regulations
and general economic condition.
i) The proper lines of communication and co-ordination between finance,
production, sales, marketing and credit control department.
Crucial Decision Areas in Credit Management
Trade credit management involves a study on (i) costs associated with the
extension of credit and accounts receivables, (ii) credit policies involving credit
standard, credit terms, collection policies, credit insurance, (iii) determination of
size of receivables, and (iv) forecasting of receivables.
Costs Associated with the extension of Credit
The major categories of costs associated with the extension of credit and
accounts receivables are (i) capital cost, (ii) administration cost, (iii) collection cost
(iv) delinquency (over due) cost and (v) default risk.
i) Capital Cost: The increased level of accounts receivable is an investment in
current assets and it involves the tying up of capital. There is a time-lag between
the sale of goods to and payments by, the customers. Meanwhile, the firm has to
pay employees and suppliers of raw materials there-by implying that the firm
should arrange for additional funds to meet its own obligations. While aviating for
payment from its customers. The cost on the use of additional capital to support
credit sales which alternatively could be profitably employed else where, is
therefore, a part of the cost of extending credit or receivables.
ii) Administrative Cost: The maintenance of receivables calls for the use of an
administrative machinery in different ways. A firm may have to create and maintain
a credit department with staff, accounting records, and even to conduct
investigations to find out the credit worthiness or otherwise of its customers.
Administrative expenses are therefore incurred on the maintenance of receivables.
 110

iii) Collection Cost: An effective maintenance of receivables depend ultimately

upon the effective collection of receivables. The cost of collection includes the
expense regarding engaging collection agencies or bill collectors, sending collection
letters, cost of discounting bills of exchanges, collection of bills of exchange and
other bank charges. A number of collection letters and reminders usually follow,
which eventually increases the cost of collection.
iv) Delinquency Cost: The cost which arises out of the failure of the customers
to meet their obligations when payment on credit sales become due after the expiry
of the period at credit is called delinquency cost. The important components of this
cost are (i) blocking up of funds for an extended period, (ii) cost associated with
steps that have to be initiated to collect the over dues e.g. legal charges.
v) Default Risk i.e., bankruptcy: This refers to the cost of writing off bad debts
in the event of debtors being adjudged as insolvent.
Credit Control Department
Where the firm is a sizable one, it is desirable that a person, called Credit
Manager, be placed in charge of Credit Control Department. The Credit Controller
or Manager should try to keep the bad debts down to the minimum and he may
advocate the restriction of the sales to customers who would pay quickly. However,
the Sales Department may be inclined to increase the sales by all possible means,
and may not be careful in selecting credit customers by keeping in mind the
question of recoverability of dues. These two interests conflict each other, though
on the whole, both are beneficial to the organization. It may be theoretically proper
to segregate the functions of Credit Control Department and the Sales Department
or even the Accounts Department. Usually most firms keep the task of credit
control in the same department as is in charge of the Sales Ledger. This method
provides an advantage of showing the limit of the credit and the actual amount
outstanding in one single record. viz., the Sales Ledger Card
Functions of a Credit Manager: The following are the functional details of a
credit manager:
i) Maintaining credit card
ii) involvement in credit decision
iii) Reporting credit position
iv) Institution of credit procedures
v) Involvement in customer’s complaints
vi) Review of credit control system and procedures
vii) Attending or initiating legal formalities or actions
viii) Decision on bad debts/doubtful debts
ix) Training the credit department personnel
x) Liaison with other departments.
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Administration of Credit Control: The following are the important aspects

involved in administration of credit control.
i) The sales invoice should indicate the due date of payment
ii) The customers ledger should be recorded with the following among
others, namely, the credit period allowed and the credit in terms of value
iii) Customer must signify his acceptance of credit terms in writing
iv) Close follow-up of realization
v) Month-end statement of account to be sent for customer’s confirmation
vi) Personal call by salesman and / or personnel from credit control
department for collection of dues.
vii) Credit assessment and review to be made to reassess the credit
worthiness of the customers. A fresh decision on credit terms will depend
on such an exercise.
There may be the necessity that persons to be entrusted for credit control
should have adequate knowledge of administering credit control
6.3.1 Credit Policy
A firm makes significant investment by extending credit to its customers and
thus requires a suitable and effective credit policy to control the level of total
investment in the receivables. The basic decision to be made regarding receivables
is to decide how much credit be extended to a customer and on what terms. This is
what is known as the credit policy. This requires the determination of (i) the credit
standard i.e., the conditions that the customer must meet before being granted
credit, and (ii) the credit terms i.e., the terms and conditions on which the credit is
extended to the customers. These are discussed as follows:
When a firm sells on credit, it takes a risk about the paying capacity of the
customers. Therefore, to be on a safer side, it must set credit standard which
should be applied in selecting customers for credit sales. The following points are
worth noting while setting the credit standard for a firm:
 Effect of a particular standard on the sales volume.
 Effect of a particular standard on the total bad debts of the firm, and
 Effects of a particular standard on the total collection cost.
Further, the above considerations are also relevant if there is proposal to
change the credit standard from the present level. The credit policy should also set
out clearly the terms of credit being offered to different types of customers.
Credit Terms
The credit terms refer to the set of stipulations under which the credit is
extended to the customers. While the custom of the market frequently dictate the
nature of the credit terms and conditions offered by a firm, the firm, nevertheless,
can design its own credit terms as a anemic instrument in its overall sales efforts.
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The credit terms specify how the credit will be the offered, including the length of
the period for which the credit will be the offered, the interest rate on the credit,
and the cost of default. The credit terms may relate to the following:
Credit Period: The credit period is an important aspect of the credit policy. It
refers to the length of time over which the customers are allowed to delay the
payment. The credit period generally varies from three days to 60 days.
Discount Terms : The customers are generally offered cash discount to induce
them to make prompt payments. Different discount rates may be offered for
different periods e.g., 3% discount if payment made within 10 days; 2% discount if
payment made within 20 days etc. Both the discount rate and the period within
which it is available are reflected in the credit terms e.g., 3/10, 2/20, net 30 means
that 3% cash discount if payment made within 10 days; 2% discount if payment
made within 20 days; otherwise full payment by the end of 30 days from the date of
sale. When a firm offers a cash discount, its intention is to accelerate the flow of
cash into the firm to improve its cash position. The length of cash discount affects
the collection period.
6.3.2 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, Capita!. 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 creditworthiness of the firm. Financial
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information is normally derived from the financial statements of the firm and
analyzed through ratio analysis.
Character: A prospective customer may have high liquidity but delay payment
to their suppliers. The character thus relates to willingness to pay the debts. 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.
Capacity : The capacity has to 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 judgment on the part
of analysis, 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 favourable. 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 analysed in general to decide
whether he customer is eligible for credit or fit into a statistical model to get an
unbiased credit rating of the customer.
If a customer falls within the desired limit of credit worthiness, the next issue
is fixing tie credit amount. This is some thing 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 worthiness of he customer and changes in the
performance of customer's industry.
6.3.3 Credit Evaluation
Assessment of the credit worthiness of a customer is subjective matter and a
lot depends upon the experience and judgement of the person taking the decision.
Evaluation of credit worthiness of a customer is a two steps procedure (i) collection
of information, and (ii) analysis of information.
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Collection of Information
In order to make better decisions, the firm may collect information from
various sources on the prospective credit customers. The following are sources of
information which can provide sufficient data or information about the credit
worthiness of a customer:
a) Bank Reference: Though the banks may be reluctant to give financial
information of its customers,-yet may be asked to comment on the financial
position of a particular customer. The customer may also be required to ask his
bank to provide necessary information in this respect.
b) Credit Agency Report: There are certain rating agencies which provide
independent information on the credit worthiness of different parties. These
agencies gather information on the credit history of different businessmen and sell
it to the firms which want to extend credit. From these agencies, a special report in
respect of a particular customer may also be obtained. In India, however, the credit
agency system is not popular and there is a need to develop such a network which
can provide reliable information.
Analysis of Information
Collection of information in respect of any customer is not going to serve any
purpose in itself. Once all the available credit information about a potential
customer has been gathered, it must be analyzed to reach at some conclusion
regarding the credit worthiness of a customer.
These characteristics can throw light on the credit worthiness or default-risk
of the customer. Step by step analysis of information may be made and assessment
should be made at various point to ascertain whether further analysis is required or
not. This has been presented Figure 1
The Figure -1 shows that a firm should go for further information and analysis
only if required. If it is evident at any stage that the customer has a satisfactory
credit worthiness, then there is no need to go for costly exercise of further analysis.
Where a customer's credit standing is either favorable or far below the pre-
established credit standards, the selection or rejection of a customer is an easy job.
The difficulty arises in case of those customer who are marginally credit worthy. In
such a situation, the financial manager must attempt to balance the potential
profitability against the potential loss from the default. Simply to look at the
immediate future in making a credit decision would be mistake. If extending a
customer credit means that the customer may become regular in the future, it may
be appropriate to take a risk that otherwise may not be prudent. The attempt of the
financial manager should be to ensure that all cash flows.
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Figure 1
Sequential Credit Analysis

6.3.4 Control of Receivables

Once the credit has been extended to a customer as per the credit policy, the
next important step in the management of receivables is the control of these
receivables. Merely setting of standards and framing a credit policy is not sufficient;
equally important is their effective implementation to control the receivables. In this
reference, the efforts may be required in two directions as follows:
Collection Procedure
Once a firm decides to extend credit and defines the terms of credit sales, it
must develop a policy for dealing with delinquent or slow paying customers. There
is a cost of both: Delinquent customers create bad debts and other cost?;
associated with repossession of goods, whereas the slow paying customers cause
more cash being tied up in receivables and the increased interest cost. The firm
should have a built in system under which the customer may be reminded a few
days in advance about the amount becoming due. After the expiry of due date of the
payment, the firm should make statements, reminders, telephone calls and even
personal visits to the paying customer. Ultimately legal action for recovery of due
amount may also be resorted to, though it can be very costly and time consuming.
 116

No doubt, that legal actions may have little effect on the ability of the customer to
pay, but it can definitely speed up the legal relief.
The overall collection procedure of the firm should neither be too lenient
(resulting in mounting receivables) nor too strict (resulting sometimes even loss of
customers). A strict collection policy can affect the goodwill and damage the growth
prospects of the sales. If a firm has a lenient credit policy, the customer with a
natural tendency towards slow payments, may become even slower to settle his
accounts Thus, the objective of collection procedure and policies should be to speed
up the slow paying customer and reduce the incidence of bad debts.
Monitoring of Receivables
In order to control the level of receivables, the firm should apply regular
checks and there should be a continuous monitoring system. The financial
managers should keep a watch on the credit worthiness of ail the individual
customers as well as on the total credit policy of the firm. For this, number of
measures are available as follows:
i) A common method to monitor the receivables is the collection period or
number of day's outstanding receivables. The average collection period may be
found by dividing the average receivables by the amount of credit sales per day i.e.,
Average CollectionPeriod  Average receivable
Credit Sales per day
Number of days sales outstanding may be calculated, say, on a weekly basis.
For example, every Saturday the firm may divide the total outstanding receivables
with the receivables daily credit sales. The quotient gives an idea as to how many
day's credit sales are uncollected. Such quotient, if ascertained for a number of
weeks, may give an idea about the trend of total receivables.
ii) Another technique available for monitoring the receivables is known as
aging schedule. The quality of the receivables of a firm can be measured by looking
at the age of receivables. The older the receivable, the lower is the quality and
greater the like hood of a default.
Both the ratios should be calculated on a continuous basis to monitor the
receivables. The ratios so calculated for the firms must then be compared with the
standard for that industry or with the past ratios of the same firm. For example, if
the receivable 3 turnover for the firm is 6 against the industry average of 8, then
there is something to /worry about. Similarly, if the average collection period is 40
days against the established credit period of 30 days only, then this is clearly an
indication of deterioration in the collection procedure and the credit evaluation
process. Both the accounting ratios may indicate e need for an immediate attention
towards the entire credit policy.
Lines of Credit
Another control measure for receivables management is the line of credit refers
to the maximum amount a particular customer may have as due to the firm s: any
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time. Different lines of credit may be allowed to different customers. As long as the
customer's unpaid balance remain within this maximum limit, the account may be
routinely handled. However, if a new order is going to increase the indebtedness of
a customer beyond his line of credit, then the case must be taken for an approval
for a temporary increase in the line of credit. The lines of credit must be reviewed
periodically for all the customers.
6.3.5 Costs of Receivables
The various costs attached with a credit policy is enumerated as follows:
Cost of Financing
The credit sales delays the time of sales realization and therefore the time gap
between incurring the cost and the sales realization is extended. This results in
blocking of funds for a longer period. The firm on the other hand, has to arrange
funds to meet its own obligation towards payment to the supplier, employees etc.
These funds are to be procured at some explicit or implicit cost. This is known as
the cost of financing the receivables.
Administrative Cost
A firm will also be required to incur various costs in order to maintain the
record of credit customers both before the credit sales as weli as after the credit
sales. Before credit sales, costs are incurred on obtaining information regarding
credit worthiness of the customers; while after credit sales, the cost are incurred on
maintaining the record of credit sales and collection thereof.
Delinquency Cost
Over and above the normal administrative cost of maintaining and collection of
receivables, the firm may have to incur additional costs known as delinquency
costs. :.f there is delay in payment by a customer. The firm may have to incur cost
on reminders, phone calls, postage, legal notices etc. Moreover, there is always an
opportunity cost of the funds tied up in the receivables due to delay in payment.
Cost of Default by Customers
If there is a default by a customer and the receivable becomes, partly or
wholly, unrealizable, then this amount, known as bad debt, also becomes a cost to
the firms. This cost does not appear in case of cash sales.
Different cost associated with the receivables have been presented in Figure 2
The above figure 2 shows that the total cost of receivables consists of cost of
financing, which is a factor of time, plus cost of administration plus cost of
delinquency plus cost of default. However, the receivables does not result in
increasing the cost only, rather they bring some benefits also to the firm.
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Figure 2
Different types of Costs of Receivables

6.3.6 Evaluation of Credit Policies

A firm may face a situation when it has several alternative credit policies
before it and has to select one such policy which is the most profitable to the firm.
For example, the firm may extend the credit of 15 days, 30 days, 40 days, 60 days
etc. to its customers. Every credit policy will result in a particulars sales level.
Normally, longer the credit period, higher will be the sales, and therefore, larger
would be the profit of the firm. Does it mean that the firm should go on increasing
the credit period? Definitely, No.
There is no doubt that increase in sales will increase the contribution (Sales -
Variable Cost). But simultaneously, the firm will face the risk of increase in other
costs also. There costs may be:
i) Increase in investment in debtors: Increase in credit period will naturally
result in higher and higher amount of outstanding debtors, which results in more
funds of the firm blocked in debtors. There is always a cost of funds to the funds.
So, the higher average debtors result in higher cost to the firm.
ii) Increase in bad debts: Longer credit period facility will attract more and
more customers of bad debts. As the sales increases (as a result longer credit
period), the chances of bad debts also increase.
iii) Other costs : Increase in debtors may also require the firm to incur some
other expenses. So, on the one hand, the firm has benefits (in the form of higher
profits) from the increase in credit period, while on the other hand, the firm has to
bear some additional costs. At the time of evaluation of different proposals of credit
policies, what is required is to compare (trade off) the costs and benefits associated
with each credit policy. The firm should select that proposal which is expected to
give highest net profit (benefits - Costs.) This comparison of costs and benefits may
be attempted as follows.
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Example - 1
A trader whose current sales are Rs.15 Lakhs per annum and average
collection period is 30 days wants to pursue a more liberal credit policy to improve
sales. A study made by a consultant firm reveals the following information:

Increase is
Credit Policy Increase in Sales
Collection Period
B 30 days 90,000

C 45 days 1,50,000
D 60 days 1,80,000

The selling price per unit is Rs.5. Average cost per unit is Rs.4 and variable
cost per unit is Rs.2.75 paise per unit. The required rate of return on additional
investments is 20 per cent. Assume 360 days a year and also assume that there are
not bad debts. Which of the above policies would you recommend for adoption?
Solution
Evaluation of Different Credit Policies
Credit Policies
Present
Particulars A B C D E
Policy
Credit 30 days 45 day 60 day 75 days 90 days 120 day
Period

No of units 3,00,000 3,12,000 3,18,000 3,30,000 3,36,000 3,40,000

@ Rs.5
Sales (Rs) 15.00,000 15,60.000 15,90,000 16.50,000 16,80,000 17,00,000
Variable 8,25,000 8,58,000 8,74,500 9,07,500 9,24,000 9,35.000
Cost @
Rs.2.75
Fixed Cost 3.75.000 3,75,000 3.75,000 3,75,000 3,75,000 3,75,000
Total cost 12,00,000 12,33.000 12,49.500 12.82.500 12,99.000 13,10.000
Profit (A) 3,00,000 3,27.000 3,40,500 3,67,500 3,81,000 3,90,000
Average 1.00,000 1,54,125 2,08,250 2.67,188 3,24.750 4.36.667
Debtors
(at Cost)
Cost of 20,000 30,825 41,650 53,437 64,950 87.333
investment
@2%(B)
Net Profit 2,80,000 2,26,175 2,98,850 3,14,063 3,16,050 3,02,667
(A-B)
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The credit policy D (credit period 90 days) is expected to increase the profit to
Rs.3,16.050 and therefore may be adopted.
6.4 REVISION POINTS
Credit Policy : Refers to the decisions regarding how much
credit be extended to a customer and on
what terms.
Credit Term : Refers to the set of stipulations under which
the credit is extended to the customer

Lime of : Refers to the maximum amount a particular

customer may have as due to the firm at any
time.

Delinquency cost : Is the additional costs incurred over and

above the normal administrative cost of
maintaining and collection of receivable.

6.5 INTEXT QUESTIONS

1. Explain the objectives of credit policy of firm
2. What is credit policy? What are the elements of credit policy?
3. What are the costs associated with receivables
4. What are the costs and benefits associated with a change in credit policy?
5. What are credit terms explain the role of credit terms in a credit policy?
6. State the role which receivables play in the overall financial picture of the
firm?
6.6 SUMMARY
The use of credit in purchase of goods and services is so common that it is
taken for granted. Selling goods or providing services on credit basis lead to
accounts 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.
6.7 TERMINAL EXERCISE
1. ………………………..refer to the set of stipulations under which the credit is
extended to the customers.
2. …………………is an important aspect of credit policy.
3. The length of the cash discount affects the…………………..
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6.8 SUPPLEMENTARY MATERIAL

1. http://shodhganga.inflibnet.ac.in/
2. http://s3.amazonaws.com/
3. http://www.icaiknowledgegateway.org/
6.9 ASSIGNMENTS
Once the credit worthiness of a customer has been assessed, how would you
go about analyzing the credit granting decision.
6.10 SUGGESTED READINGS
1. Eugene F. Brigham, Joel F. Houston Fundamentals of Financial Management
Cengage Learning
2. Srivastava Financial Management and Policy, Himalaya Publishers
3. Anil Mishra, Ragul Srivastava, Financial Management Oxford Publishers.
6.11 LEARNING ACTIVITIES
While doing your business for credit how will you choose your customer. Draft
a model and polices for choosing the customer and hight where the company has to
concentrate in decision making.
6.12 KEYWORDS
Capital Cost, Administration Cost, Collection Cost, Delinquency cost, Credit
policy, Credit terms, Credit eligibility, Credit evaluation, Collection Procedures.


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LESSON – 7

INVENTORY MANAGEMENT
7.1 INTRODUCTION
The success of a business concern largely depends upon efficient purchasing,
storage, consumption and accounting. The uncontrolled in ventures are dangerous
and at times it is called as graveyard of business. Hence, inventory control system
should be designed to ensure the provision of the required quantity of material at
the required time to meet the needs of production and sales, while at the same time
keeping the investment in them at a minimum. Inventories constitute the most
significant part of current assets of a large majority of companies in India. On an
average, inventories are approximately 60 per cent of current assets in public
limited companies in India. Because of the large size of inventories maintained by
firms, a considerable amount of funds are required to be committed in them. It is.
therefore, absolutely imperative to manage inventories efficiently and effectively in
order to avoid unnecessary investments in them. An undertaking neglecting the
management of inventories will be jeopardizing its long-run profitability and may
fail ultimately. It is possible for a company to reduce its levels of inventories to a
considerable degree, e.g., 10 to 20 per cent, without any adverse effect on
production and sales, by using simple inventory planning and control techniques.
7.2 OBJECTIVES
After completing this lesson you must be able to
 Understand the concept and importance of Inventories
 Discuss the objects of Inventory Management
 Explain the cost associated with holding Inventory
 List the tools of Inventory Management
7.3 CONTENT
7.3.1 Need for Holding Inventory
7.3.2 Management of Inventory
7.3.3 Objective of Inventory
7.3.4 Cost Associated with Holding Inventory
7.3.5 Inventory Control Techniques
7.3.6 Inventory Valuation
Inventories
Inventories are goods held for eventual sale by a firm. Inventories are thus one
of the major elements which help the firm in obtaining the desired level of sales.
Inventories can be classified into three categories.
i) Raw Materials
These are goods which have not yet been committed to production in a
manufacturing firm. They may consist of basic raw materials or finished components.
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ii) Work-in-Process
This include those materials which have been committed to production
process but have not yet been completed.
iii) Finished Goods
These are completed products awaiting sale. They are the final output of the
production process in a manufacturing firm. In case of wholesalers and retailers,
they are generally referred to as merchandise inventory.
7.3.1 Need for Holding Inventory
The question of managing inventories arises only when the company holds
inventories. Maintaining inventories involves typing up of the company's funds due
to storage and handling costs. If it is expensive to maintain inventories, why do
companies hold inventories? There are three general motives for holding
inventories.
1. The transactions motive which emphasizes the need to maintain inventories
to facilitate smooth production and sales operations.
2. The precautionary motive which necessitates holding of inventories to guard
against the risk of unpredictable changes in demand and supply forces and other
factors.
3. The speculative motive which influences the decision to increase or reduce
inventory levels to take advantage of price fluctuations.
A company should maintain adequate stock of materials for a continuous
supply to the factory for an uninterrupted production. It is not possible for a
company to procure raw materials whenever it is needed. A time lag exists between
demand for materials “and it supply. Also, there exists uncertainty in procuring raw
materials in time at many occasions The procurement of materials may be delayed
because of such factors as strike, transport disruption short supply Therefore, the
firm should maintain sufficient stock of raw materials at a give time to streamline
production Other factors which may necessitate purchasing and hold -g of raw
materials inventories are quantity discounts and anticipated price increase The firm
may purchase large quantities of raw materials than need for desired production
and sales levels to obtain quantity discounts of bulk purchasing At times, the firm
would like to accumulate raw materials in anticipations of price rise.
7.3.2 Management of Inventory
Inventories often constitute a major element of the total Working capital and
hence it has been correctly observed, “good inventory management is good financial
management”.
Inventory management covers a large number of issues including fixation of
minimum and maximum levels; determining the size of the inventory to be carried;
deciding about the "issue Price policy, setting up receipt and inspection procedure.
determine the economy order quantity; providing proper storage facilities, keeping
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check on obsolescence and setting up effective information system with regard to

the inventories. However, management of inventories involves two basic problems;
i) Maintaining a sufficiently large size of inventory for efficient and smooth
production and sales operations;
ii) Maintaining a minimum investment in inventories to minimize the direct-
indirect costs associated with holding inventories to maximize the
profitability.
Inventories should neither be excessive nor inadequate. If inventories are kept
at a high level, higher interest on storage costs would be incurred. On the other
hand, a low level of inventories may result in frequent interruption in the
production schedule resulting in underutilization of capacity and lower sales. The
objective of inventory management is, therefore, to determine and maintain the
optimum level of investment in inventories which help in achieving the following
objectives:
i) Ensuring a continuous supply of materials to production department
facilitating uninterrupted production.
ii) Maintaining sufficient stock of raw material in periods of short supply.
iii) Maintaining sufficient stock of finished goods for smooth sales operations.
iv) Minimizing the carrying costs;
v) Keeping investment in inventories at the optimum level.
7.3.3 Objective of Inventory Management
The important objectives of inventory management are:
1. To provide continuous supply of raw materials to carryout uninterrupted
production.
2. To reduce the wastages and to avoid loss of pilferage, breakage and
deterioration.
3. To exploit the opportunities available and to reduce the cost of purchase.
4. To introduce scientific inventory management techniques.
5. To provide right materials at right time, from right sources and at right
prices.
6. To meet the demand for goods of ultimate consumers on time.
7. To avoid excess and inadequate storing of materials.
8. To protect quality of raw materials.
9. To reduce the order placing and receiving costs to the minimum.
10. To ensure effective utilization of the floor space.
7.3.4 Costs Associated with Holding Inventory
The continuous flow of inventory is most essential to carryout smooth
productive activities. The success and timely supply of finished goods mainly
depends on uninterrupted supply or raw materials to the productions department.
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To ensure to this flow of raw materials, the company has to maintain adequate
quantity of inventory. Storing of these components involves many types costs and
uncertainties. As the-value of the materials, increases than the value of a rupee, it
should be maintained judiciously. Some of the costs associated in managing the'
inventories are discussed below:
Financial Cost: It is also known as capital cost. The finance required to
purchase the inventory and the cost the company bears for mobilizing; it is known
as financial cost. Therefore adequate supply of finance at cheaper cost must be
made available to maintain the inventory.
Working Capital Management
Cost of Storage : Inventory are to be stored properly by protecting the quality.
The space required for storing the inventory must be adequately provided. This cost
consists of the rent payable for storing the materials and maintenance of inventory
cast, (Insurance).
Price Fluctuation: Inventories are exposed to vide fluctuation in the prices.
Many at time, the prices of materials may be reduced. If the price paid for procuring
the materials are higher than the price that is prevailing, it is a toss to the business
firm.
Risk of Obsolescence: Due to the increased research and innovative and
creative minds of technologists, new materials and products will enter into the
market. On such circumstances, the product manufactured today becomes
obsolete.
Deterioration in Quality : In a practical situation, most of the materials stored
may not be issued to production department for various reasons. In the process;
such materials looses its quality or deteriorate itself from original value.
Theft, Damage and Accident: The materials are stored in the warehouses. If it is
not properly taken care of, it is exposed to different types of uncertainty viz., theft,
damage and fire accident etc. All these are losses or increases the cost of
production.
Order Placing Cost: Order placing cost is a permanent cost which is incurred
by the business firm to place the order for materials, the salary of clerk, manger
and establishment charges will also be considered into managing the inventory.
Inventory Carrying Cost: It includes the expenses of maintenance of stores,
bins and the salary to the staff who are in-charge of warehouses or storage. Hence
these costs are to be reduced to increase the profitability of the firm.
Cost of Shortage of Stock: Many at times, business firms may be able to
arrange the adequate supply of materials regularly for various reasons. As a result,
production work may be.: stopped. Therefore, sufficient care should be taken not to
have this cost in running the business.
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7.3.5 Inventory Control Techniques

In most manufacturing concerns inventories are controlled through the
following techniques:
i) Economic Order Quantity,
ii) Determination of Stock Levels,
iii) Inventory Turnover Ratio,
iv) Input-Output Ratio Analysis,
v) A B C Analysis,
vi) Perpetual inventory or Continuous stock taking,
vii) Value Analysis
Economic Order Quantity (E.O.Q)
The Economic Order Quantity (E.O.Q.)is the optimum or the most favourable
quantity which should be ordered for purchase each time when the purchases are
to be made. The Economic Order Quantity is one where the cost of carrying is equal
to, or almost equal to the cost of not carrying. The E.O.Q. is also known as
Recorder Quantity or Standard Order Quantity and it depends upon two factors via,
cost of carrying and cost of ordering and receiving per order. The cost of carrying or
holding costs can be estimated by the management on the basis of sales of pasy
years but costs of not carrying enough are only estimated.

2 C.O.
The formula of E.O.Q. is =
I
where, I= interest payment including variable cost of storage per unit per year.
C= Consumption of materials concerned in units.
O= Cost of ordering and receiving per order
Assumptions
i) Inventory is consumed at a constant rate,
ii) Cost do not vary over the period of time,
iii) Lead time is known and constant,
iv) Ordering cost, carrying cost and unit price are constant,
v) Holding or carrying costs are proportional to the value of stocks held,
vi) Ordering or cost varies proportionately with price.
For example, a unit of material ‘x’ costs Rs.50 and the annual consumption is
2,00,000 units. The cost of placing an order and receiving the materials is Rs. 200
and the interest including variable cost of storage per unit per year is 10% per
annum.

2 C.O.
Economic Order Quantity =
I
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2  2,00,000 200
 1,60,00,000  4,000 units
5(i.e.10% of Rs.50)
=
Determination of Stock Levels
The demand and supply method of stock control technique determines
different stock levels viz; Maximum level, Minimum level, Recorder level, Average
level, Danger level etc.
Maximum Stock Level: Represents the quantity of inventory above which
should not be allowed to be kept. This quantity is fixed keeping in view the
disadvantages of over stocking. The disadvantages of over stocking are: (i) working
capital is blocked up unnecessarily in stores and interest may have to be paid
thereon; (ii) more storage space is required so more rent, insurance charges and
other costs of carrying inventory have to incurred; (iii) there is risk of deterioration
in quality, deprecation in quantity due to evaporation, rusting etc., and risks of
obsolescence besides the risk of loss due to breakage, theft, excessive consumption
also, and (iv) possibility of financial loss on account of subsequent fall in prices.
The following are the factors helpful in deciding the limits of inventory to be
stored; (a) amount of capital available and required for purchases, (b) storage
facilities and storage costs, (c) rate of consumption of the material, (d) possibilities
of price fluctuations, (e) seasonal nature of supply of materials, (f) possibility of loss
due to fire, evaporation, moisture, deterioration in quality, etc., (g) insurance costs,
(h) possibility of change in fashion and habit which will outdate the products
manufactured from that material, (i) restrictions imposed by government or local
authority or trade association in regard to materials in which there are inherent
risks e.g. fire and explosion or as to imports or procurement, (j) economic quantity,
and (k) Lead Time.
Lead Time: From the time the requisition for an item is raised; it may take
several weeks or month’s before the supplies are received, inspected, and taken in
stock. This time is called as “Lead Time” or “Procurement Time” and involves the
time for the completion of all or some of the following activities: (i) raising of a
purchase requisition, (ii) inquiries, tenders, quotations, (iii) receiving quotations,
tenders, their scrutiny and approval, (iv) placement of order on a supplier/
suppliers, (v) suppliers time to make the goods ready (may have to be manufactured
or supplied ex-stock). (vi) Transportation and clearing, (vii) receipt of materials at
the company, (viii) inspection and verification of the materials, (ix) taking into stock,
and (x) issuing items and carrying them to the place of work.
This lead time required to procure any item can be divided into two parts
namely internal lead time (also known as Administrative Lead Time) required for
organizational formalities to be completed and external lead time (also known as
Delivery Lead Time) as shown below:
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Total Lead Time

Internal Lead Time + External Lead Time + Internal Lead Time
(Requisition order) (Placement of order and Receipt (Taking unit stock)
of goods)

It is common belief that external lead time should be controlled and reduced
but it has been found in actual practice that internal lead time constitute a
considerable part of total lead time and offers ample scope for reduction. The
management must make a determined and deliberate effort to reduce lead time by
selectively delegating powers, better paper work procedures, and fixing targets
individually for all activities. Obviously, in order the materials much in advance i.e.,
when the stock available is sufficient to last during the lead time.
Minimum Stock Level: represents the quantity below which stock should not be
allowed to fall. This is known as safety or buffer stock. The main purpose of this
level is to ensure that production is not held up due to shortage of any material.
This level is fixed after considering: (i) average rate of consumption of materials,
and (ii) lead time.
Reorder Levelor order level) is the point at which if stock of the material in
store reaches the store-keeper should initiate the purchase requisition for fresh
supplies of the materials. This level is fixed between maximum and minimum-stock
levels in such a way that the difference of quantity of the materials between the
reorder level and the minimum level will be sufficient to meet the requirement of
production up to the time the fresh supply to the material is received.
Danger Level: Means a point at which issues of the material are stopped and
issues are made only under specific instructions. This level is generally fixed below
the minimum stock level. When stock of materials reaches the danger level the
purchase officer should take special arrangements to get the materials at any cost.
Just-in-Inventory Control: The just-in-time inventory control system, originally
developed by Taiichi Okno of Japan, simply implies that the firm should maintain a
minimal level of inventory and rely on suppliers to provide parts and components
“just-in-time” to meet its assembly requirements. This may be contrasted with the
traditional inventory management system which calls for maintaining a healthy
level of safety stock to provide a reasonable protection against uncertainties of
consumption and supply-the traditional system may be referred to as a “just-in-
case” system.
The just-in-time inventory system, while conceptually very appealing, is
difficult to implement because it involves a significant change in the total
production and management system. It requires inter alias (i) a strong and
dependable relationship with suppliers who are geographically not very remote
from the manufacturing facility, (ii) a reliable transportation system, and (iii) an
easy physical access in the form of enough doors and conveniently located docks
and storage areas to dovetail incoming supplies to the needs of assembly line.
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Formulae for Determination of Stock Levels

Maximum Level = Reorder level + Reorder Quantity – (Minimum
Consumption ×Minimum Reorder period)
Reorder Level = Maximum Consumption × Maximum Reorder period
Minimum Level = Reorder Level – (Normal Consumption × Normal reorder
period)
Average Stock 1
= Minimum Level + of Reorder Quantity (or)
Level 2
1
= (Minimum stock + Maximum stock)
2
Danger Level = Maximum delivery Time × Maximum Rate of Consumption
[or]
= Minimum rate of consumption × Emergency delivery time.
Illustration - 2
From the following information calculate the Maximum stock level, Minimum
stock level, Reordering level, and Average stock level and Danger level.
a) Normal consumption 300 units per day
b) Maximum consumption 420 units per day
c) Minimum consumption 240 units per day
d) Reorder quantity 3,600 units
e) Reorder period 10 to 15 days
f) Normal reorder period 12 days
g) Time required to emergency purchase 4 days
Solution
Reordering Level = Maximum consumption × Maximum reorder period
= 420 × 15 = 6,300 units
Minimum Stock Level = Reorder Level – (Normal Consumption × Normal
reorder period)
Maximum Stock Level = Recording Level + Reorder quantity – (Minimum
consumption × Minimum reorder period)
= 6,300 + 3,600 – (240 ×10)
= 9,900 – 2,400 = 7,500 units.
1
Average Stock Level = Minimum Stock Level +Maximum Stock Level
2
Minimum consumption per day × Time required for
Danger Level =
emergency purchase.
= 240× 4 = 960 units
 130

Control through ABC Analysis – Selective Control

Different types of analysis each having its own specific advantages and
purposes, help in bringing a practical solution to the control of inventory. The most
important of all such analysis is ABC analysis. The others are:
F.S.N. – (Fast, slow, Non-moving items) Analysis
GOLF – (Government controlled, Ordinarily available, Locally available and
Foreign Items) Analysis
H.M.L. – (High, Medium, Low Cost) Analysis
S.D.E. – (Scarce, Difficult, Easily Available) Analysis
S.O.S – (Vital, Essential, Desirable) Analysis
An effective inventory control system should classify inventories according to
values so that, the most valuable items may be paid greater and due attention
regarding their safety and care, as compared to others. Hence, it is desirable to
classify the production and supply items, both purchased and manufactured,
depending upon their importance and subject each class of group of items to
control commensurate with importance. This is the principle of control by
importance and exception (C.I.E) or selective control as applied to inventories and
the technique of grouping is termed as A.B.C. analysis or classification which it
said to be “Always Better Control”. As the items are classified in the importance of
their relative value, this approach is also known as proportional (parts) Value
Analysis (PVA) or Annual Usage Value (AUV) analysis.
The general procedure for implementing the ABC technique is as follows:
i) Classify the items of inventories.
ii) Determine the expected use in units over a given period of time
iii) Determine the total cost of each item by multiplying the expected units by
its unit price
iv) Rank the items in accordance with total cost, giving first rank to the item
with highest total cost and so on
v) Calculate percentage (ratio) of number of units of each item to total units
of all items and the percentage of total cost of each item to total cost of all
items.
vi) Combine items on the basis of their relative value to form three categories
–A, B and C e.g., classify the inventory as A, B or C based on the top 20%,
the next 30% and the last 50% valuation respectively.
vii) Tag the inventory with A, B, C classification and record these
classifications in the item inventory master record.
Illustration - 3
The following information is known about a group of item. Classify the material
in A, B, C classification.
 131

Model Number Annual Consumption in Pieces Unit Price in Rs.

501 30,000 10
502 2,80,000 15
503 3,000 10
504 1,10,000 5
505 4,000 5
506 2,20,000 10
507 15,000 5
508 80,000 5
509 60,000 15
510 8,000 10
Solution
Annual Annual
Model Unit Price Rank (According
Consumption in Consumption
Number in Rs to value)
Pieces in value Rs.
501 30,000 10 3,00,000 6
502 2,80,000 15 42,00,000 1
503 3,000 10 30,000 9
504 1,10,000 5 5,50,000 4
505 4,000 5 20,000 10
506 2,20,000 10 22,00,000 2
507 15,000 5 75,000 8
508 80,000 5 4,00,000 5
509 60,000 15 9,00,000 3
510 8,000 10 80,000 7
Total 8,10,000 87,55,000

Annual
Model No. % Items Consumption % Rank
in value Rs.
A Category 502 10% 42,00,000 48% 1
506 10% 22,00,000 25% 2
Total 20% 64,00,000 73%
 132

B Category 509 10% 9,00,000 10% 3

504 10% 5,50,000 6% 4
508 10% 4,00,000 5% 5
Total 30% 18,50,000 21%

C Category 501 10% 3,00,000 31/2 % 6

1%
510 10% 80,000 1% 7
507 10% 75,000 ¼% 8
503 10% 30,000 ¼% 9
¼%
505 10% 20,000 10
Total 50% 5,05,000 6%
Grand Total 100% 87,55,000 100%
CONTROL THROUGH INVENTORY SYSTEM
The institute of Costs and Management Accountants, England defines the
perpetual inventory system as “a system of records maintained by the controlling
department which reflects the physical movements of stocks and their current
balance”. Thus, this is a method of ascertaining balance after every receipt and
issue of materials through stock records, to facilitate regular checking and to avoid
closing down for stock-taking. In order to ensure accuracy of perpetual inventory
record, it is desirable to check the physical stocks by a programme of continuous
stock-taking. Any discrepancy noted between physical stocks and the stock records
can be investigated and rectified, then and there.
7.3.6 Inventory Valuation
Materials are issued to different jobs or work orders from the stores. These
jobs or work orders are charged with the value of materials issued to them.
Following are the important methods of valuing material issues:
a) Based on cost price
i) The First in First Out (FIFO) Method.
ii) The Last in First Out (LIFO) Method.
iii) The Highest in First Out (HIFO) Method.
iv) The Next in First Out (HIFO) Method.
v) The Base Stock Method.
vi) The Specific (or Actual) Fixed Price Method.
vii) The inflated Price Method.
viii) Fixed cost method.
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ix) Average cost method.

a) Simple average price method.
b) Periodic simple average price method.
c) Weighted average price method.
d) Periodic weighted average price method.
e) Moving simple average price method.
f) Moving weighted average price method.
b) Based on Market Price Method
i) Realisable value Method.
ii) Replacement value Method.
c) Based on standard price Method
i) Current standard price.
ii) Basic standard price.
Methods based on actual cost
i) First in First Out (FIFO) Method: This method operates under the assumption
that the materials which are receives first are issued first and therefore, the flow of
cost of materials should also be in the same order. Issues are priced at the same
basis until the first batch received is used up, after which the price of the next
batch received is used up, after which the price of the next batch received becomes
the issue price. Upon this batch being fully used, the price of the still next batch is
used for pricing and so on. In other words, the materials issued are priced at the
oldest cost price listed in the stores ledger account and consequently the materials
in hand are valued at the price of the latest purchases.
Example
Receipts Issues Rs.
2nd Jan. (first consignment) 7th Jan. 600 kg.
500 kg. @ Rs.8.00 per kg. 500kgs. @ Rs.800 per kg. 4,000
5th Jan (second consignment) 100kgs. @ Rs.8.20 per kg. 820
300kg. @ Rs.8.20 per kg
Total issue value: 4,820
Advantages
1. This method is realistic in so far as it assumes that materials are issued to
production in the order of their receipts.
2. The valuation of closing stock tends to be nearer current market prices as
well as at cost.
3. Being based on cost, no unrealized profits enter into the financial result.
4. The method is easy to operate if the prices do not fluctuate very frequently.
 134

Disadvantages
1. The issue prices may not reflect current market prices and, therefore, when
price increases the cost of production is unduly low.
2. The cost of consecutive similar jobs may differ simply because the prior job
exhausted the supply of lower priced stock. This renders comparison
between different jobs is difficult.
3. The method may involve cumbersome calculations if the prices fluctuate
quite frequently.
The FIFO method is most successfully used when (a) the size and the cost of
raw material units are large, (b) materials are easily identified as belonging to a
particular purchased lot, and (c) not more than two or three different receipts are
one materials card at one time.
ii) Last in First Out (LIFO) Method: This method operates on the assumption
that the latest receipts of materials are issued first for production and the earlier
receipts are issued last, i.e., in the reverse order to FIFO. It uses the price of the
last batch receives for all the issues until all units from this batch have been issued
after which the price of the previous batch received becomes the issue price.
Usually, a new delivery is receives before the first batch is fully used, in which case
tehnew delivery price becomes the ‘last – in ‘price and is used for pricing issues
until either the batch is exhausted or a new delivery is received.
Example: Assuming the same figures which were taken in FIFO method, the
issue of 600 kgs, the value is shown below:

300kgs. @Rs. 8.20 per kg. = Rs. 2,460

300kgs. @Rs. 8.00 per kg. = Rs. 2,400

600kgs. Total value = Rs. 4,850

Advantages
i) The method keeps the value of issues close to the current market prices.
ii) No unrealised profit or loss is usually made by using this method.
iii) In periods of raising prices, the high prices of the most recent purchases are
charged to operations, thus reducing profit figure abd resulting in a tax
saving.
Disadvantages
1. The value of the closing stock may be quite different from the current
market value and hence may not be acceptable for income tax purposes.
2. Comparison among similar jobs is varying difficult because different jobs
may bear different charges for materials consumed.
3. This method does not conform to the physical flow of materials.
 135

4. The number of calculation complicates the stores accounts and increases

the possibility of clerical errors when rates of receipt are highly
fluctuating.
Under condition of rising market prices, LIFO method is generally considered
better. This is so because under LIFO method reasonably correct effect of current
prices is reflected in the cost and the cost is not understated. The quotation of
prices for the products also becomes safer than FIFO.
(iii) Highest in First Out (HIFO) Method: The method is based on the assumption
that stock of materials should be always valued at the lowest possible price.
Materials purchased at the high-test price are treated as being first issued
irrespective of the date of purchase. The method is very suitable when the market is
constantly fluctuating because cost of highly prices materials is recovered from the
production at the earliest. But it involves too many calculations as in the case with
the LIFO and FIFO methods. The method has not been adopted widely.
iv) Next in First Out (NIFO) Method: The method attempts to value material
issues at an actual price which is as near as possible to the market price. Under
this method the issues are made at the next price i.e., the price of materials which
has been ordered but not yet received. In other words, issues are at the latest price
at which the company has been committed even though materials have not yet
been physically received. This method is better than market price method under
which every time when materials are issued, their market price will have to be
ascertained. In case of this method materials will be issued at the price will hold
good for all future issues till a next order is placed.
v) Base Stock Method: The method is based on the contention that each
enterprise maintains at all times a minimum quantity of materials in its stock. This
quantity is termed as base stock. The base stock is deemed to have created out of
the first lot purchased and therefore, it is always valued at this price and is carried
forward as a fixed asset. Any quantity over and above the base stock is valued in
accordance with any other appropriate method. As this method aims at matching
current costs to current sales the LIFO method will be most suitable for valuing
stock of materials other than the base stock. The base stock method has the
advantage of charging out materials at actual cost. Its other merits or demerits will
depend on the method which is used for valuing materials other than the base
stock.
vi) Specific Price Method: Where materials are purchased for a particular job,
they should be charged to that particular job at their actual cost. This method can
always be used where materials are purchased and set aside for a particular job
until required for production. This method is best suited for job order industries
which carry out individuals jobs or contracts against specific orders. From the point
of view of costing, the method is desirable because it ensured that the cost of
materials issued is actual and that neither profit nor loss arises out of pricing. This
 136

method however, is difficult to use if purchases and issues are numerous and the
materials issued cannot be identified.
vii) Inflated Price Method: In case of certain materials wastage is unavoidable
on account of their inherent nature, e.g., if a log of timber is issued to various
departments in pieces or if it is kept for seasoning, there will be some loss in its
quantity. In such a case the production should be charged at an inflated price so as
to recover the total cost of materials over the different issues.
viii) Average Cost Method: (a) Simple Average Price: Simple average price is the
average of the prices without any regard to quantities. The calculation of simple
average price involves adding of different prices dividing by the number of different
pieces. The method operates under the principle that when materials are purchased
in lots and are put in store, their identity is lost and, therefore, issues should be
valued at the average price of all the lots in store. Though this method is very easy
to operate, but it is crude and usually produces unsatisfactory results. The value of
closing stock may be quite absurd. Moreover, materials are not changed at actual
cost and, therefore, a profit or loss will usually arise out of pricing.
b)Weighted Average Price: Weighted average price is calculated by dividing the
total cost of material in stock by the total quantity of material in stock. This method
averages prices after weighing (i.e., multiplying) by their quantities. The average
price at any time is simply the balance value divided by the balance units. Issue
prices need to be computed on the receipt of new deliveries and not at the time of
each issue as in the case of FIFO and LIFO. Thus as soon as a fresh lot is received,
an new issue price is calculated and all issues are then taken at this price until the
receipt of the next lot materials, when put in stores, is lost and therefore their cost
should reflect the average of the total supply.
Advantages
1. Since the receipts are much less frequent than issues, the method is not so
cumbersome because the calculation of the new issue price only when fresh
lots are purchased. All subsequent issues are then charged at this price
until the next lot is received.
2. The method even out the effect of widely varying prices of different
consignments comprising the stock.
3. A profit or loss may arise out of pricing.
4. Issue prices may run to a number of decimal points.
c) Periodic Simple Average Price: This method is similar to the simple average
price except that here the issue is calculated at the end of each period (normally a
month) covering the prices at which purchases were made during the period and
not at the occasion of each issue of material.
d) Periodic Weighted Average Price: The periodic weighted average price is the
weighted average price of materials purchased during a period. Is calculated by
dividing the total cost of materials purchased during a period by the total quantity
 137

of materials purchased during that period. A new average price is calculated at the
end of each period (normally a month).
e) Moving Simple Average Price: This price is obtained by dividing the total of
the periodic simple average prices of a given number of periods, by the number of
periods, by the number of periods, the last of the period being that for which
material issues are valued. The calculation of moving simple average price requires
to decide upon the number is to be calculated, the periodic simple average prices of
5 periods have to be added and total of these prices divided by 5 would give simple
moving average price…..
f) Moving Weighted Average Price: This is a derivation of the weighted average
method. To obtain the weighted average price, the weighted average price of a given
number of periods (including and preceding the period of accounting) have to be
added and divided by the number of periods.
Selection of a Suitable Method of Printing Issues: No single method can be
appropriate in all circumstances. The selection of a proper method of pricing issues
depends on the following factors : (a) the nature of the business and type of
production, e.g., intermittent such as job or continuous such as process ; (b) the
method of costing used, whether the cost accounts are maintained according to the
standard costing system, if so, method of issuing materials on standard cost should
be used ; (c) the nature of materials e.g., if material are to be kept for some time for
maturing or seasoning, an inflated price will have to be charged ; (d) the frequency
of purchases and issues ; (e) the extent of price fluctuations ; (f) The policy of the
management : if the management wants that the cost accounts should represent
the current posit in and correspond with estimates besides that they should
disclose efficiently in buying. Pricing materials issues at market price may be
suitable issued; (g) relative value of material issued and relative size of batch of
material issued; (h) length of inventory turnover period and quantity of material to
be handled to be handled ; and (1) the necessity for maintaining uniformity within
an industry.
Illustration - 4
XYZ Ltd, has purchased and issued the materials in the following order:

Rs.
January 1 Purchases 300 units 3 per unit
4 Purchases 600 “ 4 “
6 Issue 500 “ -- “
10 purchase 700 “ 4 “
15 Issue 800 “ -- “
20 Purchases 300 “ 5 “
23 Issue 100 “ -- “
 138

Ascertain the quantity of closing stock as on 31st January and state what will
be its value(in each case) if issues are made under the following methods
(a) Average cost, (b) First-in –first- out, and (c) Last-in-first out
Solution
a) Average cost method
Rs.
January 6 Issue 500 units 3.67 Peru nit
15 Issue 800 “ 3.88 “
23 Issue 100 “ 4.44 “
31 Balance 500 “ 4.44 “
Value of closing stock Rs.2,220
b) First-in-first out method
January 6 Issue 500 (3oo @ Rs.3+ 200 @ Rs.4)
15 Issue 800 (2 Rs. 4)
23 Issue 100 (@ Rs.$)
31 Balance 500 (200 @ Rs.4 +300 @ Rs.5)
value of closing stock Rs.2,300
c) Last-in-first-out method
January 6 Issue 500 @ Rs.4
15 Issue 800 @ Rs.4
23 Issue 100 @ Rs.5
31 Balance 500 (200 @ Rs.5 + 300 @ Rs.3
value of closing stock Rs.1900
Illustration - 5
The following information is obtained from the records of ABC Ltd ;

January 1 Opening stock 100 units Rs.200

10 Purchases 400 units Rs.100
25 Purchases 100 units Rs.300
31 Sales 140 Units Rs.700

On January 31st, the replacement cost was Rs.3.5 per unit. Determine the
closing stock, cost of goods sold and profit for the month using LIFO, FIFO and
replacement cost (use the format of a trading account).
 139

Solution
Trading Account
i) Using LIFO Method
Date Particulars Units Amount Date Particulars Units Amount
Jan 1 Opening Stock 100 200 Jan.31 Sales 140 700
“ 10 Purchases 40 100 Jan.31 Closing Stock 100 200
“ 25 Purchases 100 300
“ 31 Profit 300
240 900 240 900
Opening stock + Purchases – Closing stock= cost of goods sold.
[200+400]–200=Rs.400.
2. Using FIFO Method
Date Particulars Units Amount Date Particulars Units Amount
Jan 1 Opening Stock 100 200 Jan.31 Sales 140 700
“ 10 Purchases 40 100 Jan.31 Closing Stock 100 300
“ 25 Purchases 100 300
“ 31 Profit 400
240 1,000 240 1,000

Cost of goods sold = (200 + 300) – 300 + Rs.300.

3. Using Replacement Cost Method
Date Particulars Units Amount Date Particulars Units Amount
Jan 1 Opening Stock 100 200 Jan.31 Sales 140 700
“ 10 Purchases 40 100 Jan.31 Closing Stock 100 325
“ 25 Purchases 100 300
“ 31 Profit 425
240 1,025 240 1,025

Cost of goods sold=(200 +400)-325= Rs.275.

Conclusion
Replacement
LIFO FIFO
Cost Method
Rs. Rs. Rs.
Closing stock 200 300 325
Cost of goods sold 400 300 275
Profit 300 400 425
 140

7.4 REVISION POINTS

Raw materials : are inputs used in the manufacturing process.
Work-in-progress : material in the pipe line.
Finished goods completed products, ready for sale.
Ordering Cost the entire cost of acquiring raw materials.

Economic ordering : optimum quantity which minimizes the costs

quantity of inventory.
Re-order level : the stock level at which a fresh order for stock
is made. This is fixed taking into account lead
time and consumption.
Minimum Level : the stock level below which inventories are not
allowed to deplete.
Maximum Level the stock level, which is the highest in terms of
holding inventory.
ABC Analysis A method of classification of inventory items
basing on their consumption value. It is
technique of management by exception.
7.5 INTEXT QUESTIONS
1. What is inventory? Why do firms maintain inventory?
2. What are the objectives of inventory management?
3. What is the financial manager's role in respect of the management of
inventory?
4. What is meant by the ABC inventory control System. On what key premise is
this system base? What are its limitations?
5. Define Economic Order Quantity (EOQ). How can it be computed?
6. What is inventory re-order point? How is it determined?
7.6 SUMMARY
Inventory, which consists of raw materials, components and other
consumables, work-in-progress 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 determine the
amount of inventory holding. Some of the broad objectives of holding inventory are
ensuring smooth production process, price stability and immediate delivery to
customers. The inventory holding is also affected by the demand of the customers
of inventory, suppliers and storage facility. 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.
Inventory optimizing techniques such as EOQ help us to balance the cost
and benefit to achieve a desirable level of inventory. It is not adequate to just plan
 141

for inventory holding. They need to be periodically monitored or controlled.

Techniques such as ABC are useful for continuous monitoring of inventory.
7.7 TERMINAL EXERCISE
1. …………..is the optimum or the most favourable quantity which should be
ordered for purchase each item when the purchases are to be made.
2. …………… represents the quantity of inventory above which should not be
allowed to kept.
3. ……………. represents the quantity below which sock should not be allowed
to fall.
4. …………….method operates under the assumptions that the materials which
are receives first are issued first and therefore, the flow of cost of materials
should also be in the same order.
7.8 SUPPLEMENTARY MATERIAL
1. www.easystock.com
2. www.camcode.com
3. www.scribd.com
7.9 ASSIGNMENTS
Practical Problems
1. 10,000 units of a component are required per year. Rs.100 is ordering cost
on an average per order. Rs.2 is the average stock carrying cost p.a. per unit.
What is the economic ordering size? How many times should the orders be
placed and what will be total cost of ordering and of carrying cost of inventory
[Ans: E.0.Q.1,000 units :10 times Rs.2,000]
2. Two components, A and B are used as follows:
Normal usage 50 units per week each
Minimum usage 25 units per week each
Maximum usage 75 units per week each
Reorder quantity A: 300 units: B: 500 units
Reorder period A: 4 to 6 weeks: B: 2 to 4 weeks.
3. Calculate for each component (1) Reorder level, (2) Minimum level, (3)
Maximum level, and (4) Average stock level.
[Ans: [1] A 450 units, B 300 units [2] A 200 units, B 150 units
[3] A 650 units, B 750 units [4] A350 units, B 400 units]
A manufacturing company uses Rs. 50,000 materials per year. The
administration cost per purchase is Rs. 50, and the carrying cost is 20% of the
average inventory. The company currently has an optimum purchasing policy but
has been offered a 4 percent discount if they purchase five times per year. Should
the offer be accepted? If not, what counter offer should be made?
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[Ans: E.0.q. = Rs.5,000; the offer should not be accepted because the cost will
increase by Rs. 46; any counter offer of more than 5% discount should
be made].
4. The following are taken from the records of M/s Balaji & Co. Thirupathi for
the year 1994. The valuation of inventory is Re.1 per kg or litters.

Opening Stock Purchases Closing stock

Material A 700 kg. 11,500 kg. 200 kg.
Material B 200 litters 11,000 litters 1,200 litters
Material C 1,000 kg. 1,800 kg. 1,200 kg.
Calculate the material turnover ratio and express in number of days the
average inventory is held.
[Ans: Material A – 26.67 times; 14 days. Material B – 14.29 times; 26 days.
Material C – 1.46 times; 250 days.]
7.10 SUGGESTED READINGS
1. Chandra, Prasanna: “Fundamentals of Financial Management”; New Delhi,
Tata Mc Graw Hill Co.
2. Gopalakrishnan,P: “Inventory and working Capital Management”; New Delhi,
Macmillan Ltd.
3. Menon, K.S.: “Stores Management”; Madras, Macmillan India Ltd.
4. Reddy G.S., Financial Management, Himalaya Publishers ,
5. Jain , Khan, Financial Management: Text, Problems and Cases 7th Edition,
Tata McGraw Hill Publishers.
6. Vishwanthan. R. , Industrial Finance, Macmillan Publishers
7.11 LEARNING ACTIVITIES
You are Stock manager. You found that Many stocks were not utilized and
simply kept in the stores department. But for purchasing stock huge amount was
spent. Identify the ways and means to solve this issue.
7.12 KEYWORDS
Transaction motives,Precaution Motive,speculative Motive,ABC analaysis, EOQ
analaysis,carrying cost , LIFO, FIFO, HIFO,

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LESSON – 8

LONG TERM FINANCING

8.1 INTRODUCTION
As a company grows, sooner or later it will outstrip its ability to finance its
development. It may turn out that owner's personal fortune is inadequate to
maintain the momentum, or that the supply of internally generated capital is
insufficient. Nor does temporizing in the form of leasing, bank loans and term
borrowing provide the answer. At some point in their growth, most business turn to
the public market for funds. But it should be noted that bolstering company's
finances is not the only reason for going public. In a mounting number of
instances, the desire to avoid burdensome estate taxes for one's survivors has
promoted public offering of stock. Inheritance taxes, particularly in the case of
closely held corporations, can be so burdensome that often a family has to sell the
business to pay the taxes. While selling shares in a company is not the complete
answer, it does solve some of the tax problems. The market price of the shares can
be used as a satisfactory base for evaluating the worth of the estate. If necessary,
money can be raised by selling additional stock owned by the family in the open
market.
Two basic Principles of long-term are included. They are:
a) The broad goal of finance, that is, to benefit the common stockholders; and
b) The necessity of taking a long-term point of view in finance. Corporate
executives must place an ever increasing emphasis on the subject of
handling capital. Today, the financial officer would certainly be inadequately
equipped, if all he knew was how to raise money. A new, broader concept
has grown up over the years which encompasses three parts;
i) Financing: How to raise money, "financing" in its narrow sense.
ii) Investor Relations: How to keep investors (who have put up the money)
informed about the operations of a company.
iii) Cost of Capital: How much should be earned on plant, equipment and
other assets in order to adequately compensate the investors the basic
goal for investment in new projects. It can also be called profit goal.
8.2 OBJECTIVES
After learning this term you must able to
 Explain the meaning and importance of long term financing
 List all the source of Long term financing
 Discuss the importance of lease financing
 Explain the use of retained earnings as a source of long term financing
8.3 CONTENT
8.3.1 Sources of Long Term Financing
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8.3.1 Sources of Long-Term Financing

The sources of long-term finance their outlet in variety of ways. Earlier, the
traditional source of finance was share capital including ordinary share capital and
preferred share capital. Over a period of time preference share capital lost its shine
very fast and the importance of the traditional Source of ordinary share capital now
known as "equity share capital" is also gradually losing its significance. It has, to
some extent, given way partly to public deposits and partly to debentures. The
other source of long-term finance is the traditional source of borrowing inclusive of
debentures.

Fig. 1 Sources of Long Term Financing

SHARE CAPITAL
Equity is that part of the capitalization that is not debt. It is the ownership
interest, the residual claim to assets and earning and contrast with debt which
represents the first and fixed claim on both assets and earnings. If interest and
principal payments on debt are not promptly met when due, bankruptcy, loss of
control for the owner, may occur. In general, equity capital may be represented by
two main types of securities-preferred stocks and common stocks. The role of equity
in corporate financing in India has been on the decline. The bulk of the funds
raised from the capital market in recent years has been in the form of debentures
or deposits. Equity shares are purchased mainly with an eye on capital
appreciation, the yield by way of dividends being very small. Gains from capital
appreciation accrue only when shares are sold. It is difficult to visualize a market
for equity share without voting rights. It has not been possible to develop a
secondary market for debentures which offer highly attractive return.
Merits of Equity Shares
1. Company need not have the forced obligation to pay dividend to equity
shareholders. This obligation arises only when the company earns sufficient
divisible profits.
2. Equity Share is a permanent source of fund which facilities flexibility in the
usage of funds.
3. The companies need not create any charge for raising equity capital.
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4. Equity capital helps the company to exploit opportunity of Debt Equity

ratio. Only when a company has sufficient equity capital, it can raise debt capital.
5. The obligation to repay the equity capital arises only at the time of
liquidation of the company.
6. Equity shares attracts dynamic investors who are desirous to have both
capital gain as well as higher percentage of profits.
7. It also helps the shareholders to increase their liquidity position, whenever
they need money, they can dispose the shares in the stock exchange.
8. Equity shares help the holders to participate in the management of the
company through voting rights.
Demerits of Equity Shares
1. Raising only equity shares does not facilitate the company to enjoy D:E Ratio
(trading on equity).
2. Huge amount of owned funds creates inefficiency in the organisation, as it
does not have permanent obligation either to repay the principal or the interest (as
in the case of borrowings).
3. Equity shareholders may create position in the smooth running of the
organisation. Huge reserves will attract more problems from equity shareholders.
4. During boom period, equity shares may encourage too much of speculation.
The holders of these shares will indulge in speculation at the time higher profits
and high capital gains.
5. Equity shares will not attract passive investors who always prefer to have
steady income and safety of their investment.
6. Issuing excess equity shares may lead to over capitalisation.
7. During recession, issue of equity shares will become tough task and forces
the company to manage their funds only through the debt.
8. Equity shares are always associated with the expectations of the
shareholders. It is practically a difficult task on the part of the company to fulfill
the expectations of the shareholders.
9. Issue of equity capital is a dependent source of funds for which efficient
system of capital market is a must. Hence it mainly depends on efficient system of
capital market.
10. Another disadvantage of equity capital is that it cannot be recovered and
repaid only at the time of liquidation of the company.
BORROWING
The word "risk" is used in a variety of contexts to mean many different things
Even when used in a single context, as for example in the phrase "risk of debt" it
will mean different things to different people. Generally speaking the word denotes
the possibility of occurrence of an adverse event or effect. With respect to debt the
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risk is the chance of adverse effects resulting from a commitment to make cash
payments, certain in amount and timings under certain future financial
circumstances. These adverse effects may range a Modest increase in emotional
Strain of management to the event of bankruptcy. They include the such
considerations as negative income effects and interference with flexibility in future
financing. It is generally accepted that the primary incentive to use long-term debt
capital in business is the fact that debt is normally a cheaper source than retained
earnings or new equity issues. In view of the debt proportion usually considered by
business and the tax shield of the interest charge it is substantially deeper.
Assuming that the primary objective of business is to maximize net revenue. It
would appear to be highly desirable to use debt as a source of a fund and to use it
as continuously as possible.
Convertible debentures are gaining much popularity in recent times, as a
means of raising finance by the corporate sector and are being issued currently by
a large number of companies. By giving its approval for giving high rate of interest
on the debenture issues, the Government has also contributed to the rise in issue
of debentures by the companies. The factors normally governing the issue are:
i) Avoidance of concentration of share capital in the hands of financial
institutions, in case large sums are taken as term loan, through these
financial institutions, subject to the conversation clause.
ii) Restrictions on funds raised through right issues for working capital
purposes only but not for expansion/project planning, etc.
iii) Dilution of earnings in respect of all shares can be avoided through
convertible debentures.
iv) The placing of conversion option vis-a-vis ordinary helps in deferring the
dilution in earnings and creates a feeling of confidence about the upward
earning and its better performance taking into consideration the expansion
or diversification plan of the company concerned.
v) In a fast expansion programme in any industry, the timings of the
conversion of the debentures are so set that the completion of the expansion
job normally consider with the conversion timings. Thus, up to the
completion of the expansion, only a fixed rate of interest is paid by the
company.
vi) Since the interest payable on these debentures is deductible expenditure the
burden on interest after tax, therefore, is quite low. It is also quite attractive
from the investors point of view. As soon as they become equity shareholders
after the conversion, they are able to share the gains resulting from the
expansion.
vii) Since these debentures are quoted on the stock exchanges they offer
excellent liquidity.
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viii) Redemption of debentures by the company and consequent allotment of its

shares at an amount lower than its ruling market price leads to avoidance of
the liability of the investors towards the capital gains tax, unless of course
the shares are sold.
ix) The issues are now linked with the bonus shares also, as most of the
companies issuing these convertible debentures give the entitlement of
debenture holders to bonus shares in the same proportion as equity
shareholders.
Liquidity, high yield, and Non-Government Debentures capital appreciation in
one package is, in short, the investor's dream. According to M.D.Mukhi, these
features are now available with non-convertibfe debentures more particularly due to
repurchase scheme.
Advantages
1. Debenture issued by a company as means of long or medium term finance is
a cheaper source of funds.
2. Interest paid to the debenture holders is known to the company at the time
of issue. This helps the management to plan for wiser investments.
3. Interest paid to debenture holder is an expense charged against profit.
Hence it reduces the size of the profits, in turn reduces the tax liability.
4. Debentures issued by the company facilitates the management have flexible
capital structure.
5. Trading on equity can be had in building the capital structure of a company.
6. If the company's earnings are good, management can redeem the excess
debt capital and can build optimum capital mix.
7. Company need not have to follow elaborate formalities to issue debentures.
8. During recession, debt capital is the only means through which a corporate
can raise funds.
9. The instrument like convertible debenture attracts all types of investors at
all times.
10. The combination Debt to equity in the capital structure increases the
operational efficiency of the organisation.
Disadvantages
1. Issue of debentures increases the financial risk of the company.
2. It cannot be used as a means of long term investment.
3. It reduces the freedom of the management in making investments. This will
be more in case of redeemable debentures.
4. Issue of debentures may not attract all types of investors.
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5. Issue of excess debt or dependence on borrowed funds may takes the

company to disastrous situation. Hence it always call for efficient financial
administration.
PUBLIC DEPOSITS
Companies prefer public deposits because:
a) These deposits carry lower rate of interest;
b) These are unsecured deposits;
c) Less formalities are required; and
d) These deposits are comparatively for a long period in comparison with the
sources of working capital.
Advantages
1. The cost of raising public deposits is less.
2. The procedures followed at the time of raising public deposits are simple.
3. The company enjoy the benefit of trading on equity by issuing public
deposits.
4. The management of the company can raise the additional funds as and
when it requires.
5. The company need not offer any security to raise public deposits.
6. The company can think of raising funds through public deposits even during
recession.
7. Public deposits are the ideal source of medium term finance, as this can be
issued for different maturity period.
8. Floatation cost of public deposits are cheaper than the floatation cost of
equity shares.
Disadvantages
1. Large sum of money cannot be raised through the public deposits.
2. The companies must have to follow the rules and regulations strictly with
regard to the brokerage and interest charges.
3. Public deposits cannot be used as a long term permanent source of funds.
4. The maturity period of the deposits are very short.
5. It may not attract all types of investors.
6. The company that enjoys good reputation can only raise public deposits.
7. The cost of public deposits will be normally higher than the cost of debt and
preference stocks.
SAVINGS FROM NON-RESIDENTS
Savings are mobilized under the FCNR (Foreign Currency Non-resident)
scheme. In 1988-89 such deposits are expected to touch the mark of Rs.4000
crores by March 31, 1990. The Government also mobilizes savings under NRER
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(Non-Resident External Rupee) scheme, which amounted to Rs.7911 crores. The

total cumulative NRI deposits under the two schemes as on March 31, 1989
amounted to Rs.14154 crores. The future in the Indian business world raised by
Swaraj Paul's purchases of the shares of DCM and Escorts can be viewed as
ironically funny, if it did not have many serious implications for the functioning of
India's economy and policy. The importance of encouraging nonresident Indians to
invest in India was stressed by spokesmen of private business interest in the
country for quite some time and supported by those in the Government who also
hold similar views about the chances necessary in India's industrial and financial
policies. Since 1973, there has been a continuous process of what is called
"liberalization". This involves an increasing dilution of the rigours of industrial
licensing, not only in procedures but in substance, an almost complete shelving of
the MRTP Act for attaining major objectives, increasing exemption from the
application of the convertibility clauses in loan agreements, etc. The Foreign
Exchange Regulation Act was not only applied with considerable delay, but in effect
it was not used so much to reduce or eliminate foreign control in important
companies as merely to bring out a formal dilution of control through reducing
foreign equity to below 40 per cent.
Advantages
1. Under the global economic environment raising funds from Non Resident
Indians is easy.
2. It server as a means of both medium and long term financing.
3. The company raises funds through Non Resident Indian generally enjoys
good reputation.
Disadvantages
1. Raising funds from NRI's is a complex job, where a company has to follow to(
many formalities.
2. Attracting funds from NRIs will be easy and comfortable only to a reputed
companies.
3. It is highly volatile and too sensitive to the Socio-Economic and Political
changes of a country.
4. Cost of raising funds will be more.
5. The funds from these sources are mainly used for the purpose of medium
term financial requirement.
LEASE FINANCING
Leasing involves the use of an asset without the desire to assume or intend to
assume ownership. A firm acquiring an asset is called the lease and the owner of
the asset is called the Lessor. The Lessor gets a money rental at regular intervals
for its use from the lessee. It is not essential to purchase assets in order to use
them. Assets may be rented. Rentals can be based on some periodical basis. The
provision for the use of major assets is covered in a leasing contract. The contract
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includes the lease period, cancellation provisions, rental payments, additional rents
or purchase options, allocation of maintenance and other features of the
agreement. In the leasing procedure, a property is leased by its owner. Ownership is
retained with the Lessor. A clear understanding of the role to be played by the
acquisition is an essential prerequisite. If it is to bring long-term benefits to the
business, each proposal for acquisition must be tested against these requirements,
and a selection made of the projects which maximize the success potential. Leasing
is not a way of avoiding financing. It is financing and it makes no difference
whether you own profitable assets and lease unprofitable assets, or vice versa, so
long as you require both kinds. The important question is the cost of the lease in
relation to other financing alternatives. Lease arrangements lend themselves to a
wide, diversified relationship between the lessee and the Lessor. The financial
impact of a lease transaction upon termination by the lease may be nothing or may
be substantial.
Advantages - To the Lessor
1. High rentals charged on leasing transaction increases the returns to Lessor.
2. Quick decision can be made to sanction leasing.
3. Lessor can enjoy depreciation benefit. The reason behind this is that the
asset will be in the name of banker (Lessor).
4. As the banker charging the depreciation against the profit, he can enjoy tax
benefits.
5. Cost of bad debt will always be less in leasing, in other words, recovery of
lease amount will be comfortable.
6. It is highly secured means of financing.
To the Lessee
1. Leasing provides 100% finance to the Lessee.
2. Lessee can charge entire amount of rental to his profit and loss account and
can reduce his tax liability.
3. The documentation procedure to avail leasing is very simple.
4. It is off the Balance Sheet financing. In other words the leased asset will
appear only in the lessor's balance sheet.
5. D:E ratio of lessee does not affect liability side of the balance Sheet.
6. It releases the burden of excess debt on the capital mix and maintains she
D:E ratio intact.
7. It is the best means of financing high tech machines.
Disadvantages - To the Lessor
1. Though, the Lessor enjoys the benefit of depreciation, he has to treat the
rental as Income. Hence it may not be too advantageous to the Lessor.
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2. Leasing is a risky financial instrument, Lessor has to take maximum care in

evaluating the lease proposals.
3. It requires expertise analytical skill to evaluate the proposals of lessee,
which needs too much of expenses on training the employees.
4. Leasing may be provided only to blue chip companies, hence locating lessee
becomes a very big problem under competitive environment.
5. Multipoint sale tax and surcharges of different states are the main hurdles
of leasing. Because many State Governments charges sale tax on rentals.
To the Lessee
1. It serves as a medium term finance only.
2. High rentals may not attract many customers to avail leasing facility.
3. It is not suitable for Small Scale and Medium Sized industries.
4. Transfer of property along with the title after the lease period is still in
vague. There is no uniform system prevailing in the market.
5. High rentals and depreciation attracted more number of players in the
market and forced RBI to watch the functioning Leasing and Hire Purchase
financiers closely. The New guidelines of RBI on NBFCs have forced
inefficient NBFCs to close down their operations.
RETAINED SURPLUS
Expansion or even diversification of production capacity by established
companies is carried out primarily through internal resources such as retained
profits, depreciation, etc. Funds raised by way of fresh issue of share capital are
meager.
i) Financing of Expansion/Diversification Programme: Convertible debentures
offer an excellent opportunity for financing of expansion/diversification projects
without involving dilution of the existing earnings per share (EPS), thus helping
delayed equity financing. By selling convertible debentures instead of common
stock, the company will be able to lessen dilution in EPS, both at the time of sale
and the future. This is on account of the fact that, as the conversion price would be
higher than the issue price of a new equity issue, less number of members of new
shares will be added to the existing equity. The dilution in EPS is less in the case of
convertible debentures than that in the case of outright equity issue, since fewer
number of shares would be added after conversion.
ii) Financing Project with Long Gestation Period and Huge Capital Outlay:
During the construction stage, a company which is new (in the sense that it is not
promoted by an established industrial house) is likely to encounter a lack of public
support for its equity issue. This stems chiefly from the absence of a proven record.
At the same time, secured loans are likely to be available only at exorbitant interest
rates, while availability of bank finance is restricted. In such a situation, the ideal
answer from the view points of both the company and the investors is the issue of
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convertible debentures. As regards the company, it is enabled to raise the necessary

finance at relatively lower interest rates. Likewise, the investors are assured of a
fixed return during the gestation period and also are entitled to participate in the
fortunes of the project. If the venture fails, the investors are protected by their right
to have full repayment. In other words, the adoption of convertible debentures, as a
means of financing, would be extremely suitable to ventures typified by high risk
and high returns.
iii) Means of Satisfying Purchase Consideration in Amalgamations and
Mergers: Irrespective of the nature and circumstances that lead to the
amalgamation/merger, the important aspect in all the cases is the payment of the
purchase consideration. It may be paid in cash or securities or both. The payment
of cash may prove well-high impossible in these days of tight money conditions. The
issue of ordinary debentures may be another alternative, but during an inflationary
situation coupled with rising interest rates, this method may prove to be in
attractive, unless equity-linked debentures are issued. In India a common method
of satisfying the purchase consideration is through the issue of equity shares. But
this entails two disadvantages; the equity shares are expensive to service and there
will be a dilution of the interest of the shareholders of the acquiring company. The
ideal method of satisfying the purchase consideration in amalgamation schemes is.
through the issue of convertible debentures. For the company acquiring another
company, the issue of convertible debentures reduces the interest cost and also
provides it with breathing time before conversion, to consolidate the benefits of the
merger. Further, the issue of convertibles also reduces the dilution in EPS, as
otherwise the company may have to offer more equity shares than are required to
be offered through conversion.
Merits and Retained Surplus
1. Retained earnings is a permanent source of long term funds. It encourages
the company to go in for diversification and expansion programmes.
2. The cost of raising the funds does not arise, as this is a internally generated
funds.
3. Retained earnings are the funds of equity shareholders. Hence it will not
create any obligation on the part of the company either to repay the
principal (capital) or interest.
4. Company need not have to offer its assets as security.
5. Raising retained earnings will not affect the smooth functioning of the
company.
6. It helps the company to plan for the tax scientifically.
7. It is a cheaper source of funds.
8. Retained earnings helps the company to increase its goodwill and
reputation.
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9. Retained earnings helps the company to follow stable dividend policy.

10. Retained earnings also helps the company to frame strong long term polices.
Demerits of Retained Surplus
1. Huge amount of internally generated funds leads to manipulation in the
value of shares.
2. It also create a threat of over capitalization to the company.
3. Management may misuse this huge accumulated profits.
4. Retained earnings can be considered as the source of funds only when a
company has sufficient profits.
5. Huge sums of retained earnings or surplus encourages the company for over
investment and ambitious expansion programmes.
8.4 REVISION POINTS
Retained surplus - The portion of the profits which is not
distributed among the shareholders but is
retained and is used in the business.
Debenture - It is a written acknowledgement of money
borrowed.
Lease financing - Procurement of assets through lease. Alternative
to the Purchase of an assets all of own or
borrowed funds.

Equity - That part of Capitalization that is not debt. It is

ownership interest in financing.

8.5 INTEXT QUESTIONS

1.What do you understand by shares?
2 .What do you mean by debentures?
3. What do you mean by public deposits?
4. What do you mean by lease financing?
8.6 SUMMARY
Funds are require in the firm for a period of more than one year and used for
purchase of fixed assets such as land, building, machinery furniture are termed as
fixed capital. A part of working capital also of a permanent nature. Funds require
for this part of the working capital and for fixed capital is known as long term
finance. The long term finance can be raised through shares, debenture, loans from
specialized financial institutions, leasing etc.,
8.7 TERMINAL EXERCISE
1. ……………………..is that part of the capitalization that is not debt.
2. The word ……………………is used in a variety of contexts to mean many
different things Even when used in a single context.
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3. ……………………….involves the use of an asset without the desire to assume

or intend to assume ownership.
8.8 SUPPLEMENTARY MATERIAL
1. www.investopedia.com
2. www.worldbank.org
8.9 ASSIGNMENTS
1. State the purpose of long term finance.
2. Why do some firm prepare to raise capital by lease of equity shares? What
are its limitations?
3. What is debenture? What are its features?
4. Distinguish between shares and debentures?
5. What do you understand by planning back of profit? Explain its advantages.
6. Explain the different type of lease.
7. Write short note on NRI savings.
8. List of importance of lease financing.
8.10 SUGGESTED READINGS
1. Eugene F. Brigham , Joel F. Houston Fundamentals of Financial
Management Cengage Learning
2. Jain , Khan, Financial Management: Text, Problems and Cases 7th Edition,
Tata McGraw Hill Publishers.
3. Reddy G.S., Financial Management, Himalaya Publishers,
4. Anil Mishra , Ragul Srivastava, Financial Management Oxford Publishers.
8.11 LEARNING ACTIVITIES
Recently you was appointed as finance manger . Your company CEO wants
you to suggest the best long term finance. Prepare a draft .
8.12 KEYWORDS
Share Capital, Equity Shares, Public Deposits, Savings from Non Residents,
Lease Financing, Retained Surplus,


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LESSON - 9

EQUITY AND PREFERENCE SHARES

9.1 INTRODUCTION
The equity share capital is the backbone of any company's financial structure.
The word 'equity' means the ownership interest as measured by capital, reserves-
and surplus. This term is also used to refer to the unlimited interest of ordinary
shareholders. Hence, ordinary shares are often called “equities”.
9.2 OBJECTIVES
After reading this lesson you should be able to:
 Understand the features of equity shares
 Evaluate equity shares as a source of finance
 Explain Right shares, bonus shares
 Know the different kinds of preference shares
 Evaluate preference shares as a source of finance
9.3 CONTENT
9.3.1 Features of Equity Shares
9.3.2 Right Share
9.3.3 Bonus Shares
9.3.4 Preference Shares
9.3.5 Kinds of Preference Shares
9.3.6 Evaluation of Preference Shares as a source of finance
9.3.1 Features of Equity Shares
1. Risk Capital: Equity shareholders have an unlimited interest in (he
company's profits and assets. They are, in effect, the owners of the business. They
provided the so-called 'risk' or 'venture' capital of the company. In short, their
prospects rise or fall with the prosperity of their company and with the state of
business conditions in general.
2. Fluctuating Dividend: If the profits are substantial, they may get-good
dividend; if not, there may be little or no dividend. Thus, their return of income, i.e.,
dividend is of fluctuating character and its magnitude directly depends upon the
amount of profit made by a company in a particular year.
3. Changing Market Value: The par or paid up value of the equity share has no
relation to its market value. The former is fixed while the latter, i.e., the market
value of ordinary shares, depends mainly on the profit earned by the company. The
market value is determined by buyers and sellers who take into account earnings,
dividends, prospects, the quality and caliber of management and general business
outlook.
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4. Growth Prospects: The equity share of a company may also act as 'growth'
share, i.e., with prospects for future growth in case the company over a period of
time has very good scope for quick expansion. Such shares enjoy considerable
prospects of capital appreciation within 5 to 10 years.
5. Protection against Inflation: Equity shares represent the best hedging or
insurance device, fully protecting investors against rising prices and it; (b) Equity
stock also facilitates the company to take benefits of leverage by taking debt capital
which is cheaper; (c) Equity shares do not create any charge on the assets of the
company and the assets may be used as security for further financing. All this
strengthens the credit of the company.
From investor's viewpoint equity ownership gives the shareholders (i) an
opportunity to share in the profits when declared as dividends, (ii) an opportunity
to make money on appreciation in the value of the securities, (iii) to participate in
Right share issue or bonus share issue, and (iv) the opportunity to vote for directors
of the corporation. It is especially important that the motives of investors be
understood by those interested in financial management because the securities
must be made attractive to investors.
The above discussion of equity shares as a method of raising finance clearly
brings out a series of perquisites conferred on the company and shareholders. It
must not, however, be inferred that equity shares are free of limitations. In fact, the
following problems become apparent when one analyses the nature of equity shares
: (a) the issuing of equity capital causes dilution of control by the equity holders, (b)
The exclusive use of equity shares as a fund-raising device by the management
deprives it from trading on equity which results in losing opportunity of using
cheap borrowed capital, (c) Also, the excessive use of equity shares is likely to result
in over-capitalisation with all its attendant consequences, (d) It attracts only those
classes of investors who can take risk. Conservative and cautious investors (both
individual and institutional) find it difficult to subscribe for such issues.
Difference between equity and preference shares
The following are some of the difference between equity shares and preference
shares.

Point of difference Equity Shares Preference Shares

Used as a method of Used for both long term and

1. Term of financing
long term financing medium term financing.

Rate of return is
Dividend at fixed rate may
2. Nature of return fluctuating, depending
be paid or accumulated.
upon the earning

Equity shareholders are These shareholders are not

3. Owners the owners. They have owners. They have no voting
voting rights. rights.
 157

They are not subject to It can be redeemed after

4. Reedeemability redemption during the achieving the purpose or at
lifetime of the company. the end of a certain period.

Suitable for those

It has appeal for relatively
5. Type of Investors investors who are
less adventurous investors.
adventurous by nature.

Residual claimant.
6. Right of receiving
Rank next to preference Entitled for first preference
dividend
shares.

7. Right of receiving
Entitled for first
back invested capital Entitled for first preference
preference
during liquidation.

Payment of equity
dividends is optional. It
is dependent on the Payment ofprefetence
8. Financial burden discretion of the Board dividend is a fixed financial
of Directors. Therefore commitment.
there is no fixed
financial commitment.

9. Voting rights Enjoy voting rights Do not enjoy voting rights

10. Reduction of
By reorganization By repayment
capital

Generally of lower Generally of higher

11. Denomination
denomination. denomination.

Preferred by medium and

Even small investors
large investors. Small
can invest because of
12. Type ofinvestors. investors would find it
the lower
difficult to invest because of
denomination.
the higher denomination.

13. Borrowing Strengthens borrowing

Reduces borrowing capacity.
capacity capacity.

There are chances for Lesser chances for over-

14. Capitalization
over-capitalisaton. capitalization.
 158

The above table lists some of the differences between equity & pref shares.
No-par Shares: In the U.S.A. and Canada, many companies issue shares which
have no-par or face value. The total owned capital of the company is divided into a
certain number of shares. The share certificate merely states the number of shares
held by a particular holder and does not mention the face value of the shares. The
dividends on such shares are paid at the rate of given amount per share instead of
a certain percentage of the par value of each share. Such shares cannot be issued
in India, because the law requires every share to have fixed nominal value. In the
U.K., the Gedge Committee recommended that the company law should allow
companies to convert their ordinary shares having nominal value into no par value
shares. The advantages usually claimed for such shares are :
a) The balance sheet presents a realistic picture with such shares because the
capital is equal to the net worth (assets minus external liability) and is not
an imaginary amount as with shares of nominal value.
b) Since the value of such shares is related to the earnings, the shareholders
always know the real value of their holdings.
c) The shareholders are not liable to pay further calls because the total value of
a no-par share is collected in the beginning.
d) The shares need not be marketed at a discount because there is no
minimum par value of these shares. This avoids a lot of legal formality. )
e) Since the value of the shares is automatically adjusted with the earning
capacity, no reduction of capital is necessary.
On the contrary, the no-par value shares suffer from the following drawbacks:
a) The no-par value shares may easily be used to deceive ignorant investors. In
case of such shares there is no standard by which fluctuations in share
values can be ascertained.
b) Such shares make the balance sheet unduly complex and difficult to
understand. This makes the task of investors, creditors and tax authorities
difficult.
c) Unscrupulous management gets an opportunity to manipulate the sale
proceeds of shares and pay dividend out of capital.
d) The creditors lose the additional security of uncalled capital which they get
in case of partly paid shares with par value.
e) Since me capital account remains fluctuating from time to time, the
promoters may snatch unduly high amounts of remuneration for
themselves.
9.3.2 Right Shares
Whenever an existing company wants to issue new equity shares, the existing
shareholders will be potential buyers of these shares. Generally, the Articles or
Memorandum of Association of the company gives the right to existing shareholder
to participate in the new equity issues of the company. This right is known as pre-
 159

emptive right and such offered shares are called Right shares or Right Issue or
'Privileged Subscription'. The term simply indicates the fact that such shares will be
first offered to the existing shareholders.
Under Section 81 of the Companies Act, 1956 where at any time after the
expiry of two years from the formation of a company or at any time after the expiry
of one year from the allotment of shares being made for the first time after its
formation, whichever is earlier, it is proposed to increase the subscribed capital of
the company by allotment of further shares, then such further shares shall be
offered to the persons who, at the date of the offer, are holders of the equity shares
of the company, in proportion as nearly as circumstances admit, to the capital paid
on those shares at that date. Thus, the existing shareholders have a pre-emptive
right to subscribe to the new issues made by a company. This right has at its root
in the doctrine that each shareholder is entitled to participate in any further issue
of capital by the company .equally, so that his interest in the company is not
diluted.
Right Issue and Financial Policy: The issue of right shares always affects
financial policy of the company as well as the market. Some of the important ways
in which financial policy is affected are given below.
i) When the right shares at low price available then share market of the
existing shares might be adversely influenced.
ii) When the right shares at low-price are available then the potential
investors might feel tempted to invest money thereby the finances of the
business can become sound.
iii) Financial Policy will be unfavourably influenced in case right shares are
offered to existing shareholders much above their purchasing capacity.
iv) When new shares have been added then less dividend will be paid and
that will adversely affect the business.
Whenever right shares are offered it is essential to review the market trends
and earnings position of the company so as to know how the shares are being
traded in the stock market. While fixing the price of the right shares, the following
facts will have to be taken into consideration: (i) the price what the market can
bear, (ii) state of the capital market, (iii) trends in share market, (iv) profit earning
capacity of the existing shares, (v) the proposed plan of expansion, (vi) dividend
policy of the company, (vii)resource position of the enterprise, (viii) reserves position
of the company, and (xi) the size of the right issue.
Advantages of Right Issue
a) Right issue gives the existing shareholders and opportunity for the
protection of their pro-rata share in the earning and surplus of the company.
b) Existing shareholders can also maintain their proportion in the voting power
as before.
 160

c) There is more certainty of the shares being sold to the existing shareholders.
If aright issue is successful it is equal to favourable image and evaluation of
the company's goodwill in the minds of the existing shareholders:
d) The flotation costs of a right issue will be comparatively lower than a public
issue. The expenses to be incurred, otherwise of shares are offered to public,
are avoided.
Illustration - 1
A corporation earns Rs.80 lakhs after tax and has 18 lakh shares of Rs. 10
each outstanding. The market price of a share is 25 times the EPS. The corporation
plans to raise Rs. 180 lakhs of new equity funds through a rights offering and
decides to sell the new stock to shareholders at a subscription price of Rs. 60 per
share. The financial position before the company offers the right shares is as given
below:
Balance Sheet as on … … …
(Rs. in lakhs)
Liabilities Rs. Assets Rs.
Debentures @ 10% 800 Total Assets 2,000
Common Stock 200
Retained Earnings 1,000
Total 2,000 2,000
Income Statement
Total Earnings Rs.
Interest on Debt 200
Income Before Taxes 80
Taxes (60%) 160
Earnings After Taxes 96
Earnings Per Share (20 lakh 64
shares) is
Market Price of Stock is 3.20
80

i) How many rights will be required to purchase a share of the newly-issued

stock?
ii) What is the value of each right?
iii) What effect will the rights offering have on the price of the existing stock?
Solution
The corporation desires to raise Rs. 200 lakhs of new equity funds through a
rights offering. For this purpose, it will have to issue 3 lakhs of new shares to
existing stockholders
 161

New Equity Funds 18,000,000

  300,000
Subscription Price of a Share 60

The outstanding stock of the corporation is 18 lakh shares. There are,

therefore, 18 lakh rights, as one share has one right. Hence,
i) To purchase a share of the newly issued stock
1,800,000
= 6 rights will be required
300,000
ii) The value of each right

R= Mo - S
N 1

80 - 60
=
6 1

20
  Rs.2.86
7
i) The stockholder has the choice of exercising his rights of selling them. If he
has sufficient funds, and if he wants to buy more shares of the company' s stock,
he will exercise the rights. If he does not have the money, or does not want to buy
more stock, he will sell his rights. In either case, the stockholder will neither benefit
nor lose by the rights offering. This can be illustrated further. Suppose, a
shareholder has 12 shares. As each share has a market value of Rs. 80 per share,
the stockholder has a total market value of Rs. 960 in the company's stock. If he
exercises his rights, he will be able to purchase two additional shares (one share for
6 rights) at Rs. 60 each. His new investment will thus amount to:
Rs.960+(60x2)=Rs.l,080.
He now owns 12 shares of his company's stock which, after the rights offering
have a value of:
1,080
 Rs.77.14
12  2
The value of his stock is Rs, 1,080, that is to say, exactly what he has invested
in it. Alternatively, if he sold his 12 rights, which have a value of Rs. 2.86 each as
shown in (ii) above, he would receive Rs. 34.32. He would now have his original 12
shares of stock, plus Rs. 34.32 in cash. His original 12 shares of stock now have a
market value of Rs. 77.14 each-Rs.925.68 market value (77.14 x 12 = 925.68) of his
stock plus Rs.34.32 in cash is the same as the original Rs. 960 market value of
stock with which he began (80 X 12 = 960). From a purely mechanical or
arithmetical point, the stockholder neither benefits nor gains from the sale of
additional shares of stock through rights. Of course, if he forgoes to exercise or sell
 162

his rights, or if the brokerage costs of selling the rights arc excessive, he may suffer
a loss. But, in general, the issuing corporation would make special efforts to
minimise the brokerage costs; and adequate time is given to enable the stockholder
to take some action so that his losses are minimal.
Illustration - 2
A company plans to issue common stock by privileged subscription. Twenty
four rights are needed to get one additional share of stock. The corporation declares
the subscription price at Rs. 9 against the current market price of Rs. 11 per share.
You are required to find out:
a) The market value of one right when stock is selling rights;
b) The market price of the stock when the stock goes ex-rights;
c) The market value of a right when the stock sells ex-rights; and
d) The value of one share of ex-rights stock, if only 5 rights are needed to get
one additional share of stock.
Solution
a) The market value of one right, when the stock is selling rights on, is
calculated by the following formula:
Me - S
R=
N

Where Me is the rights on market price of outstanding stock;

S is the subscription price of the new stock;
N is the number of rights needed to purchase one new share.
In the above example,
11 - 9 2
R =   Re .0.08  8 paise
24  1 25
a) The market price of the stock trading ex-right is computed by the following
formula:
Me= Mo- R
where, Me is the market value of the stock trading ex-rights;
Mo is the market value of the stock with rights on;
R is the theoretical value of a right.
In the above example,
Me =11-0.08
= Rs. 10.92
This can also be worked out with another formula:
 163

(Mo X N)  S
Me = = (11 x 24)  9  273  Rs.10.92
N 1 24  1 25
a) The market value of 1 right, when the stock is selling ex-rights, may be
calculated with the following formula:
Mo - S 10.92 - 9
R= =
N 1 24
1.92
= = Re.0.08 = 8 paise
24
a) The market value of one share of ex-rights stock, if it takes only 5 rights to
subscribe to an additional share of stock, will be:
(Me x N)  S
Me = (11 x 5)  9 =
64
Me = = Rs. 10.66
N 1 5 1 6
9.3.3 Bonus Shares
Bonus shares are issued to the existing equity shareholders. When the
company has sufficient reserves and surplus but its cash position is weak. it may
think of issuing bonus shares. Issues of bonus shares in lieu of dividend are not
allowed as per section 205 of the Companies Act, 1956. By issue of bonus shares,
the accumulated profits and reserves of the company are converted into share
capital and hence it is also known as Capitalisation of Profits and Reserves.
Bonus shares may be paid to the existing shareholders in the following
manners:
a) Making the partly paid equity shares fully paid up without asking for cash
from shareholders; or
b) Issuing and allotting equity shares to existing shareholders in a definite
proportion out of profits. For example, if a company has 50,00,000 equity
shares of Rs. 10 each fully paid up and reserves of Rs. 8,00,00,000. Now the
company can issue bonus shares in the ratio of 1:1, if desired.
Bonus shares are issued for any one of the following reasons
i) to give some benefit out of the reserves accumulated in excess of present or
future probable needs of the company;
ii) to bring the issued share capital of the company in true relation to (he
capital employed in the business ;
iii) to avoid exceptionally high profits and dividends from attracting competitors
in the line where monopoly has so far been enjoyed;
iv) to prevent unduly high rates of dividends from dissatisfying their own
employees who might feel to have been underpaid and might seek for a
claim to higher wages ;
v) to prevent such excessive profits from disturbing the company's business by
creating dissatisfaction amongst even customers or suppliers.
 164

Circumstances warranting the issue of bonus shares

i) When the company wants to capitalise the huge accumulated profits and
reserves;
ii) When the company is unable to declare higher rates of dividend on its
capital, despite sufficient profits, due to legal restrictions on payment of
dividends ;
iii) when the company can not declare a cash bonus because of unsatisfactory
cash position and its adverse effects on working capital of the company ;
iv) When there is wide difference in the nominal value and market value of (he
shares of the company.
Advantages of Bonus Shares
I. Advantages to the issuing company:
a) Maintenance of liquidity position: A company can maintain its liquidity
position because cash dividends are not paid to the shareholders but bonus
shares issued by the company.
b) Remedy for under-capitalisation: In under-capitalised concern the rate of
dividend is high. But by issuing bonus shares the rate of dividend per share
can be reduced and a company -can be saved from the effect of under
capitalisation.
c) Economic issue of securities: The issue of bonus shares is the most
economical whereas other types of securities cannot be issued at this
minimum cost.
d) Other benefits: Issue of bonus shares increases the confidence of
shareholders in the company besides the conservation of control.
II. Advantages to Investors
i) Tax saving: Bonus shares are issued out of profits and free from income tax
in the hands of individual investors. Otherwise had the profits been used for
payment of dividend, such payments are subject to income tax by the
recipient of dividend income.
ii) Increase in Equity holdings: Issue of bonus shares to existing shareholders
increases the size of individual shareholdings.
iii) Increase in income: In the long run the dividend income of the shareholders is
also increased. But it will be possible only when the company is able to
maintain the same rate of dividend as before on the increased capital also.
Disadvantages of Bonus Shares
i) Issue of bonus shares excludes the possibility of new investors coming into
the company and throws more liability in respect of future dividend on the
company shares.
ii) Issue of bonus shares lowers the market value of the existing shares also in
the short-run.
 165

GUIDELINES FOR ISSUE OF BONUS SHARES

(Issued by Securities and Exchange Board of India (SEBI) on 11th June 1992)
A company, shall, while issuing bonus shares, ensure the following:
1. No bonus issue shall be made within 12 months of any public/right issue
2. The bonus issue is made out of free reserves built out of the genuine profits
or share premium collected in cash only.
3. Reserves created by revaluation of fixed assets are not capitalized.
4. The Development Rebate Reserve or the Investment Allowance Reserve is
considered as free reserve for the purpose of calculation of residual
reserves test only.
5. All contingent liabilities disclosed in the audited accounts which have
bearing on the net profits, shall be taken into account in the calculation of
the residual reserves.
6. The residual reserves after the proposed capitalization shall be atleast 40
per cent of increased paid-up capital
7. 30 percent of the average profits before tax of the company for the previous
3 1years should yield a rate of dividend on the expanded capital base of the
company at 10 per cent.
Example: Calculate the maximum amount available for capitalization applying
the residual reserve test and profitability test. All figures are in lakhs.

Rs.
Paid-up capital 160
Free reserves 120
Average profits before tax during the last 3 years 80
(i) Residual reserves test
Existing paid-up capital 160
Free reserve 120
Total 280

Let the increased paid-up capital be Rs.100. The residual reserve must be 40
percent, i.e., Rs.40.
Total Rs. 100 + Rs. 40 = Rs. 140.
40
If total is Rs. 280, residual reserve must be × Rs. 280 = Rs. 80
140
Reserve available for capitalisation Rs. (120-80) = Rs. 40
ii) Profitability test
Average profits before tax during the last 3 years Rs. 80
 166

30
30 per cent of the average profit = × Rs. 80 = Rs. 24
100
Rs. 24 should give a rate of dividend on the increased capital base at 10%
100
The increased capital base = Rs. 24 × = Rs. 240
10
Existing paid-up capital = Rs. 160
Amount available for capitalisation = Rs. 80 (Rs. 240-Rs.l60)
Therefore, the amount available for capitalisation should be the lower of (i) and
(ii), i.e. Rs. 40
1. The capital reserves appearing in the balance sheet of the company as a
result of revaluation of assets or without accrual of cash resources are
neither capitalised nor taken into account in the computation of the
residual reserves of 40 per cent for the purpose of bonus issues.
2. The declaration of bonus issue, in lieu of dividend is not made.
3. The bonus issue is not made unless the partly-paid shares if any existing,
are made fully paid-up.
4. The company:
i) has not defaulted in payment of interest or principal in respect of
fixed deposits and interest on existing debentures or principal on
redemption thereof, and
ii) has sufficient reason to believe that it has not defaulted in respect of
the payment of statutory dues of the employees such as contribution
to provident fund, gratuity, bonus etc.
5. A company which announces its bonus issue after the approval of the
Board of Directors must implement the proposals within a period of 6
months from the date of such approval and shall not have the option of
changing the decision.
6. There should be a provision in the Articles of Association of the company
for capitalisation of reserves, etc. and if not, the company shall pass a
resolution at its general body meeting making provisions in the Articles of
Association for capitalisation.
7. Consequent to the issue of bonus shares, if the subscribed and paid-up
capital exceeds authorised share capital, a resolution shall be passed by
the company at its general body meeting for increasing the authorised
capital.
8. The company shall-get a resolution passed at its general body meeting for
bonus issue and in the said resolution the management's intention
regarding the rate of dividend to be declared in the year immediately after
the bonus issue should be indicated.
 167

9. No bonus issue shall be made which will dilute the value or rights of the
holders of debentures, convertible fully or partly.
Further in respect of the non-residential shareholders, it would be necessary
for the company to obtain the permission of the Reserve Bank under the Foreign
Exchange Regulation Act, 1973.
9.3.4 Preference Shares
'Preference' share as the name implies, have a prior claim on any profits the
company may earn, but they receive only a fixed rate of dividend after the interest
has been paid to the debenture holders. Thus, it may suit the investor who wants a
limited but steady return on his money. The preferential treatment is available on
both the rights-right to receive dividend and also right to receive back the capital in
the event of dissolution or liquidation, if there be any surplus.
Features of Preference Shares
Preference shares have the following features:
1. Return of Income: As the name indicates, they have the first preference to get a
return of income, i.e., to share in the profits among all shareholders.
2. Return of Capital: Similarly, they have also the first preference or prior right to
get back their capital at the time of winding up of the company, among all
shareholders.
3. Fixed Dividend: As per terms of issue and as per Articles of Association, they
shall have a fixed rate of dividend, e.g., a maximum of 15 per cent cumulative
or non-cumulative as the case may be. Hence, they are called fixed-income
securities.
4. Non-participation in Prosperity: On account of fixed dividends, these shares
holders cannot have any chance to share in the prosperity of the company's
business. This drawback can be removed to some extent by granting them an
additional privilege to participate in the surplus profits along with equity
shareholders at a certain ratio, e.g., 2:1.
5. Non-participation in Management: As per the Act, preference shares do not
enjoy normal voting rights and voice in the management of the company's
affairs except when their interests are being directly affected, e.g., change in
their rights and privileges or arrears of dividends for more than two or three
years successively.
6. Voting Right of Preference Shares: From the commencement of the Amendment
Act of 1974, no extra voting right can be enjoyed by preference shares which
were issued prior to April 1,1956. However, private companies which are not
subsidiaries of public companies are not affected by this Section.
9.3.5 Kinds of Preference Shares
Participating Preference Shares: The preference shares which are entitled to
participate in the surplus of profits of the company available for distribution over
and above the fixed dividend are called as participating preference shares. Once the
fixed dividend on preference shares is paid, a part of the surplus profit is utilised
 168

for payment of dividend to equity shareholders. The balance again may be shared
by both equity and participating preference shareholders. Thus, the participating
preference shares are entitled to (a) a fixed dividend and (b) a share in the surplus
profits. The preference shares, which do not carry a right to participate in the
surplus profits in addition to a fixed dividend, are called non-participating
preference shares.
Redeemable Preference Shares: The share capital of a company can never be
returned to the shareholders during the life-time of the company. It will be returned
to them only at the time of winding-up of the company, should the proceeds of sale
of assets of the company remain after meeting the claims of its creditors. But sec.
80 of the Companies Act, 1956 permits a company limited by shares to issue
preference shares which may be redeemed after a specified period or at the
discretion of the company, if so authorised by the articles of the company. These
preference shares are called redeemable preference shares. It should also be
remembered that the redemption of redeemable preference shares does not amount
to reduction of capital. However, the issue of redeemable preference shares is
subject to the following conditions:
1. The issue of redeemable preference shares must be duly authorised by the
Articles of Association of the company.
2. Preference shares should be fully paid so that they can be redeemed. It only
means that the partly paid-up shares cannot be redeemed.
3. Redeemable preference shares can be redeemed only out of the profits of the
company or out of the proceeds of fresh issue of shares specifically made for
the purpose of redemption.
4. If the shares are to be redeemed out of the profits of the company a sum
equal to the value of such shares should be transferred out of the net
profits of the company to a special reserve fund called "Capital Redemption
Reserve Account".
5. The premium, if any, payable on redemption of the shares should have
provided for out of the profits of the company before the shares are
redeemed.
6. New shares up to the nominal value of the redeemable preference shares
may be issued for the purpose of redemption either before redemption of old
shares or within one month after the redemption of old shares.
7. Shares already issued cannot be converted into redeemable preference
shares.
The preference shares which are not to be redeemed after a specific period are
called irredeemable preference shares. They become a perpetual liability to the
company and cannot be redeemed during the lifetime of the company.
 169

With effect from 15-06-1988 in India a company cannot issue irredeemable

preference shares and existing irredeemable preference shares are to be redeemed
within 10 years from the above date or date of redemption which ever is earlier;
Preference shares having redemption period of ten or less years can be issued at
present. If a company is unable to redeem the preference shares, it has to petition
to Company Law Board to issue fresh redeemable preference shares in place of the
existing including the dividend there on. (Sec. 80A of the companies Act. 1956).
Cumulative Preference Shares: Normally when a company does not earn any
profit in a particular year no dividend on any share becomes payable for that year.
But the cumulative preference shares confer on the holders a right to dividend
which is cumulative in character. It only means that where in a particular year no
dividend has been declared on preference shares in the absence of profit, such
unpaid dividends would be considered as arrears and carried forward to
subsequent years for the purpose of payment. Only after the payment of such
arrears from the profits of the company in the subsequent years, any dividend on
other type of shares can be paid. All preference shares issued by a company are
only cumulative unless otherwise stated in the articles of Die Company. Those
preference shares which do not carry cumulative right to dividends are called non-
cumulative preference shares. If a company does not earn any profit in a particular
year, neither dividend is declared on non-cumulative preference shares nor is the
unpaid dividend considered as arrears and carried forward to the subsequent year
for purpose of payment.
Convertible Preference Shares: The preference shares which carry the right of
conversion into equity shares within a specified period are called Convertible
Preference Shares. The issue of convertible preference shares must be duly
authorized by the articles of association of the company. The preference shares
which do not carry the right of conversion into equity shares are called non-
convertible preference shares.
Guidelines for Issue of CCP Shares
The following is the text of guidelines for issues of cumulative convertible
preference shares:
Applicability: The guidelines will apply to the issue of Cumulative Convertible
Preference (CCP) shares by public limited companies which propose to raise
finance.
Objects of Issue: The objects of the issue of the above instrument should as
under: (i) setting up new projects, (ii) expansion or diversification of existing
projects, (iii) normal capital expenditure for modernisation, and (iv) working capital
requirements.
Quantum of Issue: The amount of issue of CCP shares will be to the extent the
company would be offering equity shares to the public for subscription. In case of
 170

projects assisted by financial institutions, the quantum of the issue would be

approved by financial institutions/banks. The applicant company should submit to
the Securities Exchange Board of India (SEBI) a realistic estimate of the project
costs, along with copies of letters indicating the approval/participation of the public
financial institutions in the financing of the project costs.
Terms of Issue: (i) The aforesaid instrument would be deemed to be equity
issue for the purpose of calculation of debt equity ratio as may be applicable.
(ii) The entire issue of CCP would be convertible into equity shares between the
end of 3 years and 5 years as may be decided by the company and approved by the
SEBI.
(iii) The conversion of the CCP shares into equity would be deemed at being
one resulting from the process of redemption of the preference shares out of the
proceeds of a fresh issue of shares made for the purpose of redemption.
(iv) The rate of the preference dividend payable on CCP would be 10 per cent.
(v) The guidelines in respect of issue of preference shares, ratio of 1:3 as
between preference shares and equity shares would not be applicable to the new
instrument.
(vi) On conversion of the preference shares into equity shares, the right to
receive arrears of dividend, if any, on the preference shares upto the date of
conversion shall devolve on the holder of the equity shares on such conversion.
The holder of the equity shares shall be entitled to receive the arrears of
dividend as and when the company makes profit and is able to declare such
dividend.
(vii) The aforesaid preference share would have voting rights, as applicable to
preference shares under the Companies Act, 1956.
(viii )The conversion of aforesaid preference shares into equity shares would be
compulsory at the end of 5 years and the aforesaid preference shares would not be
redeemable at any stage.
Denomination of CCP: The face value of aforesaid shares will ordinarily be Rs.
100 each.
Listing of CCP: The aforesaid instrument shall be listed on one or more stock
exchange in the country.
Articles of association of the company and resolution of the general body
The articles of association of the applicant company should contain a
provision for the issue of CCP. Further the company shall submit with the
application to the CCI a certified copy of special resolution in this regard under
Section 81 (IA) of the company. This resolution shall specifically approve the issue
of the CCP shares and provide for compulsory conversion of the preference shares
between the 3rd and 5th year as the case may be.
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Miscellaneous: (a) All applications should be submitted to the SEBI in the

prescribed form duly accompanied by a demand draft for fees payable under the
Act.
(b) The applications should be accompanied by a true copy of the letter of
intent/industrial licence, whichever is necessary, or registration with the Director
General of Technical Development (DGTD) for the project.
(c) In respect of companies registered under the MRTP Act, they should ensure
that the requisite approval under the said Act has been obtained before making an
application to the SEBI. Documentary evidence of the foregoing should invariably
be submitted with the application.
(d) A certificate duly signed by the secretary and/or director of the company
stating that the information furnished is complete and correct should be annexed to
the application. Similarly, a certificate from the auditors of the company stating
that the information in the application has been verified by them and is found to be
true and correct to the best of their knowledge and information, be furnished.
Merits of Preference Shares
(i) These shares are preferred by people who do not like to risk their capital
completely and yet want an income which is higher than that obtainable on
debentures and other creditor ship securities.
(ii) These shares have the merit of not being a burden on finances because
dividend on these will be paid if profits are available;
(iii) These shares are particularly useful if its assets are not acceptable as
collateral security for creditor ship securities such as debentures, bonds etc.,
(iv) These shares can well save it from the higher interest which will have to be
paid by it in case it wishes to issue debentures against assets which are already
mortgaged;
(v) The property need not be mortgaged as in the case of debentures if these
shares are issued;
(vi) Preference shares bear a fixed yield and enable the company to declare
higher rates of dividend for the equity shareholders by trading on equity;
(vii) The promoters can retain control over the company by issuing preference
shares to outsiders because these shareholders can vote only where their own
interests are affected;
(viii) In the case of redeemable preference shares, there is the advantage that
the amount can be repaid as soon as the company gets more funds out of profits.
9.3.6 Evaluation of Preference Shares as a Source of Finance
The exact role of preference shares in meeting the financial requirements is
debatable. The attitude of financial managers towards preference shares seems to
vary widely. This divergence is probably explained by the 'in-between' nature of this
type of ownership security. In creating some sort of obligation to pay a fixed
dividend, the company assumes a risk to its credit rating and shareholders
relations.
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Reasons to issue preference shares are: (a) it is desirable to enlarge the sources
of funds for the business. Certain financial institutions (and even individual
investors) that can buy equity shares cannot invest in preference issues. The yield
premium over debt is attractive to these and other investors who wish to assume
the risk of equity shareholders; (b) the sale of preference shares may be an
economical way of raising funds. If earnings of assets exceed the dividend rate and
the preference shares are non-participating, this economy is obvious; (c) the sale of
preference shares makes it possible to do business with other people's money
without giving them any participation in the affairs of management; (d) Preference
shares can be considered a type of semi-permanent equity financing; (e) Preference
share carries less risk than debt.
From the investor's viewpoint, preference share is safer than equity share
within 'the same company. Because of the priority over equity shares in the receipt
of dividends and repayment of capital, preference shareholders believe themselves
to be in a stronger position than equity shareholders. However, this advantage is
somewhat offset by the fact that preference shareholders can usually receive only a
limited return on their investment. In other words, preference shareholders
sacrifice income in return for expected safety.
The limitations attached with preference shares are quite obvious: (1) those
who doubt the usefulness of preference shares point out that it is too expensive to
use under the present tax structure. While the yield to investor on preference
shares is not much higher than on debt issues, the cost to the company is more
than double. It is so because the company cannot deduct this dividend on its tax
return; this fact is the principal drawback of preference shares as a means of
financing. In view of the fact that interest obligations on debt are deductible for tax
purpose, the company that treats to preference share dividend as a fixed obligation,
finds the explicit cost to be rather high. (2) Critics of preference shares also argue
that while no legal obligations exist to pay dividends, the passing of preference
dividends and accumulation of arrears can have an adverse effect upon the credit of
the company.
9.4 REVISION POINTS
Equity- The word 'equity' means the ownership interest as measured by
capital, reserves-and surplus.
Right share- Whenever an existing company wants to issue new equity shares,
the existing shareholders will be potential buyers of these shares.
Bonus share - Bonus shares are issued to the existing equity shareholders.
When the company has sufficient reserves and surplus but its cash position is
weak. it may think of issuing bonus shares.
Preference share - 'Preference' share as the name implies, have a prior claim
on any profits the company may earn, but they receive only a fixed rate of dividend
after the interest has been paid to the debenture holders.
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9.5 INTEXT QUESTIONS

1. What do you mean by share?
2. What do you mean by equity shares?
3. What do you understand by preference Share?
4. What do you mean by No-Par Share?
5. What do you mean by Right Share
6. What do you mean by bonus share?
9.6 SUMMARY
The word ‘equity’ means the ownership the ownership interest as measured by
capital reserve and surplus. Hence, ordinary shares are often called ‘equities’.
Risk capital, Fluctuating dividend, changing marked value, growth prospects,
protection against inflation and voting right are all the features of the equity shares.
Bonus shares are issued when the company has sufficient reserve and surplus
but its cash position is week maintenance of liquidity position, remedy for under
capitalization, and Economic issue of securities and advantages of bonus shares for
the issuing company. Tax saving, income in equity holdings, and increase in
income and advantages of bonus shares to investors.
Preference share holder have a prior claim on any profits of the company may
earn, but they receive only a fixed rate of dividend after the interest has been paid
to the debenture holders.
Return of income, return of capital, fixed dividend, non-participation in
prosperity and non-participation in management are the feature of the preference
shares.
Participating, Non participating, redeemable, Irredeemable, cumulative, non-
cumulative, convertible and non-convertible are all some kinds of preference
shares.
9.7 TERMINAL EXERCISE
1. The word ……………… means the ownership interest as measured by capital,
reserves-and surplus.
2. ………………….share holders have an unlimited interest in the company
profits and assets.
3. ………………..shares are issued to the existing equity share holders.
4. ………………..have a prior claim on any profits the company may earn, but
they receive only a fixed rate of dividends after the interest has been paid to
the debenture holders.
9.8 SUPPLEMENTARY MATERIAL
1. www.efinancemanagement.com
2. www.accounting-simplified.com
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9.9 ASSIGNMENTS
1. What are the characteristics of equity shares?
2. Critically evaluate equity shares as a source of finance both from the point
of (i) the company and (ii) the investing public.
3. What do you understand by no-par shares? State the advantages claimed
by such shares.
4. What are Right Shares? What is its significance for financial management?
5. What do you mean by Bonus Shares? State the guidelines for issue of
such shares.
6. Explain essential characteristics of preference shares.
7. State and explain the various kinds of preference shares.
8. State the conditions to which the issues of redeemable preference shares
are subjected to in India.
9. Explain the merits and demerits of preference shares as a source of
industrial finance both from the point of (f) the company and (ii) investing
public.
10. What are the relevant factors, necessary to be kept in mind by a corporate
financial controller in recommending the issue of (i) Bonus shares and
(ii) Cumulative Convertible Preference Shares?
9.10 SUGGESTED READINGS
1. Chandra, Prasanna: “Fundamentals of Financial Management”, New Delhi,
Tata McGraw Hill Co.
2. Kulkami, P.V.,: “Corporate Finance”, Bombay, Himalaya Publishing House.
3. Saravanavel, P.,: “Financial Management,” New Delhi, Dhampat Rai & Sons.
9.11 LEARNING ACTIVITIES
You are a stock broker. You have decided to create awareness among the
public in your city. How will you attract the public. Suggest a suitable programme.
9.12 KEYWORDS
Equity Shares, Preference shares, Bonus Shares, Right Shares, No-Par Share,



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LESSON –10

DEBENTURES AND BONDS

10.1 INTRODUCTION
A debenture is a document issued by the company as an evidence of debt. It is
the acknowledgement of me company's indebtedness to its-holders. Debentures and
bonds are called as creditorship securities. In the United States of America, only
unsecured bonds are termed as debentures. But in Britain no distinction is made
between debenture and bonds. In India, the words 'debentures' and 'bonds' are
used interchangeably.
The Companies Act, 1956 has not defined as to what debenture means. It
simply states that a "debenture includes debenture stock, bonds and any other
securities of a company whether constituting a charge on the assets of the company
.or not [Sec.2 (12)]. Thus, the Act only states that it is a kind of security which
constitutes a charge by way of security on issuing debentures. In other words,
debenture is a long-term promissory note which usually runs for duration of not
less than ten years.
10.2 OBJECTIVES
After reading this lesson you should be able to:
 Understand the features of debentures
 Detail the types of debentures
 Distinguish between fully convertible and partly convertible debentures
 Evaluate debentures as a source of finance
 Know the SEBI guidelines to issue debentures
10.3 CONTENT
10.3.1 Features of Debentures
10.3.2 Types of Debentures
10.3.3 Advantages of Debenture Finance
10.3.4 Limitations of Debentures
10.3.1 Features of Debentures
Debenture financing has the following features:
1. Debenture is a credit instrument; the debenture holder is a creditor of the
issuing company; Debenture is the promise by the company that it owes a
specific (debt) sum of money to the holder.
2. Provision for a Trustee: When the debenture issue is floated as a private
placement, the issuing company and the buyer(s) are the only parties to
the issue. When a debenture issue is sold to the investing public, there are
three parties to the issue; the issuer, the debenture holders, and the
trustee.
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3. Debenture holders are entitled to periodical payment of interest at agreed

rate.
4. They are also entitled to redemption of their capital as per the agreed
terms.
5. Priority in liquidation: In the event that the issuing company is liquidated,
debenture holder's claims are honoured ahead of the shareholders claims.
When more than one debenture issue must be retired, the priorities
among the debenture issues are contained in the indenture like the pan
passu clause.
6. They have no voting rights. Under Section 117 6f the Companies Act,
1956, debentures with voting rights cannot be issued
7. Usually debentures are secured by charge on or mortgage of the assets of
the company.
8. Debenture holders have the right to sue the company for any unpaid dues.
9. They can enforce their claim over the security by the sale in case of
default.
10. They can apply for foreclosure or even for winding up of the company to
safeguard their interests.
Differences between equity shares and debentures
The following are some of the differences between equity shares and
debentures

Points of difference Equity Shares Debentures

To meet long term and

To meet long term
1. Motive of issue medium term financial
financial requirements.
requirements.

Preferred by adventurous Preferred by cautious

2. Investor preference investors with risk investors who are
bearing capacity. reluctant to take risks.

Returns (dividends) are

not fixed. They are
dependent on the profits
Returns (interest) are fixed
3. Return earned. High retums in
in nature.
case of high profits and
low return in case of low
profits.

They are residual

claimants. They can Interest has to be paid to
4. Priority in return expect dividends only them before any dividend
after interest has been can be distributed.
paid on debentures and
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preference dividend has

been paid to preference
shareholders.

Their claims will be

settled only afier the
Their claims have to be
claims of preference
5. Settlement of claims settled before anything
shareholders and
during liquidation preference or equity
debenture can be
shareholders.
distributed to holders
have been settled.

Payment of equity
dividends is optional. It is
dependent on the Payment of interest on
6. Financial burden discretion of the Board of debentures is a fixed
Directors. Therefore there financial commitment.
is no fixed financial
commitment.

No redemption until Redeemable as per terms

7. Redemption
liquidation. of issue.

8. Voting rights Enjoy voting rights Do not enjoy voting rights.

9. Reduction of capital By reorganization By repayment

Generally of lower Generally of higher

10. Price
denomination. denomination

Preferred by medium and

Even small investors can large investors. Small
11. Type of investors. invest because of the investors would find it
lower denomination difficult to invest because
of the higher denommation

Strengthens borrowing Reduces borrowirg

12. Borrowing capacity
capacity. capacity.

There are chances for Lesser chances for over-

13. Capitalisation
over-capitalisaton. capitalisation.

Generally creates charge

Does not create charge on
14. Charge on assets on the assets of the
the assets.
company.

The above table differentiates equity shares and debentures.

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10.3.2 Types of Debentures

There are several types of debentures. A brief analysis about the different types
of debentures is given below.
Registered Debentures: Registered debentures are those which are recorded in
Register of Debenture holders with full details about the number, value and types
of debentures held by each of them. The payment of interest and the repayment of
capital is made t6 those whose names are registered with the company and duly in
toe Register of Debenture holders. Registered debentures are not negotiable.
Transfer of ownership of these debentures cannot be valid unless the regular
instrument of transfer, duly stamped and signed both by the owner (transferor) and
the transferee, is passed by the Board of Directors. The transfer of such debentures
is recorded in the register of the company.
Bearer Debentures or Unregistered Debentures: The debentures which are
payable to the bearer are called bearer debentures. The names of the debenture
holders are not recorded in the Register of debenture holders. They are negotiable
instruments by custom. So they are transferable by mere delivery. Registration of
transfer is not necessary.
Secured Debentures or Mortgage Debentures: The debentures which are
secured fully or partly by a charge on the assets of the company are called secured
debentures. The charge may be either a fixed charge or a floating charge.
Unsecured Debentures or Naked Debentures: The debentures which are not
secured either fully or partly by a charge on the assets of the company are called
unsecured or naked debentures. The general solvency of the company is the only
security for the holders. Here, the debenture holder is treated as an unsecured
creditor.
Redeemable Debentures: The debentures which are repayable after a certain
period are called redeemable debentures. Sometimes they can be redeemed by the
company on demand by the holders or at the discretion of the company.
Irredeemable Debentures: These debentures are also known as perpetual
debentures. These are the debentures which are not repayable during the life-time
of the company. Such debt becomes due for redemption only when the company
goes into liquidation or when interest is not regularly paid as and when accrued.
Equitable Debentures: Equitable debentures are those which are secured by
deposit of title deeds of the property with a memorandum in writing creating a
charge.
Legal Debentures: Legal debentures are those in which the legal ownership of
the property of the corporation is transferred by a deed to the debenture holders, as
security for the loans.
Preferred Debentures: Preferred debentures are those which are paid first in
the event of winding up of the corporation.
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Ordinary Debentures: Ordinary debentures otherwise known as second

debentures are paid only after the preferred debentures have been redeemed.
Convertible Debentures: Holders of these debentures are given the choice to
convert their debenture holdings into equity shares of the company at stated rates
after a specified period. Thus these debenture holders get an opportunity to become
shareholders and to take part in the company management at a later stage. On the
basis of convertibility, they can be classified into (a) Convertible and (ii)-Non-
convertible.
(a) Non-Convertible Debenture (NCDs): These debentures cannot be converted
into equity shares and will be redeemed at the end of the maturity period.
ICICI offered for public subscription for cash at par, Rs.20,00,000 of which
16% unsecured redeemable Bonds (Debentures) of Rs. 1000 each. These bonds are
fully non-convertible and interest paid half yearly on June 30 and December 31
each year. The company proposes to redeem these bonds at par on the expiry of 5
years from the date of allotment i.e. the maturity period is 5 years. But ICICI has
also allowed its investors the option of requesting the company to redeem all or part
of the bonds held by them on the expiry of 3 years from the date of allotment,
provided the bond holders give the prescribed notice to the company.
(b) Fully Convertible Debentures (FCDs): These debentures are converted into
equity shares after are specified period of time at one stroke or in instalments.
These debentures may or may not carry interest till the date of conversion-. In the
case of a fully established company with an established reputation and good, stable
market price, FCD's are very attractive to the investors as their bonds are getting
automatically converted into shares which may at the time of conversion be quoted
much higher in the market compared to what the debenture holders paid at the
time of FCD issue. Recently three reputed companies, Apple Industries Limited,
Arvind Polycot Limited and Jindal Iron and Steel Company Limited have come out
with the issue of Zero per cent FCDs for cash at par. Let us take a look at the
Jindal issue.
The total issue was for 3,01,72,080 secured Zero-Interest fully Convertible
Debentures. Of these, 1,29,30,000 FCDs of Rs. 60 each were offered to the existing
shareholders of the company on Rights basis in the ratio of one FCD for every one
fully paid equity share held as on 30.03.93. The balance of 1,72,42,080 secured
zero-interest FCDs were offered to the public at par value of Rs. 100 each.
The terms of conversion were as follows
Each fully paid FCD will be automatically and compulsorily converted into one
equity share of Rs. 10 each at a premium of Rs 90 per share credited as fully paid
up. Conversion into equity shares will be done at the end of 12 months from the
date of allotment.
(c) Partly Convertible Debenture (PCDs): These are debentures, a portion of
which will be converted into equity share capital after a specified period, whereas
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the non-convertible (NCD) portion of the PCD will be redeemed as per the term of
the issue after the maturity period. The non-convertible portion of the PCD portion
will carry interest right upto redemption whereas the interest on the convertible
portion will be only upto the date immediately preceding the date of conversion.
Let us look at the Ponni Sugars and Chemicals in greater detail. The company
is offering PCDs worth Rs.2205 lakhs of which Rs.605 lakhs is being offered the
existing shareholders. The issue is for 14,70,000 16% Secured Redeemable PCDs of
Rs.150 each. Out of this, 4.06,630 PCDs are by an off Rights Issue, in the ratio of
one PCD for every ten equity shares held. The balance of 10,66.370 PCDs are
offered to the public. Of the total face value of Rs. 150, the convertible portion will
have a face value of Rs.60 and the non-convertible portion, a face value of Rs.90. A
'tradable warrant' will be issued in the ratio of one warrant for every 5 fully paid
PCDs. Each such warrant will entitle the holder to subscribe to one equity share at
a premium which will not exceed Rs.20 per share within a period of 3 years from
the date of allotment of the PCDs. This is not included in the conversion at the rate
of 1:10. The tradable warrants will also be listed in stock exchanges to ensure
liquidity. Interest at 16% on the paid-up value of the PCD allotted shall accrue from
the date of allotment, but interest on the convertible portion of the PCD will be paid
only upto the date immediately preceding the date of conversion. The non-
convertible portion of the PCD will be redeemed in the stages at the end of the 6th,
7th and 8th year from the allotment of the PCD.
(d) Secured Premium Notes (SPNs): This is a kind of NCD with an attached
warrant that has recently started appearing-in the Indian Capital Market. This was
first introduced by TISCO which issued SPNs aggregating Rs.346.50 crores to
existing shareholders on a right basis. Each SPN is of the face value ofRs.300. No
interest will accrue on the instrument during the first 3 years after allotment.
Subsequently the SPN will be repaid in 4 equal instalments of Rs.75 each from the
end of the fourth year together with an equal amount of Rs.75 with each
instalment. This additional Rs. 75 can be considered either as interest /regular
income) or premium on redemption (capital gain) based on the tax planning of the
investor.
The warrant attached to the SPN gives the holders the right to apply for and
get allotment of one equity share for cash by payment of Rs.100 per share. This
right has to be exercised between one and one-and-half year after allotment, by
which time the SPN will be fully paid up. The instrument was first issued by IDBI,
later on followed by SIDBI. The above bond issued by IDBI has a face value of Rs. 1
lakh but was issued at a 'deep discounted' price ofRs.2700. This bond appreciates
to its face value over the maturity period of 25 years. But a unique advantage of
this bond is that it gives the investor an option of contracting upto maturity or seek
redemption at the end of every 5 years with a given deemed face value. These bonds
can be sold by the investor in the stock exchange and the difference between the
sale price and original cost of acquisition will be treated as capital gain. The bond
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has been assigned "AAA" rating by CRISIL, indicating the highest safety with regard
to payment of interest and principal.
The face value of SIDBI's Deep Discount Bond is also Rs. 1 lakh but the initial
investment required is only Rs.2,500. These bonds have got ‘AA’ rating from CRISIL
indicating high safety with regard to timely payment of principal and interest.

Nominal Rate
Period
Deemed face value (compounded Effective%
(Years) half yearly) %
After 5 5,700 15.52 16.12
After 10 12,000 15.49 16.09
After 15 25,000 15.40 15.99
After 20 50,000 15.14 15.71
After 25 1,00,000 14.98 5.54
Reasons for Issuing Covertable Bonds
The management inserts conversion feature in bond indenture for four main
reasons, viz., to sweaten the issue, to eliminate debt with unduly restrictive
conditions, to defer the sale of equity stock and prevent dilution of earnings
available to current stockholders and to reduce cost of financing. It is generally
believed that convertible bonds enjoy 'high marketability because of three-fold
benefits available to bondholders. Thus, a convertible bondholder has the
advantage of certainty of income, the priority of claim as to income and assets and
the opportunity of sharing in the profits if the company prospers. Management uses
conversion method to extinguish debt which was unduly restrictive in terms,
hampering the progress of the organization and to get rid of Burden of fixed
obligation. Frequently, when there is a slump in stock market and acquisition of
capital through equity stock possess a great problem or the company has been
caught temporarily in financial trouble or due to poor cash dividend policy it is felt
that the new stock-issue will elicit poor response from investors, the management
may decide to defer the stock issue and float convertible bond with an intention to
convert them in near future when, it is believed, earnings of the company will
improve substantially and market conditions will change. Furthermore, cost
consideration also motivates the management to issue convertible bonds. The
underwriting cost of a convertible bond is lower than common stock or ordinary
bonds because of the fact that the former is more appealing to the investor and
hence easier to sell.
Another factor, which has made convertible bond more popular with the
management, is lower interest rate. Because of conversion privilege investors may
forego higher interest.
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There are four important features of convertible securities: (i) The conversion
ratio, (ii) The conversion period, (iii) The conversion value, and (iv) The conversion
premium.
(i) The Conversion Ratio: The conversion ratio is the ratio in which the
convertible security can be exchanged for equity stock. The conversion ratio may be
stated by indicating that the security is convertible into a certain number of shares
of equity stock. In this situation, the conversion ratio is given, and in order to find
the conversion price, the face value of the convertible security is divided by the
conversion ratio. An example of this case is given below:
Illustration
A corporation has outstanding a convertible security issue-a debenture with
Rs. 1,000 face value convertible into 25 shares of equity stock. The conversion ratio
for the bond is 1:25. From this, the conversion price for the Bonds is arrived at
Rs.40.

 1,000 
 = 40
 25 
Sometimes, instead of the conversion ratio, the conversion price is given. In
that case, the conversion ratio can be obtained by dividing the face value of the
convertible by the conversion price. This case can be explained with the following
example.
Illustration
A corporation has outstanding a convertible bond with a face value of Rs.
1,000. The bond is convertible at Rs. 50 per share into equity stock. From this
information, the conversion ratio is arrived at

1:20  
1,000
 20
 50 
(ii) The Conversion Period: Convertible bonds arc often convertible only within
or after a certain period of time. Sometimes, conversion is not permitted until a
certain period has passed. In another instance, conversion is permitted only for a
limited number of years after its issuance. Sometimes, bonds may be convertible at
any time during the life of the security. Time limitations on conversion are imposed
by the corporation to suit its long-run financial needs.
(iii) Conversion Value: The conversion value of a convertible bond is the value of
the security measured in terms of the market value of the security into which it
may be converted. Since convertible bonds are convertible into equity stock, the
conversion value can generally be found simply by multiplying the conversion ratio
by the current market price of the corporation' s equity stock.
Illustration
The corporation has outstanding a Rs. 1016 bond which is convertible into Rs.
31.25 a share. The current market price of the equity stock is Rs. 32.50 per share.
The conversion ratio is, therefore, 32.
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 1,000 
  32
 31 .25 
The current market price of the equity stock is Rs, 32.50 per share.

The conversion value of the bond is Rs. 1016 

1016 
  32.5
 .25 
31
(iv) The Conversion Premium: The conversion value depends on the market
value of shares at the time of issue of convertible bonds. Normally, the market price
of the convertible security will be higher than the conversion value at the time of
issue. The difference between the two is conversion premium. It is this difference
between the market price of the shares and the low conversion value which acts as
an incentive for the investing public to invest in convertible debentures.
Where the difference between the face value and the market price is high,
companies put a premium on shares at the time of conversion and when the
difference is not high, there is normally no premium and the shares are allotted at
par.
The conversion premium is the percentage difference between the conversion
price at the price of a security and the actual size of the premium depends largely
on the nature of the company. If the company' s stock is not expected to appreciate
greatly, a low premium will be used. The convertible premium given to a convertible
security can greatly affect the future success of the security. This can be explained
by the following example.
Illustration
The corporation has issued a Rs. 1,000 convertible bond. The bond is convertible
into 20 shares of the corporation's equity stock at a price of Rs.50 per share. The
corporation's equity stock is currently selling at Rs.45 per share. From this
information, it is clear that the conversion premium is Rs. 5 per share (50-45 = 5) or
Rs.100 (5 x 20 = 100). Conversion premium in this case is 11.11 per cent

 5 
  100  11.11
 45 
Utility of Conversion Method
The conversion privilege of the bond is very appealing bond to the issuer as
well as to investing community. It enables the issuing company to attract savings of
investors even though the company's current position does not favour issue of
stock.
Furthermore, this provides a convenient and relatively easy way of getting rid
of bonded indebtedness and the fixed interest charges attached thereto. Without
making any cash payment and simply by further dividing the ownership the
company can extinguish indebtedness.
To investors who at the moment are not prepared to invest in stocks but who
are not content to continue indefinitely as creditors, conversion privilege has great
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value because it would give safety of principal and a certain ratio of income and a
right to convert it for stock in case the company prospered so that its stock paid a
high rate was reasonably secured. Thus, the purchase of convertible bonds gives
investors the opportunity to have their cake and eat it too. Such bonds also appeal
to speculators who are interested more in capital appreciation than income. They
could borrow on their bond to make a large percentage of appreciation on their
investment.
However, convertible bonds may be said to have adversely affected, though to a
limited extent, the investment position of the company's stock. In the event of
depression the consequences may be serious. Further, conversion injures the
market position of the bonds that remain unconverted. The value of such bonds will
be very low.
10.3.3 Advantages of Debenture Finance
Debenture finance has its own importance and significance in company
finances. Some of the points may be discussed as under:
i) The company is able to secure capital without giving any control to the
debenture holders.
ii) In every country and in every section of society there are investors who want
to have secured investment with an attractive rate of interest. But they are
not prepared to expose their money to risk. Debentures very much suit their
investment pattern.
iii) Debentures are less risky securities from the investors' point of view. Hence,
the company is able to raise capital through the issue of debentures at
relatively lesser cost.
iv) Debenture holders pay to the company for a specific period and cannot
withdraw their money before the expiry of that period. In this way there is
certainty about the availability of finance for a specific period and
programmes accordingly.
v) The company has the scope for 'trading on their equity' by raising the bulk of
its capital in the form of debentures with fixed rate of interest. The equity
shareholders are thus enabled to get maximum possible return out of the
residual profits, during boom period.
vi) Since debentures are generally issued on redeemable basis, the company can
avoid dyer-capitalisation by refunding the debt when the financial needs are
no longer left.
vii) Issue of debentures reduces the dependence of the company on uncertain
sources of finance such as deposits, commercial banks etc.
viii) In case the company has already incurred a number of small debts of short
duration, it may be costlier for it to maintain them. Under such
circumstances, they may be converted into a single issue of debentures
which will prove less costly.
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ix) Debentures, have a great market response during depression or when the
possibilities of inflationary profits are rare.
10.3.4 Limitations of Debentures
In spite of the fact that the debentures offer several advantages mentioned
above, it is found that, in practice they have several limitations.*
i) Debenture interest has to be paid to the debenture holders irrespective of the
fact whether the corporation earns profit or not. It becomes a great burden
on the finances of the corporation.
ii) When assets of the company get tagged to the debenture holders the result is
that the credit of the company in the market comes down arid in some cases
even the banks refuse loans to that company.
iii) If the capital structure is heavily loaded with debentures, the major part of
the company's earnings is absorbed in servicing the debt and little is left for
distribution by way of dividends. This lowers the value of shares of such
company.
iv) If the company has already raised large amount through the issue of
debentures it has to offer higher rates of interest to market its subsequent
issue of debentures.
v) From the investors' point of view, safety of capital is likely to be vitiating by
lack of control over the company's affair. The speculative ventures,
overtrading and mismanagement of the company would harm the interest of
debenture holders and weaken the safety of their capital.
vi) The proportion of fixed assets to total assets is an important determining
factor for the issue of debentures. A corporation with low proportion of fixed
assets to total assets will not find itself under congenial conditions for me
issue of debentures because it has no substantial security to offer to
debenture holders. Mostly the trading enterprises and concerns dealing in
consumer goods belong to such category.
vii) There is a ceiling imposed by financial institutions on the maximum debt-
equity ratio of a company which in turn limits the quantum of funds that
can be mobilised from this source.
viii) Since -financing from this course increases the financial risk of the
company, the equity shareholders tend to demand a higher rate of return to
compensate for the additional risk assumed.
ix) The debenture contract can have several protective covenants which restrict
the financial flexibility of the company.
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SEBI Guidelines for Issue of Debentures

SEBI has given various Guidelines for the issue of debentures. Before we look
deep into the list of guidelines, some of the post on debentures like Rights
debentures for working capital, Importance of debentures in capital structure of a
company, SEBI Guidelines on Fresh capital Share, Primary markets & secondary
markets may be of interest to you.
1. Guidelines will be applicable for the issue of convertible and nonconvertible
debentures by public limited as well as public sector companies.
2. Debentures can be issued for the following purposes:
 For starting new undertakings
 Expansion or diversification
 For modernization
 Merger/amalgamation which has been approved by financial institutions
 Restructuring of capital
 For acquiring assets
 For increasing resources of long-term finance.
3. Issue of debentures should not exceed more than 20% of gross current
assets and also loans and advances.
4. Debt-equity ratio in issue of debentures should not exceed 2:1. But this
condition will be relaxed for capital intensive projects.
5. Any redemption of debentures will not commence before 7 years since the
commencement of the company.
6. For small investors for value such as Rs. 5,000, payments should be made
in one installment.
7. With the consent of SEBI, even non-convertible debentures can be
converted into equity.
8. A premium of 5% on the face value is allowed at the time of redemption and
in case of non-convertible debentures only.
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9. The face value of debenture will be Rs. 100 and it will be listed in one or
more stock exchanges in the country.
10. Secured debentures will be permitted for public subscription.
Law Relating to Issue and Redemption of Debentures
Procedure for the issue of Debentures: A resolution authorising the issue has to
be passed by the Board of Directors of the Company at a meeting of the Board.
There must be a provision in the Article for issue of Debentures. The consent of the
SEBI has to be obtained for the issue of the debentures. The consent of the
shareholders has to be obtained at a meeting of the shareholders if the borrowings
under the debenture, together with any money already borrowed by the company
(apart from temporary loans obtained from the company's bankers in the ordinary
course of business) will exceed the aggregate of the company’s paid up capital plus
free reserves in the case of public and their subsidiaries.
Sanction of the shareholders by ordinary resolution is also necessary if the
whole or substantially the whole of any of the company's undertaking is proposed
to be charged against the debentures by unstatutory mortgage.
The particulars of the charge created by the debentures have to be filed with
the Registrar of companies within thirty days after the execution of the deed
containing the charge. A certificate of registration has to be obtained from the
Registrar and a copy of the certificate has to be endorsed on every debenture
certificate. Particulars of the debentures have also to be entered in the company’s
Register of Charges.
Where the debentures are offered to be public, then a debenture prospectus
has to be filed with the Registrar on the same date on which the said prospectus is
issued. If prospectus is not issued, then, a statement in lieu of prospectus has to be
field with the Registrar at least three days before the first allotment of debentures.
The prospectus shall state the name of the Stock exchange or exchanges if the
prospectus states that application will be made to the stock exchange or stock
exchanges. Before the tenth day after the issues of the prospectus the company
should apply for permission from the stock exchange.
The allotment becomes void if the permission has not been applied for before
the tenth day after the first issue of the prospectus, or where such permission has
been applied for within the specified time often days but has not been granted even
by one of the stock exchanges before the expiry of ten weeks from the date of the
closing of the subscription lists. If the application has not been disposed of within
the time limit stated above, it shall be deemed that the applications have not been
granted.
If the allotment becomes void, the money received from the applicants must be
repaid within eight days the expiry of the tenth day (where permission has not been
applied) or ten weeks (where permission has been refused or the period of ten
weeks has expired) as the case may be. If any such money is not paid within eight
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days after the company becomes liable to repay it, the directors of the company will
be jointly and severally liable to repay that money with interest at the rate of 12%
per annum from the expiry of the eight day, unless such directors prove that the
default was not because of their misconduct or negligence.
An appeal against the decision of the stock exchange refusing the permission
for the debentures to be dealt in on that stock exchange may be preferred under
section 22 of the Securities Contracts (Regulation) Act. If such an appeal has been
preferred then such allotment shall not be void, until the dismissal of the appeal.
In case permission has been granted to deal on a recognised stock exchange or
exchanges excess money received on application must be forthwith returned
without interest to the applicants and where the money is not repaid within eight
days from the date of allotment interest at the rate of 12% per annum on the
refundable amount accrues and penal consequences follows for default. All moneys
received from the applications for debentures must be kept in a separate bank
account with a scheduled bank. If a prospectus has been issued, the allotment of
debentures should be made after the fifth day after the date on which the
prospectus was issued.
It is not necessary to file a return of allotment with the registrar after the
allotment of the debentures. However, within three months of the allotment, the
debentures must be completed and made ready for delivery. After the allotment, the
name of the debenture holder together with his address, occupation, number of
debentures held by him, and the date of allotment to him of the debentures, must
be entered in the Register of Debenture holders. In case the number of debenture
holders exceeds fifty, then, the names of the debenture holders should be entered
in the Index of Debenture holders.
Form of Debenture: Its principal contents are as follows, (a) the date when the
principal is to be repaid by the company; (b) the rate of interest; (c) the dates on
which the interest is to be repayable; (d) a statement that the undertaking of the
company is charged with such payments; and (e) a statement that the debenture is
issued subject to "conditions".
Debenture cannot be issued to Foreigner or non-resident Indian without prior
permission of the Reserve Bank of India under the Foreign Exchange Regulation Act
and Rules made there under.
Debentures, Stock Certificates must be completed and ready for delivery
within two months after allotment or after Lodging of Transfer unless the conditions
of issue otherwise provide (Section 113 of the Companies Act, 1956). A contract to
take up debenture may be enforced by specific performance (Section 112 of me
Companies Act).
Issue of Debentures at Commission or Discount: S.129 Where any commission,
allowance or discount has been paid or from holders having bonds of not more-
man. Rs. 40,000 face value in each case.
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Guidelines for issue of Fully Convertible Debentures (FCDs) / Partially Convertible

Debentures (PCDs) / Nonconvertible debentures (NCDs)
The guidelines issued by the Securities and Exchange Board of India (SEBI) on
llth June, 1992 are as follows:
1. Issues of FCDs having a conversion period of more than 36 months will
not be permissible, unless conversion is made optional with "put and call"
option.
2. Put option: It is an option to sell a fixed amount of stocks/shares/
debentures on a certain fixed day and at a fixed price.
3. Call option: It is an option to buy a fixed amount of stocks/shares/
debentures on a certain fixed day and at a fixed price.
4. Put and call option: It is a double option to buy or sell a fixed amount of
stocks/shares/debentures on a certain fixed day and at a fixed price.
5. Compulsory credit rating will be required if conversion is made for FCDs
after 18 months.
6. Premium amount on conversion, time of conversion in stages, if any, shall
be predetermined and stated in the prospectus. The interest rate for above
debentures will be freely detenninable by the issuer.
7. Issue of debentures with maturity of 18 months or less is exempt from the
requirement of appointment of debenture trustees or creating a Debenture
Redemption Reserve (DRR). In other cases, the names of the debenture
trustees must be stated in the prospectus and DRR will be created in
accordance with guidelines for the protection of the interest of debenture
holders. The trust deed shall be executed within 6 months of the closure of
the issue.
8. Any conversion of debentures will be optional at the hands of the
debenture holder if the conversion takes place at or after 18 months from
the date of allotment, but before 36 month.
9. In case of NCDs/PCDs credit rating is compulsory where maturity period
is more than 18 months.
10. Premium amount at the time of conversion for the PCDs shall be
predetermined and stated in the prospectus. Redemption amount, period
of maturity yield on redemption for the PCDs/NCSs shall be indicated in
the prospectus.
11. The discount on the non-convertible portion of the PCDs in case they are
traded and procedure for their purchase on spot trading basis must be
disclosed in the prospectus.
12. In case, the non-convertible portions of PCD or NCD are to be rolled over
(renewed) a compulsory option should be given to those debenture holders
who want to withdraw and encash form the debenture programme. Roll
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over shall be done only in cases where debenture holders have sent their
positive consent and not on the basis of non receipt of their negative reply.
13. Before roll over of any NCDs or non-convertible portion of the PCDs, fresh
credit rating shall be obtained within a period of 6 months prior to the due
date of redemption.
14. Letter of information regarding roll over shall be vetted by SEBI with
regard to the credit rating, debenture-holders' resolution, option for
conversion and such other items which SEBI may prescribe.
15. The disclosures relating of debentures will contain amongst other things,
i) The existing and future equity and long-term debt ratio;
ii) Servicing behaviour on existing debentures;
iii) Payment of due interest on due dates on term loans and debentures;
iv) Certificate from a financial institution or banker about their 'no
objection' for a second or pariahs charge being created in favour of the
trustees to the proposed debenture issues.
10.4 REVISION POINTS
 Debentures, Equity Shares and Bonds.
 Difference between Equity Shares and Debentures
 Advantages of Debentures Finance
 Limitations of Debentures
10.5 INTEXT QUESTIONS
1.What do you mean by debenture?
2. What do you mean by bonds?
3. What do you mean by convertible debenture?
4. What do you mean by equitable debenture?
10.6 SUMMARY
A debenture is a document issued by the company as an evidence of debt. It is
the acknowledgement of the company’s Indebtedness to its holders. Credit
instrument, provision for a trustee, interest at agreed rate, redemption of their
capital, as per agreed terms. Priority in liquidation, No Voting rights are features of
the debenture. The differed kinds of debentures are registered and unregistered,
secured and unsecured, redeemable and irredeemable debenture, convertible and
non-convertible.
10.7 TERMINAL EXERCISE
1. . ……………….. is a document issued by the company as an evidence of
debt.
2. . … ………….are those which are recorded in Register of Debenture holders
with full details about the number, value and types of debentures held by
each of them .
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3. The debentures which are payable to the bearer are called …………
debentures.
4. ………………………….debentures are those which are secured by deposit of
title deeds of the property with a memorandum in writing creating a
charge.
10.8 SUPPLEMENTARY MATERIAL
1. www.moneycontrol.com
2. www.quoro.com
3. www.differencebetween.com
10.9 ASSIGNMENTS
1. Define the word 'debenture* and bring out its salient features.
2. What are the different types of debentures that may be issued by a
company?
3. What are the advantages and disadvantages of debenture finance to
industries?
4. Explain briefly the law relating to issue and redemption of debentures in
India.
5. Summarise the guidelines for issue of debentures by public limited
companies in India.
6. Account for the increasing popularity of convertible debentures with the
investing public and companies in India.
7. Are debentures becoming popular with public sector enterprises in India?
State reasons for your answer.
8. What suggestions, would you offer, to develop further the corporate
debenture market in India?
10.10 SUGGESTED READINGS
1. Chandra, Prasanna: “Fundamentals of Financial Management”, New Delhi,
Tata McGraw Hill Co.
2. Khan, M.Y. and: “Financial Management”, Jain. P. K. New Delhi, Tata
McGraw Hill Co.
3. Pandey, I.M.: “Financial Management”, New Delhi, Vikas Publishing House.
4. Saravanavel, P. : “Financial Management”, New Delhi, Dhanpat Rai & Sons.
10.11 LEARNING ACTIVITIES
You are owing a stock broker office in a city. A individual who approached you
for investing his money in stock market. How will you clarify him the difference
between debenture and bonds .
10.12 KEYWORDS
Bonds, Debentures, Registered Debenture, Equitable Debentures, Legal
Debentures, Bearer Debentures.

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LESSON – 11

LISTING AND UNDERWRITING OF SECURITIES

11.1 INTRODUCTION
In terms of Section 69 of the Companies Act, 1956, no allotment shall be made
of any share capital of a company offered to the public for subscription unless the
amount stated in the prospectus as the minimum amount to be subscribed has
been subscribed and the application money has been received by the company
whether in cash or by a cheque or other instrument which has been paid. If the
minimum subscription mentioned in the prospectus is not subscribed within 120
days from the date of opening of issue, all the application moneys are forthwith
liable to be refunded by the company within 128 days with interest for delay beyond
78 days from the date of closure of the issue as per Section 73 of the Companies
Act, 1956. In view of the far-reaching consequences of failure to rise the “minimum
subscription” there is need to ensure that this subscription is procured. Hence,
there is need for an insurance against under subscription. This is obtained from
reliable persons who undertake to procure/subscribe in the event of the failure to
evoke adequate response from the public. Such an arrangement is called
“Underwriting” and the person who undertakes is called “Underwriter”.
11.2 OBJECTIVES
After reading this lesson you should be able to:
 Understand the concept of underwriting of securities
 Recognize the need for underwriting
 Detail the different forms of underwriting
 Examine the legal provision and regulations relating to underwriting
 Evaluate Merchant Bankers as underwriters
11.3 CONTENT
11.3.1 Listing of Shares
11.3.2 Choosing an Underwriter
11.3.3 Payment of Underwriting Commission
11.3.3 SEBI Guidelines for Underwriting
11.3.4 Government Guidelines for underwriting
11.3.5 Underwriting Agreement
11.3.6 Future of Underwriting Business in India
11.3.1 Listing of Securities
Listing means the admission of securities of a company to trading on a stock
exchange. Listing is not compulsory under the Companies Act. It becomes
necessary when a public limited company desires to issue shares or debentures to
the public. When securities are listed in a stock exchange, the company has to
comply with the requirements of the exchange.
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Objectives of Listing
The major objectives of listing are
1. To provide ready marketability and liquidity of a company’s securities.
2. To provide free negotiability to stocks.
3. To protect shareholders and investors interests.
4. To provide a mechanism for effective control and supervision of trading.
Listing requirements
A company which desires to list its shares in a stock exchange has to comply
with the following requirements:
1. Permission for listing should have been provided for in the Memorandum of
Association and Articles of Association.
2. The company should have issued for public subscription at least the
minimum prescribed percentage of its share capital (49 percent).
3. The prospectus should contain necessary information with regard to the
opening of subscription list, receipt of share application etc.
4. Allotment of shares should be done in a fair and reasonable manner. In case
of over subscription, the basis of allotment should be decided by the company in consultation
with the recognized stock exchange where the shares are proposed to be listed.
5. The company must enter into a listing agreement with the stock exchange.
The listing agreement contains the terms and conditions of listing. It also contains
the disclosures that have to be made by the company on a continuous basis.
Minimum Public Offer
A company which desires to list its securities in a stock exchange, should offer
at least sixty percent of its issued capital for public subscription. Out of this sixty
percent, a maximum of eleven percent in the aggregate may be reserved for the
Central government, State government, their investment agencies and public
financial institutions.
The public offer should be made through a prospectus and through newspaper
advertisements. The promoters might choose to take up the remaining forty percent
for themselves, or allot a part of it to their associates.
Fair allotment
Allotment of shares should be made in a fair and transparent manner. In case
of over subscription, allotment should be made in an equitable manner in
consultation with the stock exchange where the shares are proposed to be listed.
In case, the company proposes to list its shares in more than one exchange,
the basis of allotment should be decided in consultation with the stock exchange
which is located in the place in which the company’s registered office is located.
For trading in the stock market, a company has to list its securities in the
stock exchange. It means that the name of the company is registered in the stock
 194

exchange. The company has to fulfill certain conditions according to Companies

Act. The company has to offer its shares or debentures to the public for
subscription. Only then, the company will be allowed to list its security in thestock
exchange. For listing shares in the stock exchange, a company must have
minimum of Rs. 5 crores as its equity capital and 60% of this i.e., Rs. 3 crores is
offered to the public.
Conditions for Listing
Before listing securities, a company has to fulfill the following conditions:
1. Shares of the company must be offered to the public through a prospectus
and 25% of each class of securities must be offered.
2. The prospectus should clearly mention opening of subscription, receipt of
application, etc.
3. The capital structure of the company should be broad-based and there
should-be public interest in securities.
4. The minimum issued capital must be Rs. 3 crores of which Rs. 1.80 crores
must be offered to the public.
5. There must be at least five public shareholders for every Rs. 1 lakh of
fresh issue of capital and 10 shareholders for every Rs. 1 lakh of offer for
sale of existing capital. On the excess application money, the company will
have to pay interest from 4% to 15%, if there is delay in refund and delay
should not be more than 10 weeks from the date of closure of subscription
list.
6. A company with paid up capital of more than Rs. 5 crores should get itself
listed in more than one stock exchange, it includes the compulsory listing
on regional stock exchange.
7. The auditor or secretary of the company applying for listing should declare
that the share certificates have been stamped so that shares belonging to
the promoter’s quota cannot be sold or hypothecated or transferred for a
period of 5 years.
8. Articles of Association of the company must have the following provisions:
i) A common form of transfer shall be used
ii) Fully paid shares shall be used
iii) No lien on fully paid shares
iv) Calls paid in advance will not carry a right to dividend and will not be
forfeited before the claim becomes time-barred.
v) Option to call off shares shall be given only after sanction by the
general meeting.
9. Letter of allotment, Letter of regret and letter of rights shall be issued
simu1taneously.
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10. Receipts for all the securities deposited, whether for registration or split
and no charges will be made for the services.
11. The company will issue consolidation and renewal certificates for split
certificate, letter of allotment, letter of rights and transfer, etc. when
required.
12. The stock exchange should be notified by the company regarding the date
of board meeting, change in the composition of board of directors, and any
new issue of securities, in place of reissue of forfeited shares.
13. Closing the transfer books for the purpose of declaration of dividend,
rights issue or bonus issue. And for this purpose, due notice should be
given to stock exchange.
14. Annual return of the company to be filed soon after the annual general
body meeting.
15. The company will have to comply with conditions imposed by the stock
exchange now and then for 1istmg of security.
Types of Listing
1. Initial listing: Here, the shares of the company are listed for the first time on
a stock exchange.
2. Listing for public Issue: When a company which has listed its shares on a
stock exchange comes out with a public issue.
3. Listing for Rights Issue: When the company which has already listed its
shares.in the stock exchange issues securities to the existing shareholders on
rights basis.
4. Listing of Bonus shares: When a listed company in a stock exchange is
capitalizing its profit by issuing bonus shares to the existing shareholders.
5. Listing for merger or amalgamation: When the amalgamated company issues
new shares to the shareholders of amalgamated company, such shares are listed.
Procedure for listing requirements
For listing the shares in the stock exchange, the public limited company will
have to submit supporting documents. They are:
1. Certified copies of Memorandum, Articles of Association, prospectus and
agreements with Underwriters.
2. All particulars regarding capital structure.
3. Copies of advertisements offering securities for sale during the last 5
years.
4. Copies of Balance sheet, audited accounts and auditors’ report for the last
5 years.
5. Specimen copies of shares and debentures, certificate letter of allotment,
and letter of regret.
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6. A brief history of the company since incorporation with any changes in

capital structure, borrowings, etc.
7. Details of shares and debentures issued for consideration other than cash.
8. Statement showing distribution of shares and particulars of commission,
brokerage, discounts or special terms towards the issue of shares.
9. Any agreement with financial institutions.
10. Particulars of shares forfeited.
11. Details of shares or debentures for which permission to deal with is
applied for.
12. Certified copy of consent from SEBI.
Listing Procedure
The following are the steps to be followed in listing of a company’s securities in
a stock exchange:
1. The promoters should first decide on the stock exchange or exchanges
where they want the shares to be listed.
2. They should contact the authorities to the respective stock exchange/
exchanges where they propose to list.
3. They should discuss with the stock exchange authorities the requirements
and eligibility for listing.
4. The proposed Memorandum of Association, Articles of Association and
Prospectus should be submitted for necessary examination to the stock
exchange authorities
5. The company then finalizes the Memorandum, Articles and Prospectus
6. Securities are issued and allotted.
7. The company enters into a listing agreement by paying the prescribed fees
and submitting the necessary documents and particulars.
8. Shares are then and are available for trading.
Procedure at the Stock Exchange
After the application is made the Listing Committee of the stock exchange will
scrutinize the application form of the company. Here, the stock exchange will
ensure the following—
1. The financial position of the company is sound
2. Solvency and liquidity positions are good
3. The issue is large and broad based to generate public interest. If the
application for listing is accepted, the listed company will be called to
execute listing agreement with the stock exchange. The company must
follow certain obligations which are:
 the company will treat all the applications with equal fairness.
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 in case of over subscription, the allotment will be decided in

consultation with stock exchanges; and
 the company will notify to the stock exchange any change in its
management, business, capital structure or bonus or rights issue of
shares.
Advantages of Listing Securities
Listing offers advantages to both the investors as well as the companies. The
following are the advantages of listing to investors:
1. It provides liquidity to investments. Security holders can convert their
securities into cash by selling them as and when they require.
2. Shares are traded in an open auction market where buyers and sellers
meet. It enables an investor to get the best possible price for his securities.
3. Ease of entering into either buy or sell transactions.
4. Transactions are conducted in an open and transparent manner subject to
a well defined code of conduct. Therefore investors are assured of fair dealings.
5. Listing safeguards investors interests. It is because listed companies have to
provide clear and timely information to the stock exchanges regarding dividends,
bonus shares, new issues of capital, plans for mergers, acquisitions, expansion
ordiversification of business. This enables investors to take informed decisions.
6. Listed securities enable investors to apply for loans by providing them as
collateral security.
7. Investors are able to know the price changes through the price quotations
provided by the stock exchanges in case of listed securities.
8. Listing of shares in stock exchanges provides investors facilities for transfer,
registration of rights, fair and equitable allotment.
9. Share holders are provided due notice with regard to book closure dates,
and they can take investment decisions accordingly.
Advantages of listing to companies
1. Listed securities are preferred by the investors as they have better liquidity.
2. Listing provides wide publicity to the companies since their name is
mentioned in stock market reports, analysis in newspapers, magazines, TV news
channels. This increases the market for the securities. As Hasting has observed,
“A listed security will receive more attention from investment advisory services
than an unlisted one.”
3. Listing provides a company better visibility and improves its image and
reputation.
4. It makes future financing easier and cheaper in case of expansion or
diversification of the business.
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5. Growth and stability in the market through broadening and diversification

of its shareholding.
6. Listing attracts interest of institutional investors of the country as well as
foreign institutional investors.
7. Listing enables a company to know its market value and this information is
useful in case of mergers and acquisitions, to arrive at the purchase consideration,
exchange ratios etc.
8. By complying with the listing requirements, the operations of the company
become more transparent and investor friendly. It further enhances the reputation
of the company.
Disadvantages of listing Securities
Listing is not without its limitations. The following are the limitations of listing:
1. Listing might enable speculators to drive up or drive down prices at their
will. The violent fluctuations in share prices affect genuine investors.
2. In case of excessive speculation, share prices might not reflect its
fundamentals. The stock markets may fail to be the true economic barometer of an
economy’s performance.
3. In case of bear markets share prices might be hammered down, and the
standing of a company might be lowered in the eyes of the investors, shareholders,
bankers, creditors, employees etc.
4. Listing of securities may induce the management and the top level
employees to indulge in ‘insider trading‘ by getting access to important
information. Such actions adversely affect the common security holders.
5. The management might enter into an agreement with brokers to artificially
increase prices before a fresh issue and benefit from that. Common public might be
induced to buy shares in such companies, ultimately the prices would crash and
the common investors would be left with worthless stock of securities.
6. Listing requires disclosing important sensitive information to stock
exchanges such as plans for expansion, diversification, selling of certain
businesses, acquisition of certain brands or companies etc. Such information might
be used by the competitors to gain advantage.
7. Outsiders might acquire substantial shares in the company and threaten to
take over the company or they might demand hefty compensation to sell their
shares.
8. Stock exchanges in India still suffer from shortcomings. Listed securities
might be utilized by scamsters to indulge in scams.
UNDERWRITING
Meaning: Underwriting is an act of undertaking or the guarantee b y an
underwriter of buying the shares placed before the public in the event of non-
subscription of the shares by the public. For this purpose, an issuing company may
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enter into an agreement with an underwriter or with the number of underwriters or

with an institution for underwriting the issue of shares to the public. There are four
types of agreement:
i) The underwriter may enter into an agreement with the issuing company to
undertake the guarantee of buying all shares offered to the public in the
event of non-subscription of the shares by the public, called firm
underwriting.
ii) For buying a portion of total issues, offered to the public in the event of non-
subscription by the public, called Standby Underwriting.
iii) The underwriter may enter into an agreement with the issuing company for
buying all the shares outright from the issuing company and arrange to sell
them to the public through his own organisation.
iv) After entering into an agreement with the issuing company, the underwriter
may invite other underwriters or underwriting firms to join with him in such
proportion as agreed by them mutually. Alternatively a system of sub-
underwriting may also be followed for distributing the risk. The issuing
company has to mention the name of the underwriters and the number of
shares underwritten by him in the prospectus as prescribed in the
Companies Act, 1956.
Contingent Underwriting: It is again provided in the case of reserved categories
only.
Who can underwrite? Underwriting is generally undertaken by: (1) Public
Financial Institutions, (2) Banks, (3) Investment Companies or Trusts of
appropriate standing or experience,
Members of the recognised stock exchange are prohibited from entering into
underwriting or placing arrangements in connection with any floatation of new
issues unless the permission of the stock exchange of which they are members is
obtained. Such permission is granted subject to certain conditions. Members are
not allowed to undertake underwriting commitments of more than 5% of the public
issue. Underwriting of issues should be widely distributed amongst the members of
stock exchange in such a way that no single member of the stock exchange is
allowed to underwrite substantial portion of the issue. New members are permitted
to share the responsibility subject to their financial position.
Authorised Merchant Bankers: The Securities and Exchange Board of India
(SEBI) registers the organisations to carry out merchant banking activities. SEBI
classifies its authorisation into 4 categories, namely. Category I, Category II,
Category in and Category IV merchant bankers. Only Category I, II and III merchant
bankers (capital adequacy Rs. 1crore, Rs. 50 lakhs and Rs. 20 lakhs respectively)
are permitted to take up underwriting business. Whenever a merchant banker is
acting as a lead manager, the merchant banker has to mandatory underwritten the
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issue. The mandatory underwriting is limited to 5%-ofthe public issue or Rs. 25

lakhs whichever is lower.
Limitations
This traditional system has many limitations. Some of the limitations are
pertaining to: (i) Capital adequacy, (ii) Control, (iii) Recovery procedure, and (iv) Legal
procedure, etc.
Capital Adequacy: Of the above categories of underwriters, only the All India
Development Financial Institutions, the All India Investment Institutions and
Banks have sufficient capital adequacy whereas members of the stock exchange
and most merchant bankers do not have enough capital. Capital/net worth is very
important in the event of issue not getting subscribed fully. When an issue does not
get fully subscribed, it devolves on the underwriters. If they do not have enough
capital, they will not be able to take up their portion or fulfill their commitment.
Authorised merchant bankers of all 3 categories referred to above are permitted to
underwrite capital issues subject to the limit that outstanding commitments of any
such individual merchant banker at any point of time do not exceed five times his
net worth (paid-up capital and free reserves excluding revaluation reserves). They
will send monthly report regarding their underwriting activities and commitments
to SEBI and to the regional stock exchanges where the merchant bankers are
located.
Control: Members of the stock exchanges, as on date, are controlled by the
respective stock exchanges. Members of the stock exchanges control the stock
exchange through an elected Governing Board. Wherever there is a default by a
member, there is no strict enforcement on him by the stock exchanges.
Recovery Procedure: In the event of development of an issue, recovery from the
members of stock exchanges becomes very difficult. There are quite a few instances
where brokers backed out of their commitment.
11.3.2 Choosing an Underwriter
In choosing an underwriter the potential issuer usually considers such factors
as the reputation of the investment bank, its past experience in doing equity issues
for companies similar to the issuer, and, more importantly, its placement power,
i.e., its ability to distribute successfully the issue on the basis of the price and other
agreed conditions. Underwriters should be atleast as selective in choosing clients as
clients are in choosing them because one of the prime assets of an investment bank
is its reputation, and the clients of an investment bank and its success in placing
issues are major factors in (hat reputation. Obviously, an unsuccessful
underwriting damages the reputation of the investment bank.
11.3.3 Payment of underwriting commission
The provisions of Section 76 of Companies Act arc to be complied with while
paying the underwriting commission. Section 76 (1) states that a company may pay
a commission to any person in consideration of:
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1. His subscribing or agreeing to subscribe, whether absolutely or

conditionally, for any shares in or debentures of the company, or.
2. His procuring or agreeing "to procure subscription whether absolute or
conditional for any shares in or debentures of the company, if the
following conditions are fulfilled:
i) The payment of the commission is authorised by the articles;
ii) The commission paid or agreed to be paid does not exceed in the case
of shares, 5% of the price at which the shares are issued or the
amount or rate authorised by the Articles, whichever is less, and in the
case of debentures, 2% of the price at which the debentures are issued
or the amount or rate authorised by the Articles, whichever is less ;
iii) The amount or rate of commission should be disclosed in the
Prospectus or Statement in lieu of Prospectus as the case may be, or in
a statement filed with the Registrar before the payment of the
commission ;
iv) The number of shares or debentures which persons have agreed to
subscribe absolutely or conditionally should be disclosed in the
Prospectus; and
v) A copy of the contract relating to the payment of the commission
should be delivered to the Registrar.
vi) No underwriting commission can be paid if the issue is privately
placed. In other words, underwriting commission is payable only on
such shares or debentures as are offered to the general public [(Section
76 (4A)]
Stock Exchange Division of the Department of Economic Affairs, Ministry of
Finance issued guidelines dated 7-5-1985 for payment of underwriting commission.
The rates of underwriting commission are in force as follows:

On amounts On amounts
devolving on the subscribed by the
underwriters public (per cent)
(per cent)
(A) Equity Shares 2.5 2.5
(B) Preference shares/convertible and
non-convertible debentures 2.5 1.5
(a) For amounts upto Rs. 5.lakhs 2 1
(b) For amounts in excess of Rs. 5
lakhs

Note: (i) The above underwriting commission is maximum ceiling rates within
which any company will be free to negotiate the same with the underwriters.
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(ii) Underwriting commission will not be payable on the amounts taken up by the
promoters group, employees, directors, their friends and business associates,
(iii) The underwriter gets commission at the above rates on shares, debentures
undertaken by him irrespective of the number of shares & debentures subscribed
by the public. Even if the issue is fully subscribed by the public, he will get
commission at the above rates on all shares & debentures paid by him.
11.3.4 SEBI Guidelines for Underwriting
The Securities and Exchange Board of India (SEBI) has issued guidelines for
issue of capital by companies.
The guidelines pertaining to underwriting are enumerated hereunder
a) Underwriting is mandatory for the full issue and minimum requirement of
90% subscription is also mandatory for each issue of capital to public.
Number of underwriters would be decided by the issuers.
b) If the company does not receive 90% of issued amount from public
subscription plus accepted devolvement of underwriters, within 120 days
from the date of opening of the issue, the company shall refund the
amount of subscription. In the case of the disputed devolvement the
company should refund the subscription if the above conditions are not
met.
c) The Lead Managers) must satisfy themselves about the net worth of the
underwriters and the outstanding commitments and disclose the same to
SEBI.
d) The underwriting agreement may be filed with the stock exchanges.
Underwriting should be only for issue to the public which will exclude
reserved/preferential allotment to reserved categories. In other words, underwriting
is mandatory only to the extent of net offer to the public.
Minimum subscription clause is applicable for both the public and right issue
with a right of renunciation.
The intention is that the lead manager should satisfy himself in whatever
manner he deems fit about the ability of the underwrites to discharge their
underwriting obligations. There is no need for lead managers) to furnish any
certificate to SEBI in this behalf. A statement to the effect that in the opinion of the
lead managers, the underwriters' assets are adequate to meet their obligations
should be incorporated in the prospectus.
11.3.5 Government Guidelines for Underwriting
Government has issued guidelines relating to the underwriting of capital
issues to be followed by the stock exchanges, merchant bankers and other agencies
associated with the management of the public issues of capital. These should be
read along with SEBI guidelines:
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i) The stock exchanges will satisfy themselves that the company's securities
which are being underwritten would be officially quoted on a recognised
stock exchange;
ii) The members of the stock exchange desiring to underwrite will satisfy
themselves that the company has duly complied with the listing regulations;
iii) The Governing Bodies of recognised stock exchanges shall have the
discretion to refuse permission or impose such conditions in respect of the
underwriting of securities by members of stock exchanges as they may deem
necessary in the special circumstances of any given case;
iv) The underwriting of the public issues should be distributed amongst the
members of the stock exchanges as widely as possible;
v) No member should be allowed to undertake an underwriting commitment of
more than 5 per cent of the public issue; and
vi) The stock exchanges should prescribe procedures for advance action to be
taken by the companies, merchant bankers, etc., for making underwriting
arrangement so as to ensure that all the relevant information is furnished in
the draft prospectus which is submitted to the stock exchanges for approval.
11.3.6 Underwriting Agreement
It is an agreement entered into between the company and the underwriters
agreeing to underwrite the proposed issue of the company. The agreement should
provide the amount of the issue agreed to be underwritten by the underwriters in
case of under-subscription and the commission payable for such undertaking. It
should also stipulate that in the event of under-subscription, the underwriters or
their nominees would take up the shares for which they are liable or atleast that
quantity of issue which would make up the minimum subscription, within three to
four weeks of the closing of subscription list. The agreement should provide that
the underwriters would be discharged of their underwriting obligations to the extent
of applications bearing their stamps.
In order to avoid unfair discrimination between the underwriters, the company
should ensure that application forms supplied and distributed among the members
of stock exchanges do not bear the stamp of any underwriter.
11.3.7 Future of Underwriting Business in India
With the introduction of free pricing of securities, underwriting business is
undergoing metamorphic changes. Gone are the days when the underwriting
business was taken less seriously by the parties involved. There are already reports
of under-subscription of quite a few public issues and consequent devolvement on
underwriters. Capital adequacy assumes significance for fulfilling underwriting
obligations in the event of devolvement. Only Financial Institutions and Commercial
Banks have enough capital adequacies to meet such obligations. Merchant
Bankers' foremost task is, therefore, to enhance their capital base.
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Moreover, companies are also not happy with the situation. Bulk holdings with
underwriters also expose them to a takeover bid. There has, in fact, been a reported
instance of a major underwriter taking over a company whose issue was under
subscribed.
Further, with mega issues coming in large number, it becomes essential to go-
in for syndicate approach. There is already a forceful demand from underwriters'
associations for upward increase in underwriting commission. In the free pricing
scenario, a liberal free market driven fee structure is likely to emerge, sooner or
later. Brokers are also demanding that bank finance be made available to them to
carry on the business of underwriting.
Merchant bankers/underwriters will also have to develop a large investor base
and network throughout India since they would be required to approach the
investor directly and would also have to provide efficient secondary market services.
Lastly the merchant bankers/underwriters will have to be selective in new
floatation’s. The fundamental strengths of the companies will, therefore, come
under sharper focus and there will be increasing demand for more and more
financial information and disclosures about the performance of the companies. The
underwriters will have to develop their own assessment network for critical
appraisal of projects. The market driven forces will, therefore, help the capital
market to attain greater depth and maturity in the coming years.
11.4 REVISION POINTS
1. Listing- Listing means the admission of securities of a company to trading
on a stock exchange
2. Underwriting -Underwriting is an act of undertaking or the guarantee b y an
underwriter of buying the shares placed before the public in the event of non-
subscription of the shares by the public.
11.5 INTEXT QUESTIONS
1. What do you mean by underwriting?
2. Why do we lisit the shares?
3. What is underwriting commission
11.6 Summary
Underwriting is an act of undertaking or the guarantee by an underwriter of
buying the shares placed before the public in the event of non – subscription of the
shares by the public. Public Financial Institutions, Banks, Investments Companies
are an underwriter for underwriting. Government and securities and exchange
board of India have issued guidelines for issues of capital by companies. It is an
agreement entered into between the company and the under writers agreeing to
underwrite the proposed issue of the company.
Listing means the admission of securities of a company to trading on a stock
exchange. Listing is not compulsory under the Companies Act. It becomes
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necessary when a public limited company desires to issue shares or debentures to

the public. When securities are listed in a stock exchange, the company has to
comply with the requirements of the exchange.
11.7 TERMINAL EXERCISE
1. The shares of the company are listed for the first time on a stock exchange
is known as ………………………. .
2. …………………. is an act of undertaking or the guarantee b y an
underwriter of buying the shares placed before the public in the event of
non-subscription of the shares by the public.
11.8 SUPPLEMENTARY MATERIAL
1. www.bseindia.com
2. www.sebi.gv.in
3. www.nseindia .com
4. www.sharegyan.com
5. www.investorwords.com
11.9 ASSIGNMENTS
1. What is underwriting of securities? State the guidelines issued by
Government of India and SEBI in this connection.
2. Explain the legal provisions and regulations regarding payment of
underwriting commission.
3. Explain the salient features of underwriting of securities by merchant
bankers
11.10 SUGGESTED READINGS
1. Pandey, I.M.: “Financial Management”, New Delhi, Vikas Publishing House.
2. Rathnam, P.V.: “Financial Advisor”, Allahabad, Kitab Mahal.
11.11 LEARNING ACTIVITIES
1. Assume that a manufacturing company approached you for doing the
underwriting of shares for their company. How will you do the underwriting process .
2. What the procedures to be followed for listing share in the stock exchange.
11.12 KEYWORDS
Underwriting, Listing of shares,underwriting commission, contingent underwriting,
Initial Listing, Listing of public issue, Minimum public offer, Fair allotment.


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LESSON – 12

TERM LOANS AND RETAINED EARNINGS

12.1 INTRODUCTION
Since 1950s, the role of term-loans has considerably increased and in many
cases greater reliance is being placed on term-loans vis-à-vis the owned funds,
because of the growth of term-lending institutions and growing participation by
commercial banks in term-lending.
Term-loan: The term 'Term-Finance' relates to the money, required either for
setting up a new unit or financing the expansion/diversification/modernisation of a
project in terms of land, building, plant and machinery or permanent addition to
current assets, with a duration which may extend beyond 3 years and may extend
upto 10 years or even more in certain cases. Thus, 'term-loan' is a debt instrument
that has a longer maturity providing a specific but large amount of financing, and
contains a repayment schedule (typically in annuity form) that requires the
borrower to make regular principal and interest payments. Term-loans are a type of
trading on the equity and thus increase the borrower's financial leverage. Hence,
term-loan is a business project-oriented medium or long term loan with a maturity
of more than 3 years. Commercial banks and various financial institutions
constitute the hard core of the term financing in India. Specialised financial and
investment institutions were established in India as an integral part of the capital
market. Such institutions are known as Development Banks or Term Finance
Corporations e.g. The Industrial Development Bank of India (1964), the Industrial
Finance Corporation of India (1948), the Industrial Credit and Investment
Corporation of India (1955), the State Financial Corporations (1951), the National
Small Industrial Corporation Limited (1955), the Industrial Reconstruction Bank of
India (1971), and the Unit Trust of India (1964). Small Industries Development
Bank of India (SIDBI) 1990 etc. The terms and conditions usually vary from
institution to institution and also depending upon the purpose of loan.
Purposes of Term Loans: Some of the important purposes for which term loans
are sought are given below:
a) An undertaking might be interested in installing new plants, for which it
might need term loan, in the hope that installed capacity will enable the
firm to repay the loans quickly.
b) It may need money for the purchase of permanent assets and additions in
the property which already it has.
c) Due to repaid industrialisation many undertakings might need loans to
take advantage of industrialisation process.
d) Some undertakings might need term-loans for modernisation of their
plants.
e) Loans sometimes become unavoidable for refinancing of funded debts.
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f) Some of the firms might be paying heavy interests on bond issues. Such
loans can go a long way in reducing the bond interest burden. Obviously it
is not a minor relief.
g) A term-loan can also help in rearranging of maturities, elimination of
restrictive provisions of the bond issues and in returning redeemable
preference shares.
12.2 OBJECTIVES
After reading this lesson you should be able to:
 Understand the concept of term loan
 Identify the purposes of term-loans
 Detail the features of term-loans
 Explain the covenants of term-loan agreement
 Evaluate term-loan as a source of finance
 Know the significance of retained earnings
 Understand the factors affecting size of relative earnings
 Detail the various kinds of Reserves and surplus
 Ascertain the financial significance of depreciation funds/polices
12.3 CONTENT
12.3.1 Distinctive Features of Term-Loans
12.3.2 Appraisal of Term-Loan Proposal: Feasibility Studies
12.3.3 Balancing of various factors
12.3.4 Terms & Conditions of Term-Loan Agreement
12.3.5 Retained Earnings
12.3.6 Features and Significance of Retained Earnings
12.3.7 Factors Affecting Size of Retained Earnings
12.3.8 Reserves
12.3.9 Surplus
12.3.10 Financial Significance of Depreciation Funds/Policies
12.3.11 Factors Complicating Depreciation Policy
12.3.12 Factors that affects Choice of Methods
12.3.1 Distinctive Features of Term-Loans
Term-loans are negotiated directly between borrower and lender. As a result,
the provisions contained in the loan agreements can differ widely. Because the loan
is obtained directly from the lender, term loans can be viewed as a form of private
placement except registration requirements.
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a) Purposes: Term-loans are granted for purposes such as expansions,

diversification, modernisation and renovation schemes; sometimes they may also be
granted for liquidation of prior debts.
b) Security (Collateral): The security cover for term-loans comprises the existing
(fixed) assets as well as those to be acquired from such loans; usually, first legal
mortgage on such assets is created in favour of the creditor. Besides, personal
guarantees of the promoters, directors etc., are also obtained to ensure continuity
of the interests of the sponsors of the project.
c) Project-Oriented Approach: The approach of the term-lending institution is
project-oriented. The underlying theory of term-loan is that the ability of the
borrower to repay the loan is judged by the flow of anticipated income from the
project rather than from the liquidity of his assets. The term-lending institutions
thoroughly examine the viability and profitability of the project in order to assess
the repaying capacity and feasibility of project from economic, technical,
commercial, managerial, financial and social point of view.
d) Period (Repayment Schedule): Generally, term-loans are repayable in semi-
annual instalments over a period of 3 to 15 years, including an initial grace period.
e) Interest Rate: The rate of interest on term-loans is usually 1-2 points above
the bank's advance rate, but, the development banks charge a rate of interest less
than that on short period loans.
f) Refinance: Term-loans are eligible for refinance facilities from the Industrial
Development Bank of India, Small Industries Development Bank of India, Export
Import Bank of India, etc.
g) Consortium Approach: Where the total term-loan required by an industrial -
unit is too large for a single bank, some form of participation arrangement is also
made on the part of different financial institution. Such a consortium approach is
known as co-financing or joint financing of projects.
h) Follow-up Measures: As the term-loan spreads over a number of years,
several post-sanctions measures are undertaken e.g. the assisted concern is
required to submit regular progress reports about the project under construction;
the term-lending institution also sends its officials to inspect the progress of the
project.
i) Commitment Charge: The lending institution also charges a nominal
commitment charge of 1 to 2 % per year on the un utilised portion of loan from a
stipulated date. With effect from 1990-91 financial institutions have decided to
replace commitment charge with it asks upfront charge or front end charge as is
the-practice internationally.
j) Nominee Director: It is not uncommon for a creditor institution to nominate
its representation in the board of directors of the borrowed unit.
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k) Convertibility Clause: Recently the term-lending institution insists for

conversion of whole or part of loans into equity by inserting the convertibility clause
in the Loan Agreement itself. This convertibility clause enables the creditor to
participate in the prosperity of a successful project.
l) Bridge Loans: Sanctioning and disbursement of term loans requires some
time. In the mean time borrowing units require funds to meet their immediate
needs. The borrowing unit makes an arrangement with the commercial banks or
lending financial institutions for temporary but short-term loans from them for the
purpose, which is known as Bridge loans. Such loans are granted normally on -the
personal guarantee given by promoters or directors and repaid immediately after
sanctioning and out of these term loans.
m) Covenants: a Term loan contains both affirmative and negative covenants.
Affirmative covenants require the borrower to keep the lender informed of its financial
position by submitting periodical financial statements-actual and projected or any
event that have or could have a significant impact on the borrowers financial
position. Negative covenants restrict or prohibit the borrower from specified actions
such as increasing its dividend payments, require maintaining minimum liquidity
and imposing capital structure changes.
12.3.2 Appraisal of Term-Loan Proposal: Feasibility Studies
There are broadly six aspects of appraisal of term lending proposals. They are
i) Technical feasibility
ii) Economic feasibility
iii) Commercial viability
iv) Managerial competence
v) Financial feasibility and
vi) Social considerations.
An appraisal for all the six factors in aggregate will certainly help the financier
to decide the viability of the proposal for finance.
(i) Technical Feasibility: The examination of this aspect requires a thorough
assessment of the various requirements of the actual production process and
includes a detailed estimate of the goods and services needed for the project-land,
machineries, trained labour or training facilities, raw-materials, transportation,
fuel, power, water etc. Where these resource factors arc not domestically available
and are to be imported, conditions in the foreign market and the Government policy
at home are to be reviewed vis- a-vis the question of availability of the foreign
exchange in the country. For certain projects, foreign experts of foreign training of
local staff may be necessary. Another important feature of technical feasibility
relates the types of technology to be adopted for the project. In case new technical
processes are adopted from abroad attention is to be paid to the differences in
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conditions. The lending banks should employ techno crafts or consultants to study
the projects on their technical aspects.
(ii) Economic (Marketing) Feasibility: This aspect of an appraisal relates to the
earning capacity of the project. Earning of the project depends on the volume of
sales. Therefore, it is highly pertinent to determine how much output of the new
unit or the additional production from an established unit, the market would be
able to absorb at given prices. In other words, it takes in to account the total output
of the product concerned and the existing demand for it with a view to establishing
whether there is an unsatisfied demand for the product. Two general indicators of
the existence of unsatisified demand are the price level and the prevalence of
controls. Then demand is greater than the available supply and there are no
controls, prices would be much higher than the production cost yielding abnormal
profits to producers. On the other hand, where price controls like rationing and
what not are in force in respect of certain products, it is prima facie that the entire
demand is not being met by current production.
Possible future changes in the volume and pattern of supply and demand will
have to be estimated in order to assess the long run prospects of the industry as
well as, earning capacity of the unit. In calculating the future demand, the lending
bank has to take into consideration the potentialities of the export market, the
changes in incomes and prices, the multiple use of the product, the probable
expansion of the industries using such goods and the growth of new industries
requiring them. On the supply side, several factors which go to affect supply
position such as the competitive position of the unit in question, existing and
potential competitors, the extent of capacity utilisation, units cost advantages and
disadvantages, structural changes and technological innovation bringing
substitution into the market should also be scrutinized.
(iii) Commercial Viability: The appraisal of commercial aspects of a project
involves a study of the proposed arrangements for the purchase of raw materials
and sale of finished products etc. The basic question to be asked in this respect are
whether adequate arrangements have been made for buying the materials and
services needed to construct the facility, and when the construction is finished, for
obtaining power, labour and raw materials to operate the plant and market its
product. The problems are much the same for all projects during the construction
phase. The main objective is to see that the proposed arrangements will ensure that
the best value is obtained for the money spent.
In the operating phase, commercial problems vary considerably from sector to
sector. In industry, the likely terms of purchase of the ingredients of production
and of the sale of products need careful examination, since these terms may have
an important bearing on the amount of working capital required. Where the
concern proposes to appoint sole-selling agents, the same should be examined in
the interest of the concern and from the public policy angle.
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(iv) Managerial Competence: To a large extent, the lending bank's confidence in

the repayment prospects of a loan is conditioned by its opinion of the borrowing
unit's management. Where the technical feasibility, economic feasibility and
financial feasibility are well established but the integrity and resourcefulness of the
management is doubtful, the proposal is worth leaving where it is. Thus it has been
aptly remarked that appraisal of management is the touch-stone of term credit
analysis. The calibre of the people with whom he is dealing can be judged with
reference to their know-how of the business as reflected in their purchase,
production, sales, labour, personal credit and financial policies.
(v) Financial Feasibility: The financial position of the concern has to be
examined during the currency of the loan. For having a proper perspective of the
financial position, it is not sufficient to consider a single year's performance as
revealed in the Balance Sheet and Profit and Loss Account. On the other hand, a
dynamic view has to be taken organisation in next few years. The basic data
required for a financial analysis can be grouped under the following heads: (a) Cost
of the' project (whether additional or new), (b) Cost of the production and
profitability, (c) Cash flow estimates (sources and application of funds) during the
currency of the loan (d) Projected Working capital requirement, (e) Projected Profit &
Loss Account and Balance Sheet at the end of each financial year during the period
of the loan.
The cost of the project should normally include study of the following items:
Land (including development expenses), building, machinery and plant (including
spare parts, insurance, freight, duty, transportation to site, and erection charges),
technical know-how (including consulting and engineering fees), preliminary
expenses, pre-operative expenses (upto start of normal production, interest during
construction, allowance for unseen costs), and net working capital requirements.
The usual sources of finance are share capital, debenture capital, reserves and
surplus, retained earnings, long-term borrowing and deferred payments.
The profitability of an enterprise depends on the total cost of production and
aggregate sale price of the output. In calculating the total cost of production the
data regarding each element/component of cost of the product are essential; the
tendency to under-estimate the cost of production should be avoided. Before
estimating sale in money terms it is necessary to estimate the sales which are likely
to be made, not only for one year, but during each of the next three or four years.
The volume of sales is influenced by a variety of factors, including the quality of the
product, its price and the general market conditions. The cost of production and
sales estimates are also useful in working out the "break-even" point which would
indicate to the banker the ability of the industry to face a difficult situation.
Cash-flow estimates are obtained for the future period (of years) during which
the term loan will be outstanding. These estimates are necessary to ascertain as to
when the project will need money for different purposes, and what different sources
for such funds are repayment of instalments of loans arranged according to the
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cash accruals shown in cash-flow statement. The cash flow estimates in respect of
a new concern will have to be prepared on the basis of the prospects for the project
under consideration. For an existing concern, however, the estimates would take
into account the cash flow arising from its current business as well as from the
expansion under consideration.
The Balance Sheets and Profit and Loss Accounts for the past three to five
years can be studied as a first step in financial appraisal of existing concerns. The
second step would be the preparation of estimates of the cash flow statements for
the next four to five years. The third step would be the preparation of the projected
balance sheets for a similar period. The figures in the cash-flow statements would
provide a link between the balance sheet of one year and the next. For a new
project all the necessary figures must come from the cash flow estimates. The
proforma will reflect the projected financial position of the concern in the future
years.
As a pre-sanction measure, the lending bank should depute an officer to verify
the correctness of the information furnished by the borrower, and supplement it if
necessary through investigation. The valuation of the assets and the depreciation
policy adopted by the concern has also to be checked. After sanctioning a term loan
and disbursing it, the lending bank has to make post-sanction inspection to ensure
whether the amount borrowed has been actually used for the purpose for which it
was borrowed and whether terms and conditions of the loan have been complied
with; the value of the security, production, sales, position regarding insurance and
defaults in repayment, if any, should be reviewed at regular intervals.
(vi) Social Consideration: The social objectives of the project are also considered
keeping in view the interests of the general public. The projects, which offer large
employment potential, which canalise the income of the agricultural sector for
productive use or project which are located in totally less-developed areas or
projects which will stimulate small industries or the growth of ancillary industries
are given special considerations.
Energy Management and Ecological aspects: Along with economic and social
appraisal, ecological considerations are also kept in view and given due weight. It is
ensured that the applicant concern has made adequate provision for treatment of
effluents so that the environmental pollution remains under control. In the context
of high priority and significant importance being given to the question of conservation
and use of alternative sources of energy. Term financing institutions have been
attaching considerable importance to the 'energy management', while financing
industrial projects. For this purpose, the steps proposed to be taken for the
conservation of energy or uses of alternate sources of energy are now examined in
depth, while appraising a project.
12.3.3 Balancing of Various Factors
While it is necessary to look into all the above aspects of appraisal, the extent
of investigation and the importance to be attached to each aspect depend upon the
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circumstances of individual projects. Not all term loan proposals may require full-
scale appraisal of all aspects. For instance, in the case of a project, which is
obviously profitable, a general consideration of the unit's position with reference to
its cash-flow should suffice. Again, where the product has an assured market, a
laborious market analysis is needless. In the ultimate analysis, however, the skills
lie in identifying and sorting out strong points and weak points and arriving at a
final view on the project. Weakness located in certain areas may be offset by
strengths in other areas. Possibly, sound management and bright economic outlook
may outweigh mediocre caliber of management and doubtful economic prospects.
In some cases, negative factors may dominate; managerial competence may be so
much below par as to off-set all other considerations. In this way, a large number of
variations and combinations are possible. Thus, the crucial responsibility of me
lending bank lies in balancing judiciously different considerations for arriving at a
proper decision. There cannot be ready-made formulae, by using which a term-loan
proposal can be pronounced as acceptable or otherwise.
Nevertheless, scientific approach helps considerably in arriving at proper
decisions. There is no mechanical substitute for a banker's judgment. Decision-
making in this area calls for full appreciation of all relevant factors and sound
judgment based on experience.
12.3.4 Terms & Conditions of Term-Loan Agreement
Term loans attract several restrictive terms and conditions” other than those
related to creation of charges. Different lending institutions stipulate different kinds
of conditions depending on the nature of the project, the borrower, etc. The
commercial banks stipulate only a minimum number of conditions, whereas the
financial institutions apply a large number of more comprehensive conditions. By
and large the main clauses of a term-loan are as follows:
(a) Government clearance: The loan agreement stipulates the borrowing
company to obtain all relevant government clearances as may be applicable, and
sanctioning of loan must not be construed to be lifting of any other restrictive
barrier by the government such as licensing, MRTP clearance, capital goods
clearance for imported machines, import licence, FERA, RBI clearance, clearance
from the SEBI for security issues, etc.
(b) Consent of other lenders: Usually for a consortium loan, the condition an
institution stipulates is that for other parts of the loan the borrower should be able
to satisfy other lending institutions separately.
(c) Repayment: Repayment of any existing loan or long-term liabilities is to be
made in concurrence with the financial institutions.
(d) Additional loans: Any additional loans to be taken by the Company, the
interest to be paid and repayment of the principal are, usually, subject to the
financial institution's consent.
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(e) Capital structure: The term-loan agreement may stipulate the equity and/or
preference shares the company must issue in order to support the project. It may
also stipulate changing of proportionate shareholding between the various owner
groups, mainly between the Indian and the overseas entrepreneurs.
(f) Dividend declaration: As long as there is a loan outstanding, and declaration
of dividend beyond certain percentage is made subject to the lender's approval.
(g) Directorship: Usually, a term lending institution may reserve the right to
nominate one or more directors (called Nominee Directors) to the board of the
borrowing company to indicate the institution's views to the management. Any
intervention by the institutions is usually done through the nominee directors.
(h) Commercial agreement: Usually any major commercial agreement such as
any orders for equipment, consultancy, collaboration agreement, selling agency
agreement, agreement with senior management personnel, etc., needs the
concurrence of the term lending institutions if they are entered into after the loan
agreement has been signed.
(i) Restriction to expand: Any further expansion plan would need to be cleared
by the institutions as it may have an adverse impact on the future cash flow of the
company. No expansion plan can be contemplated without the knowledge of the
institutions once the loan agreement has been signed.
(j) Restriction to create further charge: The borrower is usually not allowed to
create any further charge on the assets without the knowledge of the financial
institutions.
(k) Information: The borrower must agree to furnish any information which die
institution may consider to be relevant, as and when they are asked for, within a
reasonable time.
(l) Organisation: Depending on the nature of the project, the financial
institutions may insist on appointing suitable personnel in the organisation to their
satisfaction. This could be in the area of marketing, R & D, design or production,
depending on the nature of project.
(m) Shareholding: The institutions, usually, stipulate that the promoters
cannot dispose of their shareholdings without the consent of the lending
institutions. This is made with a view to keeping the promoters involved as long as
the institutions remain involved.
(n) Convertibility: Any large loans from all-India financial institutions (usually
above Rs. 50 lakhs) attract a convertibility clause, as in debentures. The
institutions normally ask for 20 percent convertibility, and sometimes accept a firm
allotment of shares in lieu of such a convertibility clause, hr an era of liberalisation,
the convertibility condition has been dispensed w.e.f. April 1991.
(o) Additional clause: Usually, the term-loan agreement carries a clause where
by the financial institution can insert any other restrictive clause at a later date at
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their option. The purpose of this clause is to bolster the security in case any future
unforeseen developments weaken the security.
(p) Project finance: Usually, the term-loan agreement puts one or more clauses
like the borrower will make arrangements to raise the other part of the project
finance to the satisfaction of the particular lending institution. This clause
safeguards an institution against any unforeseen happening by which the other
participating institutions back out, but it is unable to do so just because the
sanction letter has been issued earlier.
(q) Equity Kicker: Lenders also may require so called equity kickers. For
example, a commercial bank lender may require the borrower to pay an agreed
upon percentage of any profits generated from the loan. An insurance company
may use an equity kicker in the form of options, like warrants, that allow the
insurance company to purchase a specified number of equity shares directly-from
borrower at a price that is set below the borrower's current market share price.
12.3.5 Retained Earnings
From the financial viewpoint, the earnings of a business enterprise for any one
year are channelised into three main directions: (i) the Government's share in the
profits through income tax, (ii) the portion to the shareholders as cash dividend;
and (iii) the residual amount retained in the business. Dividend and retained
earnings are 'controlled by the decisions of corporate management. They decide
how much profit should be paid to shareholders in the form of dividend and how
much to be retained in the business. Higher the dividend rate lower would be the
quantum to profit retained in the business. The management has to strike a
balance between the decisions in such a manner that neither the continuous flow of
business operations is interrupted nor the shareholders requirements of steady
dividend payment remain unsatisfied.
12.3.6 Retention of Earnings
Business enterprises try to save a part of their current earnings for meeting
future financial needs of expansions, modernisation, rationalisation and replacement
programmes. The main feature of retained earnings is that it is an internal source of
finance and emanates from profits not distributed to shareholders in the form of
dividend. The other names of retained earnings are ‘internal financing’, 'self-
financing' or 'plaguing back of profits'. The process of creating savings the form of
reserves and surpluses for its utilisation in the business is technically referred to
plaguing back of profits.
12.3.7 Features and Significance of Retained Earnings
(i) The main feature of retained earnings is that it is an internal source of
finance. This method of financing avoids any long-term debt and does not dilute the
ownership.
(ii) Retained earnings for expansion, modernisation etc. is an ideal
arrangement from the point of view of corporate management because there is no
immediate pressure to pay a return on this portion of the funds though it does have
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a cost which the firm has to bear, also this source can be used without creating
charge against assets of the company.
(iii) Retained earnings augment the capital base of the business. This puts the
company in a better position to borrow more funds.
(iv) Retained earnings can be utilised for purposes of paying off the old debts of
the company and paving a way for greater amount of new funds.
(v) Decision to retain has direct and indirect advantages to shareholders.
Retention of earnings offers the benefit of tax saving to shareholders. With increased
retention of earnings, the shareholder's equity magnifies. Better credit worthiness of
the business results into higher share prices and future growth prosperity.
(vi) Greater reliance on the use of retained earnings also helps reducing the
burden on the financial system of the country.
12.3.8 Factors Affecting Size of Retained Earnings
The amount of earnings that may be retained in the business is affected by
multiplicity of factors such as the characteristics of the industry and company,
level of profits of the company, management policies about depreciation, dividends
policy, and taxation policy.
i) Characteristics of Industry and Company: The policy relating to earnings
retention varies not only from industry but among companies within a given
industry and within a company from time to time. Growth industries and growth
companies are usually characterized with low pay-out and high retention rates. The
reasons are obvious. The more repaid the growth, the greater the demand for
additional funds for expansion. The higher the profitability, the greater the
temptation to retain funds but this is with the basic dividend policy.
ii) Level of Profits of the Company: Not withstanding any thing else, larger the
level of profits, greater the amount of earrings available for retention. However, the
size of profits is a function of factors such as the demand of product, cost of
production and distribution, price, structure of the products, degree of competition
in the market, general price level etc.
(iii) Management policy regarding Depreciation: At the very outset, it may be
categorically specified that depreciation is not a source of funds, however, the
inclusion of depreciation expense in the profit and loss statement reduces the net
income and hence the income tax and to that extent the funds are available with
the business. This is because in the present face of ever-rising prices, larger
amount of depreciation in initial years will have greater time value. This is possible
with the adoption of the accelerated depreciation policy. The straight line method of
depreciation, on the other hand, does not make available larger amounts of funds
with the business in the initial life of the asset but charges it uniformly.
(iv) Dividend Policy: One of the vital factors affecting the magnitude of retained
earnings is the dividend policy followed by the management. There is an inverse
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relationship between the pay-out ratio and retention of earnings. A liberal dividend
policy would reduce the amount of retained earnings.
(v) Taxation Policy: Higher the rate of corporate tax (corporate tax rate is fixed,
but the rates are different for different companies) smaller the amount of funds
available for retention. The rate of corporate tax is higher in case of a closely held
company and also the rate of distribution of profits. Such companies, therefore, are
in a less privileged position to retain bigger amounts of earnings. At present, there
exists no provision to encourage retention of corporate earnings except the
provision of depreciation being allowed as tax deductable expense.
Advantages of Retained Earnings: The advantage of retention of earnings or
self-financing for the convenience of study can be classified under three groups:
(i) the corporation, (ii) the shareholders, and (iii) the country.
Advantages to the Corporation
a) A cushion to absorb the shocks of business vicissitudes
b) Ease in financing schemes of rationalisation.
c) No dependence on fair-weather friends,
d) Helps in stabilising the dividend policy.
e) Deficiencies of depreciation can be made good.
f) Easy retirement of bonds or debentures.
Advantages to the Shareholders
a) Safety of investment
b) Rise in the market value of securities
c) Profit by retaining the shares
d) Evasion of super-tax
Advantages to the Country
a) Aids in capital formation.
b) Greater, better and cheaper production is facilitated
c) Smooth and continuous functioning of the enterprise
d) Quick financing of rationlisation schemes
Dangers of Excessive Retention of Earnings
The preceding description might give the impression that retention is always
beneficial to shareholders, company and the nation. This is not so. Excessive
retention of earnings and their reckless utilisation is detrimental to the interests of
all.
To Shareholders
(i) The first obvious effect of excessive retention of earnings is that it results
into foregoing dividends for a long period and to a large extent.
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(ii) The corporate management may enjoy the accumulated earnings to finance
the needs of the company in which they are interested even though shareholders
may have interest in them, thus bringing little or no gain to them. Shareholders are
benefited out of this source only when management invests the amount of retained
earnings in projects contributing to their wealth, i.e., the return on projects is
greater than the cost involved in retained earning.
To the Company
i) If the accumulated earnings are indiscriminately used for the issue of bonus
shares, it may result into over-capitalisation of the company; with its evil
consequences like reduced future dividends, share prices, manipulation etc. The
company's financial stability may be threatened.
ii) Excessive retention of earnings by one company in relation to its
competitors may, over a long period of time, result into occupying monopoly
position in the market. Like over-capitalisation, monopoly position has its own evil
consequences for consumers and society.
iii) Excessive retention of earnings also increases the manipulative powers of
the company management. For instance, the management may manipulate share
prices. By reducing the rate of dividend, in the first instance, it may cause down fall
of prices in the market and using this opportunity to buy shares at reduced prices.
Subsequently, a higher rate of dividend may be declared causing an increase in
share prices and then using the same opportunity to sell them at increased prices.
To the Nation: Excessive retention of earnings may not do any social good also.
Retained earnings will not be used for capital formation and in socially profitable
investments. Use of retained earnings for manipulative purposes will certainly
upset the financial system of the country.
12.3.9 Reserves
Meaning: 'Precaution is better than cure' is a common sense maxim. On the
same principle, 'Provision' should be made in business also for all possible
contingencies. According to Companies Act 1956, the expression 'provision' shall
mean any amount written off or retained by way of providing for depreciation,
renewals or diminution in value of assets, retained by way of providing for any
known liability of which the amount cannot be determined with substantial
accuracy. The term 'Reserves' has not been specifically defined in the Act, but it
refers to that amount which has been provided for any purpose other than those
mentioned above. It has been stated that any amount retained by way of providing
for any known liability, is in excess of the amount which in the opinion of the
directors is reasonably necessary for the purpose, the excess shall be treated for
this purpose as a reserve and not as a provision.
Kinds: Reserves may be general reserve or specific reserve. General Reserve is
that part of the profits of the company which is set aside for meeting any future
emergency. Its various purposes may be: (i) to stabilise the economic condition of
the company, (ii) to meet the increasing demands of the business, (iii) to meet
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casual losses, or (iv) to conceal the real profits of the company. In the last case they
are known as 'Secret Reserves'. Specific reserves are usually created out of profits
of capital nature. Such reserves cannot be utilised for dividend distribution, their
main objective is to stabilise the economic condition of the company.
Reserve can be classified into three categories: (i) valuation reserves, (ii) liability
reserves, or (iii) proprietary reserves. Valuation reserves are used to restore the
integrity of investment when assets have suffered a loss in value. They are also
known as specific reserves. Proprietary reserves comprise a number of reserve
accounts like reserve for dividends, and general reserve. Liability reserves are
provided to take into account the liabilities arising out of current operations like
reserve for taxes or reserve for pensions, etc." Liability reserve is more in the nature
of valuation reserve than of proprietary reserve. Valuation reserve is a matter of
necessity while proprietary reserve is usually a matter of financial prudence.
Valuation reserve is a charge against profit and loss account while proprietary
reserve is an appropriation of profits. Proprietary reserves help in increasing the
equity of the shareholders in the company.
12.3.10 Surplus
The term 'surplus’ represents the undistributed earnings of the company, i.e.,
the balance of profits which remains after paying the dividend. Surplus is regarded
as a welcome sign by the management. It reflects upon the sound earning capacity
of the company. Surplus can be divided into three main classes:
(a) Earned Surplus: It is created by the net profits from operations after
meeting all the expenses there from. Sometimes, past accumulated profits are also
transferred to earned surplus account. Different revenue reserves are also,
sometimes, transferred to such surplus account.
(b) Capital Surplus: Such surplus are those which are created out of capital
gains and non-recurring receipts. It is also known as 'paid-in-surplus'.
(c) Revaluation Surplus: These surpluses arise from revaluation of assets. The
appreciation in the value of fixed assets can be transferred to surplus account. This
is particularly done in the periods of raising prices or when the outlook for future is
bright.
Uses of Surplus: The accumulated surplus can be utilised by the company for
a variety of uses, e.g., for (i) reducing the value of fixed and working capital,
ii) writing off intangible assets like goodwill, preliminary expenses, reorganization
expenses, etc., (iii) equalising the rate of dividend payment [but it is possible only if
(a) they are actually realised in cash, (b) they are not likely to affect the liquid
position of the company adversely, (c) they remain after revaluation of all assets
and liabilities of a company, and (d) the Articles, of Association of the company
permit such distribution], (iv) absorbing the shocks of business cycles, (v) making
up the deficiencies of loss, (vi) financing schemes of betterment deficiencies fall
short. For instance, obsolescence may be more rapid than anticipated or deteriorated
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economic conditions may prevent the collection of debts regarded collectible. Under
such circumstances, the deficiency can be made good out of accumulated surplus.
12.3.11 Financial Significance of Depreciation Funds/Policies
The significance of depreciation funds can be discussed with reference to
certain management's decision.
i) Internal Investment Decision: The provision of depreciation in accounting reports
does not in any way affect investment decision implied by the replacement of an
asset. Depreciation is taken into consideration indirectly by comparing the cash
proceeds generated by asset with the cost thereof.
ii) Measuring Performance: As the performance is, generally, measured by
either income or return on investment both of which depend on the method of
depreciation accounting. The straight line depreciation gives reasonably good
measure of income in case of the revenues and maintenance requirements are
constant throughout the life of the asset, but it distorts (he return on investment
which would increase with the decrease in the book value of the asset due to
depreciation.
iii) Fund generation: Generally, it is thought that depreciation is a source of
funds. It is not the function of depreciation accounting to provide funds for
replacement which must come from the revenues of the business and the charge for
depreciation neither increases nor decreases the amount available to purchase
equipment. Even the making of charges to income and setting up of reserves for
depreciation give no assurance regarding the availability of funds for replacement
unless they are in some way ear-marked for the purpose.
iv) Make or Buy Decisions: his a make or buy decision, a relevant cost would be
a cost that could be avoided if the part was not made and it would not be relevant
cost which would be incurred irrespective of the decision taken. The depreciation of
the factory building cannot be avoided by the elimination of one phase of
production and in this would not be relevant in making the decision.
v) Pricing Decisions: A firm is expected to produce at a point where its marginal
cost equals marginal revenue and to fix a price equal to the average revenue that
will sell the appropriate quantum of output. In this context, depreciation is not
taken into account in arriving at decisions regarding price fixation. In spite of the
fact that he may set the price as dedicated by competition, he. is bound to recover
not only the fixed costs but also make a profit if he is skilful in market
manipulations through timely pricing decisions.
12.3.12 Factors Complicating Depreciation Policy
A decision regarding depreciation method becomes complex due to the
following considerations:
a) Tax Implication: In India the Income Tax law prescribes a method of
depreciation i.e., the Diminishing Balance Method. If a company adopts the
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Straight Line method then it will have to declare a different income for taxation
purposes as opposed to the income reckoned for accounting purposes.
b) Impact on Dividend Distribution: The Company cannot pay dividends except
out of profits: Profit means the surplus left after providing for depreciation under
any of the recognised methods. If the management chooses the straight line method
the distributable surplus in the earlier years would be larger. This would enable the
management to declare dividend more easily than if they follow the diminishing
balance method.
c) The Cash Flow Implication: Cash flow is the difference between sales revenue
and cash cost. If the depreciation figure is less the quantum of profit would be more
and vice versa. Thus the profit plus depreciation followed has its influence on the
quantum of distributable profit and hence on the quantum of dividend. It has
already been stated that the quantum of cash flow from operations is not be
affected by a change in the method of depreciation.
d) Depreciation and Changing Price Levels: Depreciation being the process of
allocation of the historical cost over a period of years. Another object of depreciation
which is building up of a adequate funds to replace the asset at the end of its full
service. If depreciation is calculated on the estimated replacement cost of the asset
then this important objective could be met. But this would lead to arbitrary and
highly volatile depreciation charges in each year.
12.3.13 Factors that Affect the Choice of Method
The most widely used methods of providing for depreciation are the Straight
Line Method and the Reducing Balance Method, but the factors that affect the
choice of methods are as follows:
a) The passage of time-predominantly recognised by the Straight Line Method.
b) The use of the asset-predominantly recognised by the Product Method.
c) The rapid deterioration of assets as, for example, loose tools where the
Revaluation Method may be used.
d) The effect of associated procedures such as costing methods which can aid
the calculation of depreciation by, for example, the Production Method.
e) The possible onset of obsolescence and, therefore, the early written-off of
the major portion of cost by using, for example, the Reducing Balance
Method.
f) Company Connection Influence: The Sum of Years Digits method is rarely
used in Great Britain but widely used in America. A subsidiary in this
country may be required to follow the American practice..
g) The Effect of Maintenance Expenditure: To equalise product costs an
attempt may be made to match low maintenance costs with high
depreciation or vice versa in any one accounting period. An example, this is
the use of the reducing balance method but the point tends to be
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theoretical since the balancing of such charges would be extremely difficult

in practice.
h) The intention to provide funds for the business at the end of the
anticipated asset life as a result of setting aside the depreciation provision,
e.g., use of the Sinking Fund or Endowment Policy Method.
i) The need to recognise that funds invested in the asset should be providing
a return e.g., use of the Annuity Method.
j) The effect of taxation: For tax computation, the rates used for tax purposes
may be adopted by the company.
It is important to choose a method which results in a fair allocation to the
accounting period and to product cost. It is possible, for example, to have
misleading product cost data if two identical products are produced on two different
machines and one machine is fully depreciated and the other machine is not. In
this situation, a different depreciation allocation may be made in the costing
records from the one adopted for the financial accounts. Alternatively, the
depreciation may be treated as a fixed cost and excluded from product cost, e.g.,
where marginal costing is used.
12.4 REVISION POINTS
1. Features of retained earnings-Internal sources of finance
2. Factors affecting size of retained earnings-Level of profit, management
policy, dividend policy,Taxation Policy
3. Valauation Reserve – used to restore the integrity of investment
4. Proprietary Reserve- comprises of many number of reserve account
5. Earned surplus- created by net profits
6. Revaluation Surplus –Arises from revaluation of assets.
12.5 INTEXT QUESTIONS
1. What are the factors affecting size of retained earnings?
2. What is meant by Reserves and Surplus?
3. What is term-financing?
12.6 SUMMARY
Dividend and retained earnings are controlled by the decisions of corporate
management.
Factor affecting size of retained earnings are characteristics of industry and
company. Level of profits of the company, management policy regarding
depreciation, dividend policy and taxation policy.
The advantage of retention of earnings or self financing for the convenience of
study, can be classified under three groups (1) the corporation, (ii) the share
holders and (iii) the country.
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Reserves has been stated that any amount retained by way of providing for any
known liability, is excess of the amount which in the opinion of the directors is
reasonably necessary for the purpose, the excess shall he treated for this purpose
as a reserve and not as a provision.
Reserves may be general reserve and specific reserve.
The term ‘surplus’ is represents the undistributed earnings of the company.
i.e., the balance of profits which are remain after paying the dividend. Surplus can
be classified as earned surplus, capital surplus and revaluation surplus.
Term loan is a debt instrument that has a longer maturity providing a specific
but large amount of financing, and contains a repayment schedule that requires
the borrower to make regular principle and interest payments.
I.F.C; I.D.B.I; I.C.I.CI; S.F.C; are some of example of financial institutions for
providing term loan.
Installing new plants, expansion of the business, diversification and
modernization of the project are some of the purposes of term loan.
The features of term loan are expansion, modernization, and renovation,
schemes, security, project – oriented approach, repayment, schedule (3 to 10 years)
Interest rate (slightly higher than bank rate), refinance and commitment charges. (1
to 2%).
There are broadly six aspects of appraisal of term landing proposals. They are
technical feasibility, economic feasibility, commercial viability, managerial
competence, financial feasibility and social consideration.
12.7 TERMINAL EXERCISE
1. ………………………………. surplus are those which are created out of capital
gains and non-recurring receipts.
2.. ………………………………. reserves are provided to take into account the
liabilities arising out of current operations like reserve for taxes or reserve for
pensions, etc
12.8 SUPPLEMENTARY MATERIAL
1. www. investopedia.com
2. www. accountingcoach.com
3. www.accountingtools .com
12.9 ASSIGNMENTS
1. Why are reserves created and how do they serve in stabilising profits and
value of the firm?
2. State the advantages of retained earnings as a source of finance viz. Self-
financing from the view of a nation, shareholders and the company.
3. What are the dangers inherent in excessive retention of earnings?
4. Explain the financial significance of depreciation policies and methods.
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5. Explain the major sources of term-finance in India.

6. What are die special features of term-loans? Discuss the disadvantages
attached with term-loans.
7. What precautions will be taken by term-lending institutions while granting
term-loans?
8. What are the broad aspects of appraisal of term-loan proposals in India?
9. Explain the terms and conditions usually found in term-loan agreements
12.10 SUGGESTED READINGS
1. Chandra, Prasanna: “Fundamentals of Financial Management”, New Delhi,
Tata McGraw Hill Co.
2. Khan, M.Y. and: “Financial Management”, Jain. P.K. New Delhi, Tata
McGraw Hill Co.
3. Pandey, I.M.: “Financial Management”, New Delhi, Vikas Publishing House.
4. Rathnam, P.V. : “Financial Advisor”, Allahabad, KitabMahal.
5. Saravanavel, P .: “Financial Management”, New Delhi, Dhanpat Rai & Sons.
6. Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.
7. Saravanavel, P.: Financial Management, New Delhi, Dhanpat Rai & Sons.
12.11 LEARNING ACTIVITIES
1. Bring out factors that affect the size of a retained earnings in the current
scenario .
2. The success of a business concern depends in no small a measure upon the
way in which its earnings are computed, distributed and retained.” Comment upon
this statement.
3. Write an essay on the correct policy in regard to the allocation of a
company's earnings to depreciation reserves and dividends?
12.12 KEYWORDS
Retention of Earnings, Reserves, Surplus, Dividend , Revaluation surplus,
Earned surplus, Capital surplus, Valuation reserves, Liability reserves.


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LESSON – 13

DIVIDEND AND DIVIDEND POLICY

13.1 INTRODUCTION
Dividend decision is one of the three fundamental decisions, a finance
manager has to deal with there is no commitment (statutory or otherwise) to pay
dividend to equity shareholders however, companies do pay dividend: consistently,
regularly and in most of the cases, ever increasing too. The two important
dimensions of dividend decision are: first, the equity shareholders provide funds to
the company in expectation of a return in the form of dividend. Second, the
companies have new projects for which fresh funds are required. If profits are
ploughed back, these funds can be used to take up new investments but then, the
equity shareholders have to sacrifice current dividend in expectation of higher
future dividends there is a running controversy on the relationship between the
dividend decision and value of the firm.
13.2 OBJECTIVES
 After completing this lesson, you must be able to
 explain the meaning of dividend
 discuss the statutory provisions for dividends
 explain the concept of dividend policy
 analyse the issues involved in dividend policy
 examine the factors influencing dividend policy
 list out the types of dividend policy
13.3 CONTENT
13.3.1 Meaning
13.3.2 Statutory provisions for dividend
13.3.3 Dividend policy
13.3.4 Objectives of dividend policy
13.3.5 Issues involved in dividend policy
13.3.6 Dividend Policy decision
13.3.7 Factors influencing dividend policy
13.3.8 Types of Dividend policy
13.3.9 Forms of dividend
13.3.1 Meaning
Dividend is divisible profit distributed amongst the members c company in
proportion to their shares in such a manner as is prescribed the Memorandum and
Articles of Association of the company. It is a share of the profits of a company
dividend amongst its shareholders. According Lamplough vs. Kent Waterworks, in
the ordinary sense the word divide means the sum paid and received, or the
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quotient forming the share of I divisible sum payable to the recipient. The director's
power to recommend dividend, if they think it is in the interest of the company even
if there profits. The directors may transfer profits to a depreciation fund or to a
reserve fund and the minority of shareholders cannot object to the majority of the
shareholders agreeing to such funds or to capitalisation of profits Dinshaw M. Petit
(1926). They know the financial position of the company and decide what should be
paid to the shareholders. They make recommendation that such and such amount
may be paid to the shareholders.
13.3.2 Statutory Provisions for Dividends
According to Regulation 85 of Table A, “the company in general meeting may
declare dividends, but no dividend shall exceed the amount recommended by the
Board.” At the annual general meeting the shareholders. consider the
recommendations of the directors regarding the payment of dividend than what has
been recommended by the directors though, they may reduce the amount. They
have no right to get the dividend as recommended by the directors until a resolution
to that effect is passed at the general meeting of the shareholders. Following are the
statutory provisions concerning payment of dividends:
1. Calculated per share: Dividend is usually paid per share though a company
may pay dividend to the shareholders according to the amount paid on each share
if the Articles so provide.
2. Through Cheque or warrant: Sec, 205(3),provides that dividend must be paid
in cash or by means of a cheque or warrant sent through post to the registered
shareholder except when the company decides to capitalize profits or reserves by
the issues fully paid or bonus shares for paying up any amount for the time being
unpaid or any shares held by the shareholders. Thus scrip dividends cannot be
paid now.
3. Given Out of profits: The same section lays down that dividend can be paid
only out of the profits after providing depreciation. It cannot be paid out of capital
except under certain circumstances. In the case, the directors will be jointly and
severally liable to refund that amount to the company. If the directors pay dividend
out of fictitious profits, they along with the auditors will be liable to compensate the
company. ,
4. Profit Transfer to reserve: According to the Companies (Amendment) Act,
1974, before a dividend is paid, a company must transfer profits to reserves not
exceeding ten percent. According to Sec.205(2A) a company may be permitted to
transfer more than ten per cent of its profits to reserves with the prior approval of
the Central Government.
5. Out of Profits of previous year: Dividends may be paid out the accumulated
profits and reserves of the previous years after having provided depreciation for
these years, provided the profits in any years are insufficient.
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6. Out of Government money: Dividend may be paid out of the moneys provided
by any state or Central Government in pursuance of the guarantee given by that
Government.
7. Without depreciation: The Central Government may, if it thinks necessary to
do so in the interest of the public, permit any company to pay dividend in any
financial year or years without the provision for depreciation in any of the previous
years.
8. To Share holders: The dividend shall be payable only to the registered
shareholders or to their orders or their bankers (sec. 206). In the case of joint
holder the dividend warrant shall be posted to the address of the holder whose
name appears first in the Register of Members or to one as the joint holders may
direct the company in writing.
9. To warrants Holders: According to Sec. 206, in case the company has issued
share warrants, dividend may be paid to the bearer of such warrants or to his
bankers.
10. Paid within 42 days: The company must pay dividend to the shareholders
within 42 days of the declaration of the dividend.
11. Transfer of unpaid dividend: A company must transfer the unpaid dividend
within seven days after the expiry of 42 days of the declaration of the dividend to a
special account called "Unpaid Dividend Account of ...Co. Ltd/Private Co., Ltd." in a
Scheduled bank. If the amount 'is not transferred, the company shall pay interest @
12% per annum. Any dividend which remain unpaid for a period of three years shall
be transferred to the general revenue account of the Central Government. If a
claimant makes an application to the company for the payment of the unclaimed
dividend, the company should forward it to the Central Government which will make
the necessary payment to the shareholder. Default in the above requirements, will
make every officer liable to tbe punished with simple imprisonment up to seven days,
and to be fined up to five hundred rupees per day till the default continues.
12. Punishment on Failure to pay dividend: According to Sec. 207 any party
liable to pay the dividend or issue the dividend warrants, may be punished with
simple imprisonment up to seven days and may also be liable to be fined for failure
to pay the dividend within 42 days.
13. Approval Interim dividend: A company cannot declare or pay in interim
dividend without the previous approval of the Central Government nor is a
company allowed to distribute any assets without such approval.
13.3.3 Dividend Policy
Most of the companies follow certain principles for the declaration of dividend.
But dividend should be declared only out of divisible profit. If the company incure
loss at any particular year it should not distribute dividend in that year. Dividend
policy means it is the policy of the company with regard to quantum of profits to be
distributed as dividend. The basic concept of the dividend policy is that the
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company desires and take any future action regarding the payment of dividend with
help of the company law board.
According to Weston and Brighan defines dividend policy as "Dividend policy
determines the division of earnings between payment to shareholders and retained
earnings"
13.3.4 Objectives of Dividend Policy
1. To Maximise wealth: The dividend policy of a firm aims at the
maximising the owner's wealth. It is formulated not merely to increase the share
price in the short run, but to maximise the owner's wealth in the long run. The
shareholders may not fully appreciate such a dividend policy and may prefer
immediate dividends to future dividends and capital gains and the share prices may
drop in the market. It is the responsibility of the management to make the owners
aware of the objectives and, implications of dividend policy so that the market
reaction is favourable.
2. To Provide Sufficient Finance: In the absence of adequate finances wealth
maximisation objective would remain a sheer dream. The management has to
decide what shall be the proper ratio between dividends and retained earnings so
that the twin objectives of short term interest of shareholders and long-term gain of
expansion are realised.
14.3.5 Issues Involved in Dividend Policy
The following basic issues are involved in formulating a dividend policy which
affects the financial structure, the flow of funds liquid, stock prices and the
shareholders satisfaction. Therefore, the management exercises a high degree of
judgement in establishing a sound dividend pattern.
1. Cost of Capital: One of the considerations for taking a decision whether to
distribute divided or not is cost of capital. The Board calculates the ratio of rupee
profits, the business expects to earn (Ra) to the rupee profits that the shareholders
can expect to earn outside (Re) i.e., Ra/Rc. If the ratio is less than one, it is a signal
to distribute dividend and if it is more than one, the distribution of dividend will be
discontinued.
2. Realisation of objectives: In formulating the dividend policy the main
objective of the firm, i.e., maximisation of wealth for shareholders including the
current rate of dividend should be aimed at.
3. Shareholders group: A company with low pay – out heavy Reinvestment
attracts share holders interested in capital gains rather than in current income.
On the contrary, a company with high dividend pay – out attracts those who are
interested in a current income.
4. Release of corporate earnings: Dividend distribution is a means of
distributing unused funds. Dividend policy affects the share holder’s wealth by
varying its dividend pay-out ratio. In dividend policy the financial manager decides
whether or not to release corporate earnings.
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13.3.6 Dividend Policy Decision

Dividend is the portion of earnings which is distributed among the
shareholders. In other words, dividend policy determines the division of earnings
between payments to shareholders and retained earnings. Formulation of proper
dividend policy is one of the major financial decisions to be taken by the financial
managers. We give here the importance and significance of dividend policy.
Retained earnings are one of the most important sources of internal funds for
meting the financial needs of the company for its growth and development. The
dividend distribution to equity shareholders involve the outflow of cash. Both,
growth of the company and dividend distribution to shareholders are desirable. But
these goals are in conflict. A high dividend rate means less retained earnings, which
may consequently result in slower growth and lower market rate per share. In view
of this determining the dividend policy is one of the important functions of finance
manager and he must very carefully divide the allocation of earnings between
dividends and retained earnings.
Dividend policy may have a critical influence on the value of the firm. If the
value of the firm, is a function of its dividend payment ratio, the dividend policy will
affect directly the firm's cost of capital.
A company which wants to pay dividends and also needs funds to finance it
investment opportunities will have to depend on external source of finance such as
I issuing debentures and equity shares. Dividend policy of the firm thus affects
both long-term financing and the wealth of shareholders. Because of this, the
decision of the company to pay dividend may be shared by two possible view points,
viz., (i) as a long-term financing decision and (ii) as a wealth maximisation decision.
As a long term financing decision: When dividend decision is treated as a
financing decision, the net earnings of the firms may be viewed as a source of long-
term financing. With this approach, a company will pay dividend only when it does
not have profitable investment opportunities, it can issue equity to the public, but
retained earnings are preferable. Because dividends reduces the amount of funds
available to finance profitable investment opportunities. Hence, either company's
growth is restricted or the company may be forced to depend on other costly
sources of financing. Thus, the dividend policy which involves retaining of earnings,
is a long term financing decision related to management of capital structure of the
firm.
As a wealth maximisation decision: The tendency of most of the shareholders
is to give a higher value to the near dividends than the future values in the market.
Higher dividends increase the value of shares and low dividends decrease the value.
In order to maximise wealth, i.e., maximisation of the value of the firm to its
shareholders, the management must declare sufficient dividends.
The management of a firm must carefully decide its dividend policy. If more
net earnings are retained, the shareholders dividend is decreased and the market
price of the shares may be adversely affected. But the use of retained earnings to
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finance profitable projects will increase future earnings per share. On the other
hand, if the firm increases dividend, there may .be a favourable reaction in the
stock market, but the firm may have to forego some investment opportunities for
want of funds. Because of this, the future earnings of share may decrease. In view
of this the management should decide dividend policy carefully, so that the net
earnings are divided between dividends and retained earnings in an optimum way
to achieve the objective of maximising the wealth of shareholders. Shareholders'
wealth includes not only market price of shares quoted in stock market but also
current dividends. Thus, dividends are more than just a means of distributing
unused funds. Dividends policy to a large extent affect the financial structure, the
flow of funds, corporate liquidity, stock prices, growth of the company and
investor's satisfaction. That is why, dividend policy has much significance and the
management has to decide it very carefully.
Dividend Policy and Valuation of the Firm
There has been a difference of opinion on the relationship between the divided
policy and value of the firm. Dividend policy is basically concerned with deciding
whether to pay dividend in cash now, or to pay increased dividends a later stage or
distribution of profits in the form of bonus shares. The current dividend provides
liquidity to the investors but the bonus share will bring capital gains to the
shareholders. The investor's preferences between the current cash dividend and the
future capital gain have been viewed differently. Some are of the opinion that the
future capital gain are more risky than the current dividends while others argue
that the investors are indifferent between the current dividend and the future
capital gains. The basic question to be resolved while framing the dividend policy
may be stated simply. What is sound rationale for dividend payments? In the light
of the objective of maximizing the value of the share, the question may be restated
as: Given the firm's investments and financing decisions, what is the effect of the
firm's dividend policies on the share price? Does a high dividend payment decrease,
increase or does not affect at all the share price? The relationship between the
dividend policy and value of the firm can be examined in terms of different models.
While agreement is not found among the models as to the precise relationship, it is
still worthwhile to examine some of these models to gain insight into the effect
which the dividend policy might have on the market price of the share.
Two schools of thoughts have emerged on the relationship between the
dividend policy and value of the firm. One school associated with Walter, Gordon,
etc., holds that the future capital gains (expected to result from lower current
dividend payout) are more risky and the investors have preference for current
dividends. The investors do have a tilt towards those arms which pay regular
dividend. So, the dividend payment affects the market value of the share and as a
result the dividend policy is relevant for the overall value of the firm. On the other
hand, the other school of thought associated with Modigliani and Miller holds that
the investors are basically indifferent between current cash dividends and future
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capital gains. These schools of thought on the relationship between dividend policy
and value of the firm have been discussed as relevance and irrelevance of
dividends.
13.3.7 Factors Influencing Dividend Policy
Many factors influence a company in its divided policy. We give here a list of
major factors which influence dividend policy of a concern.
1. Stability of earnings: Stability of earnings is one of the important factors
influencing the dividend policy. If earnings are relatively stable, a firm is in a better
position to predict what its future earnings will be and such companies are more
likely to pay out a higher percentage of its earnings in dividends than a concern
which has fluctuating earnings. Generally, the concerns which deal in necessities
suffer less from fluctuating incomes than those concerns which deal with fancy or
luxurious goods.
2. Financing Policy of the Company: Dividend policy may be affected and
influenced by financing policy of the company. If the company decides to meet its
expenses from its earnings, then it will have to pay less dividend to shareholders.
On the other hand, if the company feels, that outside borrowing is cheaper than
internal financing, then it may decide to pay higher rate of dividend to its
shareholder. Thus, the internal financing policy of the company influences the
dividend policy of the business firm.
3. Liquidity of Funds: The liquidity of funds is an important consideration in
dividend decisions. According to Guthmann and Dougall, "Although it is customary
to speak of paying dividends 'out of profits', a cash dividend only be paid from
money in the bank. “Payment of dividend means, a cash outflow, and hence, the
greater the cash position and liquidity of the firm is determined by the firm's
investment and financing decisions. While the investment decisions determine the
rate of asset expansion and the firm's needs for funds, the financing decisions
determine the manner of financing’.
4. Dividend, Policy of Competitive Concerns: Another factor which influence is
the dividend policy of other competitive concerns in the market. If the competing
concerns are paying higher rate of dividend than this concern, the shareholders
may prefer to invest their money in those concerns rather than in this concern.
Hence, every company will have to decide its dividend policy, by keeping in view the
dividend policy of other competitive concerns in the market.
5. Past Dividend Rates: If the firm already exists, the dividend rate may decide
on the basis of dividends declared in the previous years. It is better for concern to
maintain stability in the rate of dividend and hence, generally the director will have
to keep in mind the rate of dividend declared in the past.
6. Debt Obligations: A firm which has incurred heavy indebtedness is not in a
position to pay higher dividends to shareholders. Earning retention is very
important for such concerns which are following a programme of substantial debt
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reduction. On the other hand, if the company has no debt obligations, it can afford
to pay higher rate of dividend.
7. Ability to Borrow: Every company requires finance both for expansion
programmes as well as well as for meeting unanticipated expenses. Hence, the
companies have to borrow from the market, well established and large firms have
better access to the capital market than new and small, firms and hence, they can
pay higher rate of dividend. The new companies generally find it difficult to borrow
from the market and hence they cannot afford to pay higher rate of dividend.
8. Growth needs of the Company: Another factor which influences the rate of
dividend is the growth needs of the company. In case the company has already
expanded considerably, it does not require funds for further expansions. On the
other hand, if the company has expansion programmes, it would need more money
for growth and development. Thus when money for expansion is not needed, then it
is easy for the company to declare higher rate of dividend.
9. Profit Rate: Another important consideration for deciding the dividend is the
profit rate of the firm. The internal profitability rate of the firm provides a basis for
comparing the productivity of retained earnings to the alternative return which
could be earned elsewhere. Thus, alternative investment opportunities also play an
important role in dividend decisions.
10. Legal requirements: While declaring dividend, the board of directors will
have to consider the legal restriction. The Indian Companies Act 1956, prescribes
certain guidelines in respect of declaration and payment of dividends and they are
to be strictly observed by the company for declaring dividends.
11. Policy of Control: Policy of control is another important factor which
influences dividend policy. If the company feels that no new shareholders should be
added, then it will have to pay less dividends. Generally, it is felt, that new
shareholders, can dilute the existing control of the management over the concern.
Hence, if maintenance of existing control is an important consideration, the rate of
dividend may be lower so that the company can meet its financial requirements
from its retained earnings without issuing additional shares to the public.
12. Corporate Taxation Policy: Corporate taxes affect the rate of dividends of the
concern. High rates of taxation reduce the residual profits available for distribution
to holders. Hence, the rate of divided is affected. Further, in some circumstances,
government puts dividend tax on distribution of dividends beyond a certain limit.
This may also affect rate of dividend of the concern.
13. Tax Position of Shareholders: The tax position of shareholders is another
influencing factor on dividend decisions. In a company if a large number of
shareholders have already high income from other sources and are bracketed in
high income structure, they will not be interested in high dividends because the
large part of the dividend income will go away by way of income tax. Hence, they
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prefer capital gains to cash gains, i.e., dividend capital gains here we mean capital
benefit derived by the capitalisation of the reserves or issue of bonus shares.
l4. Effect of Trade Cycle: Trade cycle also influences the dividend policy of the
concern. For example, during the period of inflation, funds generated from
depreciation may not be adequate to replace the assets. Consequently there is a
need for retained earnings in order to preserve the earning power of the firm.
15. Attitude of the Interested Group: A concern may have certain group of
interested and powerful shareholders. These people have certain attitude towards
payment of dividend and have a definite say in policy formulation regarding
dividend payments. If they are not interested in higher rate of dividend,
shareholders are not likely to get that. On the other hand, if they are interested in
higher rate of dividend, they will manage to make company declare higher rate of
dividend even in the face of many odds.
13.3.8 Types of Dividend Policy
The alternative dividend policies are the following :
1. A stable dividend policy.
2. Policy of no immediate dividends.
3. Policy of regular and extra dividends.
4. Policy of regular bonus shares.
5. Policy of regular dividends plus bonus shares.
6. Policy of irregular dividends.
1. STABLE DIVIDEND POLICY
The stable dividend policy maintains regularity in paying dividend even though
its amount fluctuates from year to year and may not be related to earnings. Thus
stability of dividends means regularity of the amount paid out. It can take three
distinct forms:
i) Constant dividend per share.
ii) Constant percentage of net earnings.
iii) Constant dividend per share and extra dividend.
i) Constant Dividend Per Share: Here the management follows the policy or
paying, a fixed amount of dividend per share every year irrespective of the
flucations in the earnings. This does not mean that the rate of dividend will never
be increased. When the earnings of the company increase at a new level of
earnings, it increases the rate of dividend per share.
This dividend policy is easy to follow when company earnings are stable. If
earnings fluctuate widely, the company can follow this policy by maintaining a
dividend flucation fund in surplus years which is invested in marketable securities
so that they may easily be realised in bad years to pay the dividend in those years.
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ii) Constant Percentage of Net Earning: Some companies follow the policy of
paying a fixed percentage of net profits as dividend every year. This is a policy of
constant pay-but ratio. For example, if a company adopts a 40 pay – out ratio, it
means, 40 percent net earnings of the company will be paid-out to shareholders
every year as dividend. No dividend is paid in the year of loss. Under this policy
internal financing is automatic. In the above case, 60% of the profits are transferred
to reserves. This policy leaves nothing to the management's discretion.
iii) Constant Dividend Per Share Plus Extra Dividend: Here, the management
fixes the minimum rate of dividend per share to reduce the possibility of not paying
a dividend. In the years of prosperity the company pays extra dividend. This policy
commits a fixed rate of dividend per share plus an extra dividend in the periods of
prosperity.
ADVANTAGES OF STABLE DIVIDEND POLICY
The stable dividend policy is considered to be the best, due to the following
advantages
(A) ADVANTAGES TO INVESTORS
1. Confidence Among Shareholders: A regular and stable dividend payment
creates confidence and removes uncertainty from-the minds of the shareholders. It
presents a bright future of the company and gives confidence to the shareholders.
2. Income Conscious Investors: As the investors are generally income conscious
they favour a stable rate of dividend.
3. Stability in Market Price of shares: Other things being equal, the market
prices vary with the rate of dividend the company declares on its equity shares. The
value of shares of a company having a viable dividend policy does not fluctuate
widely even if the earnings of the company are lower than the previous year. Thus,
this policy stabilises the market price of the stock.
4. Encouragement to Institutional Investors: A stable dividend policy attracts
institutional investors who generally prepare a list of securities, mainly
incorporating the securities of the companies having stable dividend policy in which
they invest their surpluses or their long-term funds such as pensions or provident
funds etc.
(B) ADVANTAGES TO COMPANY
1. Increase in Goodwill and Credit: Stability and regularity of dividends affects
the market price of shares and increases the general credit of the company that
pays it in the long run.
2. Better Financial Planning: A company with stable dividend policy may
formulate its financial planning faster and easily because the financial manager can
correctly estimate the future demand and supply of capital in the firm. Timing of
dividend payment can be forecasted easily by preparing cash flow statement.
However, the stable dividend policy is not without any drawbacks. The highest
danger associated with a stable dividend policy is that once it is adopted by the
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firm, it cannot be changed without seriously affecting the confidence of

shareholders in management and the credit-worthiness of the company. Therefore
the dividend rate should be fixed at a lower level so that; it can be maintained even
in years with reduced profits.
2. POLICY OF NO IMMEDIATE DIVIDENDS
Payment of dividends is desirable from the company's and shareholder's point
of view, though it is not compulsory. The board of directors may decide to pay no
dividends even though the earnings are substantial and available for the purpose.,
A -company following this policy may justify it under the following conditions.
(i) The company is new and growing.
(ii) As the needed capital cannot be raised except at very high cost and
earnings, therefore, it must be ploughed back in the business.
(iii) The shareholders are willing to wait for a return on their investment and
are content to have their holdings appreciate in value (capital gains).
The no-dividend policy may cause dissatisfaction to shareholders because of
non-payment of current dividend.? After a period of no dividends, while surplus is
increasing, it may be a good policy to issue bonus shares (stock dividend) so that
net worth of the company is not affected.
3. POLICY OF REGULAR AND EXTRA DIVIDENDS
This policy carries out regular (stable) dividend are. At the same time it is not
an unusual practice for companies to pay extra year-end dividends. In order to
avoid any possible misunderstanding, it is advisable to clearly indicate to
shareholders the amounts of regular and extra dividends so that in future
shareholder would not get disillusioned with the company if extra dividend is not
paid. Large companies usually number their dividends and level them as regular or
extra.
4. POLICY OF REGULAR STOCK DIVIDENDS
A stock dividend policy refers to the distribution of share in lieu of or in addition
to cash dividend known as bonus share in India to the existing shareholders. This
policy results in constantly increasing the number of outstanding shares of the
company. It is justified under the following conditions:
(i) If there are earnings available with the company but the need is to retain
cash in the business.
(ii) If the company has modernisation and extension programmes and needs to
finance them immediately.
The policy of regular stock dividends is not generally advisable. It can apply
only temporarily. In periods of reduced earnings, the constant cutting up of the
corporate ownership into a larger number of shares may prove harmful. The value
of shares may fall below a desirable range from the standpoint of late financing^
Shareholders having a strong preference for cash dividends would feel totally
disillusioned with the company.
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5. POLICY OF REGULAR DIVIDENDS AND STOCK DIVIDENDS

This dividend policy pays regular (stable) dividend in cash and stipulates the
extra dividend in stock. It is justified under the following conditions :
(i) If a company wants to continue its records of regular cash payment.
(ii) If the company has reinvested earnings that it want to capitalise.
(iii) If the company wants to give shareholders a share in the additional
earnings but cannot afford to use up its cash.
6. POLICY OF IRREGULAR DIVIDENDS
This policy is based upon the assumption that shareholders are entitled to as
much dividend as earnings and the financial condition of the company warrant.
The corporate management may declare dividends which is entirely appropriate for
a company that has highly unstable earnings. If this dividend policy is adopted by a
company with stable earnings, it will have disastrous consequences for the
company and shareholders.
13.3.9 Forms of dividend
Payment of dividend can be classified into the following forms.
1. Cash dividend
Dividend is paid to the shareholders in the form of cash is called cash
dividend. The usual practice followed by the company is to pay dividend in cash. It
results hi out flow of fund from the firm. Hence the firm should maintain adequate
cash resources for payment of cash dividend.
2. Bond dividend
The company does not have sufficient cash reserves to pay the dividend, it may
issue bonds as against the amount due to the shareholders by way of dividend is
known as bond dividend. Actually it is not popular hi our country.
3. Property Dividend
Property dividend is those which can be paid by the company to its
shareholders in the form of property instead of payment of dividend in cash.
However this type of dividend is not popular in India.
4. Stock Dividend
Payment of stock dividend is popularly known as issue of bonus shares in
India. Because in any particular year the company does not have an adequate cash
reserves it must decide to pay dividend in the form of shares. Normally the
company may issue its own shares to the existing shareholders in lieu of cash
dividend or in addition to cash dividend.
13.4 REVISION POINTS
Dividend : A distribution to share holders out of Profits
or reserves available for this purpose.
Dividend Policy : The policy concerning the quantum of profits
to be distributed as dividend.
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Right shares : Shares moved to a shareholders under his

pre-emptive rights
Bonus Shares : Shares allotted by capitalisation of reserves
or surplus of a corporate enterprise.
13.5 INTEXT QUESTIONS
1. What do you mean by dividend?
2. What is meant by dividend policy?
3. Discuss the different types of dividend
4. Describe the different types of dividend policy?
5. Write short note on stable dividend policy
6. State the merits and demerits of stock dividend
7. What do you think are the determinants of the dividend policy of corporate
enterprises?
13.6 SUMMARY
The term dividend refers to that of the Profits of a company which is
distributed amongst the share holders. The term dividend policy refers to the policy
concerning quantum of Profits to be distributed as dividend. The concept of
dividend policy implies that companies through their Board of Directors evolve a
pattern of dividend payments which has a bearing on future action. The dividend
decision of the firm is of crucial importance for the financial manager since it
determines the amount of Profit to be distributed among shareholders and the
amount of profit to be retained in the business. While taking dividend decision, the
management will obviously take into amount the effect of the decision on the
maximization of share holders wealth. Payments of dividend can be in different
forms like cash dividend, bond dividend, properly dividend, stock dividend etc. This
lesson presents an overview of different types of dividend policies.
13.7 TERMINAL EXERCISE
1. Dividend is paid to the shareholders in the form of cash is called ……………
2. ………………………………………. dividend policy maintains regularity in
paying dividend even though its amount fluctuates from year to year and
may not be related to earnings.
3. …………………………… is the portion of earnings which is distributed
among the shareholders.
13.9 SUPPLEMENTARY MATERIAL
1. www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/cfpacket2spr14.pdf
2. www.sol.du.ac.in/mod/book/view
1.9 ASSIGNMENTS
1. Explain the significance of dividend decisions in financial management.
 238

2. Outline and analyse the fundamental issues concerning corporate dividend

Policy.
3. Explain the various external and internal factors which influence the
dividend decision of a firm.
4. What are the different types of dividends that can be paid by a company?
5. What are the advantages and disadvantages of stock dividend to die
company and to the shareholders? Explain.
6. Describe die various provisions of Companies Act, 1956 governing die
declaration and payment of dividend.
13.10 SUGGESTED READINGS
 Maheswari S.N., “Financial Management Principles and Practices” Sultan
Chand & Sons, New Delhi (2010).
 Antony Robert. N and Reece, James.S. “Management Accounting
Principles” Tata Mc Graw Hill (2004).
 Chandra, Prasanna: “Fundamentals of Financial Management”, New Delhi,
Tata McGraw ?11 Co.
 Pandey, I.M.: “Financial Management”, New Delhi, Vikas Publishing House.
 Saravanavel, P. : “Financial Management”, New Delhi, Dhanpat Rai & Sons.
13.11 LEARNING ACTIVITIES
As a firm's financial manager, would you recommend to die board of directors
that the firm adopts as policy a stable dividend payment share or a stable pay-out
ratio?
13.12 KEYWORDS
Cost of Capital, Stability of Earnings, Stable Dividend Policy, Bond Dividend,
Stock Dividend, property Dividend.


 239

LESSON – 14

THEORIES OF DIVIDEND
14.1 INTRODUCTION
The investors basically have two desires viz. (a) high percentage of dividends
and (b) maximum earnings per share or increase in their investments. These two
factors influences the dividend policies. The term dividend refers to the divisible
profits of the company to its equity shareholders. The percentage of dividend is
mainly a decision of the management which is decided on the basis of the present
earnings, growth rate and opportunities for expansion and diversification. If a firm
pays high dividend and maintains less amount of retained earnings, it has to
depend on external finance for their investment opportunities which may at times
give negative reflection on the wealth of the company. If a firm keeps retained
earnings and pays lesser amount of dividend to equity shareholders and finances
such funds for investment opportunities, it increases the wealth of the company.
Subsequently, a company can attain its objective of wealth maximisation.
Therefore, the financial manager has to consider all these issues at the time of
financing the dividend policy.
14.2 OBJECTIVES
After completing this lesson you must be able to
 Describe the theories of dividend
 Explain the relevance and irrelevance of dividend policy
14.3 CONTENT
14.3.1 Theories of Dividend
14.3.2 Walter’s Model
14.3.3 Gordon’s Model
14.3.4 MM Model
14.3.1 Theories of Dividend
There are conflicting opinions regarding the impact of dividend decision and
the value of the firm. The dividend theories can be classified under the following
two groups.
(i) Relevance concept of dividend (Theories of Relevance)
(ii) Irrelevance concept of dividend (Theories of Irrelevance)
i) Relevance concept of dividend
It indicates that there is a relationship between firms dividend policy and the
firms position in the stock market. Myron Gordon, John linter, James Walter,
Richardson and others are associated with the relevance concepts of dividend. If the
company declares higher rate of dividend automatically its value increase in the
stock market. Suppose it declares low dividend rate, immediately its value decrease
in the market. As information about the rate of dividend is immediately
communicated to the investors and also the profitability of the firms.
 240

ii) Irrelevance concept of dividend

Irrelevance concept of dividend was developed by soloman, Modigliani and
Miller. According to this approach there is no such relationship between the rate of
dividend and the value of the firm in the stock market, i.e. The dividend policy has
no effect on the share price of the company and is therefore it does not have any
consequence. Under this approach investors do not differentiate between dividends
and capital gains. The investors ultimate aim is to earn higher return on their
investment.
14.3.2 Walter's Model
According to the Walter’s model, dividend policy of the firm depends on the
internal rate of return (r) and cost of capital (k) of the firm.
Assumptions of Walters model
(i) The entire financing of the firm only through the retained earnings. It does
not use the new equity or debt.
(ii) Entire earnings are distributed or reinvested in the firm.
(iii) The firm has a very long life.
(iv) Earnings of the firm and the rate of dividends do not change while
determining the value. Walter formula for determining the market price per share is
as follows.
D  r Ke(E - D)
Market price per share P 
Ke
P = Market price of an equity share
D = Dividend per share
r = Internal rate of return
E = Earnings per share
Ke = Cost of equity capital.
Criticism of Walters’s model
Walters approach has been criticised on account of various assumptions made
by prof. Walter in formulating his hypothesis.
(i) Internal rate of return remain constant is not true, because the rate of
return changes with increase or decrease in investment.
(ii) This model assumes that the cost of capital remain constant. Actually the
cost of capital also change because of a firms risk pattern does not remain
constant.
(iii) The basic assumptions of the Walters model is that all the investments are
financed only through retained earnings. This assumption is not real. Actually
firms do raise funds not only from the retained earnings but also through equity
and new debt also.
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14.3.3 Gordon's Model

Myron J. Gordon has also put forth a model arguing for relevance of dividend
decision to valuation of firm. The model is founded on the following assumptions.
(i) The firm is an equity firm. No external financing is used and investment
programmes are financed exclusively by retained earnings.
(ii) The internal rate of return (r) and are appropriate discount rate (k) for the
firm are constant.
(iii) The firm has perpetual life and its stream of earnings are perpetual.
(iv) The corporate taxes do not exist.
(y) The retention ratio (b) once decided upon is constant. Thus the growth rate
(g) (g=br) is also constant.
(vi) Cost of capital (k) is greater than the growth rate (g).
Like Walter, relevance of dividend policy to valuation of firm has been held by
Gordon. He is of the view that investors always prefer dividend income to dividend
to be obtained in future because they are ration be non - chalant to take risk. The
payment of current dividends completely any possibility of risk. They would lay less
emphasis on future compared to the current dividend. This is why when a firm
retains its share value receives set back. Investors preference for current dividend
exists even in situation where r = k. This sharply contrasts with Walter's 1 holds
that investors are indifferent between dividends and retention when r=k.
Gordon's Formula
Gordon has provided the following formula to determine the ma a share.
D E (1 - b)
(P)  (or)
k-g k - br

Where,
D = Dividend per share
k = Cost of capital
g = Growth rate = b x r
E = Earnings per share
b = Retention ratio
r = Rate of return. Implications
Implications
(a) The optimal payout ratio for a growth firm is Nil
(b) The payout ratio for a normal firm is irrelevant
(c) The optimal payout ratio for a declining firm is 100%.
Criticisms
(i) Assumption of 100% equity funding defeats the objective of maximization of
wealth, by leveraging against a lower cost of debt capital.
 242

(ii) Constant rate of return and current opportunity cost are not in tune with
realities.
Theories of Irrelevance (Irrelevance concept of dividend)
These theories associated with Modigliani and Miller hold that policy has no
effect on the share prices of a firm and is therefore of no co Investors are basically
indifferent between current cash dividends capital gains. They are basically
interested in getting higher return investments. If the firm has adequate investment
opportunities giving rate of return than the cost of retained earnings, the investors
will be satisfied with the firm for retaining the earnings. However, in case, the
expected return on projects is less than what it would cost, the investors would
prefer to receive dividends. So, it is needless to mention that a dividend decision is
nothing but a financing decision. In short, if the firm has profitable investment
opportunities, it will retain the earnings for investment purposes or if not, the said
earnings should be distributed by way of dividend among the investors/shareholders.
2.5 Modigliani-Miller Hypothesis (M.M. Model)
Modigliani-Miller argue that value of a firm is determined by its earnings
potentiality and investment pattern and not by dividend distribution. According to
them, the dividend decision is irrelevant and it does not affect the market value of
equity shares, because the increase in wealth of shareholders resulting from
dividend payments will be offset subsequently when additional share capital is
raised. If the additional capital is raised in order to meet the funds requirement, it
will dilute the existing share capital which will reduce the share value to the
original position.
Assumptions
The above theory is based on the following assumptions:
(i) Capital markets are prefect. Investors are free to buy and sell securities.
They are well informed about the risk and return of all types of securities. There are
no transaction costs. The investors behave rationally. They can borrow without
restrictions on the same terms as the firms do,
(ii) There are no corporate and personal taxes. If taxes exist, the tax rates are
the same for dividend and-capital gains.
(iii) The firm has a fixed investment policy under which at each year end, it
invests a specific amount as capital expenditure.
(iv) Investors are able to predict future dividends and future market prices and
there is only one discount rate for the entire period.
(v) All investments are funded either by equity or by retained earnings.
Determination of Market price of share
Under M.M. Model, the market price of a share at the beginning of the period
(Po) is equal to the present value of dividends received at the end of the period plus
the market price of the share at the end of the period.
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P0 = Present value of Dividends received + Market price of the share at the end
of the period.
This can be expressed as follows:
D1 P D P
P0 = + 1  1 1
1  Ke 1  Ke 1  Ke
The market price of the share at the end of the period ( P1 ) c as follows:
P1 = P0 (1+Ke)-D1
Where,
P1 = Market price per share at the end of the period.
P0 = Market price per share at the beginning of the period i.e price.
Ke = Cost of equity capital
D1 = Dividend per share at the end of the period.
Determination of No. of New shares
The investment requirements of a firm can be financed by retained earnings or
issue of new shares or both. The number of new shares to b determined as follows:
Investment Proposed xxx
Less: Retained earnings available for investment:
Net income xx
(-) Dividends distributed xx xxx
Amount to be raised by issue of new shares xxx
Amount to be raised by issue of new shares
 No. of New Shares =
Issues price per share
Implications
(i) Higher the retention ratio, higher is the capital appreciation enjoyed by the
shareholders. The capital appreciation is equal to the amount retained.
(ii) If the firm distributes earnings by way of dividends, the share dividends
equal to the amount of capital appreciation if the firm had retained the amount of
dividends.
Criticisms
The MM model may be criticized as follows:
(i) The assumption of perfect capital market is theoretical in perfect capital
market is never found in practice.
(ii) Following propositions on dividend are impracticable and unrealistic:
(a) Investors can switch between capital gains and dividends
(b) Dividends are irrelevant, and
(c) Dividends do not determine the firm value.
 244

(iii) The situation of zero taxes is not possible.

(iv) The assumption of no stock floatation or time lag and no transactions costs
are impossible.
Example - 1
The following information is available in respect of ABC Ltd.:
Earning per share (EPS or E) = Rs.10 (Constant)
Cost of Capital, Ke = .10 (Constant)
Find out the market price of the share under different rate of return,
r, of 8%, 10% and 15% for different payout ratios of 0%, 40%, 80% and 100%
Solution
The market price of the share as per Walter’s model may be calculated for
different combinations of rate of return and dividend payout ratios (the earnings per
share, E, and the cost of capital, Ke, taken as constant) as follows.
If the rate of return, r = 15% and the dividend payout the ratio is 40%, then
D (r / ke )( E  D)
P= 
Ke Ke
4 (.15 / .10)(10  4)
P= 
.10 .10
 40  90  Rs.130.
Similarly, if r =8% and dividend payout ratio = 80%, then
8 (.08 / .10)(10  8)
P= 
.10 .10
 80  16  Rs.96.
The expected market price of the share under different combinations of ‘r’ and
payout ratio have been calculated and presented in Table 1.
Table 1 : Market Price under Walter’s Model for Different Combinations of ‘r’ and
Payout ratio
r = 15% r = 10% r = 8%
D/P Ratio 0% Rs. 150 Rs. 100 Rs. 80
40% 130 100 88
80% 110 100 96
100% 100 100 100

It may be seen from Table 4.1 that for a growth firm (r = 15% and
r > ke), the market price is highest at Rs. 150 when the firm adopts a zero payout
and retains the entire earnings. As the payout increases gradually from 0% to
100%, the market price tends to decrease from Rs. 150 to Rs. 100. For a firm
having r< ke (i.e., r = 8%), the market price is highest when the payout ratio is 100%
and the firm retains no profit. However, if r=ke=10%, then the price is constant at
 245

Rs. 100 for different payout ratios. Such a firm have any optimum payout ratio and
every payout ratio is as good as any other.
So, the prepositions of the Walter's Model are testified by the mathematical
formation. It provides a framework which explains the relationship between
dividend policy and the firm. As far as the assumptions underlying the model hold
good, the behaviour market price of the share in response to the dividend policy of
the firm can be explained the help of this model. However, the limitation of this
models is its assumptions. The fresh investments only out of retained earnings and
no external financing is seldom found in real life. The assumption of constant ‘r’
and constant ‘ke’ is also unrealistic and does good. As more and more investments
are made, the risk complexion of the firm will change and consequently the ke may
not remain constant.
Example -2
The EPS of XYZ Ltd. is Rs. 10 and the cost of equity capital, ke
is 10%. Both are expected to remain constant for several years. The rates of return
on fresh investment by the may be 8%, 10% or 15%. Apply Gordon's Model and find
out the market price of the share payout ratios of 0%, 40%, 80% and 100%.
Solutions
The market price of the share as per Gordon's model may be calculated as
follows:
E (1  b)
P=
Ke  br
If r = 15 % and payout ratio is 40%, then the retention ratio, b, is .6 (i.e., 1 -
.4) and the growth rate, g = br = .09 (i.e., .6 x .15) and the market price of the share
is
E (1  b)
P=
Ke  br
10(1  .6)
P=
.10  .09
 Rs.400
If r = 8% and payout ratio is 80%, then the retention ratio, 6, is .2 (i.e., 1 - .8)
and the growth rate, g = br = .016 (i.e., .2 x .08) and the market price of the share is
10(1  .2)
P=
.10  .016
 95
The expected market price under different combinations of ‘r’ and dividend
payout ratio have been calculated and placed in Table 2.
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Table 2.: Market Price under Gordon's Model for Different Combinations of ‘r’ and
Payout ratio
r = 15% r = 10% r = 8%
D/P Ratio 0% 0 0 0
40% Rs. 400 Rs. 100 Rs. 77
80% 114 100 95
100% 100 100 100

On the basis of figures given in Table 2, it can be seen that if the firm adopts a
zero payout then the investor may not be willing to offer any price. For a growth
firm (i.e r>Ke>br), the market price decreases when the payout ratio is increased.
For a firm having r<Ke, the market price increases when the payout ratio is
increased.
If r = kc, the dividend policy is irrelevant and the market price remains con Rs.
100 only. However, Gordon has argued that even if r = ke, the dividend payout ratio
matters and the investors being risk averse prefer current dividends which are
certain, to future capital gains which are uncertain. The investors will apply a
higher capitalization rate i.e., ke to discount the future capital gains. This will
compensate them for the uncertain capital gain and thus the market price of the
share of a firm which retain will be adversely affected.
Gordon's conclusions about the relationship between the dividend policy and
the value of the firm are similar to that of Walter's model. The similarity is due to
the reason that the underlying assumptions of both the models are same. Both
models suggest that a firm adopt a suitable dividend policy depending upon the
relationship between the rate of or its investment and capitalisation rate of the
equity shareholders.
Example - 3
Details regarding three companies are given below :
Nel Ltd. Mel Ltd Gel Ltd
r=18% r = 20% r=8%
k=15% k-20% k=10%
E = Rs.30 E = Rs.40 E = 20
By using Walter's model, you are required to
(i) Calculate the value of an equity share of each of these companies dividend
payout is (a) 30%, (b) 60%, (c) 100%;
(ii) Comment on the results drawn.
Solution
I. Nel Ltd
(a) Computation of value of an equity share when payout is 30%
 247

D
 r   (E - D)

Value of an equity share 
k
k
D = Dividend per share = EPS x Payout ratio
= 30 x 30% = Rs. 9
r = Rate of return = 18%
k = Cost of capital = 15%
E = Earnings per share = Rs. 30

9
 0.18   (30 - 9)

Value of an Equity Share 
 0.15 
0.15

(b) Computation of value of an equity share when payout is 60%

D = Dividend per share = 30 x 60% = Rs.18

 0.1   (30 - 18)

18   
Value of an Equity Share 
 0.15 
0.15
32.4
  Rs.216
0.15
(c) Computation of value of an equity share when payout is 100%
D = Dividend per share = 30 x 100% = Rs.30

18  
 0.18   (30 - 30)

Value of an Equity Share 
 0.15 
0.15
30
  Rs.200
0.15
Analysis: Nel Ltd. is a growth firm (r>k). If payout increases, share price
declines. It is better to retain the entire profit with the firm. So, the ideal payout is
0%.
II. Mel Ltd.
(a) Computation of value of an equity share when payout is 30%

D
 r   (E - D)

Value of an equity share 
k
k
D = Dividend per share = EPS x Payout ratio
= 40 x 30% = Rs.12
r = Rate of return = 20%
k = Cost of capital = 20%
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E = Earnings per share = Rs. 40.

12  
 0.20  (40 - 12)

Valueof an Equity Share 
 0.20
0.20
40
  Rs.200
0.20
(b) Computation of value of an equity share when payout is 60%
D = Dividend per share = 40 x 60% = Rs. 24

24  
 0.20  (40 - 24)

Valueof an Equity Share 
 0.20
0.20
40
  Rs.200
0.20
(c) Computation of value of an equity share when payout is 100%
D = Dividend per share = 40 x 100% = Rs. 40

40  
 0.20  (40 - 40)

Valueof an Equity Share 
 0.20
0.20
40
  Rs.200
0.20
Analysis : Mel Ltd. is a growth firm (r=k). Dividend payout does not affect the
value of equity share of the firm.
III. Gel Ltd.
(a) Computation of value of an equity share when payout is 30%

D
 r   (E - D)

Value of an equity share 
k
k
D = Dividend per share = EPS x Payout ratio
= 20 x 30% = Rs.6
r = Rate of return = 8%
k = Cost of capital = 10%
E = Earnings per share = Rs. 20.

40  
 0.08   (20 - 6)

Value of an Equity Share 
 0.10 
0.10
17.2
  Rs.172
0.10
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(b) Computation of value of an equity share when payout is 60%

D = Dividend per share = 20 x 60% = Rs. 12

12  
 0.08   (20 - 12)

Value of an Equity Share 
 0.10 
0.10
18.4
  Rs.184
0.10
(c) Computation of value of an equity share when payout is 100%
D = Dividend per share = 20 x 100% = Rs. 20

20  
 0.08   (20 - 12)

Value of an Equity Share 
 0.10 
0.10
20
  Rs.200
0.10
Analysis: Gel Ltd. is a declining firm (r<k). If payout ratio increases, the value
of an equity increases. It is better to distribute all the profits to the shareholders of
the firm. Hence, the ideal payout is 100%
Problem 4: The following information is available in respect of ABCD Ltd. Cap
rate =10%; Earning per share Rs. 40.
Assumed rate of return on investments: (i) 12% (ii) 10% (iii) 8%.
Show the effect of dividend policy on market price of shares applying Walter's
formula dividend payout ratio is (a) 0% (b) 50% (c) 100%
Solution
According to the Walter's model,

R
D    ( E - D)
P= k
Market price per share, k
D = Dividend per share r = Return on investments
K = Cost of capital E = Earning per share
(a) Market price per share if payout is 0%
Dividend = 0% EPS = Rs. 40.

r = 12%(G) r = 10% (N) r =8% (D)

R  12% (G) R  10% (N) R  8% (D)
10 10 10
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P  0  (.12/.10)(40 - 0) 0  (.10/.10)(40 - 0) 0  (.18/.10)(40 - 0)

0  (1.2)40 O  (1) (40) O  (.8) (40)
. 10 . 10 . 10
0  48 48 0  40 40 0  32 32
.10 .10 .10 .10 .10 .10
 Rs.400
 Rs.400  Rs.320
b) Market price per share if payout is 50%
Dividend = 50% of EPS = 50% of Rs. 40 = 20

r = 12%(G) r = 10% (N) r =8% (D)

20  (0.12/0.10)(40 - 20) 20  (0.10/0.10)(40 - 20) 20  (0.10/0.10)(40 - 20)
0.10 0.10 0.10
20  (1.2) (20) 20  (1) (20) 20  (0.8) (20)
1.10 1.10 1.10
20  24 44 20  20 40 20  16 36
0.10 0.10 0.10 0.10 0.10 0.10
 Rs.440  Rs.400  Rs.360

(c) Market price per share if payout is 100%

Dividend = 100% of EPS = 100% of Rs. 40

r = 12%(G) r = 10% (N) r =8% (D)

20  (0.12/0.10)(40 - 20) 20  (0.10/0.10)(40 - 20) 20  (0.10/0.10)(40 - 20)
0.10 0.10 0.10
r  12% (G) R  10% (N) R  8% (D)
40  (0.12/0.10) (40 - 40) 40  (0.10/0.10) (40 - 40) 40  (0.8/0.10) (40 - 40)
1.10 0.10 0.10
40  (1.2)(0) 40  (1) (0) 40  (0.8)(0)
0.10 0.10 0.10
40  0 40 40  0 40 40  0 40
 Rs.400  Rs.400
0.10 0.10 0.10 0.10 0.10 0.10
Conclusion
1. When r is 12% (r > k), market price is the highest for a payout of 0%. Hence
ideal payout is 0%.
(a) When r is 10% (r = k), dividend policy has no effect on share price.
(b) When r is 8% (r < k), market price is the highest for a payout of 100%.
Hence ideal payout is 100%
Problem 5: Nidhi Corporation Ltd. Belongs to a risk class of which the
appropriate capitalization rate is 10%. It currently has 1,00,000 shares quoting
Rs.100 each. The company proposes to declare of a dividend of Rs.6 per share at
the end of the current fiscal year which just begun.
 251

Answer the following questions based on Modigliani and Miller Model and
assumption of no taxes.
(i) What will be the price of the shares at the end of the year if dividend is not
declared?
(ii) What will be the price if dividend is declared?
(iii) Assuming that the company pays dividends, has a net income of Rs.10
lakhs and plans.
New investments of Rs.20 lakhs during the period, how many new sham us be
issued (iv) Is the MM Model realistic? What factors might mar its validity?
Solution
Price at the end of the year P1 = P0 + (1 + Ke) – D1
i) If dividend is not declared
P0 = Current market price = Rs.100
Ke = Cost of equity capital = 10% or 0.10
D1 = Dividend to be paid at the end of the period = 0
P1 = 100 (1 +0.10) -0; P1 = 100 (1.10)-0 = Rs. 110
ii) Price of the share if dividend is declared
P1 = .P0 + (1 + Ke) - D1
P0 = Rs. 100
Ke = 10% or 0.10
D1 = Dividend = Rs.6
P1 - 100 (1 + 1.10)-6 = 100 (1.10)-6 = Rs. 110-6 = Rs. 104
iii) Computation of No .of shares to be issued:
Rs. Rs.
Investment period 20,00,000

Net Income 10,00,000

Dividend distribution Rs.6 x 1,00,000 -6,00,000
Retained earnings available for investment 4,00,000
New shares to be issued for 16,00,000
Issue Price (if dividend if paid) 140
No. of shares to be issued = Rs.16,00,000  104 = 1,50,385
iv) The MM Model is unrealistic. Because of the following factors
a) There are no corporate taxes
b) There is no difference in the tax rates applicable to dividends and capital
gains.
c) There are no floatation and transaction costs.
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d) There is no uncertainty about the future of the firm.

Problem 6: The earnings per share of-ARP Ltd. is Rs.8. The rate of capitalize
10%. The productivity of retained earnings is 15%.
Compute the market price per share if the payout is 0% 25%, 50%, and 100%
inference can be drawn from the above exercise?
Solution
Under the Walter's model,
D  (r /k)(E - D)
MarketpriceP 
k
D = Dividend per share = 0
R = Rate of return = Productivity of retained earnings
= 15% or 1.15
K = Cost of capital = 10% or 1.10
E = Earnings per share = Rs.8
a) Market price per share if payout is 0%
D = Dividend per share = 0
Market price per share
0  (0.15/0.10 (8 - 0)
P
0.10
1  (1.5) (8) 0  12
   Rs. 120
0.10 0.10
b) Market price per share if payout is 25%
Dividend = 25% of EPS = 25% of Rs.8 = Rs. 2
Market price per share
2  (0.15/0.10 (8 - 2)
P
0.10
2  (1.5) (6) 2  9 11 2  9 11
      Rs.110
0.10 0.10 0.10 0.10 0.10
c) Market price per share if payout is 50%
Dividend = 50% of EPS = 50% of Rs.8 = Rs. 4
Market price per share
4  (0.15/10 (8 - 4)
P
0.10
8  (1.5) (0) 4  6 10
    Rs.110
0.10 0.10 0.10
d) Market price per share if payout is 75%
Dividend = 75% of EPS = 75% of Rs.8 = Rs. 6
Market price per share
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8  (0.15/10 (8 - 8)
P
0.10
8  (1.5) (0)

0.10
80
  Rs.8
0.10
Results & Comments
Rate of return of Excellent Ltd. is higher than the cost of capital (r=15%
k=10%) Hence it is a growth firm.
The market price at different payouts are :
0% - Rs. 12 0 25% - Rs. 110 50% = Rs. 100
75% - Rs. 90 100% = Rs. 80
The market price is the highest when the payout is 0%. As payout increase,
market price comes down. Hence, the ideal payout is 0%
Problem 7
ABC has a total investment of Rs. 5,00,000 in assets and 50,000 outstanding
ordinary shares at Rs. 10 per share (par value). It earns a rate of 15% on its
investment and has a policy of retaining 50% of the earnings. If the appropriate
discount rate of the firm is 10%, determine the price of its share using Gordon's
model. What shall happen to the price of the share if the company has a payout of
80% or 20%.
Solution
Earnings
Earnings @ 15% on assets of Rs. 5,00,000 = Rs.75,000
No. of shares = 50,000
EPS : 15% or Rs. 1.5
Current Growth rate = br
15% of 50% = 7.5% when payout is 50%
E = EPS (1.6125)
b = Retained Earnings in 50%
Ke = Cost of capital
r = actual rate of capitalization or IRR
br = growth rate or IRR
Applying Gordon’s Model PO would be

Market Price At 50% DP 80% DP 29% DP

E(1 - b) 1.6125 (1- 50) 1.6125 (1 - 2) 1.6125 (1- 80)
P
o ke - br 1 - .75 1 - .75 1 - .75
 Rs. 32.15  Rs. 1290  Rs. 51.60
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Note: Current earning per share is Rd. 1.5 and the EPS at period 1 with grow
rate of 7.5% would be 1.5 x 0.75 = Rs. 1.6125.
14.4 REVISION POINTS
 Walter’s Model – Dividend policy is an active variable that influences share
price and also value of firm.
 Gordon’s Model – Dividend decisions are relevant and it affects the value of
firm.
 MM Hypothesis – The value of a firm is determined by the earnings
potentially and investment pattern and not by dividend distribution.
14.5 INTEXT QUESTIONS
1. Define Walters Model
2. Define Gordons Model
3. Define M.M Model
14.6 SUMMARY
There are two schools of thought on the relationship between dividend policy
and the value of the firm. Relevance of Dividends and irrelevance of dividends.
According to relevance of dividends, the decision is an active variable influencing
the valve of the firm. The choice of dividend policy always offers the value of
enterprise. The irrelevance of dividends policy advocates that the dividend paid by a
firm should be viewed as a residual i.e. the amount left over after all acceptable
investment opportunities have been undertaken. Walter’s model and Gordon’s
Model supports the theory that dividends are relevant. The choice of dividend
policies affects the valve of enterprise because it maximise the wealth of
shareholders. According to Modigliani and Miller dividends are irrelevant to the
valve of shares and firm because it does not affect the wealth of share holders.
14.7 TERMINAL EXERCISE
1 …………………….. argue that value of a firm is determined by its earnings
potentiality and investment pattern and not by dividend distribution.
2. ………………………….. put forth a model arguing for relevance of dividend
decision to valuation of firm.
3. According to the …………………… Model , dividend policy of the firm
depends on the internal rate of return (r) and cost of capital (k) of the firm.
14.8 SUPPLEMENTARY MATERIAL
1. chttp://flash.lakeheadu.ca/
2. www.yourarticlelibrary.com/theories/theories-of-dividend.
3. http://makemynote.weebly.com/
14.9 ASSIGNMENTS
1. Discuss Walter Model of share valuation.
2. Explain the assumptions and implications of Gordon’s dividend model.
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3. Explain the Modigilani – Miller hypothesis of dividend irrelevance. Does this

hypothesis suffer from limitations.
4. Raj Ltd. earns Rs.5 per share. The capitalisation rate is 10% and the return
an investment is 12% under Walter’s model determine (a) optimum payout (b)
Market price of the share if the pay out is 20% and 40%
5. A company belongs to a risk class for which the appropriate capitalisation
rate is 10% It currently has outstanding 25,000 shares selling at Rs.100 each. The
firm is contemplating the declaration of dividend of Rs.5 per share at the end of the
current financial year. The company express to have a net income of Rs.2.5 lakh
and has a proposal for making new investment of Rs.5 lakh. Show that, under MM
assumptions, the payment of dividend does not affect the value of the firm.
6. From the following date given below, determine the market price per share
under Gordon’s Model.
EPS B 8; Retention ratio (b) = 25%
Capitalisation rate (k) = 10%; Rate of return (r) = 15%
14.10 SUGGESTED READINGS
 Hampton John. J., Financial Decision making, Tata Mc Graw Hill, New Delhi
(2000).
 Jain S.P and Narang K.L., Financial Management, Kalyani Publishers
(2010).
 Pandey,I.M.; Financial Management, New Delhi, Vikas Publishing House.
 Rathnam, P.V.; Financial Advisor, Allahabad, Kitab Mahal.
 ShannaR.K. & GuptaS.K.; Financial Mgt., Ludhiana, Kalyani Publishers.
14.11 LEARNING ACTIVITIES
1. Give a critical appraisal of the traditional approach and the Modigliani-
Miller Approach to the problem of capital structure.
2. Is the M.M. thesis realistic with respect to capital structure and the value of
a firm? If not, what are their main weaknesses?
14.12 KEYWORDS
Cost of Capital,Market Price Per Share,Market Vaue Per Share,Corporate
Taxes, Retention Ratio,Cost of Equity Capital,Dividend Per Share,


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LESSON – 15

DIVIDEND POLICY AND DIVIDEND PAY-OUT RATIO

15.1 INTRODUCTION
A firm can use its earnings either to pay dividends to its shareholders or to
funds for other purposes such as financing new investments or retiring the debts.
The firm must decide on the amount or proportion of earnings to be paid out as
dividends and the amount to be retained for internal financing. The more the
earnings used for dividends, the less will be the amount available for investment,
which may mean that the investment proposals will have to be financed by external
funds. At the time of designing a dividend policy for the firm, the financial manager
must not overlook the investor's/share holder’s preference for current cash
dividends. But this does not mean that the whole of the profit of the firm be
distributed. He has to keep in mind the importance of retained earnings as an
internal source of finance.
The dividend policy and the financing of investments are interdependent. The
long-term dividend policy of the firm and the financing programme of its
investments imply a trade-off. Assuming that the firm has already decided about
how much to invest and also has chosen its capital mix for financing these
decisions, the decision to pay a larger dividend results in deciding to retain little
profits which in turn results in greater reliance on external equity financing.
Conversely, given the firm's investment and financing decisions, a small dividend
payment corresponds to high profit retention with lesser needs for external funds.
This trade-off is fundamental to the formulation of a dividend policy.
Dividend payment to shareholders is one of the few ways that the firm can
directly affect the market price of the share and the wealth of the shareholders. A
dividend policy adopted by a firm should be one which helps maximizing its
contribution towards increasing the wealth of the shareholders. There are two
important and fundamental dimensions of dividend Policy. These are:
(i) The dividend payout ratio, which indicate the amount of dividends
distributed relation to the earnings, and
(ii) The stability of dividends which may be as important to any investor as the
amount of dividend is.
In the first instance, the financial manager has to decide as to how much
distributed, or to decide the dividend payout ratio (DP ratio). A whole lot of other
economic legal and procedural constraints are also to be considered while framing a
dividend the following discussion, all these factors have been analysed.
15.2 OBJECTIVES
After completing this Lesson you must be able to
 Explain the meaning of Dividend pay-out ratio
 Discuss the factors affecting dividend pay-out ratio
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 Highlight the importance of pay-out ratio

 Describe the non-cash dividends
 Explain the advantage of stock dividend.
15.3 CONTENT
15.3.1 Dividend pay-out ratio
15.3.2 Importance of pay-out ratio
15.3.3 Types of D/P ratio policies
15.3.4 Non-Cash Dividends
15.3.1 Dividend Payout Ratio
The DP ratio is the percentage of dividend distributed out of total profit after
tax. It may be calculated follows:
Dividendpaid to share holders
DP Ratio  , or
Net Profitafter tax
Dividendto Equity Shareholders
 , or
Profit after Tax - Pref. Dividend
DividendPer Share
 , or
EarningsPer Share
For example, if out of the total profits after tax of Rs. 50,00,000, the firm
dividends amounting to Rs. 30,00,000. In this case, the DP ratio is 60%, i.e.
30,00,000/- Rs. 50,00,000.
If the company has liability of preference dividends of Rs. 15,00,000, then the
available for equity shareholders is Rs. 35,00,000 and dividend distribution of Rs.
30,0 o equity shareholders means a dividend payout of 30,00,000 + 35,00,000, i.e.,
85.71% profits which are not distributed are known as retained earnings. The
Retention Ra he ratio of retained earnings to profit after tax. The DP ratio and
retention ratio (usually denoted by b) are complementary. There are several factors
affecting the DP ratio. Some of these are :
1. Liquidity: The dividend represent distribution of profits and payment of
dividend results in decrease in cash. However, the profits need not necessarily
assure the availability of liquid funds. A large amount of profit does not, in any
way, indicate that cash is available for payment of dividends. The firm's position in
liquid cash is basically independent of the earnings. A company with sizable
earnings may be generating cash from operations, but these funds are either re-
invested in the firm itself or are used to pay for maturing the debts. A firm may be
profitable but still a cash poor. Since the dividends are payable in cash, the firm
must have sufficient cash. Thus, the liquidity position of the firm is an important
consideration while deciding the dividend payout.
A firm having tight liquidity or tight working capital position may not find itself
in a position to pay dividends even if the profits are sufficient enough. This is
particularly true of chose firms which operates in growth scenario where profits are
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required to be reinvested in the working capital to support expanding operating

activities. The cash generating ability of the firm and present liquidity position will
be important consideration for deciding dividend policy of the firm. There is no
denying the fact that a firm should not endanger its operational liquidity through
distribution of cash dividends to the shareholders.
It may be true that in some cases, the cash shortages may be temporary and
the normal cash inflows from operations will quickly restore the liquidity position to
safer levels, management may be justified in borrowing short-term funds to cover a
cash shortage that perhaps made more acute by the payment of cash dividend. The
liquidity requirement explain why many firms skip the dividends altogether, or
lower the amounts of c dividend payments during economic recession.
2. Fresh Investments Plans: A firm, which has fresh investment opportunities,
requires funds for financing of these. Such a firm will have a tendency to adopt a
low DP ratio. This will ensure availability of more and more funds to the firm and
that too at no apparent or explicit cost, as the retained earnings have no explicit
cost. Moreover, if the firm does not have access to external financing (either in form
of share capital or in form of borrowings), then the firm will have no options but to
generate the resources internally by ploughing back the profits. This also requires a
low payout ratio to be adopted by the firm. On the other hand, a firm, having no
immediate growth plans or investment opportunities, may adopt liberal or high DP
ratio.
Growing firms are tempted at times to be less generous in Growing firms
distributing dividends to the shareholders in the form of cash tempted at times to
dividends. Whether or not these succumb to the temptations less generous
depends upon how they evaluate the question of long-run corporate interest versus
the short-run effects of cash dividends payment. The decision to retain earnings for
purposes of firm's growth must therefore, be made by balancing the short-run
interest of the shareholders, best served by the cash dividend payments, against
the long-run growth interests, best promoted by retention of profits; with at least
the implicit suggestion such retention and their reinvestment will produce both
higher future dividend and potential capital gains.
3. Flotation Costs: The financing obtained from external sources is costly in
terms of flotation costs and the required periodic outflows in the form of interest,
dividends repayments. Retained earnings, on the other hand, are free from such
costs. To distribute generous amount of cash dividends to the shareholders and
then to raise equal amount back by selling new securities will, therefore, result in
higher costs to the firm. However choice between retained earnings and raising new
capital from external sources for financing the growth is always not so clear. The
retained earnings may be insufficient to meet the financial requirements. The
problem then becomes one of constantly planning for future external financing to
supplement the funds provided by retained earnings in order to finance the
investment plans.
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4. Control: The dividend payout reduces the funds position and results in
lower internal accruals. The firm may then have to raise funds externally. If the
funds are to be raise issuing equity share capital (either because of market
conditions or because of debt-equity ratio considerations), then the issue of fresh
equity share capital may result in dilution management control. The present
shareholders in general and the management of the firm in particular, may not
favour higher DP ratio which may ultimately force the firm to raise the funds
externally by issuing additional share capital. Even if the fresh funds are raise by
issue of debt securities, the lenders may have their representation on the Board.
The control of the firm will not be endangered; however, there will be an outsider on
the Board. The present management look into this aspect also before deciding for
the DP ratio.
5. Shareholders' Discontent: The firm need not annoyed the present
shareholders. Although, the ultimate dividend policy depends upon numerous
factors, the avoidance of shareholder's discontent is important. If the present
shareholders become dissatisfied with the existing dividend policy, they may sell
their holdings to some other group and thereby increasing the possibility of dilution
of control. The takeover of a firm is more likely when the shareholders are
dissatisfied with the dividend policy of the firm. The firm should find out the
expectation of the shareholders in deciding the DP ratio.
The factors identified above show that deciding the DP ratio for a firm is a
critical decision. On one hand, paying too much in dividends create several
problems. The firm may find itself short of funds for new investment and may have
to incur the cost associated with new issues of securities or capital rationing. On
the other hand, paying too little in dividends can also create problems. For one, the
firm will find itself with a cash balance that increases over time, which can lead to
investments in 'bad' projects, especially when the interest of the management in the
firm are different from those of the shareholders. However, a firm while designing
the dividend policy must attempt to answer two questions namely:
1. How much cash is available to be paid out as dividend after meeting capital
expenditures and working capital requirements needed to sustain future growth?
2. How good are the proposals that are available before the firm? In general,
the firms that have good proposal will have an easy time with dividend policy, since
the share holders will expect that the cash accumulated in the firm will be invested
in these projects and eventually earn high returns. On the other hand, the firms
that do not have good proposals may find themselves under pressure to pay out all
cash profits (of course, subject to legal restrictions) to the shareholders.
DP Ratio and Cash Profits: Dividends are paid in cash. However, the amount of
dividends may be more or less than the cash profits generated by operation.
Different repercussions may follow:
If a firm pays lesser than what is available as cash profits, it may give rise to
different consequences as follows:
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(a) When a firm pays out less than it can afford, it accumulates cash. If a firm
does not have good proposals (now or in future) to invest this cash, then it may face
several possibilities. In the most benign case, such cash gets invested in financial
assets.
(b) As the cash accumulates, the financial manager may be tempted to take on
projects that do not meet the minimum rate of return requirements. These actions
will clearly lower the value of the firm.
(c) Another possibility is that the management may decide to use the cash to
finance an acquisition which may result in the transfer of wealth of the
shareholders of the acquired firm.
However, the result of low payout may be more positive for firms that have a
better selection of projects and whose management has a history of earning good
returns for the shareholders. The long-term effects of cash accumulations for such
firms are generally positive for the following reasons:
(i) The presence of projects that earn returns greater than the hurdle rate
increases the likelihood that the cash will be productively invested in the long run.
(ii) The high returns earned on internal projects reduces both the pressure and
the incentive to invest to poor projects.
On the other hand, if a firm pays more than what is available as cash profits,
it may give rise to different consequences as follows:
(a) When a firm pays out more in dividends than it has available as cash
profits, it is creating a cash deficit which has to funded by drawing on the firm's
own cash balance or borrowing money or issuing securities.
(b) The cash that is paid out as dividends could have been used to invest in
some of good projects, leading to a much higher return and much higher price to
shareholders. So, it can be argued that the firm is paying a hefty price for dividend
policy.
15.3.2 Importance of Payout Ratio
Dividend payout ratio (D/P ratio) maybe defined as the percentage share of net
earning distributed to the shareholders as dividends. Dividend policy involves the
decision to payout earnings or to retain them for reinvestment in the firm. The
retained earnings constitute a source, of financing. The payment of dividends result
in the reduction of cash, and in total assets. The dividend policy of the firm affects
both the shareholder's wealth and the long-term growth of the firm. The D/P ratio
should be determined with reference to maximising the wealth of the firm's owners
and providing sufficient funds to finance growth. The firm's dividend policy (D/P
Ratio) should be one which can maximise the wealth of its owners in the long run.
A low D/P ratio may cause a decline in share prices.
Generally, companies adopt the policy of a target dividend payout ratio in the
long run. According to Lintner, dividends are adjusted to changes in earnings but
only with a lag. The authorities in financial management establish relationship
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between cash flow and dividend payouts. Cash flows are earnings plus depreciation
and depletion charges. When dividends are related to cash-flows rather than to
earnings, the payout pattern shows the following changes:
(i) The payout percentages drop to lower levels.
(ii) It appears to be more stable when dividends are related to cash flow rather
than to earnings.
Based on cash flows, payout percentage is more stable and lower in
comparison to earning payout. While taking final decision about cash dividend, the
study of cash flow payout can help the management in following a sound policy of
management of income.
15.3.3 Types of D/P Ratio Policies
1. Constant Dividend Per Share: Here a company follows a policy of paying a
certain fixed amount per share as dividend. For example, on a share of face value of
Rs. 10, a firm may pay a fixed amount of, say, Rs. 2.50 as dividend year after year
irrespective of the level of earnings even when it suffers losses. When the company
reaches new levels of earnings and expects to maintain it, the annual dividend per
share may be increased. While the earnings may fluctuate from year to year, the
dividend per share is constant. In order to pursue such a policy, a firm whose
earnings are not stable would have to make provisions in years when earnings are
higher for payment of dividends in lean years. Such firms usually create a "reserve
for dividend equalisation. The balance standing in this fund is normally invested in
such assets as can be readily converted into cash.
2. Constant Payout Ratio Policy: The term payout ratio refers to the ratio of
dividend to earnings or the percentage share of earning used to pay dividend. In
constant payout ratio policies a firm pays a constant percentage of net earnings as
dividend to the shareholders. A stable dividend payout ratio implies that the
percentage of earnings paid out each year is fixed. Dividends would fluctuate in
proportion to the earnings of the company. When the earnings of a firm decline
substantially or there are a loss in a given period, the dividends, according to the
target payout ratios, would be low or nil. For example, if a firm has a policy of 50%
target payout ratios, its dividends will range between Rs. 5 and zero per share on
the assumption that the earnings, per share are Rs. 10 per share and zero (or less)
per share respectively.
3. A Regular and Extra-dividend Policy: Some firms establish a policy of a
constant rupee dividend (or a fixed percentage) referred to as a regular dividend. If
earnings are higher than normal in any year, the firm may pay an additional or
extra dividend. By designing the amount by which the dividend exceeds the normal
payments as an extra dividend, the firm avoids giving false hopes of increases
dividends in coming periods to existing and prospective shareholders. The use of
the regular extra dividend pattern is particularly common among companies that
experience cyclical shifts in earnings.
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By establishing a regular dividend which is paid each year the firm gives
investors a stable dividend income necessary to build their confidence in the firm.
The extra dividend permits them to share in the spoils if the firm experiences an
especially good period. Firms using this policy may also raise the rate of regular
dividend after increase in earnings has been achieved. However, is extra dividend
should not be allowed to become a regular event. The use of target payout ratio in
establishing the regular dividend level is advisable.
15.3.4 Non-Cash Dividends
a) Scrip Dividends: Bonus Shares: Dividend payment is an important way
through which the market price of the share and hence the wealth of the
shareholders can be maximized. Dividend payment affects the liquidity position of
the firm. There is another way of utilization of profits to reward the shareholders,
without however, affecting the current liquidity position of the firm. This is known
as script dividend or issue of bonus shares by capitalization of profits. Bonus
shares are the shares issued by the company (free of cost) by capitalization of
profits and revenues.
In order to issue bonus shares, the company has to pass a resolution for
creating of new shares out of reserves and profits. These shares are then
distributed among the shareholders in proportion to their holding. The bonus
shares do not alter the proportional ownership of the firm as far as the existing
shareholders are concerned. As the bonus issue does not affect the cash flows or
the operational efficiencies of the firm, there should not be any change in the total
value of the firm. The issue of bonus shares results in Tease in number of shares
and increases the paid-up capital of the company without involving any monetary
transaction. The number of shares increases as a result of bonus shares,
consequently the book value and the earnings per share of the company will
decrease (other things remaining same). The market price per share would decrease
but the shareholders are no worse off after the bonus, notwithstanding such
decrease, because they receive a compensatory increase in the number of shares.
b) Motives for Issue of Bonus Shares: Issue of bonus shares is, in fact, a nor
transaction. It does not affect the total value of the firm. Now if the effect of bonus
shares on the shareholders wealth is nil, then why do firms issue bonus shares? It
may be found that profitable companies have been making regular bonus issues,
some shareholders may consider the bonus issue as the substitute of cash
dividend. Other firms may view bonus shares as a supplement to cash dividend and
use them in periods in which they have posted good results. The announcement of
the bonus issue conveys information to the capital market about the future
prospects of the firm. In fact, the use of bonus shares as sig bright future may
increase the firm's value.
Companies have a common tendency to issue bonus shares to their
shareholders. Many companies have issued bonus shares once a while, whereas
some other companies have issued bonus shares on a regular basis. Companies
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such as Colgate-Palmolive Ltd., Bajaj Auto Ltd., Hindustan Lever Ltd., Infosys Ltd.,
Ingersoll-Rand Ltd. have issued bonus shares on a regular basis. During 2004,
Infosys Ltd. declared a bonus in the ratio of 3 : 1. There are many companies whose
95% or more of the total paid-up capital has been issued as shares. The companies
may prefer issue of bonus shares as against the payment of cash dividend for
several reasons as follows :
1. Issue of Bonus shares utilises a part of the profit of the company and also
rewards the shareholders but without affecting the liquidity of the company. By
issuing bonus shares, a company in fact, shares the growth of the company with
the shareholders who are rewarded not in terms of cash but in terms of capital
receipt, i.e., bonus shares. Therefore, the company, on the one hand, is able to
satisfy the expectations of the shareholders (to get returns on their investments),
and also simultaneously, on the other, is able to preserve the liquidity of the
company.
2. Bonus issue helps a company to streamline its capital structure and to bring
its paid up share capital in line with the capital employed in the business. After
bonus issue, the paid up capital increases and approaches the capital employed.
3. Bonus issue increases the number of shares. If a company issues bonus
shares in the ratio of 1:1, then the market price of the share after bonus issue will
tend to be 50% of the market price before issue of such bonus shares. Thus, the
company may be in a position to keep the market price of the share within the
reach of the common investors. Bringing the price down, increases the number of
potential buyers for the shares, leading to a higher share price.
4. Bonus shares is capital receipt and it is not taxable in the hands of the
issuing company as well as the shareholders. In India, however, in case of
dividends paid in cash, the paying company has to pay a corporate dividend tax,
while the issue of bonus shares does not require any tax payment immediately.
5. Issue of bonus shares increases the goodwill of the company in the capital
market and build a confidence among the investors and thus helps raising
additional funds in future. In fact, the issue of bonus shares is always taken and
evaluated positively by the capital market.
The issue of bonus shares by companies in India is regulated by legal
provisions. There is not much in the Companies Act, 1956 however, Guidelines
have been issued from time to time regulating the issue of bonus shares. The
Securities and Exchange Board of India (SEBI) has issued the guidelines for issue
of bonus shares on June 11, 1992 and later modified these guidelines in 2000. The
guidelines for the issue of bonus shares can be summarised as follows:
(i) These guidelines are applicable to existing listed companies.
(ii) Issue of bonus shares after any public/rights issue is subject to the
condition that no bonus issue shall be made which will dilute the value or right of
the holders of debentures, convertible fully or partly. In other words, no company
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shall, pending conversion of FCDs/PCDs, issue any shares by way of bonus unless
similar benefit is extended to the holders of such FCDs/ PCDs, through reservation
of shares in proportion to such convertible part of FCDs/ or PCDs.
(iii) The bonus issue is made out of free reserves built out of the genuine
profits or share premium collected in cash only.
(iv) Reserves created by revaluation of fixed assets are not capitalised.
(v) The declaration of bonus issue, in lieu of dividend, is not made.
(vi) The bonus issue is not made unless the partly-paid shares, if any existing,
are made fully paid-up.
(vii) The company has not defaulted in payment of interest or principal in
respect of fixed deposits and interest on existing debentures or principal on
redemption thereof, and has sufficient reason to believe that it has not defaulted in
respect of the payment of statutory dues of the employees such as contribution to
provident fund, gratuity, bonus, etc.
(viii) A company which announces its bonus issue after the approval of the
Board of Directors must implement the proposals within a period of six months
from the date of such approval and shall not have the option of changing the
decision.
(ix) There should be a provision in the Articles of Association of the company
for capitalization of reserves, etc., and if not, the company shall pass a Resolution
at its General Body Meeting making provisions in the Articles of Association for
capitalization.
(x) Consequent to the issue of bonus shares if the subscribed and paid-up
capital exceed the authorized share capital, a Resolution shall be passed by the
company at General
c) Bonus Debentures: Hindustan Lever Ltd. has been consistently paying
regular dividends to shareholders. It has rewarded them with bonus shares also
from time to time. It has come out with a novel idea (first time in India) of
distributing the profits among the shareholders in the from of debentures.
The company issued bonus debentures (face value Rs. 6 per debenture) in the
ratio of 1:1 to the existing shareholders. The tenure of the debentures was 18
months from the date issues and carried a coupon rate of 9%. These debentures
were issued by capitalization of General Reserve A/c, which tantamount to payment
of dividend for the purpose of corporate dividend tax. The company paid the
amount of corporate dividend tax at the applicable rate, to the Government. During
the life of the debentures, the debenture holders. (i.e., the shareholders) got the
interest and on maturity, they got the redemption cash. The crux of the situation is
that the company paid a dividend, and for t period, it paid the interest.
Instead of issuing the bonus debentures, the company could have issued
bonus shares but it would have merely implied conversion of general reserve into
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equity shares without any underlying outflow of cash. The bonus issue would also
involve permanent increase in the equity share capital of the company. The
company would have continued to and capital in excess of needs. The motive for
issue of bonus debentures can be substantiated as follows :
HLL has been a cash rich company and in a way to profitably use these funds
is to make one or more major acquisition in the area of interest to the company. In
view of the fresh investment opportunities before the company, HLL believed that it
would still have cash and capital in excess of its needs. The restructuring of the
General Reserve by issue of bonus debenture ensured the company of the cash so
that any fresh investment opportunity, if occur during the tenure of the debentures,
could be availed. If no such opportunity is there, cash would be returned to
debenture holders. The shareholders had access to cash represented by debentures
as the debentures were listed. In all, the scheme was beneficial to shareholders.
d) Buyback of Shares: The buyback of shares is a situation when a company
uses its accumulated profits (represented by sufficient liquid assets) to cancel or
retire a part of its outstanding shares by purchasing from the market or directly
from the shareholders. This is particularly relevant when the shares are available in
the market at a price below the book value. When shares are repurchased for
cancellation, the underlying motive is to distribute excess cash among the
shareholders. The cancellation of shares means that the present shareholders will
receive cash for their shares. The general rationale for the repurchase is that as
long as the earnings remain constant, the repurchase of shares reduces the
number of shares outstanding and thus, raising the earning per share and the
market price of the share. The repurchase of shares for cancellation can be viewed
as a type of reverse and the EPS and the market price are increased by reducing
the number of outstanding shares. Whenever a company wants to repurchase its
shares, it must disclose it to the shareholders. The company may have different
methods of shares repurchase. 1 three widely used approaches to shares
repurchase as follows:
1. Repurchase Tender Offer: In a repurchase tender offer, a firm specifies a
price it will buy back the shares, the number of shares it intends to repurchase and
the period of time for which it will keep the offer open and invites the shareholders
to submit their shares for the repurchase. The firm may also retain the flexibility to
withdraw the offer if insufficient number of shares are submitted for repurchase.
During 1996, Indian Rayon Industries Ltd. repurchased its shares as per tender
offer.
2. Open Market Repurchase: In the case of open market repurchase, the firm
buys the shares in the market at the prevailing market price. The open market
repurchase can be spread out over longer time periods than tender offers. In terms
of flexibility, the open market repurchase provides the firm more freedom in
deciding when to repurchase and how many shares to be repurchased.
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3. Negotiated Repurchase: In this case, the firm may buy shares from a large
shareholder at a negotiated price. This form of repurchase can be adopted only
when a large shareholder, generally one of the promoter groups, is willing to sell the
shares.
The rationale for repurchase of shares is basically in the form of increased EPS
for the remaining shares and the increased market priced of the shares. For
example, a company has 1,00,000 equity shares of Rs. 10 each fully paid up. The
EPS of the company is Rs. 2.50 and the market price is Rs. 50 giving a price
earnings ratio of 20. Presently, the company has a net profit (after tax) of Rs.
2,50,000 (i.e., 1,00,000 x Rs. 2.50) and it expects to maintain the same level of
earnings in the coming years.
The company has been contemplating to pay a dividend of Rs. 2 per share (i.e.,
total dividends of Rs. 2,00,000) which will raise the market price from Rs. 50 to Rs.
52 (cum-dividend). However, if instead of distributing cash dividend of Rs.
2,00,000, the company decides to repurchase the shares, it can repurchase 3,846
shares (i.e., Rs. 2,00,000/- Rs. 52) and then the remaining outstanding shares
would be 96,154 (i.e., 1,00,000 - 3,846) only. The EPS for the next near (assuming
same earning for the next year) would be Rs.2,50,000/96,154= Rs. 2.60 and the
market price of the share is expected to be Rs. 52 (i.e., Rs. 2.60 x 20).
So, if the dividends were paid to the shareholders, they would have received
Rs. 2 in cash and the market price would have been Rs. 50 (ex-dividend), giving a
gain of Rs.2 to the shareholders. However, if repurchase takes place, the remaining
shareholders (after repurchase of 3,846 shares) would have gained by Rs. 2 in the
form of market price from Rs. 50 to Rs. 52 (as a result of increase in EPS from Rs.
2.50 to Rs. 2.60). It may be noted that the above calculations are based on the
assumption that the shares could be purchased at a net price of Rs. 52 and the PE
ratio remains same at 20. If the shares could be purchased at a price less than Rs.
52, then the gain to shareholders would be higher and vice-versa.
Although, the reduction in number of shares might increase earning per share,
the effect is usually a consequence of higher leverage and not of share buyback.
Furthermore, the increase in leverage would increase the riskiness of the shares
and lower the price earnings ratio. Whether this will increase or decrease the price
of the share will depend upon whether the firm is moving to its optimal position by
repurchasing, in which case the price will increase, or moving away from it, in
which case the price will fall. There are several advantages of using share
repurchase as an alternative to payment of cash dividend to the shareholders.
These may be enumerated as follows:
1. The cash dividend imply a commitment to continue payment in future
periods, whereas shares repurchase is a one-time return of cash. Consequently,
firms having excess cash flows, which are uncertain about their ability to continue
generating these cash flows in future periods, should repurchase the shares instead
of paying cash dividend.
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2. The decision to repurchase shares affords the firm with more flexibility to
reverse the decision and/or to spread the repurchase over a longer period than
does the decision to pay a dividend.
3. Shares repurchases are more focused in terms of paying out cash only to
those shareholders who need it. Only those who need the cash can tender their
shares for buy-back, whereas those who do not want the cash can continue to hold.
4. Shares repurchase may provide a way of increasing insiders control in the
firm as it reduces the number of shares with the outsiders. If the insiders do not
tender their shares for buyback, they will end up holding a larger proportion of the
firm a having greater control.
Thus, the shares repurchase allows firms to return cash to the shareholders
and still maintaining flexibility in terms of future periods. In general, however, the
net benefit of shares repurchase, relative to dividend, will depend upon the
following considerations:
(a) Stability of cash flow: If the excess cash flows are temporary or unstable,
the firms should repurchase the shares; if the cash flows are stable, then the firm
may dividends.
(b) Predictability of future investment needs: Firms that are uncertain about the
magnitude of future investment opportunities are more likely to use shares
repurchase as a means of returning cash to the shareholders.
(c) Undervaluation of the shares: The shares repurchase is more relevant when
the shares are found to be undervalued. In such a case, the firm can accomplish
two objectives: First, if the shares remain undervalued, the remaining shareholders
will benefit if the firm buyback the shares at a price less than the true value, and
second, the shares repurchase may send a signal to the capital market that the
share is undervalued and then the market will react accordingly pushing up the
price of the share.
Though, the shares repurchase decision is a dividend decision, it may also be
view an investment decision or a financing decision. As an investment decision the
share repurchase may be thought of as an investment of investible surplus in own
shares which the long run would help to maximize the shareholders wealth.
However, it must be noted that no firm can survive by investing only in its shares.
As a financing decision, the share repurchase may help a firm to increase the
financial leverage. The debt financing remaining same, the shares buyback will
result in reducing the paid-up capital and hence the financial leverage would
increase. By issuing debt and then repurchasing the shares, a firm can immediately
alter its capital mix towards a higher proportion of debt. Rather than choosing how
to distribute cash to the shareholders, the firm is using a shares repurchase as a
means to change the capital structure or the leverage. So, the share repurchase
may seem to be a financing decision.
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Advantage of Stock Dividend (or Bonus Shares)

a) Advantages for Issuing Company
1. Maintenance of liquidity position: By issuing bonus share, company does
not pay cash to the shareholders and by this company can maintain its liquidity
position.
2. Satisfaction of shareholders: By the issue of bonus shares, the equity of
shareholders in the company increases. By this, the confidence of investors will
increase in the soundness of the corporation and accordingly it benefit the
shareholders.
3. Economical issue of capitalisation: The issue of bonus shares involves
minimum cost and hence it is the most economical issue of securities.
4. Remedy for under capitalisation: Rate of dividend in under capitalised
companies is high and by issuing bonus shares, the rate of dividend per share can
be reduced. Hence, company can be saved from the effect of under capitalisation.
5. Enhance prestige: By issuing bonus share, the company increases its credit
standing and its borrowing capacity goes high in the eyes of lending institutions.
6. Widening the share for market: A company interested in widening the
ownership of its shares may issue bonus shares. Some of the old shareholders will
sell their new shares and by this the object of the company is achieved.
7. Finance for expansion programmes: By issuing bonus shares, the
expansion and modernisation programmes of a company can be easily financed.
Hence the company need not depend much on out side agencies for finances.
8. Conservation of Control: Maintenance of existing control is possible by
issuing bonus shares. Generally, it is felt that the new shareholders can dilute the
existing control of the management, over the concern. This can be avoided by
issuing bonus shares.
a) Advantages to the Investors
1. Increase in their equity: By issuing bonus shares, the equity of the
shareholders is increased in the company. For example, Mr. X is the owner of 40
equity shares of Rs. 100 each. Now the company issues 8 bonus shares to him.
Before the issue of bonus shares, his equity was Rs. 4,000 in the company but now
his equity is increased to Rs. 4,800.
2. Marketability of shares is increased: When the company issues bonus
shares, the marketability of its shares is increased. By this the shareholders are
benefited.
3. Increase in income: If the company can maintain the same rate of dividend
as before on the increased capital also, the shareholders income will increase.
4. Increase demand for shares: When a company issues bonus share, its
image increases. Hence, there will be increased demand for the shares of the
investors.
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Disadvantage of Stock Dividend (of Bonus Shares)

a) For Company
1. Issue of bonus shares leads to an increase in the capitalisation of the
corporation. This can be justified only if there is a proportionate increase in the
earning capacity of the company.
2. Issue of bonus shares results in more liability on the company in respect of
future dividends.
3. It prevents new investors from becoming the shareholders of the company.
4. Control over the management of the company is not diluted and the present
management may misuse its position.
b) For Investors
1. Some shareholders prefer cash dividends instead of bonus shares. Such
shareholders may be disappointed.
2. Issue of bonus shares lowers the market value of existing shares too.
15.4 REVISION POINTS
1. D/P ratio: The DP ratio is the percentage of dividend distributed out of
total profit often tax.
2. Bonus shares: Shares issued by the company free of cost by capitalisation
of profits and revenues.
3. Buy back of shares : When a company uses its accumulated profits to
cancel or retire a part of its outstanding shares by purchasing from market
or directly from the shareholders.
15.5 INTEXT QUESTIONS
1. Discuss the importance of Payout ratio in dividend decision.
2. Describe the important payment ratio policies
3. List out the non-cash dividends
4. Enumerate the advantages and disadvantages of Bonus shares.
15.6 SUMMARY
Dividend payment is an important consideration used by present as well as
prospective shareholders in valuing the worth of the share. There are two important
and fundamental dimensions of dividend policy. These are: The dividend pay out
ratio and stability of dividends. The Dividend pay out ratio is the percentage of
dividend distributed out of total profit after tax. Dividend payment is an important
way through which the market price of the share and hence the wealth of the
Shareholders can be maximised. Dividend payments affects the liquidity position of
the firm. Stock dividend is the form of issue of bonus share to the equity
shareholders in lieu or addition to the cash dividend. It is a permanent capitalisation
of earnings.
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15.7 TERMINAL EXERCISE

1. The ………………………………………..ratio is the percentage of dividend
distributed out of total profit after tax.
2. The …………………………………is a situation when a company uses its
accumulated profits (represented by sufficient liquid assets) to cancel or retire a
part of its outstanding shares by purchasing from the market or directly from the
shareholders
15.8 SUPPLEMENTARY MATERIAL
1. http://www.investopedia.com/
2. www.efinancemanagement.com
3. www.myaccountingcourse.com
15.9 ASSIGNMENTS
1. Explain the advantages of stock dividend for a issuing company.
2. Explain the various methods of share repurchase
15.10 SUGGESTED READINGS
1. Jain and Narang, Financial Management, Kalyani publishers, (2010).
2. Reddy, Appanniah, Financial Management, Himalaya Publishing House,
Mumbai (2013).
3. Anil Mishra , Ragul Srivastava, Financial Management Oxford Publishers.
15.11 LEARNING ACTIVITIES
As a firm's financial manager, would you recommend to die board of directors
that the firm adopts as policy a stable dividend payment share or a stable pay-out
ratio?
15.12 KEYWORDS
Dividend Pay-Out Ratio, Liquidity, Constant dividend per Share, Constant Pay-
out Ratio Policy, Scrip Dividends, Buy Back of Shares.

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LESSON – 16

COST OF CAPITAL
16.1 INTRODUCTION
The cost of capital is the minimum rate of return a firm can earn on its
investment. The sources of capital of a firm must be in the form of preference
shares, equity shares, debt and retained earnings. In modern financial world the
concept of cost of capital is very important in the Seas of financial management.
Simply cost of capital of a firm is the weighted average cost of their different
sources of financing. The cost of capital of firm or the minimum rate of return
expected by its investors has a direct relation with risk involved in the organization.
Generally the firm involved heavy risk; it is the indication of higher rate of cost of
capital.
4.2 OBJECTIVES
After completing this lesson, you must be able to
 Define the term cost of capital
 Explain the assumptions of cost of capital
16.3 CONTENT
16.3.1 Definition of cost of capital
16.3.2 Contents of cost of capital
16.3.3 Importance of cost of capital
16.3.4 Assumption of cost of capital
16.3.1 Definitions of cost of capital
(i) James C. Van Home defines cost of capital as "a cut - off rate for the
allocation of capital to investments of projects. It is the rate of return on a project
that will leave unchanged the market price of the stock".
(ii) "Cost of capital is the minimum required rate of earnings or the cut - off
rate of capital expenditures"-Solomon Ezra.
(iii) "The rate of return the firm requires from investment in order to increase
the value of the firm in the market place" - Hampton, John J.
(iv) "The rate that must be earned on the net proceeds to provide the cost
elements of the burden at the time they are due" - Hunt, William and Donaldson.
Based upon the above definition it express that the cost of capital is otherwise
called as minimum rate of return or cut off rate which a firm must expect to earn
on its investment
16.3.2 Contents of Cost of Capital
1. Return at Zero Risk: This includes the projected rate of return on investment
when the project does not involve any business or financial risk.
2. Premium for Business Risk: The cost of capital includes premium for
business risk. Business risk refers to the changes in operating profit on account of
changes in sales. The projects involving higher risk than the average risk can be
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financed at a higher rate of return than the normal rate. The suppliers of funds for
such projects will expect a premium for increased business risk. Business risk is
generally determined while taking capital budgeting decisions.
3. Premium for Financial Risk: The cost of capital includes premium for
financial risk arising on account of higher debt content in capital structure
requiring higher operating profit to cover periodic payment of interest and
repayment of principal amount on maturity. As the chances of cash insolvency of a
firm with higher debt content in its capital structure increase, the suppliers of
funds would expect a higher rate of return as a premium for higher risk.
The above three components of cost of capital may be expressed by the
following equation :
K = Co + b + f
Where, K = cost of capital; Co - the riskless cost of financing; b = business risk
premium; f = financial risk premium.
16.3.3 Importance of Cost of Capital Concept
The concept of the cost of capital is important in the following managerial
decisions:
1. Capital Budgeting Decision: Cost of capital may be used as the measuring
rod for adopting an investment proposal. The firm will choose the project which
gives a satisfactory return on investment not less than the cost of capital incurred
for its financing. Cost or capital is the key factor in deciding the project out of
various proposals pending before the management. It measures the financial
performance and determines the acceptability of investment opportunities by
discounting cash flow under present value method. Net Present Value (NPV) or
profitability index or benefit cost of ratio uses the cost of capital to discount the
future cash inflows. Under Internal Rate of Return method (IRR). It is compared
with the cost of capital. Thus, the cost of capital provides the criterion of accepting
or rejecting the proposals in capital budgeting.
2. Designing the Corporate Financial Structure: In this the cost of capital is a
significant factor. It is influenced by the changes in capital structure. An efficient
financial executive keeps an eye on capital market fluctuations. He seeks to achieve
a sound and economical capital structure for the firm. Keeping in view, objective of
financial management to maximise the shareholder's wealth, the financial executive
logically follows that he should try to substitute the various method of financial in
an attempt to minimise the cost of capital so as to increase the market price and
earning per share.
3. Decision about the Method of Financing: An efficient financial executive
must have the knowledge of the fluctuations in the capital market. He should
analyse the rate of interest on loans and normal dividend rates in the market from
time to time. He may have a better choice of the source of finance which bears the
minimum cost of capital, whenever the company requires additional finance.
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4. Optimum Resources Mobilisation: The concept of cost of capital may be used

as a medium of optimum resources mobilisation on a national scale. It may help
the government departments in determining priorities on a more sound basis.
5. Evaluation of Performance of Top Management: The cost of capital framework
may be used to evaluate the financial performance of top management. This will
involve a comparison of actual Probabilities of the projects undertaken with the
projected overall cost of capital and an appraisal of the actual incurred in raising
the required funds.
6. Other Areas of Decision Making: The measurement of the cost of capital is
important in many other areas of decision-making such as dividend decisions,
working capital management policies, capital budgeting, capital expenditure control
etc.
16.3.4 Assumptions of Cost of Capital Theory
1. Business risk complexion of the firm remains unaffected by accepting and
financing a new investment proposal: The term business risk refers to the variability
in operating profits (EBIT) due to changes in sales. If a firm accepts a project having
more than average risk, the suppliers of funds are likely to expect a higher rate of
return than the average rate. This increases the cost of capital. The business risk
complexion is generally determined by the capital budgeting decisions. However, in
determining a firm's cost of capital it is assumed that the business risk of a firm
remains unaffected by the acceptance and financing of new investment proposals.
2. The firm's financial risk complexion remains unaffected by the acceptance and
financing of new projects: The term financial risk refers to the risk arising on
account of changes in financial leverage or capital structure. A higher debt content
in capital structure increases the financial risk, as the firm would require higher
operating profits to cover the periodic interest payment and repayment of principal
amount of debt at the time of maturity. Thus, an increase in debt capital and
preference shares in the capital structure increases the chances of cash insolvency
of the firm. Therefore, the suppliers of funds would expect a higher rate of return
from such firms as compensation for financial risk. However, in the analysis of cost
of capital, the firm's financial structure is assumed to remain unaffected by the
acceptance and financing of new projects.
3. The cost of capital for source is determined on an after-tax basis in order to
ensure consistency: The cost of debt capital requires tax adjustment as interest
paid on debt constitutes a deductible expense for determining taxable income.
However, dividend payments to preferential well as equity shareholders are not
deductible for determining taxable income. As the business and financial risks are
assumed to remain constant the cost of each type of capital is affected by the
change in the demand of the supply of each type of funds.
4. Inclusive Cost: Inclusive cost is the average of the various specific costs of
the different components of capital structure at a give time. The concept of inclusive
or average cost is relevant for overall investment decision as an enterprise employs
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a mix of different sources. This overall cost of capital is an acceptable criterion for
various investment proposals.
5. Normalised Cost: These are the long-term costs obtained by some averaging
process from which cyclical element is removed and normally used in taking over
all investment decisions.
6. Opportunity Costs: The opportunity cost of a decision means the sacrifice of
alternatives required by that decision. It is the rate of return the shareholders
foregoes by not putting his fund elsewhere because they have been retained by the
management.
7. Historical Cost and Future Cost: Historical costs are those which are
calculated on the basis of existing capital structure. Future cost relate to the cost of
funds intended to finance the expected project. In financial decision - making, the
future costs and not the historical costs are the relevant costs. Historical costs are
useful for analysing the existing capital structure. Future costs are widely used in
capital budgeting and capital structure designing decisions.
8. Explicit Cost and Implicit Cost: The explicit cost is the discount rate that
equates the present value of the cash inflows which in increment; to the taking of
the financing opportunity with present value of it incremental cash outflows. It is
the "internal rate of return of cash flows c financing opportunities." All sources of
funds have implicit costs but they arise only when the funds are used. It is
generally said that cost of retained earnings is an opportunity cost or implicit costs
in the sense that it is the rate of return at which the shareholders could have
invested these funds had these been distributed among them. The implicit cost of
capital is opportunity cost. It is the rate of return associated with the best
investment opportunity for the firm and its shareholders that will be foregone if the
project present under consideration by the firm were accepted.
16.4 REVISION POINTS
Cost of Capital: The cost of capital is the minimum rate of return a firm can
earn on its investment.
Importance of cost of Capital: Capital Budgeting Decision, Designing the
corporate financial Structure, Decision about the method of financing, Optimum
resource Mobilization.
Assumption of cost of capital Theory: Business risk is unaffected, Financial
risk is also unaffected, inclusive cost, Normalized cost, opportunity cost, Historical
Cost, Explicit cost, implicit cost.
16.5 INTEXT QUESTIONS
1. Define cost of Capital
2. What are the Content of cost of capital?
3. What are the important of cost of capital?
16.6 SUMMARY
The cost of capital is the minimum rate of return a firm can earn on its
investment. The sources of capital of a firm must be in the form of preference
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shares, equity shares, debt and retained earnings. Cost of Capital: It may be
recalled that the cost of capital is usually taken to be the cut-off rate for
determining whether an investment opportunity should be rejected (or) accepted.
Expected return is compared with the required return. The principle of cost of
capital is applicable equally to the public sector under taking also. The concept of
cost of capital based on cut-off rate, lending/ Borrowing Rate, opportunity cost,
explicit cost and implicit cost composite cost, average cost, and specific cost etc.
marginal cost of capital. Assumptions of the cost of capital are two types one is
business risk is unaffected and another one is financial risk is also unaffected.
16.7 TERMINAL EXERCISE
1. The ………………………………..is the minimum rate of return a firm can earn
on its investment.
2. The …………………………includes premium for financial risk arising on
account of higher debt content in capital structure requiring higher operating profit
to cover periodic payment of interest and repayment of principal amount on
maturity.
3. ………………………….may be used as the measuring rod for adopting an
investment proposal.
16.8 SUPPLEMENTARY MATERIAL
1. http://www.utdallas.edu/
2. http://www.docsity.com/
16.9 ASSIGNMENTS
1. What is the relevance cost of capital in corporate investment and finance
for a profit making firm?
2. How debt is regarded as the cheapest source of finance for a profit making
firm?
16.10 SUGGESTED READINGS
1. Chakraborthi, S.K.: “Corporate capital Structure and Cost of Capital,” New
Delhi, Vikas publishing House.
2. Chandra, Prasanna : “Fundamentals of Financial Management,” New Delhi,
Tata McGraw Hill Co.
3. Khan, M.Y. and Jain, P.K. : “Financial Management,” New Delhi, Tata
McGraw Hill Co
4. Pandey, I.M.: “Capital structure and cost of capital”, New Delhi, Vikas
Publishing House.
16.11 LEARNING ACTIVITIES
Correlate the assumption of capital theory with the present capital market
situation and give your views with suitable examples.
16.12 KEYWORDS
Cost of Capital, Inclusive Cost , Normalisied Cost, Opportunity Cost, Historical
Cost.
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LESSON – 17

COMPUTATION OF COST OF CAPITAL

17.1 INTRODUCTION
The term cost of capital refers to the minimum rate of return a firm most earn
on its investment so that the market value of the company's equity shares does not
fall. This is in consonance with the overall firm' s objective of wealth maximisation.
This is possible only when the firm earns a return on the projects financed by
equity shareholder's funds at a role which is at least equal to the rate of return
expected by them. After calculating the cost of each component of capital, the
average cost of capital is generally calculated on the basis of weighted average
method. This may also be termed as overall cost of capital.
17.2 OBJECTIVES
After completing this lesson ,you must be able to
 Discuss the computation of cost of capital
 Explain the weighted average cost of capital
 Define CAPM
17.3 CONTENT
17.3.1 Computation of cost of capital
17.3.2 Cost of debt
17.3.3 Cost of preference share capital
17.3.4 Cost of equity capital
17.3.5 Cost of retained earnings
17.3.6 WACC
17.3.7 CAPM
17.3.1 Computation of Cost of capital
Computation of overall cost of capital of a firm involves the following.
i) Computation of cost of each specific source of finance
ii) Computation of weighted average cost of capital.
i) Computation of cost of each specific source of finance
Computation of each specific source of finance are as follows.
a) Debt
b) Preference shares
c) Equity shares
d) Retained earnings
17.3.2 Cost of debt
(1) Debt issued at par, at premium or discount:
Cost of irredeemable Debt:- (Before tax)
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Irredeemable debt are those which is not redeemable during the entire life
time of the company.
I
Cost of debt (Kd) NP
Kd= Cost of debt
I = Interest NP = Net Proceeds,
i) When debt is issued at par
NP = Face value - Issue expenses
ii) When debt's issued at premium
NP = Face value + Premium - Issue expenses
iii) When debt is issued at discount:
NP = Face value - Discount - Issue expenses
After tax cost of debt:
(1  T)
Kd 
NP
Cost of redeemable debt:- (Before tax)
Redeemable debt refers to the debt which is to be redeemed or repayable after
the expiry of a fixed period of time. Formula for computing the cost of redeemable
debt is as follows.
I  ( P _ NP ) / n
Kd (Beforetax ) 
( P  NP ) / 2
I = Annual Interest Payment
P - Par Value of debentures
NP = Net proceeds of debentures
n — Number of years to maturity.
Cost of redeemable debt: (after tax)
Kd (after tax) = Kd (Before tax) x (1 - T)
Cost of Existing Debt
Formula for computing cost of existing debt are as follows.
Annualcost before tax
Cost of Existingdebt (Beforetax) 
Average value of debt (Av)

Note: Annual cost before tax

Interest per annum XX
Add: Annual amortization of the differences XX
Between face value and net realizable value XX
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 FaceValue Realizableprice 
i.e.,   XX
 No of years 
Annual cost before tax
Average value of debt
Average value of debt can be calculated with help of the following formula.
NP  RV
AV 
2
1  Normal cost of capital
Real cost of debt 
1  Inflationrate
AV = Average value
NP=Net proceeds
RV=Redemption value
Cost of Zero Coupon Bonds
The rate of interest is not specified in the zero coupon bonds. The cost of zero
coupon is calculated by the trail and error method using present value tables, i.e.,
which rate equalizes, the sent value of outflow to the present value of inflows.
Inflation Adjusted Cost of Debt
Formula for calculating inflation adjusted cost of debt as under.
1  Normal cost of capital
Real cost of debt 
1  inflation rate
Note: In actual practice the real cost of debt is adjusted for inflation. So we can
calculate the real cost of debt. cost of debt.
17.3.3 Cost of preference share capital
Normally a fixed rate of dividend is payable on preference shares. But in the
practical sense preference dividend is regularly paid by the companies when they
earn sufficient amount of profit.
1. Cost of irredeemable preference capital
The cost of preference capital which is calculated by applying the following
formula.
DP
KP 
NP
KP = Cost of preference Share Capital
DP = Fixed preference dividend
NP = Net proceeds of preference shares
i.e., Net amount realized from the issue of preference shares.
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i) When preference shares are issued at par

DP
KP  [Note: NP = Face Value - Issue expenses]
NP
ii) When preference shares are issued at a premium
DP
KP   Face value  Premium  Issue Expenses
NP
iii) When preference shares are issued at a discount:
DP
KP 
NP [Note: NP = Face Value - Discount - Issue expenses]
2. Cost of redeemable preference shares
Redeemable preference shares are those which are to be redeemed after the
expiry of specified period of time. Formula for computation of cost of preference
shares are as follows.
D  ( P  NP) / n
KP 
( N  NP) / 2
17.3.4 Cost of Equity Capital
Generally the computation of cost of equity capital is a difficult task. Because
different experts have different approaches. Any person investing money in equity
shares, they actually expect receiving dividends. The market price of the equity
shares also depends on the return expected by the shareholders. Therefore cost of
equity capital may be defined as the minimum rate of return that a firm must earn
on its investment, and also the market price of the equity shares on unchanged.
Computation of cost of equity capital may be divided into the following
categories.
1. The external equity or new issue of equity shares.
2. The retained earnings.
The external equity or new issue of equity share
Different authors having different explanations and approaches. The following
are some of the methods employed to determine the cost of equity capital.
1. Dividend price method or dividend yield method
The cost of equity capital is calculated as follows.
D D
Ke  or
NP NP
Where
Ke = Cost of equity capital
D = Expected dividend per share
NP = Net proceeds per share (in case of new issue)
MP = Market price per share (in case of existing shares).
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2. Dividend price plus growth (D/P +g) approach

According to this method cost of equity capital is calculated on the basis of the
dividend yield and the growth rate in dividends. The computation of cost of equity
capital according to this approach can be obtained using the following formula.
D D
Where, Ke   g (or) g
NP MP
Ke = Cost of equity capital
D = Expected dividend per share
NP = Net proceeds per share (in case of new issue)
MP = Market price per share (in case of existing shares)
g = Growth rate in dividends.
3. Earnings price (E/P) approach
Earnings price approach is otherwise called as earnings model. According to
this approach the cost of equity capital is the earning per share which determines
the market price of the share. However this approach takes into account both
dividends as well as retained earnings. The formula for computation of cost of
equity capital is as follows.

EPS EPS
Ke  or
NP MP
Ke : Cost of equity capital
EPS : Earnings per share
NP : Net proceeds (in case of new issue)
MP : Market price (in case of existing shares)
4. Realised yield method
According to this method the cost of equity capital is calculated on the basis of
return actually realised to the shareholders from the company. The dividends, and
the capital gains are only the return to the shareholders. The cost of equity capital
is the determined rate at which present value of inflows is equal to the present
value of outflows. The exact rate is found out by trial and error method.
15.3.5 Cost of Retained Earnings
Retained earnings are the accumulated amount of undistributed profits
belonging to the equity shareholders, provide a major source of financing
expansion and diversification projects. Their cost is the opportunity cost of these
funds. If these were distributed to the shareholders, they would have reinvested
them in the same company by purchasing its equity and earned on these additional
shares the same rate of return as they are earning on their existing shares. Thus,
the cost of retained earnings is the same as the cost of equity capital. By the same
logic the cost of depreciation funds/reserves are also reinvested in income
generating assets of the company in the same way as equity funds and retained
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earnings, and have the same cost as that of cost equity capital. However, as the
retained earnings do not involve the payment of personal income-tax as well as any
flotation cost, their cost is slightly lower than the cost of equity capital. The cost of
retained earnings may be calculated as per the following formula:

 DPSX100 
Kr =  MP  G(1  T)(1 B)

or Kr = Ke (1-T) (1-B)
Where, DPS =. dividend per share;
MP = current price per share;
T = Shareholders' personal tax rate;
B= percentage brokerage cost;
Ke = equity holders' required rate of return;
G = percentage growth in expected dividends.
Problem 1— Calculate the Cost of Retained Earnings from the following
information:
Current Market Price of a Share Rs. 140.
Cost of Floation/Brokerage per Share 3% on Market Price.
Growth in Expected Dividends 5%.\
Expected Dividend Per Share on New Shares Rs. 14. Shareholders' Marginal/
Personal Tax Rate 30%/.
SOLUTION

K 
 DPSX100  G (1 - T)(1 - B)
1  MP 


 Rs.14 X 100  5%  (1 - 30) (1 - 03)
 Rs. 140 
 (10%  5%) (.7) (.97)
 15% X.7X.97 - 10.19% approx
Problem 2 -XYZ company is earning a Net Profit of Rs. 25,00,000 per annum.
The shareholders expected Rate of Return (K) is 15% . The Marginal Tax Rate is
30%. Investment of the retained earnings in new shares involves brokerage cost of
3% . Assuming that the entire earnings are distributed to the shareholders,
determine the Cost of Retained Earnings.
SOLUTION
Kr = Ke (1-T) (1-B)
= 15% (1-30) (1-.03)
= 15% x 7 x .97 - 10.19% approx
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In the above illustration the logic of the-calculation of the K,. is that the
company must earn a rate of retained earnings equal to their expected rate of
return on new equity share’s. If the earnings are distributed to the shareholders for
reinvestment in new shares, the net amount available to them this purpose would
be as follows :

Dividends Payable to Shareholders Rs. 25,00,000

Less : Personal Taxes @ 30% Rs. 7,50,000
Dividends after Tax Rs. 17,50,000
Less: Brokerage Cost @ 3% of Rs. 52,500
Net Amount Available for Investment Rs. 16,97,5000
Earnings or Reinvestment Rs. 2,54,625
(15% on Rs. 16,97,5000)

If the entire earnings of Rs. 25,00,000 are paid to the shareholders after
paying taxes and brokerage cost of Rs. 7,0,000 and Rs. 52,500 respectively, the
shareholders can reinvest Rs. 16,97,500 on which they can earn Rs. 2,54,625. The
rate of return required by the equity holders is 15%. However if the company
retains the entire earnings', no personal income-tax and brokerage -cost will be
payable and the entire earnings, amount of Rs. 25,00,000 will be available for
reinvestment on which Rs. 2,54,625 must be earned. The rate of return expected by
the shareholders 'on the retained earnings representing the cost of retained
earnings would come to 10.19 % calculated as follows:
Rs. 2,54,625
Kr  100  10.19 approx
Rs. 25,00,00

The computation of cost of retained earnings makes it difficulty to ascertain

the personal tax rates of large number of shareholders with varying taxable
incomes which is extremely difficult. It is impossible to determine a single tax-rate
for the shareholders: A weighted average tax- rate may be calculated to avoid this
problem. The calculation of this tax-rate is however, equally difficult and cannot
be consistently applied in actual practice.
17.3.6 Weighted Average Cost of Capital
A company has to employ owner's funds as well as creditors funds to finance
its project so as to make the capital structure of the company balanced and to
increase the return to the shareholders. The total cost of capital is the aggregate of
costs of specific sources. The composite cost of various sources of funds, weights
being the proportion of each source of funds in the capital structure. Weighted
average, and not the simple average, is relevant in calculating the overall cost of
capital. The composite cost of all capital lies between the least and the most
expensive funds. This approach enables the maximisation of corporate-profits and
the wealth of the equity shareholders by investing the funds in a project earning in
excess of the cost of its capital-mix. Weighted average is an average of the costs of
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specific source of capital employed in a business, properly weighted by the

proportion, they hold in the firm's capital structure. As against the simple average,
weighted average is useful due to the fact that the proportion of various sources
funds in the capital structure of a firm are different. As the overall cost of capital
should take into account the relative proportions of different sources, weighted
average, is useful. Following are the factors in the computation of weighted average
cost of capital:
(i) Computation of weights to be assigned to each type of funds.
(ii) Assignment of costs to various source of capital.
The calculation of weighed average cost may be obtained by adding up the
products of specific cost of all types of capital multiplied by their appropriate
weights. The cost of capital should be calculated on after tax basis. The
components costs to be used to measure the weighted cost of capital should be
after tax costs. Of the several approaches followed in this assignment of weights to
specific sources of funds two are commonly used i.e. market value approach book
value approach.
1. Market Value Approach: As the cost of capital is used as a cut- off rate for
investment projects, the market value approach is considered better • due to the
following reasons:
i) It evaluates the profitability as well as the long term financial position of
the firm.
ii) Investor always considers the committing of his funds to an enterprise and
adequate return on his investment. In such cases, book value are of little
significance.
iii) It does not indicate the true economic value of a concern.
iv) It considers price level changes.
2. Book Value Approach: As the market value fluctuates widely and frequently
the use of book value weights is preferred in practice due to following reason:
i) The companies set their targets in terms of book value.
ii) It can easily be calculated from published accounts.
iii) The Investors generally use the debt-equity--ratio on the basis of published
figures to analyse the riskiness of the firms.
SELECTION OF CAPITAL STRUCTURE
The next problem in, calculation the weighted average cost is the selection of
capital structure from which the weights are obtained. There maybe following
possibilities, (a) Current capital structure either before or after the projected new
financing (b) Marginal capital structure i.e., proportion of various types of capital in
total of additional funds to be raised at a certain time, and (c) optimum capital
structure. The current capital structure is the optimal capital structure and may be
used in the assignment of weights. The marginal capital structure is irrelevant here.
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The following is the capital structure and the explicit after tax-costs for each
component:

Debt Rs. 15 Lakhs 4%

Preference Shares Rs. 5 Lakhs 8%
Equity Shares Rs. 10 Lakhs 11%
Retained Earnings Rs. 20 Lakhs 10%
Rs. 50 Lakhs

If the above current capital structure is used as weights, the weighted average
cost of capital will be as follows:

Source of Proportion to Specific Product

capital Total capital (W) cost (C) (WXC)

Debt .3 .4 1.2
Preference Shares .1 .8 .8
Equity Shares .2 11 2.2
Retained Earnings .4 10 4.0
Weighted average cost of 8.2%
capital
UTILITY OF WEIGHTED AVERAGE COST OF CAPITAL
1. In financial decision making the after-tax cost of capital is more relevant:
The weighted average cost of capital can be computed on after tax basis. In its
calculation, each source of capital funds gets the weightage according to its
contribution in the, total capital. In practice, different sources of funds are used in
different proportions. Thus, the relative importance of the various sources of funds
is recognised in the computation of the weighted average cost of capital.
2. The average cost of capital-provides one single figure —This may be used as
discount factor is computing the discounted cash inflows of the future stream of
earnings.
LIMITATIONS OF WEIGHTED-AVERAGE COST OF CAPITAL
1. Cost of funds is not independent to value of funds: In calculation weighted
average cost of capital, it is as assumed that the cost of raising funds is
independent to the value of funds raised. This presumption does not hold good in
practice.
2. Fluctuation of cost of various sources of funds: It is presumed that the
present cost of the various sources of funds would remain the same in future also.
Which is not true in actual practical life.
3. Fluctuation in Weighted Average cost: The specific costs are based upon the
existing capital structure. These will change when additional funds have been
 285

raised. Thus the weighted average cost of capital once calculated may not hold true
for a long time particularly beyond one accounting year due to the impact of
retained earnings.
4. Useless in some circumstances: The weighted cost of capital cannot be used
in the following circumstances.
(i) If the company is trying to bring about radical changes in its debt policy.
(ii) If the dividend policy of the company is being changed with the objective of
readjustment of the proportion of retained earnings.
(iii) If the growth objectives of the company are being changed.
(iv) If there is a change in capital structure involving a change in debt- equity
mix.
MODIGLIANl - MILLER APPROACH OR INDEPENDENT APPROACH
Modigliani-Miller suggest that the cost of capital of the firm is an independent
factor and has no concern with the capital structure. Any change in the capital
structure of the concern does not affect the cost of capital. This approach denies
the basic fact that leverage influences the price of equity sharps. It explains that
irrespective of the proportion of debt included in the capital structure the value of
firm arid cost of capital is the same for all the firms because of the arbitrate in the
capital market. Arbitrate precludes substitutes from selling at different prices in the
same market.
ASSUMPTIONS
There are no taxes (corporation or individual).
1. NOI: The average expected future Net Operating Income (NOI) is represented
by a subjective random variable and that all investors agree on the expected value
of this probability distribution.
2. Same Risk Class: All the firms can be classified into equivalent risk class
and the firms in a class termed as ' homogeneous '. Thus, all firms within a risk
class have equal business, risk with similar operating environment. All firms
within an industry are assumed to be within the same risk class.
3. Capital market are perfect: (i) All investors are rational and have full
information of the capital market, (ii) Investors can sell or but securities freely,
(iii) Investors can borrow without any restriction on the same terms and conditions
as the firm can, and (iv) there is not transaction costs and information costs.
4. Shift by Individual Investor: Individual investor neutralises any change in the
leverage oh corporate account by an equivalent and balancing change in his
leverage on personal accounts. It is, therefore, assumed that the individual investor
can easily shift the proportions of equity shares to bonds or highly geared shares to
low-geared shares.
5. Dividend: The dividend payout ratio is 100%.
6. Taxes: There are no taxes (corporation or individual).
 286

17.3.7 Capital asset pricing model: |CAPM|

It is an economic model that describes how securities are priced in the market
place. It considers the risk element in determining the cost of equity capital.
Under this method the cost of equity capital is the return required by the investors.
Normally it involve two elements.
(i) The risk - free return (Rf)
(ii) The premium for risk (Pr)
Therefore, the cost of equity capital may be calculated in the following.
Ke = Rf+ Pr
Computation of Pr = β (Rm - Rf)

Where,
Pr is the premium for risk
 = Beta value, a measure of risk
Rm = Market return
Rf = Risk free return

Cost of equity capital is Ke = Rf + pr

 Cost of equity capital = Rf +  (Rm - Rf)

Problem - 1 The following particulars relate to Ambuja Ltd.

Rs.
Equity share capital 1,00,000 shares of Rs.10 10,00,000
Profit after tax 9,00,000
Current market price of equity share 75
(a) Calculate the cost of equity.
(b) What is the cost of retained earnings if the average personal tax rate of
shareholder's is 30% and the brokerage cost for making new investment is 2%.
Solution
EPS
(a) Cost of equ Ke 
MP
Profitaftertax Rs.90,00,000
EPS    Rs.9
No.ofequityshares 10,00,000
MP  Marketprice  Rs.75
9
Cost of equitycapitalK   0.12 or 12%
75
 287

(b) Cost of retained earnings %

Cost of equity capital Ke = 12.00
Less: Tax at 30% on 12 = 3.60
8.40
Less: Brokerage at 2% on 8.40 = 0.17
Cost of retained earnings r = 8.23
REALISED YIELD METHOD
Problem 2: Mr. Kumar purchased shares in Saradha Textiles Ltd. at Rs.317
per share, in January 2006. He held them for five years and sold them in January
2011 for Rs.500
The dividend per share received by himself was as under:
2006 - Rs. 15; 2007 - Rs. 15; 2008 - Rs. 18
2009 - Rs. 18; 2010 - Rs.20
Calculate the cost of equity capital.
Solution: Here cost of equity capital is the internal rate of return (IRR). It is the
rate at which total present value of in-flows is equal to total present value of
outflows. The IRR is calculated by trial and error method.
Calculation of Present Value of Inflows at 10% and 15%
Present Present
P.V. P.V.
Inflows Value of value of
Year factor at Inflows factor at
Rs. inflows at inflows at
10% 15%
10% 15%
2006 15 .909 13.635 15 .870 13.050
2007 15 .826 12.390 18 .756 11.340
2008 18 .751 13.518 18 .658 11.844
2009 18 .683 12.294 18 .572 10.296
2010 20 .621 12.420 20 .497 9.940
2011 500 .564 282.000 500 .432 216.000
Total present value = 346.257 TPV 272.470

Present value of outflow = Cost of the share = Rs. 317

At 10% total present value of inflows = 346.257
At 5% total present value of inflows = 272.470
Decrease in TPV 73.787
The IRR lies between 10% and 15%
It is found as follows:
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For a decrease of 73.787, increase in rate = 5% (15% - 10% )

For a decrease of 29.257, (346.257 - 317) increase in rate

5
 X 29.257  1.98
73.787
Internal Rate of Return = 10 + 1.98 = 11.98 %
At this rate, total present value of inflows will be Rs. 317
@ Cost of equity capital = IRR = 11.98% 10.
Problem - 3: 1-1-2015 Mr ‘X’ Ltd. Offers for public subscription of equity
shares of Rs.10 each at a premium of 10%. The company pays an underwriting
commission of 5% on the issue price. The equity shareholders expect a dividend of
15%.
(a) Calculate the cost of equity capital.
(b) Calculate the cost of equity capital, if the market price of the share is
Rs.20.
Solution
D1
(a) Cost of equity capital Cost of equitycapitalKe 
NP
D1 = Expected dividend per share = 15% of Rs.10 = 1.50
NP = Net Proceeds:
Issue price = Face value + Premium 10% (10+1) = 11.00
Less: Underwriting commission 5% = 0.55
Net proceeds per share = 10.45

1.50
Cost of equity capital K =  .1435 or 14.35%
10.45
b) If the market price is Rs.20
D1
Cost of equity capital Ke 
MP
D1 = Expected dividend per share = Rs. 1.50
MP = Market Price per share = Rs. 20
1.50

Cost of equity capital Ke 20 = .075 or 7.5%
Problem - 4: Mr. ‘X’ is a shareholder in India Polyester Ltd. The earnings of the
company have varied considerably. Mr X feels that the long run average dividend
would be Rs. 3 per share. He expects that the same pattern would continue in
future. Mr. X expects a minimum rate of earning of 15%.
 289

At what price Mr. X should buy the share of the company?

Solution
D1
Cost of equity capital, Ke = MP
Therefore:
D1
MP = Market price per share = Ke
D1 = Expected dividend = Rs.3
Ke = Cost of equity capital = 15%

3 3
Marketprice i.e.  Rs. 20
15% 15
It would be advisable to purchase the share at Rs.20
Problem – 5: The market price of an equity share of G Ltd. Is Rs.80. The
dividend expected a year hence is Rs. 1.60 per share. The shareholders anticipate
a growth of 7% in dividends.
Calculate the cost of equity capital.
Solution
D1
Cost of equity capital, Ke  g
MP
D1  Expected dividend per share  Rs.1.60
Mp  Market price per share  Rs.80
g  Growth rate individend 7%
1.60
Cost of equity capital Ke   7 %  0.05  0.07  0.12 or12%
80
Cost of equity capital  12%

Problem – 4: From the following capital structure of a company calculate the

overall cost of capital using (a) Book value weights and (b) Market value weights

Book Market value

Source
value (Rs.) (Rs.)
Equity share capital (Rs. 10 shares) 45,000 90,000
Retained earnings 15,000
Preference share capital 10,000 10,000
Debentures 30,000 30,000

The after - tax cost of different sources of finance is as follows: Equity Share
Capital: 14%, Retained Earnings : 13%, Preference Share Capital 10%, Debentures:
5%
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Solution
a) Computation of Weighted Average Cost of Capital
(Book value weights)
Total after tax
Amount (2) After tax
Source of funds (1) Rs. Cost (4) = (2)
Rs. cost (3)
x(3)
Equity share capital 45,000 14% 6,300
Retained Earnings 15,000 13% 1,950
Preference share capital 10,000 10% 1,000
Debentures 30,000 5% 1,500
1,00,000 10,750

10,750
Weighted Average cost of capital = x100  10.75%
1,00,000
b) Computation of weighted Average cost of capital
(Market value weights)

Amount (2) After tax Total after tax Rs.

Source of funds (1)
Rs. cost (3) Cost (4)=(2)x(3)
Equity share capital 90,000 14% 12,600
Preference share capital 10,000 10% 1,000
Debentures 30,000 5% 1,500
1,30,000 15,100

15,100
Weighted average cost of capital = x 100  11.61%
1,30,000
17.4 REVISION POINTS
 Cost of capital: The minimum rate of return a firm must earn on its
investments to maintain the market value of its equity shares
 Average cost of capital : It is the weighted average cost based on cost of each
component of funds employed by a firm.
 Combined cost: It is the composite cost of capital from all sources
 Specific cost: It is cost of a specific sources of finance
17.5 INTEXT QUESTIONS
1. What do you mean by cost of debt?
2. What do you mean by cost of preference share capital?
3. What doy you mean by cost of equity Capital?
4. Define Cost of retained earnings?
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5. What do you mean by weighted average cost of capital.?

6. Define CAPM.
17.6 SUMMARY
The term cost of capital refers to the minimum rate of return a firm most earn
on its investment so that the market value of the company's equity shares does not
fall. This is in consonance with the overall firm' s objective of wealth maximisation.
This is possible only when the firm earns a return on the projects financed by
equity shareholder's funds at a role which is at least equal to the rate of return
expected by them. After calculating the cost of each component of capital, the
average cost of capital is generally calculated on the basis of weighted average
method. This may also be termed as overall cost of capital.
17.7 TERMINAL EXERCISE
1. . ………………… is an economic model that describes how securities are
pricied in the market place.
2. ………………. Earnings are the accumulated amount of undistributed profits
belongings to the equity share holders.
3.Computation of ……………………….capital is a difficult task.
4.The rate of interest is not specified in the ………………………..bonds
17.8 SUPPLEMENTARY MATERIAL
http://education.svtuition.org/
http://www.savannahstate.edu/
www.exinfm.com/training/cost_of_capital.doc
17.9 ASSIGNMENTS
1. How will you determine the cost of equity capital in a growth company?
2. How would you calculate the cost of retained earnings?
3. What is weighted average cost of capital? How is it determined?
4. Differences between
(i) Specific cost and composite cost
(ii) Explicit cost and implicit cost
(iii) Historical cost and future cost.
5. How will you compute the cost of equity capital under CAPM?
6. Write note on inflation adjusted cost of debt.
7. How is the cost of zero coupon bonds determined?
PROBLEMS
1. A firm issues debentures of Rs.1,00,000 and realises Rs.98,000 after
allowing 2% commission to brokers. Debentures carry interest rate of 10%. The
debentures are due for maturity at the end of 10th year at par. Calculate cost of
debt.
 292

2. A company considering raising of funds of about Rs.100 Lakhs by one of

two alternative, methods. Viz, 14% institutional term loan, and 13% non -
convertible debentures. The tern loan option would attract no major incident cost.
The debentures would have to be issued at a discount of 2.5% and would involve
cost of issues of Rs.1 lakh. advise the company as to the better option based on the
effective cost of capital each case. Assume a tax rate of 50%.
3. A company issues Rs.10,00,000, 13% Debentures at a discount of 5%. The
debentures are redeemable after 5 Years at a premium of 5%. Calculate before tax
and after tax cost of debt, if the tax rate is 50%.
4. Alpha Ltd., issued 10% Redeemable preference shares of Rs.100 each,
redeemable after 10 years. The floatation costs are 5% of the nominal value.
Computer the effective cost to the company if the issue is made at (a) par, (b) a
premium of 5% and (c) a discount of 5%.
5. The capital structure and after tax cost of different sources of funds are
given below :

Amount Proportion to After tax cost

Sources of funds
Rs. total %
Equity share capital 7,20,000 .30 15
Retained earnings 6,00,000 .25 14
Preference share 4,80,000 .20 10
capital
Debentures 6,00,000 .25 8

Your are required to compute the weighted average cost of capital.

17.10 SUGGESTED READINGS
 Lawrence J. Gitman Principles of Managerial Finance Pearson
 Srivastava Financial Management and Policy, Himalaya Publishers
 Anil Mishra, Ragul Srivastava, Financial Management Oxford Publishers.
17.11 LEARNING ACTIVITIES
1. How debt is regarded as the cheapest source of finance for a profit making
firm?
2. Cost of preference capital is generally lower than the cost of equity, state
the reasons.
17.12 KEYWORDS
Cost of Debt, Cost of preference share capital,Cost of equity capital, Cost of
retained earnings.


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LESSON – 18

CAPITAL STRUCTURE
18.1 INTRODUCTION
The term ‘Financial Structure’ refers to total liabilities While ‘Assets structure’
Refers to total assets. Having determined the finance required for a project to be
Undertaken, the question arises what shall be the proportion of various securities.
Deciding the proportion of securities is deciding capital structure. Thus, capital
structure refers to the proportion of equity capital, preference Capital, reserves,
debentures, and other long term depts. To the total capitalization. Capital structure
decision is not taken only when starting an enterprise. In the beginning the
entrepreneur may decide a ‘target capital structure’. But the capital structure
decisions are made whenever additional finances are to be raised. Capital structure
planning, is a very important part of the financial planning, as it plays an
important role in minimizing the cost of funds.
According to Gerestenberg, “capital structure of a company refers to the make-
up of its capitalization and it includes all long term capital resources Viz.Shares,
Loans, reserves, and bonds. While drafting a capital structure, care must be taken
to see that it is flexible i.e., it should be able to incorporate any future changes, if
necessary. It is often suggested that a capital structure should be such which can
maximize the long run value per ordinary share in the market; for an individual
company, there is necessity for attaining a proper balance among dept and equity
sources in its capital structure.
18.2 OBJECTIVES
After completing this lesson, you must be able to
 Explain the meaning of capital structure
 Distinguish between capitalisation and capital structure
 Discuss the importance of sound capital structure
 Describe the factors determining capital structure
18.3 CONTENT
18.3.1 Meaning of capital structure
18.3.2 Definitions of capital structure
18.3.3 Distinctions between capitalisation and capital structure
18.3.4 Characteristics of optimal structure
18.3.5 Importance of sound capital structure
18.3.6 Factors determining capital structure
18.3.7 Technique of planning of the capital structure
18.3.1 Meaning of Capital Structure
Capital structure of a company cannot be the composition of long-term
sources of funds, such as-ordinary shares, preference shares, debentures, bonds,
long-term funds. It implies the determination of form or make-up of a company's
capitalisation.
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18.3.2 Definitions of Capital Structure

1. “Capital structure is the permanent financing of the firm, represented
primarily by long-term debt, preferred stock, and common equity, but excluding all
short-term credit. Common equity includes common stock, capital surplus and
accumulated retained earnings.” - Weston and Brigham.
2. “The term capital structure is frequently used to indicate the long- term
sources of funds employed in a. business enterprise.” -Robert H.Wessel.
3. “From a strictly financial point of view, the optimum capital structure is
achieved by balancing the financing so as to achieve the lowest average cost of long
term funds. This, in, turn produces the maximum market value of the total
securities issued against a given amount of corporate income” -Guthman and
Dougall.
4. “Capitalisation embraces the composition or the character of the structure
as well as the amount” - Husband and Dockeray.
18.3.3 Distinctions Between Capitalisation and Capital Structure
1. Difference in Scope: Capitalisation refers to the-total accounting value of all
the capital regularly employed in the business, which includes share capital, long-
term debt, reserves and surpluses. On the other hand capital structure refers to the
proportion of different sources of long-term funds in the capitalisation of a
company.
2. Difference in Objectives: Capitalisation is concerned with the determination
of the total amount of capital required for the successful business operation on the
other hand capital structure is concerned with the determination of the
composition of different long-term sources of funds, such as debentures, long-term
debt, preference capital and ordinary share capital including retained earnings.
In order to maximise the shareholder's wealth, the financial manager should
attempt to achieve an optimal capital structure which refers to an ideal
combination of various sources of long-term funds so as to minimise the overall
cost of capital and maximise the market value per share.
18.3.4 Characteristics of Optimal Structure
Following are the characteristics of an optimal of capital structure.
1. Simplicity: A sound capital structure is simple in the initial stage are to the
limits of the number of issues and types of securities. If the capital structure is
complicated from the very beginning by issuing different types of securities, the
investors hesitate to invest is such a company. The company may also face
difficulties in raising additional capital in future. Thus it is advisable to issue equity
and preference shares in developing an optimum capital structure. Debentures and
bonds should be reserved for futures financial requirements.
2. Minimum Cost: A sound capital structure attempts to establish the security
- mix in such a way as to raise the requisite funds at the lowest possible cost. As
the cost of various sources of capital is not equal in all circumstances it is
ascertained on the basis of weighted average cost of capital. The management aims
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at keeping the expenses of issue and fixed annual payments at a minimum in order
to maximise the return to equity shareholders.
3. Maximum Return: A balanced capital structure is devised in such a way so
as to maximise the profits of the corporation through a proper policy of trading on
equity so as to minimise the cost of capital.
4. Minimum Risk: A idea capital structure possesses the quality of minimum
risk. Risks, such as increase in taxes, rates of interests, costs, etc., and decrease in
prices and value of shares as well as natural calamities adversely affect the
company’s earning. Therefore, the capital structure devised in such a way as to
enable it to afford the burden of these risks easily.
5. Maximum Control: A sound capital structure retains the ultimate control of
a company with the equality shareholders who have the right to elect directors. Due
consideration is given to the question of control in management while deciding the
issue of securities. The existing shareholders may not be able to retain control. If a
large number of equity shares are issued the company issues preference shares or
debentures instead of equity shares to the public because preference shares carry
limited voting rights and debentures do not have any voting rights. The capital
structure of a company is changed in such a way which would favourably affect the
voting structure of the existing shareholders and increase their control on the
company's affairs.
6. Flexible: A flexible capital structure enables the company to make the
necessary changes in it according to the changing conditions and make it possible
to procure more capital whenever required or redeem the surplus capital.
7. Liquid: In order to achieve proper liquidity for the solvency of a corporation,
all such debts are avoided which threaten the solvency of the company. A proper
balance between fixed assets and current assets is maintained according to the
nature and size of business.
8. Conservative: In division of the capital structure a company follows the
policy of conservatism. It helps in maintaining the debt capacity of the company
even in unfavourable circumstances.
9. Balanced Capital: A balance is necessary for the optimum capital structure
of a company. As both, under capitalisation and over-capitalisation are injurious to
the financial interests or a company, there is a proper co-ordination between the
quantum of capital and the financial needs of the corporation. A fair capitalisation
enables a company to make full utilisation of the available capital at minimum cost.
10. Balanced Leverage: A sound capital structure attempts to secure a balanced
leverage by issuing both types of securities, i.e., ownership securities and
creditorship securities. Shares are issued when the rate of capitalisation is high,
while debentures are issued when rate of interest is low.
18.3.5 Importance of Sound Capital Structure
1. Minimised Cost: The primary objective of a company is to maximise the
shareholders’ wealth through minimization of cost. A well-advised capital structure
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enables a company to raise the requisite funds from various sources at the lowest
possible cost in terms of market rate of interest, rate expected by prospective
investors, expense of issue etc. This maximise the return to the equity shareholders
as well as the market value of shares held by them.
2. Maximised Return: The primary objective of every corporation is to promote
the shareholders interest. A balanced capital structure enables company to provide
maximum return to the equity shareholders of the company by raising the
requesting capital funds at the minimum cost.
3. Minimised Risks: A sound capital structure serves as an insurance against
various business risks, such as-increase in costs, interests rates, taxes and
reduction in prices. These risks are minimised by making suitable adjustments in
the components of capital structure. A balanced capital structure enables the
company to meet the business risks by employing its retained earning for the smooth
business operations.
4. Controlled: Though the management of a company is apparently in the
hands of directors, indirectly, a company is controlled by equality shareholders who
have the right to elect directors. As preference share holders carry limited voting
rights and debentures holders do not have any voting rights, a well-devised capital
structure ensures the retention of control over the affairs of the company with in
the hands of the existing equity shareholders by maintaining a proper balance
between voting right and non-moving right capital.
5. Liquid: An object of a balanced capital structure is to maintain proper
liquidity which is necessary for the solvency of the company. A sound capital
structure enables a company to maintain a proper balance between fixed and liquid
assets and avoid the various financial and managerial difficulties.
6. Optimum Utilisation: Optimum utilisation of the available financial resources
is an important objective of a balanced financial structure. An ideal financial
structure enables the company to make full utilisation of available capitally
establishing a proper co-ordination between the quantum of capital and the
financial requirements of the business. A balanced capital structure helps a
company to elimate both the states of overcapitalization and under capitalisation
which are harmful to financial interests of the company.
7. Simple: A balanced capital structure is aimed at limiting the number of
issues and types of securities, thus, making the capital structure as simple as
possible.
8. Flexible: Flexibility of capital structure enables the company to raise
additional capital at the time of need^ or redeem the surplus capital. It not only
helps in fuller utilisation of the available capital but also eliminates the two
undesirable states of over-capitalisation and under capitalisation.
18.3.6 Factors Determining Capital Structure
The factor determining capital structure of a company may be internal or
external.
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A. INTERNAL FACTORS
1. Nature of Business: Companies having stable earnings can afford to raise
funds through sources involving fixed charges, while other companies have to rely
heavily in equity share-capital. Public utilities, extractive, financing and
merchandising enterprises are more stable in their earnings and enjoy greater degree
of freedom from competition than industrial concerns.
2. Regularity of Income: Capital structure is affected by the regularity of income.
If a company expects regular income in future, debentures and bonds should be
issued. Preference shares may be issued if a company does not expect regular income
but it is hopeful that its average earnings for a few years may be equal to or in excess
or the amount of dividend to be paid on such preference shares.
3. Certainty of Income: If a company is not certain about any regular income in
future, it should never issue any type of securities other than equity shares.
4. Desire to control the Business: If the control of the company is to be retained
within few hands, a large proportion of funds is raised by issuance of non-voting
right securities, such as-debentures and preference shares, a majority of voting right
securities, i.e., equity shares are held by the promoters or their relatives to control
the affairs of the business. Thus, majority of funds are raised from public retaining
the control of the company with the promoters or the existing shareholders.
5. Development and Expansion Plans: Capital structure of a company is affected
by its development and expansion programmes in future. The amount of authorised
capital is kept higher so that the requisite amount may be raised at the time of need.
In the beginning the company collects capital by issuing shares. Thereafter, capital
structure is devised in accordance with the future development and expansion
programmes. The requisite capital is raised preference shares and debentures.
6. Purpose of Finance: An important factor determining the type of capital to be
raised is the purpose for which it is required. If funds are needed for some productive
activity directly adding to the profitability of the company, capital may be raised by
issuing securities bearing fixed charges like preference shares and debentures. On
the other hand, if funds are needed for such purposes as betterment, maintenance,
etc., which do not directly add to the earnings of the company retained earnings;
equity share capital will be the better source of financing.
7. Characteristics of Management: Varying in skill, judge experience, temperament
and motivation management evaluates the risks differently and its willingness to
employ debt-capital also differ capital structure is influenced by the age, experience,
ambition, confidence conservativeness and attitude of the management.
8. Trading on Equity: Trading on equity means the regular borrowed capital as
well as equity capital in the conduct of a company’s business. If a company
employs borrowed capital including preference capital to increase the rate of return
on equity shares, it is said to be trading on equity.
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9. Debt Capacity and Risk: After a certain extent the use of borrowed capital
become risky for the company because it leads to increase in the liability of interest
payment adversely affecting the company's income reducing its liquidity. Excessive
use of borrowed funds endanger solvency of the company in the long-run.
10. Cost of Capital: Cost of capital is an important determinant of capital
structure of a company. It influences the profitability and general rate of earnings,
a company must raise capital funds by borrowing when rate of interest is low, and
by issuing equity shares when rate of earnings and share prices are high.
11. Capital Gearing Ratio: The ratio of equity share capital to the total capital is
called ‘Capital Gearing’. When the ratio of equity shares is low in the total capital
structure, it is called ‘High Gearing’. On the contrary when the ratio of equity
shares in the total capital structure of a company is high, it is called ‘Low Gearing’
12. Flexibility: The capital structure must have flexibility as to increase or
decrease the funds as-per requirements of the enterprise. Excessive dependence on
fixed cost securities make the capital structure rigid due to fixed payment of
interest or dividend, these sources should be kept in reserve for emergency and
expansion purposes.
13. Simplicity: The capital structure must have simplicity, so t financial crisis
may be avoided.
B. EXTERNAL FACTORS
1. Tastes and Preferences of Investors: An ideal capital structure is one which
suits the needs of different types of customers. Its success largely depends upon
the psychological conditions of different types of investors. While some investors
prefer security of investment and stability of income others prefer higher income
and capital appreciation. Hence, shares and debentures should be issued in
accordance with the tastes and preferences of all types of customers.
2. Conditions of Capital Market: Conditions of capital market have a direct
bearing on the capital structure. In times of depression the possibilities of profit are
the least and rate of dividend on equity shares comes down. Hence the investors
would prefer to invest in debentures and not in equity shares.
3. Cost of Capital: As the cost of capital issue affects the capital structure of a
company. The capital structure should be designed to minimise the commission
payable to brokers, middlemen and underwriters or the discount payable on issue
of debentures and bonds. A company should raise funds by issuing different types
of securities in such a way as would minimise the cost of capital issue.
4. Present Statutes and Rule: Capital structure is influenced by the statures
and rules prevailing in the country. In India Banking Companies act restricts a
banking company from issuing any type of securities other than equity shares.
5. Possible Changes in Law: Besides complying the legal restrictions, a
company's capital structure is also influenced by possible changes in the law of the
country. For example, if a company's income is taxed at a higher rate then the
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directors should issue debentures because the amount of interest payable to

debenture holder is deducted while computing the company's total income.
Whereas it is a statutory deduction, dividend is not an accepted deduction.
18.3.7 Technique of Planning the Capital Structure
A widely used financial technique of EBIT-EPS Analysis is generally applied to
determine an appropriate capital structure of a firm. This technique involves the
comparison of alternative methods of financing under various assumptions of EBIT.
The choice of combination of sources with the capital structure would be one
which, for a given level of EBIT, would ensure the largest earnings per share (EPS).
Alternatively, the choice of combination should ensure the maximum market price
per share (Market price = EPS x P/E ratio).
Point of Indifference
Indifference point refers to the EBIT level at which EPS remains unchanged
irrespective of debt-equity mix. Given the total amount of capitalization and the
interest rate on bonds, a firm reaches indifference point when it earns exactly the
same amount of income what it has promised to pay on debt. In other words, rate
of return on capital employed is equal to rate of interest on debt at indifference
point. Indifference point of EBIT changes with variation in the total funds to be
raised or the interest rate to be paid on borrowed capital.
The indifference point can be determined with the help of following formula.
( x  I1 )(1-T)-P.D ( x  I 2 )(1-T)-P.D

N1 N2
Where,
X = EBIT
I1, = Interest under financial Plan 1
I2 = Interest under financial Plan 2
T = Tax rate
P.D= Preference Dividend
N1 = No. of equity shares (or) Equity share capital under Plan 1
N2 = No of equity shares (or) Equity share capital under Plan 2
18.4 REVISION POINTS
Capital Structure: is the permanent financing of the firm, represented primarily
by long term debt, preferred stock and the common equity .
Characteristics of capital structure: Simplicity, Minimum Cost, Maximum
Return, Minimum Risk, Maximum Control, Flexible, Liquid, Conservative, Balanced
Capital
Factors determining Capital Structure:Internal Factors, External Factor
18.5 INTEXT QUESTIONS
1. What is meant by capital structure?
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2. What do you mean by optimum capital structure?

3. What do you understand by trading on equity?
4. State the essentials of an appropriate capital structure
5. What are the factors to be kept in mind while determining the capital
structure of a firm?
6. Write a short note on indifference point.
18.6 SUMMARY
Capital structure refers to the make up of a firm’s capitalisation. In other
words, it represents the mix of different sources of long-term funds such as equity
shares, Preference shares, Long-term loans, retained earnings etc., in the total
capitalisation of the company.
18.7 TERMINAL EXERCISE
1. The term ………………………………is frequently used to indicate the long-
term sources of funds employed in a. business enterprise.
2. ……………………………….is an important determinant of capital structure of
a company.
3. The ratio of equity share capital to the total capital is called ……………….
4. …………………………… Point refers to the EBIT level at which EPS remains
unchanged irrespective of debt-equity mix.
18.8 SUPPLEMENTARY MATERIAL
1. http://people.stern.nyu.edu/adamodar/pdfiles
2. http://www.unext.in/
18.9 ASSIGNMENTS
1. Explain the factors that determine the capital structure of the company
with suitable examples.
2. Enumerate the importance of a sound capital structure
18.10 SUGGESTED READINGS
1. Jain, Khan, Financial Management: Text, Problems and Cases 7th Edition,
Tata McGraw Hill Publishers.
2. Vishwanthan. R., Industrial Finance, Macmillian
3. Vyuptakesh Sharan Fundamentals of Financial Management, Dorling
publishers
18.11 LEARNING ACTIVITIES
If you want to buy a share how will you come to conclusion that the company
is having a sound capital structure. Explain this situation taking the current trend
in the capital market.
18.12 KEYWORDS
Capital Structure, Minimum Cost, Maximum control, Balanced capital,Point of
Indeference.

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LESSON – 19

THEORIES OF CAPITAL STRUCTURE

19.1 INTRODUCTION
Different theories have been propounded by different authors to explain the
relationship between capital structure, cost of capital and value of the firm. The
main contributors to the theories are Durand, Ezra Solomon, Modigliani and Miller.
The important theories discussed below are:
1. Net Income Approach.
2. Net Operating Income Approach.
3. The Traditional Approach.
4. Modigliani and Miller Approach.
19.2 OBJECTIVES
After Completing this lesson, You must be able to
 Know the different approaches to the problem of capital structure
 Describe the theories of Capital Structure
 Explain the M.M. Theory and offer criticisms to it
19.3 CONTENT
19.3.1 Theories of capital structure
19.3.2 Net Income Approach
19.3.4 Net operating Income approach
19.3.5 Traditional Approach
19.3.6 Modigliani Miller Approach
19.3.7 Criticism of MM Approach
19.3.2 Theories of Capital Structure
The objective of a firm should be directed towards the maximization of the
value of the firm. The capital structure decision should be examined from the point
of view of its impact on the value of the firm. If the value of the firm can be affected
by capital structure or financing decision, a firm would like to have a capital
structure which maximizes the market value of the firm.
There are broadly four approaches in this regard. These are:
i) Net Income (NI) Approach
ii) Net operating Income (NOI) Approach
iii) Traditional Approach
iv) Modigliani and Miller Approach
These approaches analyse relationship between the leverage, cost of capital
and the value of the firm in different ways. However, the following assumptions are
made to understand the relationship:
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a) There are only two sources of funds Viz., Debt and Equity (No preference
share capital).
b) The total assets of the firm and its capital employed are constant. (No
change in capital employed). However, Debt-Equity mix can be changed.
This can be done by
i) Either by borrowing debt to repurchase (redeem) equity shares or
ii) By raising equity capital to retire (repay) debt.
c) All residual earnings are distributed to equity shareholders (No retained
earnings)
d) The firm earns operating profit and it is expected to grow. (No losses).
e) The business risk is assumed to be constant and is not affected by the
financing mix decision (No change in fixed cost or operating risks).
19.3.3 Net Income (NI) Approach
This approach has been suggested by Durand According to this approach, a
firm can increase its value or lower the overall cost of capital by increasing the
proportion of debt in the capital structure. In other words, if the degree of financial
leverage increases, the weighted average cost of capital will decline with every
increase in the debt content in total capital employed, while the value of firm will
increase. Reverse will happen in a converse situation.
The NI Approach is based on the following three assumptions:
a) There are no corporate taxes.
b) The cost of debt (Kd) is less than cost of equity (Ke).
c) The use of debt content does not change the risk perception of investors. As
a result both the K. and K remain constant.
The total market value of the firm (V) under the NI approach is determined
with the help of the following formula:
V=S+D
Where, V = Total market value of the firm
S = Market value of equity shares
D = Market value of Debt
Net Income
Market value of equity share (S) 
Equity capitalisation rate

Earnings available to share holders


Cost of equity (ke)

The over all cost of capital (K0) or weighed average cost of capital is ascertained
EBIT
as follows: K o
Value of firm (V)
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19.3.4 Net Operating Income (NOI) Approach

This approach has been suggested by Durand. According to this approach,
the market value of the firm is not affected by the capital structure changes. The
market value of the firm is ascertained by capitalizing the net operating income at
the overall cost of capital which is constant. The market value of the firm is
determined as follows.
EBIT (Net operatingIncome)
Marketvalueof firm(V)
Overallcost of capital(K )
o
The value of equity can be ascertained by applying the following equation :
Value of equity (S) = Market value of firm (V) – Market value of debt (D)
EBIT (Earnings after interest,before tax)
Cost of equity (Ke)
Value of equity (S)
The NOI approaches based on the following assumptions:
a) The overall cost of capital remains constant for all degree of debt-equity mix.
b) The market capitalizes the value of firm as a whole. Thus the split between
debt and equity is not important.
c) The use of less costly debt funds increases the risk of shareholders. This
causes the equity capitalization rate to increase. Thus the advantage of debt is set
off exactly by increase in equity capitalization rate.
d) There are no corporate taxes.
e) The cost of debt is constant.
19.3.5 Traditional Approach
This approach is also known as intermediate approach as it takes a midway
between NI approach (that the value of the firm can be increased by increasing
financial leverage) and NOI approach (that the value of firm is constant irrespective
of the degree of financial leverage). According to this approach, the use of debt upto
a point is advantageous. It can help to reduce the overall cost of capital and
increase the value of the firm. Beyond this point, the debt increases the financial
risk of shareholders. As a result, cost of equity also increases. The benefit of debt is
neutralized by the increased cost of equity. Thus, upto a point, the content of debt
in capital structure will be favourable. Beyond that point, the use of debt will
adversely affect the value of the firm. At that point, the capital structure is optimal
and the overall cost of capital will be the least.
19.3.6 Modigliani and Miller Approach
Modigliani and Miller approach explain the relationship between capital
structures, cost of capital and value of the firm under two conditions:
i) When there are no corporate taxes
ii) When there are corporate taxes are assumed to exist.
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When there are no Corporate Taxes

This approach is identical to NOI approach, when there are no corporate taxes.
Modigliani and Miller argue that whenever there are no taxes the cost of capital and
value of the firm are not affected by capital structure or debt equity mix. In other
words this theory describe at any particular situation the cost of capital is not
affected by changes in the capital structure i.e. the debt - equity mix is irrelevant in
the determination of the total value of a firm. Debt is cheaper than equity, but the
use of debt increases the financial risk and the cost of equity. This increases in cost
of equity, offsets the advantage of the low cost of debt. Net result of this process the
overall cost of capital remains unchanged. According to MM approach the total
value of a firm is determined by its operating income or EBIT.
Arbitrage process
Arbitrage means buying of an asset or any security in one market at low price
and selling it the another market at a higher price. The impact of such action is
that the market value of the securities of the both the firms are similar in all
respects except in their capital structures. It restores the equilibrium value of the
securities.
For example two firms namely X and Y are identical except that Y uses debt
content in its capital structure while X does not have debt in its capital structure. If
the market value of the firm Y is higher than the market value of the firm X.
Investors in firm Y will sell their shares in the overvalued firm. And at the same
time they will buy the shares in under valued firm.
The market value of the shares in the firm X increases and automatically the
demand of its shares will increases. On the other hand the market value of shares
of firm Y declines due to selling pressure. Consequently the market value of X and
Y lead to become more or less equal,
When there are corporate taxes
MM argued that the capital structure would affect the cost of capital and the
value of the firm even there are corporate taxes. In any firm having debt content in
its capital structure, the cost of capital will decrease and the market value of the
shares, increase. A levered firm should have therefore a greater market value as
compared to an unlevered firm. The total value of the levered firm would exceed
that of the unlevered firm by an amount equal to the levered firm and its debt is
multiplied by the tax rate.
Leveled firm
In any firm having debt content in its capital structure is known as leveled
firm.
Un leveled firm
In any particular firm does not having debt content in its capital structure is
known as unleveled firm.
Assumptions
The MM hypothesis is based upon the following assumptions:
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i) There are no corporate taxes

ii) There is a perfect market
iii) 100% payment to share holders i.e. all the earnings are distributed to the
share holders.
iv) There are no transaction costs
v) All the firms can be grouped into homogenous risk classes. Investors
expected earnings have identical risk characteristics.
19.3.7 Criticism of MM approach
MM approach suffers the following criticism
i) Rate of Interest: According to the MM assumption firms and individual can
borrow loan and lend them at same interest rate. But in reality this is not possible
because firm having higher credit standard as compared to individuals. So
individuals have to pay higher rate of interest than the firms for their borrowing.
ii) Transaction Costs: Buying and selling of securities involves transaction
costs. As per the assumptions of MM approach that there is no transaction costs.
But in the real sense buying and selling securities incure the transaction costs.
iii) Corporate Taxes: One of the assumption of the MM approach there are no-
corporate taxes. But it could not be acceptable because corporate taxes are definite
reality, and the cost of borrowing funds is a tax deductible item.
iv) Personal leverage is no substitute for corporate leverage: Whenever the firm
borrows the liability of its investor is limited only to the extent of his proportionate
shareholding. Suppose the company is forced to go for its liquidation in a situation
when an individual borrows he has an unlimited liability and his personal property
is liable for the settlement of creditors. Under the above basis personal leverage is a
perfect substitute for corporate leverage is not valid.
v) Markets are not perfect: Arbitrage process is the strong foundations for MM
approach. For this process markets have to be perfect. In actual practice there is an
absence of perfect market. So automatically the arbitrage process may fail to work
and also difficult to determine the equilibrium point.
Illustrations
Problem – 1: NCP Company Ltd. has an all equity capital structure consisting
of 20,000 equity shares of Rs.100 each. The management plans to raise Rs.30
lakhs to finance a programme of expansion. Three alternative methods of financing
are under consideration.
i) Issue of 30,000 new shares of Rs.100 each
ii) Issue of 30,000 8% debentures of Rs.100 each
iii) Issue of 30,000 8% preference shares of 100 each.
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The company's expected earnings before interest and taxes (EBIT) are Rs.10
lakhs. Deter-mine the earnings per share in each alternative assuming a corporate
tax rate of 50 per cent. Which alternative is best and why?
Solution
EPS under Different Financial Plans
Plan I Plan II Plan III
Equity Debt Preference
Financing Financing Share
Rs. Rs. Rs.
(i) Earnings before interest and 10,00,000 10,00,000 10,00,000
taxes (EBIT)
(ii) Less : Interest on debentures - 2,40,000 -
8% on
(iii) Earnings before tax 10,00,000 7,60,000 10,00,000
(iv) Less : Tax at 50% 5,00,000 3,80,000 5,00,000
(v) Earnings after Tax 5,00,000 3,80,000 5,00,000
(vi) Less : Preference dividend - - 2,40,000
8% on 30,00,000
(vii) Earnings available to equity 5,00,000 3,80,000 2,60,000
share holders
(viii) No. of equity shares (v) 50,000 20,000 20,000
(ix) Earnings per share Rs. (vii)  10 19 13
(viii)

a) No. of Equity shares in plan 1 = Existing shares + New issue

= 20,000 + 30,000 = 50,000
Comments
The earning per share is the highest in plan II – (Debt financing) Hence, it is
advisable for the company to issue 30,000 debentures to raise the additional
finance.
Problem – 2: A Ltd. company needs Rs.6,00,000 for construction of a new
plant. The following three financial plans are feasible.
i) The company may issue 60,000 equity shares of Rs.10 each
ii) The company may issue 30,000 equity shares of Rs.10 each and 3,000
debentures of Rs.100 each bearing 8% coupon rate of interest.
iii) The company may issue 30,000 equity shares of Rs.10 each and 30,000
preference shares of Rs. 100 each bearing 8% rate of dividend.
The profit before interest and taxes (PBIT) is expected to be Rs.1,50,000.
Corporate tax rate is 50%.
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Calculate the earnings per share under the three plans. Which plan would you
recommended and why?
Solution
EPS under Different Plans
Plan I Plan II Plan III
Equity Equity & Equity &
Financing Debt Preference
Rs. Rs. Rs.
Profit Before interest and Taxes 1,50,000 1,50,000 1,50,000
Less : Interest 8% on 3,00,000 - 24,000 -
Profit Before Tax 1,50,000 1,26,000 1,50,000
Less : Tax at 50% 75,000 63,000 75,000
Profit after tax 75,000 63,000 75,000
Less : Preference divided
8% on 3,00,000 - - 24,000
Profit available to equity
Share holders - (i) 75,000 63,000 51,000
No. of equity shares (ii) 60,000 30,000 30,000
Earnings per share (i)  (ii) 1.25 2.10 1.70
Earnings per share are the highest under plan 2. Hence plan 2 is
recommended.

Problem – 3: Zavier of equity Ltd. wants to implement a project for which Rs.60
lakhs is to be raised. The followed financial plan is under evaluation.
Plan A : Issue of 6 lakh equity shares of Rs. 10 each
Plan B : Issue of 30,000 10% non-convertible debentures of Rs.100
each and issue of 3 lakhs equity shares of Rs.10 each.
Assuming a corporate tax of 55%, calculate the indifference point. Also
calculate the EPS under Plan A and Plan B.
Solution
The indifference level refers to the level of EBIT at which the EPS under plan A
and plan B are equal.
Plan A Plan B
Equity Financing Equity + Debt Financing
( X  I1 ) ( I  T )  P.D ( X  I 2 ) ( I  T )  P.E

S2 S2
Where
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X = EBIT T = Tax rate = 55% = .55

I1 = Interest under plan A = 0 S1 = No. of equity shares
I2 = Interest under plan B Under plan A = 6 lakhs

3000 debentures of S1 = No. of equity shares

Rs. 100 each under plan B = 3 lakhs
= 30,00,000 10% = 3,00,000
P.D. = Preference Dividend = 0

(X - 0) (10 - 55)- 0 (X - 3) (1 - .55)- 0


6 3
(X) (.45) (X - 3) (.45)

6 3
(.45X) (.45X - 1.35)

6 3
By cross multiplication,
x3 = (.45X – 1.35)6
(.45X)

1.35X = 2.70 X – 8.10

1.35 X – 2.70X = - 8.10
-1.35X = - 8.10
X = 8.1`0 + 1.35 = 6
EBIT = Indifference Level = Rs.6,00,000
When EBIT is 6,00,000, EPS under plan A and Plan B are equal.
Net Income Approach
Problem - 4
X Ltd is expecting an annual EBIT of Rs.2,00,000. The company has
Rs.2,00,000 in 10% Debentures. The equity capitalisation rate (ke) is 12%. You are
required to ascertain the total value of the firm and overall cost of capital. What
happens if the company borrows Rs.2,00,000 at 10% to repay equity capital?
Solution
Value of firm
under NI approach = Market value of equity + Market value of debt.
(i) Calculation of Market value of equity

Rs.
Earnings before interest & Taxes (EBIT) 2,00,000
Less : Interest (2,00,000 x 10%) 20,000
Earnings available to equity shareholders 1,80,000
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Earningsavailableto equityshare holders

Marketvalueof equity
Cost of equity(kc )
1,80,000
  Rs.15,00,000
12%
i) Calculation of value of firm
Value of firm = Market value of equity + Market value of debt
= 15,00,000 + 2,00,000
= Rs. 17,00,000
(iii) Calculation of overall cost of capital (k0)
EBIT
k   100
o Valueof firm
2,00,000

17,00,000
 11.7%
Calculation of value of firm when the company borrows Rs.2 lakh to pay off
equity capital
(i) Calculation of market value of equity

Rs.
EBIT 2,00,000
Less : Interest (4,00,000 x 10%) 40,000
Earnings available to equity shareholders 1,60,000

1,60,000
Marketvalueof equity   Rs.13,33,33
12%
ii) Calculation of value of firm
Value of firm = Market value of equity + Market value of debt
= 13,33,333 + 4,00,000
= Rs. 17,33,333.
iii) Calculation of overall cost of capital (k0)
EBIT
k   100
o Valueof firm
2,00,000

17,33,333
 11.54%
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Net Operating Income Approach

Problem - 5
Dewey Ltd. has an EBIT of Rs.4,50,000. The cost of debt is 10% and the
outstanding debt is Rs.12,00,000. The overall capitalisation rate (k0) is 15%.
Calculate the total value of the firm and equity capitalisation rate under NOI
approach.
Solution
i) Calculation of Market value of firm
EBIT
Marketvalueof firm   100
Overallcost of capital(k o )
4,50,000

15%
 Rs. 30,00,000
ii) Calculation of Market value of firm
Market value of firm = Market value of equity + Market value of debt
 Market value of equity = Market value of firm – Market value of debt
= 30,00,000 – 12,00,000
= Rs.18,00,000
iii) Calculation of earnings available to equity share holders
Rs.
EBIT 4,50,000
Less : Interest (12,00,000 x 10%) 1,20,000
Earnings available to equity shareholders 3,30,000
(iv)Calculation of equity capitalisation rate (ke)
Earningsavailableto equityshare holders
k   100
c Marketvalueof equity
3,30,000

18,00,000
 18.33%
Traditional Approach
Problem – 6
Kincaid Ltd. has a EBIT of Rs.6,00,000. Presently the company is entirely
financed by equity capital of Rs.40,00,000 with equity capitalisation rate of 16%. It
is contemplating to redeem a part of its capital by introducting debt financing. It
has two options – to raise debt to the tune of 30% or 50% of the total funds.
It is expected that for debt financing upto 30% will cost 10% and equity
capitalisation rate will rise to 17%. However, if the firm opts for 50% debt, it will
cost 12% and equity capitalisation rate will be 20%.
 311

Compute the market value of the firm, market value of equity and the overall
cost of capital.
Solution
Statement showing Market value of firm, equity and overall cost of capital
30% Debt 50% Debt
0% Debt
Particulars (Rs.12 lakhs) (Rs.20 lakh)
Rs.
Rs. Rs.
EBIT 6,00,000 6,00,000 6,00,000
Less: Interest - 1,20,000 2,40,000
(12 lakh x 10%) (20 lakh x
12%)
Earnings available to equity 6,00,000 4,80,000 3,60,000
share holders
Equity capital rate (ke) 16% 17% 20%
Market value of equity 37,50,000 28,23,529 18,00,000
 6,00,000  4,80,000  3,60,000
     
 16%   17%   20% 
Add: Market value of debt Nil 12,00,000 20,00,000
Market value of firm 37,50,000 40,23,529 38,00,000
Overall cost of capital (K0)

EBIT  6,00,000  16%  6,00,000  14.9%  6,00,000  15.79%

 100 
   40,23,529   38,00,000 
Market value of firm  37,50,000     

Analysis
If debt of Rs.12 lakh is used, the value of firm increases and the overall cost of
capital declines. However, if the level of debt is increased to Rs.20 lakh, the value of
firm declines and the overall cost of capital increase. Thus, debt is beneficial only
upto a point.
Modigliani Miller Approach
Problem - 7
Two firms R and S are identical except in the method of financing. Firm R has
no debt, while firm S has Rs.3,00,000 8% Debentures in financing. Both the firms
have a Net operating income (EBIT) of Rs.1,20,000 and equity capitalization rate of
12%. The corporate tax rate is 35%. Calculate the value of the firm using MM
approach.
Solution
(i) Computation of value of Firm R which does not use any debt (unlevered)
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Earnings available to equity share holders

Value of firm 
Equity capitalisation rate
EAT

ko

Rs.
EBIT 1,20,000
Less : Interest Nil
EBT 1,20,000
Less : Income Tax @ 35% 42,000
EAT 78,000
78,000
Value of firm   Rs. 6,50,000
12%
ii) Computation of value of Firm S which uses debt (levered)
Value of Firm S = Value of unlevered firm + (Tax rate x Debt) (Levered)
= 6,50,000 + (0.35 x 3,00,000)
= Rs. 7,55,000
Illustration – 1
(a) A company expects a net income of Rs. 80,000. It has Rs. 2,00,000, 8%
Debentures. The equity capitalisation rate of the company is 10%. Calculate the
value of the firm and overall capitalisation rate according to the Net Income
Approach (ignoring income-tax).
(b) If the debenture debt is increased to Rs. 3,00,000, what shall be the value
of the firm and the overall capitalisation rate?
Solution
a) Calculation of the value of the firm Rs.
Net Income 80000
Less: Interest on 8% Debentures of Rs. 2,00,000 16000
Earnings available to equity shareholders 64000
Equity Capitalization Rate 10%
100
Market Value of Equity = 64.000 x
10
= Rs. 6,40,000
Market Value of Debentures = Rs. 2,00,000
Value of the Firm Rs.6,40,000 + Rs.2,00,000 = Rs. 8,40,000
Calculation of overall capitalisation rate
Earnings  EBIT 
Overall Cost of Capital (Ke) =  
Value of the firm  V 
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80,000
x100  9.52%
= ,40,000
8

b) Calculation of value of the firm if debenture debt is raised to Rs. 3,00,000

Rs.

Net income 80,000

Less: interest on 8% Debentures of Rs 300000 24,000
Earnings available to equity shareholders 56,000

Equity Capitalisation Rate 10%

100
Market Value of Equity = 56,000 × = Rs. 5,60,000
10
Market Value of Debentures = Rs. 3.00,000
Value of the Firm Rs.5,60,000 + Rs.3,00,000 = Rs. 8,60.000
80,000
Overall Capitalisation Rate = = 100 = 9.30%
8,60,000
Thus, it is evident that with the increase in debt financing the value of the firm
has increased and the overall cost of capital has decreased.
Illustration - 2
(a) A company expects a net operating income of Rs. 1,00,000. It has
Rs. 5,00,000, 6% Debentures. The overall capitalisation rate is 10%. Calculate the
value of the firm and the equity capitalisation rate (cost of equity) according to the
Net Operating Income Approach.
(b) If the debenture debt is increased to Rs. 7,50,000 what will be the effect on
the value of the firm and the equity capitalisation rate?
Solution
(a) Net Operating Income = Rs. 1,00,000
Overall Cost of Capital= 10%

Net Operating Income  EBIT 

Market Value of the firm (V) =  
Overall Cost of Capital  K e 

100
= 1,00,000 × = Rs. 10,00,000
10
Market value of firm Rs. 10,00,000
Less : Market Value of Debentures Rs. 5,00,000
Total Market Value of Equity Rs. 5,00,000
Equity Capitalisation Rate or Cost of equity (ke)
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EarningsAvailableto Equity Shareholders  EBIT - I 

or  
= Total Market Value of Equity Shares  V-B 

[Where, EBIT means Earnings before Interest and Tax

V= Value of the firm
B = Value of debt capital (Bonds)
I = interest on debt]
100000 30000
x100
= 1000000 500000
70000
= x100 = 14%
500000
(b) If the debenture debt is increased to Rs. 7,50,000, the value of the firm
shall remain unchanged at Rs. 10,00,000. The equity capitalisation rate will
increase as follows:
EBIT - I
Equity Capitalisation Rate (ke) =
V-B
1,00,000 45,000 55,000
X100 = X100 = 22%
= 10,00,000 7,50,000 2,50,000
Illustration - 3
Compute the market value of the firm, value of shares and the average cost of
capital from the following information.
Net operating Income Rs.2,00,000
Total Investment Rs. 10,00,000
Equity capitalizing rate:
a) If the firm uses no debt 10%
b) If the firm uses Rs.4,00,000 debentures 11%
c) If the firm uses Rs.6,00,000 debentures 13%
Assume that Rs.4,00,000 debentures can be raised at 5% rate of interest
whereas Rs.6,00,000 debentures can be raised at 6% rate of interest.
Solution
Computation of market value of firm, value of
Shares & the average cost of capital
a) No debt b) Rs.4,00,000 c) Rs.6,00,000
5% Debentures 6% Debentures
Net Operating Income Rs.2,00,000 Rs.2,00,000 Rs.2,00,000
Less: Interest i.e. Cost of debt -- 20,000 36,000
Earnings available to equity Rs.2,00,000 Rs.1,80,000 Rs.1,64,000
shareholders
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Equity Capitalization Rate 10% 11% 13%

100 100 100
Market Value of Share 2,00,000 x 1,80,000 x 1,64,000 x
10 11 13
= Rs.16,36,363 Rs.12,61,538
Rs.20,00,000
Market value of debt -- 4,00,000 6,00,000
(debentures)
Market value of firm 20,00,000 20,36,363 18,61,538
Earnings EBIT
Average Cost of Capital = or
Value of the firm V

2,00,000 2,00,000 2,00,000

x 100  10% x 100  9.8% x 100  10.7%
20,00,000 20,36,363 18,61,538

It is clear from the above that if debt of Rs. 4,00,000 is used the value of the
firm increases and the overall cost of capital decreases. But if more debt is used to
finance in the place of equity, i.e., Rs. 6,00,000 debentures, the value of the firm
decreases and the overall cost of capital increases.
Illustration - 4
A company has earnings before interest and taxes of Rs.1,00,000. It expects a
return on its investment at a rate of 12.5%. You are required to find out the total
value of the firm according to the Modigliani-Miller theory.
Solution
According to the M.M. theory, total value of the firm remains constant. It does
not change with the change in capital structure.
EarningsBefore Int.and Tax
Total value of firm 
Overall Cost of Capital

EBIT
or V =
Ke
1,00,000
=
12.5
100
100
= 1,00,000 x = Rs.8,00,000
12.5
Illustration - 5
There are two firms X and Y which are exactly identical except that X-does not
use any debt in its financing, while Y has Rs. 1,00,000 at 5% debentures in its
financing. Both the firms have earnings before interest and tax of Rs. 25,000 and
equity capitalization rate is 10%. Assuming the corporation tax of 50%, calculate
the value of the firm.
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Solution
The market values of firm X which does not use any debt
EBIT
V=
KO

25,000
100
= 10 = 25000x
100 10
= Rs. 2,50.000.
The market value of Firm Y which uses debt financing of Rs. 1,00,000
Vt = Uu + td
= Rs.2,50,000+5x10.000
= Rs.2,50,000 + 50.000
= Rs.3,00,000.
EXERCISE
I. EBIT ANALYSIS
1. A firm requires total capital funds of Rs.50 lacs and has two options; All
equity; and Half equity and Half 15% debt. The equity shares can be currently
issued at Rs.100 per share. The expected EBIT of the company is Rs.5,00,000 with
tax rate at 40%. Find out the EPS under both the financial mix.
2. ABC Ltd has an EBIT of Rs. 1,60,000. Its capital structure consists of the
following securities
10% Debentures Rs. 5,00,000
12% Preference Shares Rs. 1,00,000
Equity shares of Rs.100 Rs. 4,00,000
The company is in the 55% tax bracket. You are required to determine :
a) The company’s EPS
b) The percentage change in EPS associated with 30% increase and 30%
decrease in EBIT.
II. INDIFFERENCE POINT
1. Universal Ltd. wants to implement a project for which Rs.60 lakh is to be
raised. The following financial plans are under evaluation :
Plan A : Issue of 6 lakhs equity shares of Rs.10 each,
Plan B : Issue of 30,000 10% of non-convertible debentures of Rs.100 each
and issue of 3 lakhs equity shares of Rs.10 each.
Assuming a corporate tax of 55%, calculate the indifference point.
2. A new project under consideration by your company requires a capital
investment of Rs.150 lakh. The required funds can be raised either through the sale
 317

of equity shares or borrowed from a financial institution. Interest on term loan is

15% and tax rate is 50%. If the debt-equity ratio insisted by the financing agencies
is 2:1 calculate the point of indifference for the project.
NET INCOME (NI) APPROACH
3. Krishna Ltd is expecting an annual EBIT of Rs.2,00,000. The company has
Rs. 7,00,000 in 10% debentures. The cost of equity capital or capitalization rate is
12.5%. You are required to calculate the total value of the firm. Also ascertain the
overall cost of capital.
4. Annapoorna Steel Ltd., has employed 15% Debt of Rs.24,00,000 in its
capital structure. The net operating income of the firm is Rs. 10,00,000 and has an
equity capitalization rate of 16%. Assuming that there is no tax. find out the value
of the firm under the NI Approach
NET OPERATING INCOME (NOI) APPORACH
5. Skylekha Ltd. has an EBIT of Rs.2,50,000. The cost of debt is 8% and the
outstanding debt is Rs. 10,00,000. The overall capitalization rate (K 0) is 12.5%.
Calculate the total value of the firm and equity capitalization rate under NOI
Approach.
6. Sun Ltd., expects a net operating income of Rs.2,40,000. It has Rs.
12,00,000, 10% Debentures. The overall capitalization rate is 15%. Calculate the
value of the firm and cost of equity according to the NOI Approach.
MODIGLIANI AND MILLER APPROACH
7. (With tax) Merry Ltd. has earnings before interest and taxes (EBIT) of
Rs. 30,00,000 and a 40% tax rate. Its required rate of return on equity in the
absence of borrowing is 18%. In the absence of personal taxes, what is the value of
the company in MM world (il with no leverage; (ii) with Rs.40,00,000 in debt; and
(iii) with Rs. 70, 00,000 in debt?
8. Two firms M and N are identical in all respects except the degree of leverage.
Firm M does not use any debt in its financing (unlevered). Firm N has 8%
debentures of Rs. 6,00,000 (levered). The firms have earnings before interest and
taxes (EBIT) of Rs.2,00,000 and the equity capitalization rate is 12.5%.
Assuming the corporate tax at 50%, calculate the value of the firms using MM
approach.
19.4 REVISION POINTS
 Net Income approach: Higher debt content in the capital structure will result
in decline in the over all or weighted average cost of the capital.
 Net operating Income approach: The market value of the firm is not at all
affected by the capital structure changes.
 Traditional Approach: This approach is also known as intermediate
approach as it takes a midway between NI approach (that the value of the
firm can be increased by increasing financial leverage) and NOI approach
 318

(that the value of firm is constant irrespective of the degree of financial

leverage).
 MM Approach: Modigliani and Miller approach explain the relationship
between capital structures, cost of capital and value of the firm under two
conditions: (i)When there are no corporate taxes (ii)When there are corporate
taxes are assumed to exist.
19.5 INTEXT QUESTIONS
1. Describe the traditional approach to capital structure
2. Explain the net income approach to capital structure
3. Discuss the net operating income approach to capital structure
4. Explain the Modigliani and Miller approach to capital structure
5. Describe the arbitrage process under MM approach.
19.6 SUMMARY
The important theories of capital structures are net income approach, net
operating income approach, the traditional approach, and Modigliani and miller
approach.
Net income approach theories propound, that a company can increase its
value and reduce the overall cost of capital by increasing the proportion of debt in
this capital structure.
According to the net operating income approach change in capital structure of
a company does not affect the market value of the firm.
The traditional approach, assets that the cost of capital is not independent of
the capital structure of the firm and there is an optional capital structure.
Under the Modigliani – Miller approach on “Cost Capital” Suggests that there
is no correlation between cost of capital and debt – equity ratio.
19.7 TERMINAL EXERCISE
1. According to………………………….. approach, a firm can increase its value or
lower the overall cost of capital by increasing the proportion of debt in the capital
structure.
2. According to ……………………………. approach, the market value of the firm
is not affected by the capital structure changes.
3. According to …………………………… approach, the use of debt upto a point
is advantageous.
4. ………………………………approach explain the relationship between capital
structures, cost of capital and value of the firm under two conditions.
19.8 SUPPLEMENTARY MATERIAL
1. http://www.morldtechgossips.com/
2. http://www.bauer.uh.edu/
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19.9 ASSIGNMENTS
1. Explain "Net Income approach" to the problem of capital structure.
2. Explain "Net Operating Income Approach" as suggested by Durand to
capital structure planning.
3. Explain briefly the view of traditional writers on the relationship between
capital structure and the value of the firm.
4. How can the effect of profitability on designing an appropriate capital
structure be analyzed? Illustrate your answer with the help of EBIT-EPS
analysis.
5. "The total value of a firm remains unchanged regardless of variations in its
financing mix". Discuss this statement and point out the role of arbitraging
and home made leverage.
19.10 SUGGESTED READINGS
1. Jain, Khan, Financial Management: Text, Problems and Cases 7th Edition,
Tata McGraw Hill Publishers.
2. Vishwanthan. R., Industrial Finance, Macmillian
3. Vyuptakesh Sharan Fundamentals of Financial Management, Dorling
publishers
19.11 LEARNING ACTIVITIES
1. Give a critical appraisal of the traditional approach and the Modigliani-
Miller Approach to the problem of capital structure.
2. Is the M.M. thesis realistic with respect to capital structure and the value
of a firm? If not, what are their main weaknesses?
19.12 KEYWORDS
Net Income Approach, Net Operating Income Approach, Traditional Approach,
Modigliani and Miller Approach,EBIT, EBT,


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LESSON – 20

LEVERAGES
20.1 INTRODUCTION
Cost structure, capital structure and asset structure are very important
factors in maximizing earnings per share (EPS) or return on Equity (ROE) of a
company. Cost structure in terms of fixed and variable costs, gives rise to ‘operating
leverage’ and the (optimal) capital structure, in terms of fixed cost and variable cost
securities, to financial leverage. The optimal capital structure is the one that strikes
a balance between these risks and returns and thus maximizes the price of the
stock. The capital structure decision is significant managerial decision which
influences the shareholders return and risk and ultimately the value of firm.
Before, discussing operating and financial leverages let us consider the concept of
leverage first.
Meaning of Leverage: The term ‘leverage’ has been borrowed from physical
science where it refers to s device (lever) by which heavy objects (Weights) is lifted
with a small force. In business parlance, it refers to the relationship between
percentage changes in fixed cost and in earnings before interest and taxes (EBIT)
Viz. operating profit. Thus, leverage may be defined as the employment of assets
out of funds for which the firm pays a fixed cost or fixed return. The fixed cost or
fixed return may be thought of as the fulcrum of a lever. When the revenues less
variable costs (or earnings before results. When the operating income is less than
the fixed cost or fixed return, the result is negative or unfavourable leverage.
Leverage belongs to the category of capital-gearing. This is an American term
which has appropriately the same meaning as “gearing”. It is one of the most
important tools in the hands of corporate financial managers. If used judiciously it
can maximize the return to equity shareholders
20.2 OBJECTIVES
After completing this lesson you must be able to
 Explain the meaning of leverage
 Define the term leverage
 List out the types of leverages
 Discuss the importance of leverages
 Distinguish operating and financial leverage
20.3 CONTENT
20.3.1 Meaning of Leverage
20.3.2 Definition of Leverage
20.3.3 Operating Leverage
20.3.4 Financial Leverage
20.3.5 Composite Leverage
 321

20.3.6 Importance of leverages

20.3.7 Readjustment in capital structure
20.3.8 Difference between operating and financial leverage
20.3.1 Meaning of Leverage
Leverage has been defined as “the action of a lever, and mechanical advantage
gained by it”. A lever is a rigid piece that transmits and modifies force or motion
where forces are applied at two points and turns around a third. In simple words, it
is a force applied at a particular point to get the desired result. The physical
principle of the lever is instinctively appealing to most. It is the principle that
permits the magnification of force when a lever is applied to a fulcrum. The term
leverage, it is possible to lift the objects, which is otherwise impossible. The term
leverage refers generally to circumstances which bring about an increase in income
volatility. In business, leverage is the means which a business firm can increase the
profits. The force will be applied on debt; the benefit of this is reflected in the form
of higher returns to equity shareholders. It is termed as “Trading on Equity”
20.3.2 Definition of Leverage
l. “Leverage is the ratio of net returns on shareholders' equity and the net rate
of return on total capitalisation. - Ezra Soloman.
2. “Leverage may be defined as percentage return on equity to. percentage
return on capitalisation. - J.E. Walter.
3. “Leverage may be defined as meeting a fixed cost of paying a fixed return for
employing resources or funds.” - S.C.Kuchhal.
4. “Leverage is the employment of an assets or funds the firm pays a fixed
cost or fixed return.” - James Horne
TYPES OF LEVERAGES
Leverages are of three types – (1) Operating leverage, (2) Financial leverage,
(3) Composite leverage.
20.3.3 Operating Leverage
It is the tendency of the operating profit to change disproportionately with
sales. A company is said to have a high degree of operating leverage if it employs a
greater amount of fixed cost: and a small amount of variable costs. On the other
hand if the company employs a greater amount of variable costs and a smaller
amount of fixed costs, it is said to have a low operating leverage. Therefore, the
degree o operating leverage will depend on the amount of fixed element in the
operating cost structure of the company. In the absence of fixed operating costs
there will be no operating leverage.
The operating leverage is calculated for studying the effects on company's
income at different levels of sales . It can be determined by the following formula :
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Contribution C
OperatingLeverage or
OperatingProfit OP
(Total sale - Total Variable Costs
or 
(Total sale Total Variable Costs) - Fixed Costs
N(SP - VC)
or 
N (SP - VC) - FC

where, N is the number of units sold, SP is the selling price per unit, VC is
variable cost per unit, FC is the total fixed cost.
The operating leverage maybe favourable or unfavourable. Where the
contribution exceeds the fixed costs, the operating leverage is termed as favourable,
and vice verse.
Degree of operating leverage is the percentage change in profits resulting from
a percentage change in sales. It may be put in the form of the following formula:
Percentagechanges in Profits
Degree of Operating Leverage
Percentagechange in sales
Operating profit means “Earnings before Interest and Tax” (EBIT). The
operating leverage shows the impact of change in sales on the operating profits. If a
company has a high degree of operating leverage, a small change in sales will bring
a large change in operating profits. Thus, the operating profits of a company having
a high degree of operating leverage increase at a faster rate than the increase in
sales. Likewise, the operating profits of such a company also fall at a faster rate
than the decrease in its sales.
Most companies do not like operative leverage. It is a very risky situation
because a small decrease in sales can excessively damage the company's efforts to
increase its profits.
Illustration – 1: The installed capacity of ABC company’s factory is 500 units.
Actual capacity used in 300 units. Selling price per unit is Rs.15. Variable cost per
unit is Rs.77 per unit. Calculate the operating leverage in each of the following
three situations:
i) When fixed costs are Rs.500
ii) When fixed cost are Rs.1,000
iii) When fixed cost are Rs.1,500
SOLUTION
COMPUTATION OF OPERATING LEVERAGE
Situation Situation Situation
(i) (ii) (iii)
Total sales (300 units @ Rs.15) 4,500 4,500 4,500
Less: Total Variable Cost (300 x 7) 2,100 2,100 2,100
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Contribution 2,400 2,400 2,400

Less: Fixed Costs 500 100 1,500
Operating Profit 1,900 1,400 900
Operating Leverage
Contribution 2,400 2,400 2,400
Operating Profit 1,900 1,400 900
=1.3 1.7 2.7

Thus the degree of operating leverage increases with every increased in fixed
cost in the total structure of the company. If sales volume increases by one percent,
the operating profit would increase by 2.7 percent. This involves a greater amount
of risk because if sales happen to decrease by one percent the operating profit will
come down by 2.7 percent. Therefore higher the operating leverage, the higher
would be the operating profit and higher would be the risk.
20.3.4 Financial Leverage
It is also known as 'trading on equity* It is the ratio of long-term debt to total
funds employed. It is defined as the tendency of the residual net income to change
disproportionately with operating profit. It signifies the presence of fixed cost capital
(dentures and preference shares) in the total capital structure of the company. It
uses fixed interest bearing debts and fixed dividend bearing preference share
capital along with the equity share capital structure of the company Higher the
amount of fixed interest/dividend bearing securities, higher is the financial leverage
and vice versa. From the shareholders point-of view, financial leverage may be
favourable or unfavourable.
a) Favourable Leverage: The leverage is favourable so long as the company
earns more on the assets purchased the funds as compared to the fixed cost paid
for their use.
b) Unfavourable Leverage: The leverage is unfavourable when the company
does not earn as much as the funds cost.
Financial leverage may have favourable or unfavourable effect on the
company's total earnings before interested and taxes (EBIT) as well as on earnings
per shares (EPS). It proves a blessing when company's earnings increase. It is a
curse when company's earnings are insufficient to meet the debt obligations. It
indicates the change in taxable income (profit before tax) as a result of change in
the operating income or profit (earning before interest and taxes). It can be
computed according to the following formula :
Operating Profits or EBIT
FinancialLeverage
(EBIT - Interest)or PBT
EBIT = Earning Before Interest and Taxes
PBT = Profit Before Taxes.
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The degree of financial leverage indicates the percentage change in taxable

profit (i.e., PBT) as a result of percentage Change in operating profit (i.e., EBIT).
Thus the degree of financial leverage can be calculated by multiplying the above
equation by 100. Financial leverage cannot exist if the quotient as per the above
formula is not more than one. For example, a company has a choice of the following
three financial plans. You are required to calculate the financial leverage in each
case and interpret the same.

Financial Financial Financial

Plan I Plan II Plan III
Equity Capital 4,000 2,000 6,000
Debt 4,000 6,000 2,000
Operating Profit (EBIT) 800 800 800
Interest @ 10% on Debt 400 800 200
SOLUTION
COMPUTATION OF FINANCIAL LEVERAGE
Financial Financial Financial
Plan I Plan II Plan
(Rs.) (Rs.) (Rs.)
Equity Capital 4,000 2,000 6,00
Debt 4,000 6,000 2,000
Total Capital 8,000 8,000 8,000
Operating Profit (EBIT) 800 800 800
Interest on Debt 400 600 200
Profit before tax (PBT) 400 200 600
EBIT 800/400 =2 800/200 =4 800/600=1.33
FinancialLeverage
PBT
EBIT 800 800 800
Degreeof Fin.Leverage  100  100  20%  100  400%  100  133%
PBT 400 200 600

Although the total amount of capital in all three choices is the same, the
capital structure is different. Similarly, though the EBIT in all the three case is the
same, still financial leverage is varying. Financial leverage in case o Plan I is 2. It
means that every : 1% change in operating profit will result in 2% change in the
taxable profits, or every 1% change in operating profit will result in 200% change in
the taxable profit (PBT). A high financial leverage means high fixed financial cost
and high financial risk. In financial plan II, the degree of financial leverage is much
higher Iie., 400 % than i the financial risk to the company. Increase in fixed
financial cost require necessary increase in EBIT level. If a company fails to do so, it
may b technically forced into liquidation. Although the financial plan III has lower
financial leverage, but it may put the company into financial trouble if it EBIT fall
down.
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20.3.5 Composite Leverage

It measures percentage change in operating profit as result of percentage
change in sales, and financial leverage measures percentage change in taxable
profits or earnings per share (EPS due to percentage change in operating profit i.e.,
EBIT. While operating leverage explains the degree of operating risk, financial
leverage indicate the degree of financial risk. Both these leverage are closely
concerned wit the company's capacity to meet its fixed cost obligation. Their
combined effect will measure the company's financial strength. Composite leverage
expresses the relationship between sales revenue and taxable income or EBT. It
helps the management in finding out the percentage change in4 taxable income as
a result of percentage change in sales. The degree of combined effect of operating
and financial leverages can be computed as follows :
Composite Leverage = Operating Leverage X Financial Leverage
C OP C
 x 
OP PBT PBT
where, C = Contribution (i.e., Sales-Variable Cost)
OP = Operating Profit or EBIT
PBT = Profit Before Tax but after interest
For example a company has sales of Rs. 50,000. The variable costs are 40% of
sales whereas the fixed operating costs are Rs. 15,000. The amount of interest
payable of long-term debt is Rs. 5,000. Find out the composite leverage and
illustrate its impact on the company's taxable income if sales increases by 5%.
SOLUTION
STATEMENT SHOWING COMPUTATION OF COMPOSITE LEVERAGE
Rs.

Less : Sales 50,000 20,000

Variable Costs (40% of sales)
Less : Contribution (C) 30,000 15,000
Fixed Operating Costs
Earnings Before Interest and Tax (EBIT) or Operating 15,000 5,000
Profits (OP)
Less : Interest
Taxable Income or Profit Before Tax (PBT)
C 30,000
CompositeLeverage  3
PBT 10,000

10,000
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The composite leverage of '3' indicates that with a change of Rs. in sales
revenue, the taxable income will change by Rs.3. In other words, 10% change is
sales revenue will result in 30 % changes in taxable income. This can be verified by
the following calculations when the salt

Rs.
Increased Sales 52,500
Less : Variable Costs (40% of Sales) 21,000
Contribution 31,500
Less : Fixed Operating Costs 15,000
EBIT or Operating Profit (OP) Less : Interest 16,500
5,000
Taxable Income or Profit Before Tax (PBIT) 11,500

It is evident from the above computation that due to 5% increase sales

revenue, the taxable income or profit before tax has increased by 15%. This can be
verified as follow :
Percentage Increase in Taxable Income (PBT)
Increasein Profits
  100
Base Profit
1,500
  100  15%
10,000
20.3.6 Importance of Types of Leverages
1. Financial leverage- It is superior as it indicates the market price the shares.
The management is always anxious to increase the market price of shares by
increasing the net worth of the company. For this purpose t management resorts to
'trading on equity’ which helps in increasing the company's operating profits, and
at the same time in increasing t company's operating profits, and at the same time
in increasing the marl price of its shares.
2. Operating Leverage - A company cannot go indefinitely in raising the fixed
cost capital. If a company goes on employing greater proportion of debt capital, the
marginal cost of each subsequent debt will also go increasing because each
subsequent lender will demand higher rate interest. Further, the company's
inability to offer sufficient assets and security to each subsequent lender will also
pose as serious limitation before the management to employ further debt capital.
Furthermore, a company with widely fluctuating income cannot afford to employ
greater proportion of debt capital or a high degree of financial leverage.
3. Composite - A proper combination of operating and financial leverage is a
blessing for the company's growth. On the conversely, < improper combination of
these leverages may prove to be a curse for the company's survival. Although a
right combination of these leverages is very big challenge for the management, but
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a company should strive to have balance -of these leverages as they have
tremendous acceleration and declaration effect on its operating profit (EBIT) and
earning per share (EPS).
A high degree of operating leverage accompanied by a high degree of financial
leverage makes the position of the company very risky. This is the result of the
employment of excessive assets by the company for which has to use a large sum*of
debt capital and incur high fixed costs. The risk arising due to the fixed costs of
using assets and fixed interest charges further intensified in case of fall in the
company's earnings. Greater fluctuations in earnings may be the result of a high
degree operating leverage. A high degree of financial leverage will lead to wide
fluctuations in shareholders earnings. It will result in more than proportionate
change in earnings per share (i,e., EPS) even on account of a minor change in
operating profits (i.e., EBIT) The company will untimely face the problem of
inadequate liquidity or insolvency. This does not suggest that a company should
opt for a low degree of operating or financial leverage, which is an indication of the
cautious policy followed by the management, as the company will be losing many
profits earning opportunities. Thus, a company should make all possible efforts to
combine the operating and financial leverages in such a way as would suit its risk
bearing capacity.
A company with high operating leverage should have a low financial leverage
instead of a high financial leverage. Likewise, a firm with low operating leverage
should have a high financial leverage provided it has sample opportunities for the
profitable employment of the borrowed funds. Nevertheless, a low operating
leverage followed by a high financial leverage is considered to be in ideal situations
for the maximisation of the company's profits with minimum risk.
20.3.7 Readjustment in Capital Structure
Readjustment in capital structure is inevitable due to changes in economic
trend. It means of easing tension and giving corporation a better opportunity to
pursue its purposes. Following are the important reasons responsible for
readjustment in the capital structure of a business corporation:
1. Legal Requirements: Changes in the statues in force make it obligatory on
the part of corporation to effect the requisite changes in their existing capital
structure. For example, the Indian Companies Act, 1956 abolished the deferred
shares and asked the companies to have only equity preference shares. The
companies were forced to make the necessary changes in their capital structure by
convening deferred shares into equity shares.
2. Attracting Investors: The company may split its shares of high face- value
into low-face value. In order to make them more attractive and popular among
investors, especially when the company's shares have very limited market due to
high face-value subject to wide price fluctuations. Generally investors prefer to
invest in low face-values shares. Therefore, a company has to make the necessary
changes in the face-value of its shares for rising substantial share capital.
3. Capitalisation of Retained Earnings: With the progress of a company its
earnings also increase creating the state of under capitalisation. The company has
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to capitalise its reserves and surplus by issuing bonus shares to the existing
shareholders. This require changes in capital structure.
4. Combination and Amalgamation: To simplify the merger and amalgamation,
the concerned companies are required to readjust their capital structure. The
intrinsic value of shares of the concerned corporation is equalised. This leads to
change in the capital structure of a companies.
5. Writing-off Assets: Sometimes, current assets of a company are de-arranged
due to continuous heavy losses. The value of fixed assets come down due to heavy
reduction in their values. The company's balance sheet displays, a deficit requiring
adjustment of liabilities to offset the deficit c assets. This requires an adjustment in
the company's capital structure by the reducing the value of shares to the real
worth of the company's assets.
6. Simplifying the Capital Structure: Corporations issue a variety o securities to
accommodate their development programmes. When market conditions are
favourable, the corporation consolidate such securities ij order to simplify the
capital structure resulting in change in capital structure
7. Restoration of Balance in the Financial Plan: If a company ha excessively
issued fixed cost structure i.e., debentures and preference share which have
strained financial positions, the management may redeem the securities out of the
proceeds of issue of equity shares as and when the market conditions are
favourable. These readjustments may reset the balance in the financial position of
the company. This may also serve as means of easing tension and giving a better
opportunity to the corporation to pursue its purpose.
8. Avoidance of Default on Debentures: Unable to pay-off interest on debentures
or principal amount on due dates a company may make certain arrangements with
its bankers or debentures holders to avoid dissolution the company resulting from
the default on debentures. Here, change in capital structure has been sought as a
means of avoidance of default on debentures which may lead to the dissolution of
the company.
9. Funding the Accumulated Dividend: If a company has large accumulated
dividend on preference shares, it may enter into arrangements with the preference
shareholders either to accept bonds against their claim in the accumulated balance
of dividend. In favourable market conditions many companies reduce the rate of
dividend. In favourable market conditions many companies reduce the rate of
dividend on preference shares, either calling the old shares or issuing new shares
for cash to redeem the old ones.
20.3.8 Difference between Operating and Financial Leverage
Operating Leverage Financial Leverage
1. Operating leverage is related to 1. Financial leverage is more concerned
the investment activities (capital with financial matters(Mixing of debt
expenditure decision) Equity in Capital structure)
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2. The fluctuation in the EBIT can 2. The changes of EPS due to D: E Mix
be predicated with the help of is predicted by financial leverage.
operating leverage.
3. Financial Manager uses the 3. The uses financial leverage to make
operating leverage to identify the decisions in the liability side of the
items of assets side of the Balance Sheet.
Balance Sheet.
4. Operating leverage is used to 4. Financial leverage is used to
predict Business risk. analyse the financial risk.
Illustrations
Example 1: From the following calculate financial, operating and Combined
Leverage.
Sale 10,000 units Rs. 25 per unit as the selling price
Variable Cost Rs. 5 per unit
Fixed Cost Rs. 30,000 and Interest Cost Rs. 15,000
Solution
Rs.
Sales (10,000 x Rs. 25 per unit) = 2,50,000
Less: Variable Cost (10,000 x Rs. 5 per unit) = 50,000
Contribution = 2,00,000
Less: Fixed cost = 30,000
Operating profit (EBIT) = 1,70,000
Less: Interest = 15,000
Earning before Tax = 1,55,000

EBIT (Operating Profit)

(a) FinancialLeverage
EBT (Earnings before Tax)
1,70,000
  1.09 times
1,55,000

(Contribution)
(b) OperatingLeverage
EBT (OpertingProfit)
2,00,000
  1.17 times
1,70,000

(Contribution) EBIT
(b) CombinedLeverage 
EBIT EBT
2,00,000 1,70,000
 
1,70,000 1,55,000
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2,00,000
  1.29 times
1,70,000
Example - 2: From the following data, Calculate Operating, Financial and
Combined Leverage.
Interest Rs. 10,000; Sales 15,000 units @ Rs. 10 per unit and variable Cost
Rs. 4 per unit; Fixed Cost Rs. 20,000.
Solution
Master Table
Rs.
Sales (15,000 x Rs. 10 per unit) = 1,50,000
Less: Variable Cost (15, 000 x Rs. 4 per unit) = 60,000
Contribution = 90,000
Less: Fixed cost = 20,000
Operating profit (EBIT) = 1,70,000
Less: Interest = 10,000
Earning before Tax = 60,000
Example - 3 : Calculate two companies in terms of its financial and operating
leverages.
EBIT (OperatingProfit)
(a) FinancialLeverage
EBT (Earningsbefore tax)
70,000
  1.16 times
60,000
(Contribution)
(b) OperatingLeverage
EBIT (OperatingProfit)
90,000
  1.28 times
70,000
(c) Combined Leverage = F.L. x O.L.
= 1.166 x1.28 = 1.49 times
Firm A Firm B
Sales Rs. 20,00,000 Rs. 30,00,000
Variable cost 40% Sales 30% Sales
Fixed cost Rs. 5,00,000 Rs. 70,00,000
Interest Rs.1,00,000 Rs. 1,25,000
Master Table
Firm A Firm B
Rs. Rs.
Sales 20,00,000 30,00,000
A : 40/100 x 20,00,000 8,00,000
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B : 30/100 x 30,00,000 9,00,000

Contribution 12,00,000 21,00,000
Less : Fixed Cost : Firm A 5,00,000
Firm B 7,00,000
Operation Profit (EBIT) 7,00,000 14,00,000
Less : Interest : Firm A 1,00,000
Firm B 1,25,000
EBT 6,00,000 12,75,000
EBIT (OperatingProfit)
(a) FinancialLeverage
EBT (Earningsbefore Tax)
70,000 14,00,000
Firm A   FirmB 
60,000 12,75,000
Firm A  1.16 times; Firm B  1.09 times
(Contribution)
(b) OperatingLeverage
EBT (OperatingProfit)
12,00,000 21,00,000
Firm A   FirmB 
7,00,000 14,00,000
Firm A  1.17 times; Firm B  1.5 times
Firm A = 1.71 times: Firm B = 1.5 times
20.4 REVISION POINTS
Leverage: It refers to the employment of an asset or funds for which the firm
pays a fixed cost or fixed return.
Financial Leverage: The tendency of the residual net income to vary
disproportionately with operating profit.
Operating leverage: The tendency of the operating profit to vary disproportionately
with sales.
Composite leverage: It is combination of both operating and financial leverages.
It expresses the effect of change in sales over change in taxable profit.
20.5 INTEXT QUESTIONS
1. What is meant by the term leverage?
2. What do you mean by Financial Leverage?
3. What do you mean by Operating leverage?
4. What do you mean by Composite Leverage?
20.6 SUMMARY
The main aim of any business unit is to maximise the wealth of the firm and
increased return to the equity shareholders. Earnings per share are a barometer
through which performance of an industrial unit can be measured. This could be
achieved by applying the principles of leverage. The operating leverage and the
financial leverage are the two quantitative tools used by the financial experts to
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measure the return to the owners and market price of equity shares. A company
should try to have a balance of the two leverages because they have got tremendous
accelerations or declaration effect as EBIT and EPS.
20.7 TERMINAL EXERCISE
1. ………………………… leverage is the tendency of the operating profit to
change disproportionately with sales.
2…………………………. leverage is defined as the tendency of the residual net
income to change disproportionately with operating profit.
3. ………………………………. measures percentage change in operating profit as
result of percentage change in sales, and financial leverage measures percentage
change in taxable profits or earnings per share.
20.8 SUPPLEMENTARY MATERIAL
1. http://ocw.mit.edu/
2. http://www.morldtechgossips.com/
3. http://wps.aw.com/
4. http://www.docsity.com/
20.9 ASSIGNMENTS
1. Define Leverage. Explain its types and its significance.
2. “Operating leverage is determined by firm’s cost structure and financial
leverage by the mix of debt equity funds used to finance the term’s fixed assets.
These two leverage combined provide a risk profile of the firm” Explain.
3. Explain the concept of operating leverage and financial leverage.
4. Does financial leverage always increase the EPS? Explain.
5. Calculate the degree of (i) operating leverage (ii) financial leverage (iii)
combined leverage from the following data :
Sales 100000 units @ Rs. 2 per unit = Rs.200000
Variable cost per unit @ Rs.0.70
Fixed cost Rs.1,00,000 Interest charge Rs.3,668
20.10 SUGGESTED READINGS
 Maheswari S.N. Financial Management, Sultan chand & Sons, New Delhi
(2010).
 Agarwal, Financial Management, Sanjeev Publications, Mercot (1998).
20.11 LEARNING ACTIVITIES
Why must the financial manager keep in mind the firm’s degree of financial
leverage in evaluating various financial plans? When does financial leverage become
favourable?
20.12 KEYWORDS
Operating leverage, Financial Leverage, Composite Leverage, Contribution,
Operating Profit, Variable costs,, Fixed Operating Costs,

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LESSON – 21

CORPORATE RESTRUCTURING: Mergers Amalgamations and

Acquisitions
21.1 INTRODUCTION
A company may grow internally, or it may go externally through acquisitions.
The objective of the firm in either case is to maximise existing shareholders wealth.
Another company can be acquired through merger, take-over, consolidation etc. A
merger is a combination of two companies where only one survives. The merged
company goes out of (corporate) existence, leaving its assets and liabilities to the
acquiring corporation. Consider the merger of Tata Fertilisers Ltd (TFL) with Tata
Chemical Limited (TCL), the promoting company. Under the scheme of merger, TFL
shareholders are offered 17 shares of TCL (market value per share was Rs. 114), for
every 100 shares of TFL held by them. Further, TPL's cumulative convertible
preference (CCP) shareholders who may not want to accept shares in exchange were
given the option of cash payment of Rs. 15 for every share they held. In this merger,
TCL is an acquiring company, which survives where as TFL is being the acquired
company, which ceases to exist.
A merger is different from a 'consolidation', or amalgamation which involves
the combination of two or more companies whereby entirely new company is
formed. All the old companies cease to exists, and their equity shares (common
stock) are exchanged for shares in the new company. For example, Hindustan
Computer Ltd (HCL), Hindustan Instruments Ltd., Indian Software Company
Ltd(ISCL) and Indian Reprographics Ltd(RFL) were amalgamated in April 1986 as a
new company called HCL Ltd. In this amalgamation, all the four amalgamated
companies lost their identify and formed a new company known as HCL Ltd. When
two companies of about same size combine, they usually consolidate; on the other
hand, when the two companies differ significantly in size, usually a merger is
involved. Though it is important to understand the distinction, the terms 'merger*
and 'consolidation' tend to be used interchangeably to describe the combination of
two companies.
The term 'take-over' means the acquisition by one person or group of persons
or by a company of sufficient shares in another company to give the purchaser
control of that other company. A 'take-over' in this sense differs from merger as the
company which is taken over by the purchaser remains in existence while in
merger one of the two companies goes out of existence. Thus, the take-over tends to
denote the situation where one business offers to buy out of the owners of another,
often against the wishes of the board of directors or groups of shareholders. The
dividing line between the two is indistinct. A number of situations which are
presented as mergers are effectively take-over bids. The directors of the taken over
company, being unable to control effectively the course of events in their business,
are glad of the opportunity to come to an arrangement with another business which
preserves their self-esteem by presenting the operation as merger.
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The primary motivation for mergers is to increase the Value of combined

enterprise. If companies A and B merge to form company C, and if C's value
exceeds that of A and B taken separately, then synergy is said to exist. Synergistic
effects can arise from three sources (i) operating economies resulting from
economies of scale in production or distribution, (ii)financial economies, including a
higher Price-Earnings ratio or a lower cost of debt, or both, and (iii)increased
market power due to reduced competition. Operating and financial economies are
socially desirable, but mergers that reduce competition are both undesirable and
illegal.
21.2 OBJECTIVES
After completing this lesson, you must be able to
 Explain the meaning, objectives of corporate restructuring
 Differentiate between mergers, amalgamations and acquisitions
 Discuss the reasons for mergers and acquisitions
 State the different types of mergers
 Explain evaluation of a merger proposal
21.3 CONTENT
21.3.1 Meaning of corporate restructuring
21.3.2 Objectives of corporate restructuring
21.3.3 Forms of corporate restructuring
21.3.4 Mergers, Amalgamations and acquisitions
21.3.5 Reasons for mergers and acquisitions
21.3.6 Types of mergers
21.3.7 Synergy of mergers and acquisitions
21.3.8 Dangers of mergers
21.3.9 Financial evaluation of merger proposal
21.3.1 Meaning of Corporate Restructuring
The term corporate restructuring may simply be defined a comprehensive
process by which a company can consolidate business operations and strengthen
its position for achieving desired objectives-staying, synergetic, slim, competitive
and success It involves significant reorientation, reorganisation or realignment
assets and liabilities of the organisation through conscious management actions
with the objective of drastically altering the quality and quantity of the future cash
flow streams. The underlying objective of corporate restructuring is to conduct the
business operations in an efficient, effective and competitive manner so as to
increase the organisation's market share, brand power, and synergies. In the
emerging scenario, joint ventures, alliances, mergers, amalgamations and take-
overs are becoming the easiest and quickest way to expand capacities and acquire
dominance over the market.
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9.3.2 Objectives of Corporate Restructuring

An organisation may go for corporate restructuring for any one or more of the
following objectives:
1. Growth: In order to survive, an organisation must grow over a period of
time. Growth is measured in terms of sales, profits and assets. Increase in sales is
a direct indicator of the growth in a firm's operations, since increase in sales
volume indicates that the firm has been able to maintain its competitive edge and
has enlarged its market. Similarly, increase in profits has in store for the
shareholders' higher returns.
2. Technology: The fast phase of technological change marks it obligatory for
the technologically weaker firms to enter into technical collaboration with the firms
having superior technology to survive. As a matter of fact, this has resulted into
international restructuring and acquisitions to take the advantage of improved and
latest technology.
3. Government Policy: In order to adapt itself to changed environment because
of change in Government's policies, the firms may be required to go for corporate
restructuring.
4. Exchange Rate Fluctuations: The movement in the prices of international
currencies has impact on the effective price paid for acquisitions. The firms can
decide the profitability or otherwise of domestic operations as compared to carrying
out off-shore operations.
5. Economic Stability: The economic cycles and conditions may force the firms
for consolidation and / or diversification of their business operations. It has
generally been observed that during the economic recession, the industries try to
restructure itself to be more effective through consolidation and spin-offs while in
case of prosperous situations there are a number of takeovers and acquisitions.
6. To Reduce Dependence: In order to reduce dependence and ensure continuous
and reliable supply of raw materials etc., the firms may go for restructuring in the
form of mergers and acquisitions.
9.3.3 Forms of Corporate Restructuring
The corporate restructuring may take any of the following forms:
1. Expansion: The is is the most common and convenient form of restructuring
as it involves only increasing the existing capacity of the business and does not
involve any additional technical expertise.
2. Diversification: This involves entering into a line of business or product
different from the existing line of activity which can be conveniently and
economically combined with the existing activities of the business. This is a very
common form of restructuring and carried out with the objective of widening the
risk base. However, diversification into areas which are totally unrelated may bring
more problems to the business than possible benefits.
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A firm may grow internally or externally. A firm is said to grow internally when
it expands its area of operation. The firm may expand its activities in the same
product or different lines of product etc.
A firm may grow externally through combining or joining with other firms, or
acquiring other firms. Combination of firms is probably the fastest way to grow.
There are various forms of business combinations, which can result in external
growth. Three forms of combination which are usually applied with the objective of
expansion are: (i) Mergers; (ii) Amalgamations or Consolidations; and (iii)
Acquisitions or take Overs.
3. Collaboration: It refers to the process where an organisation joins hands
with another organisation which is technically or financially superior and
resourceful. This form of restructuring has becoming quite popular in developing
countries since collaboration brings both funds and advanced technology.
4. Spinning Off/Demergers: It refers to the process where a business division or
a product line of a company is separately reorganised into a different entity. The
entity so formed may either be in the form of a subsidiary company or altogether a
separate company.
5. Hive-off: It refers to sale of a loss making division or a product line by a
multi-product company. This serves a dual purpose. The buyer is benefitted
because of low acquisition cost of a completely established product line which he
can conveniently combine with his existing business and thus increase his profit
and market share.
6. Mergers, Amalgamations and Acquisitions: As stated earlier, [mergers,
amalgamations and acquisitions help in having a faster growth of the firm. As a
matter of fact, Indian industrialists today feel that merger is now the best route to
achieve a size for their company which is comparable with global companies for
giving effective competition to them.
21.3.4 Mergers Amalgamations & Acquisitions
Meaning of Merger The term merger refers to a situation where a company
acquires the whole of the assets and liabilities or a part thereof constituting an
undertaking of another company (or companies) and the latter is (are) dissolved.
The acquired company pays the shareholders of the merged company (or
companies) cash or securities and continues to operate with the resources of the
merged company (or companies) together with its own resources. It is thus,
synonymous with the term 'absorption'.
Meaning of Amalgamation. The term "amalgamation" or "consolidation" refers
to a situation where two or more existing companies are companies are combined
into a new company formed for the purpose. The old companies cease to exist and
their shareholders are paid by the new company in cash or in its shares or
debentures.
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According to Section 2 (1A) of the Income Tax Act 1961, the term
amalgamation means the merger of one or more companies with another company
or merger of two or more companies to form one company in such a manner that-
(i) all the property of the amalgamating company or companies immediately
before the amalgamation becomes the property of the amalgamated company by
virtue of the amalgamation,
(ii) all the liabilities of the amalgamating company or companies immediately
before the amalgamation become the liabilities of the amalgamated company by
virtue of the amalgamation,
(iii) shareholders holding not less than nine-tenths in value of the shares in
the amalgamating company or companies (other than shares already held therein
immediately before the amalgamation or by a nominee for, the amalgamated
company or its subsidiary) become shareholders of the amalgamated company by
virtue of the amalgamation).
Meaning of Acquisition: The term "acquisition" or "takeover" refers to acquiring
of effective working control by one company over another. The control may be
acquired either through purchase of majority of shares carrying voting rights
exercisable at a general meeting, or controlling the composition of the Board of
Directors of the other company. The company acquiring controlling shares or voting
power is termed as the holding company, while-the company in which the shares
are acquired as the-holding company, while the company in which the shares are
acquired is termed as the subsidiary company. It may be noted that for acquiring
effective control over another company it is not necessary to own 51% of the share
capital of another company. For a widely held company ownership of 20% or as
Utile as 10% of the share capital out-standing may constitute: effective working
control. The advantage of acquisition is that it allows a company to acquire control
over another company by investing much less than what would be necessary for a
merger.
21.3.5 Reasons for Mergers or Acquisition
The following are the important reasons for mergers amalgamations or
acquisitions of firms.
1. Increase in effective value
The principal reason for these external combinations is that the value of the
company so formed by combining resources is greater than the sum of the
independent values of the merged companies. For example, if A Ltd. and B Ltd.,
merge and form a company C Ltd., the effective value of C Ltd. is expected to be
greater than the sum of the independent values of A Ltd. and B Ltd.
Similar is the case with acquisition. By acquiring the assets of Larsen and
Tubro, Reliance Industries has now highest value of assets under its umbrella. This
take-over changed the Indian Corporate scene to a great extent.
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2. Operating Economics
Combination of two or more companies results in a number of 'operating
economics. Duplicate facilities can be eliminated.
3. Economies of scale
The amalgamated company can have larger volume of operations as compared
to the combined individual operations of the amalgamating companies. It can, thus,
have economies of scale by having intensive utilisation of production plants,
distribution network, engineering services, researches and development facilities,
etc. However, such an advantage accrues only when the companies in the same line
of business are combined, Le„ there is a horizontal merger.
4. Tax Implications
In several amalgamation schemes, tax implications play a crucial role. A
company with heavy cumulative losses may have little prospects of taking
advantage of carrying forward the losses and meeting them out of future profits and
thus taking advantage of the tax benefits.
5. Elimination of Competition
The combining of two or more companies under the same name, would result
in elimination of competition between them. They would save in terms of
advertising cost. This may probably benefit the consumer, in terms of goods being
available at lower price.
6. Better Financial Planning
Merger results in better financial planning and control. For example, a
company having a long gestation period may merge itself with another company
having short gestation period. As a result of this merger, the profits coming from
the company with short gestation period can be used to improve the financial
requirements of the company with long gestation period. Later, when the company
with long gestation period starts giving profits, it will benefit the amalgamated
company as a whole. Similarly, the surplus funds of acquiring company may be
more effectively utilised in the acquired company.
7. Growth
As mentioned earlier, the desired rate of growth may not be achieved through
internal expansion. A company may find that through external combination faster
and balanced growth can be achieved.
8. Stabilisation through diversification
External combinations like merger, amalgamation or acquisition, helps a
company in achieving stabilisation in its earning by diversifying its scope of
operations. A company experiencing wide economic fluctuations and cyclical phases
in its earning due to nature of its product or business may merge with another
company, whose business cycle is different from its own. This merger of companies
different business cycles, will bring consistent earnings to the business as a whole.
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9. Dilution under FEMA

A foreign company operating in India may merge with an Indian company in
order to meet the requirements of Foreign Exchange Management Act for diluting
its foreign shareholdings.
10. Backward Forward Integration
The company which does the assembly of the products manufactured by some
other company may merge with that company manufacturing and assembling the
entire range of products under same roof. It may also merge with its main
consumers. This would bring a better interaction between different functional
areas, resulting in improved efficiency, reduced costs, effective control and
reduction prices for the company's products.
11. Personal Reasons
The shareholders of a closely held company may desire that their company be
acquired by another company that has an established market for it shares. This will
also facilitate the valuation of t shareholders' holdings for wealth tax purposes.
12. Economic Necessity
The Government may also direct the merger of two or more sick i into a single
unit to make them financially viable.
21.3.6 Types of Mergers
Mergers can be of the following types:
1. Horizontal Merger
This is the joining of two or more companies in the same area of business.
Thus, in case of this merger, two or more companies which are producing
essentially the same products or providing the same services or which are in direct
competition with each other join together. For example, two booksellers or two
manufacturers of motorcycles may merge with each other. Such a merger would be
a horizontal merger.
2. Vertical Merger
This is the joining of two or more companies involved in different stages of the
production or distribution of the same product or service. Thus, in case of this
merger, two or more companies which are engaged in the production of same goods
or services but at different stages of production or service routes join together. For
example, a coal mining company and a railway company which carries coal to
different industrial units may merge together. Such a merger will be termed as a
vertical merger.
3. Conglomerate Merger
This is joining of two or more companies whose businesses are not related with
each other either vertically or horizontally. The companies involved in the merger
may be manufacturing totally different products. Of course, there may be some
common features between them such as same channel of distribution or
technological area. For example, a company engaged in manufacturing activities
 340

may get itself merged with a company engaged in insurance business. The two
businesses are totally different and, therefore, such merger is termed as
conglomerate merger.
4. Reverse Merger
In case of an ordinary merger, a profit making company takes over another
company which may or may not be making a profit. The objective is to expand or
diversify the business. However, in case of; reverse merger, a healthy company
merges into a financially weal company and the former company is dissolved. The
basic philosophy c reverse merger is to take advantage of the provisions of Income
Tax Act, 1961 which permits a company to carry forward its losses to se off against
its future profits.
5. Cross Border Merger and Acquisitions
The term cross border merger and acquisitions involves mergers and
acquisitions of firms belonging to different countries of the world, recent years,
there has been a substantial increase in the quantum such acquisitions and
takeover in Europe and USA. The UK has be the most important foreign investor in
USA in recent years with British companies making large acquisitions.
21.3.7 Synergy of Mergers and Acquisitions
The term synergy refers to benefits resulting from mergers and acquisitions
because of coordinated action. The synergy may be of three types:
1. Operating synergy: It is mostly in the form of cost reductions which are the
result of economies of scale or economies of scope. Economies of scale decrease the
average cost through technological economies, which affect the minimum size of the
plant in an industry, or managerial economies, which result in lower production
and distribution costs. Economies of scope result from increase in the number of
products offered. A company will be able to utilize one set of input to provide a
broader range of products and services. Operating synergy is most likely to accure
from horizontal merger between two companies in the same line of business.
2. Financial synergy: It refers to the impact of a merger on the cost of capital
for the merging entities. One of the financial benefits of diversification is termed as
the "coinsurance effect". The acquisition of a company which is less responsive to
fluctuations in the economy would give the acquiring company a steady stream of
earnings.
3. Managerial synergy: This is in the form of availability of highly trained
managerial personnel at the least cost and the benefit of the latest technology.
21.3.8 Dangers of Mergers
Mergers involve the following dangers:
1. Elimination of healthy competition
Merger may involve absorption of small, efficient and growing units into a
larger unit. Thus, it eliminates individual undertakings: competent to offer stiff
competition necessary for healthy growth industrial units.
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2. Concentration of economic power

It has already been stated above that all types of mergers have inherent
tendency of concentration of economic power. Monopolistic conditions may be
created which are ultimately to the disadvantage the consumers.
3. Adverse effects on national economy
Concentration of economic power, elimination of competition, etc., ultimately
result in deterioration in the performance of the merged undertakings. This is going
to affect adversely the national economy.
21.3.9 Financial Evaluation of a Merger Proposal
A merger proposal be evaluated and investigated from the point of view of
number perspectives. The engineering analysis will help in estimating the extent of
economies of scale, while the marketing analysis may be undertaken to estimate
the desirability of the resulting distribution network. However, the most important
of financial analysis or financial evaluation of a target candidate. An acquiring fin
pursue a merger only if it creates some real economic values which may arise f.
source such as better and ensured supply of raw materials, better access to capital
better and intensive distribution network, greater market share, tax benefits, etc.
The shareholders of the target firm will ordinarily demand a price for their
shares that reflects the firm's value. For the would-be purchaser, this price may be
high enough to negate the advantage of merger. This is particularly true if several
acquiring firms are: merger partner, and thus, bidding up the prices of available
target candidates. The point here is that the acquiring firm must pay for what it
gets. The financial evaluation of a candidate, therefore, includes the determination
of the total consideration as well as the form of payment, i.e., in cash or securities
of the acquiring firm. An important dimension financial evaluation is the
determination of Purchase Price.
Determining the Purchase Price: The process of financial evaluation begins
determining the value of the target firm, which the acquiring firm should pay. The
purchase price or the price per share of the target firm may be calculated by taking,
account a host of factors. Such as assets, earnings etc.
Therefore, the value of the firm should be assessed on the basis of the facts
and figures collected from various sources including the published financial
statements of the tar£ firm. The following approaches may be undertaken to assess
the value of the target firm:
1. Valuation based, on Assets: In a merger situation, the acquiring firm
'purchases' the target firm and, therefore, it should be ready to pay the worth of the
latter. The worth of the target firm, no doubt, depends upon the tangible and
intangible assets of the firm. The value of a firm may be defined as:
Value of all Assets
- External Liabilities
Net Assets or Value
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In order to find out the asset value per share, the preference share capital, if
any, is deducted from the net assets and the balance is divided by the number of
equity shares. It may be noted that the values of all tangible and intangible assets
are incorporated here. The value of goodwill may be calculated if not given in the
balance sheet, and included. However, the fictitious assets are not included in the
above valuation.
a) Book value of the assets: In this case, the values of various assets given in
the late e sheet of the firm are taken as worth of the assets. From the total of the
book values of all the assets, the amount of external liabilities is deducted to find
out the net worth of the firm. The net worth may be divided by the number of equity
shares to find out the value per share of the target firm.
b) Realisable value of the assets: In this case, the current market prices or the
realisable values of all the tangible and intangible assets of the target firm are
estimated and from this the expected external liabilities are deducted to find out the
net worth of the target firm. The realisable value may be estimated on the basis of
the valuation of the appraisal agencies. The valuation based on realizable values,
definitely, has an edge over the valuation based c book values, as the former gives a
current and close approximation to the worth of the target firm while the latter may
give an outdated worth of the target firm.
2. Valuation based on Earnings: The target firm may be valued on the basis of
its ear lags capacity. With reference to the capital funds invested in the target firm,
the firms value will have a positive correlations with the profits of the firm. Here,
the profits of the firm CE either be past profits or future expected profits.
In the earnings based valuation, the PAT (Profit After Taxes) is multiplied by
the Price Earnings Ratio to find out the value.
Market Price Per Share = EPS x PE ratio.
The earnings based valuation can also be made in terms of earnings yield as
follows :
EPS
Earnings Yield  100
MPS
The earnings yield gives an idea of earnings as a percentage of market value of
a share. It may be noted that for this valuation, the historical earnings or expected
future earning may be considered.
Earnings valuation may also be found by capitalising the total earnings of the
firm as follows :
Earnings
Value   100
Capitalisation rate
3. Dividend-based Valuation: In the cost of capital calculation, the cost of equity
capital, ke is defined (under constant growth model) as :
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D (1  g) D
k  o g 1 g
c P P
o o
This can be used to find out the P0 as follows :
D (1  g) D
P  o  1
o K -g K -g
c c
4. CAPM-based Share Valuation: Capital Assets Pricing Model is discussed in
detail in Chapter 12. The CAPM is used to find out the expected rate of return, R S,
as follows:
Rs = IRF + (RM-IRF)
where, RS = Expected rate of return
IRF = Risk free rate of return
RM = Rate of Return on market portfolio
 = Sensitivity of a share to market
5. Valuation based on Cash Flows: Valuation of a target firm can also be made
on the basis of firm's cash flows. In this case, the value of the target firm may be
arrived at by discounting the cash flows, as in the case of NPV method of capital
budgeting as follows:
(i) Estimate the future cash inflows (i.e., Profit after tax + Non-cash expenses).
(ii) Find out the total present value of these cash flows by discounting at an
appropriate rate with reference to the risk class and other factors.
(iii) If the acquiring firm is agreeing to takeover the liabilities of the target firm,
then these liabilities are treated as cash outflows at time zero and hence deducted
form the present value of future cash inflows [as calculated in step (ii) above].
(iv) The balancing figure is the NPV of the firm and may be considered as the
maximum purchase price, which the acquiring firm should be ready to pay. The
procedure for finding out the valuation based on cash flows may be summarized as
follows:

n C
MPP   i -L
i - i (l  k)i
where, MPP = Maximum Purchase Price,
Ci = Cash inflows over different years,
L = Current value of liabilities, and
k = Appropriate discount rate
However, in this valuation model, the main problem is to estimate the future
cash flows and the determinations of the appropriate discount rate. More over,
expected cash flows may be calculated either from the point of view of the total firm
or from the point of view of the equity shareholders.
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6. Other Methods of Valuation: There are two other methods of valuation of

Investors provide funds to a company and expect a minimum return which is the
opportunity cost of the investors, or, what the investors could have earned
elsewhere. If the company is earning less than this opportunity cost of the
investors, the company is belying the expectations of the investors. Conversely, if it
is earning more, then it is creating additional value. New concepts such as
Economic Value Added (EVA) and Market Value Added (MVA) can be used along
with traditional measures of Return on Net Worth (RONW) to measure the creation
of shareholders value over a period.
a) Economic Value Added: EVA is based upon the concept of economic return
which refers to excess of after tax return on capital employed over the cost of
capital employed. The concept of EVA, as developed by Stern Stewart & Co. of the
U.S., compares the return on capital employed with the cost of capital of the firm. It
takes into account the minimum expectations of the shareholders. EVA is defined
in terms of returns earned by the company in excess of the minimum expected
return of terms the investors. EVA is calculated as the net operating profit
(Earnings before Interest but after Taxes) minus the capital charges (capital
employed x cost of capital). This can be presented as follows.
EVA = EBIT - Taxes - Cost of funds employed
= Net Operating Profit after Taxes - Cost of Capital Employed
where, Net Operating Profit after Taxes represents the total pool of profit
available to provide a return to the lenders and the shareholders, and Cost of
Capital Employed is Weighted Average Cost of Capital x Average Capital employed.
(b) Market Value Added: MVA is another concept used to measure the
performance and a "a measure of value of a firm. MVA is determined by measuring
the total amount of fund that have been invested in the company (based on cash
flows) and comparing with the current market value of the securities of the
company. The funds invested include borrowed and shareholders funds. If the
market value of securities exceeds the funds invested, the value has been created.
Corporate restructuring is a broader term and includes many things. In
addition to mergers, takeovers and acquisitions, it also includes rearrangement of
corporate control, demergers and divestments. In fact, corporate restructuring
incorporates almost any change in capital structure, in corporate control, in
organisational set up or in ownership that is outside the normal course of business.
Buy back of shares and preferential issue of shares to promoters are also part of
restructuring process.
21.4 REVISION POINTS
 Corporate restructuring: It is a comprehensive process by which a company
can consolidate its business operation and strengthen its position for
achieving the desired objectives – staying synergic competitive and
successful.
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 Merger: It refers to a situation where a company acquires, the whole of the

assets and liabilities or a part thereof constituting an undertaking of another
company and the later is dissolved.
 Amalgamation and Consolidation: It refers to a situation where two or more
existing companies are combined into a new company formed for the
purpose.
21.5 INTEXT QUESTIONS
1. What do you mean by corporate restructuring?
2. What are the objectives of corporate restructuring?
3. What are the forms of corporate restructuring?
4. What do you mean by amalgamations?
5. What do you mean by acquisitions?
6. What do you mean by meregers?
21.6 SUMMARY
Mergers and Acquisitions as forms of business combination are increasingly
being used for undertaking restructuring of corporate enterprises the World over. In
a broader sense, the term merger includes consideration, amalgamation, absorption
and take over. The mergers can take place in the form of absorption or
consolidation. In mergers and acquisition the resources of more than are entity are
pooled together to create synergies. The synergy may be of three types namely
operating synergy, financial synergy and managerial synergy. Mergers are execute
for the growth of the organisation. Mergers lead to economies of scale, maximum
utilisation of capacity, operating economics, mobilasation of financial resources,
rehabilitation of sick units, reduction in cost etc.,
21.7 TERMINAL EXERCISE
1. ………………………. Merger is the joining of two or more companies in the
same area of business
2…………………………. Merger is the joining of two or more companies involved
in different stages of the production or distribution of the same product or service.
3……………….. merger is joining of two or more companies whose businesses
are not related with each other either vertically or horizontally.
21.8 SUPPLEMENTARY MATERIAL
1. http://www.edupristine.com/
2. http://www.icaiknowledgegateway.org/
3. http://www.exinfm.com/
21.9 ASSIGNMENTS
1. Explain the terms ‘Amalgamation’, ‘Mergers’ and ‘Acquisition’
2. Explain the reasons for merger or amalgamation of companies
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3. What financial considerations affect the decision relating to merger of

corporate enterprises?
4. What is taken by reverse bid?
5. List out the advantages and disadvantages mergers
6. Examine several recent mergers and point out the principal motives for
merging in each case
7. Explain the distinction between a tax free and a taxable merger. State the
circumstances in which you would expect buyer and seller to agree to a
taxable merger.
8. Do you have any rationale explanation for the great fluctuations in
aggregate merger activity and the apparent relationship between merger
activity and stock prices?
9. Explain the various issues to be considered in Mergers and Acquisitions
decisions.
10. Give brief summary of SEBI guidelines on merger of companies in India.
21.10 SUGGESTED READINGS
 Murthy, Financial Management, Margham Publications (2010).
 Maheswari, S.N., ‘Financial Management’, Sultan Chand & Sons, New Delhi
(2010).
21.11 LEARNING ACTIVITIES
Examine a recent merger in which at least part of the payment made to the
seller was in the form of stock. Use stock market prices to obtain an estimate of the
gain from the merger and the cost of the merger.
21.12 KEYWORDS
Corporate Restructuring, Merger, Amalgamations, Acquisitions, Vertical
Merger, Horizontal Merger, Conglomerate Merger, Reverse Merger, Cross Border
Merger.


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LESSON – 22

FINANCIAL MANAGEMENT OF SICK UNITS

22.1 INTRODUCTION
The term ‘industrial sickness’ in banking means the unsatisfactory working of
industrial units resulting in non-payment of bank dues. Such sickness, can be
attributed to both internal as well as external factors. The external factors are
shortage of raw materials, shortage of power etc. While the internal factors are
inefficiency and/or dishonest management, diversion of resources, utilisation of
current assets for non-current and long-term purposes, obsolescence of technology
and machinery etc.
22.2 OBJECTIVES
After completing this lesson you must be able to
 Explain the meaning and causes of industrial sickness
 Analyse the stages of industrial sickness
 Discuss the steps for formulating and implementing a nursing program for
a sick unit.
 Explain the steps taken by Government of India to rehabilitation of Sick
Units.
22.3 CONTENT
22.3.1 Sick Industrial unit
22.3.2 Causes of Sickness
22.3.3 Rehabilitation of sick units
22.3.4 Problems in Rehabilitation of sick units
22.3.5 Nursing Programme for sick units
22.3.6 Steps to be taken for Nursing Programme
22.3.7 Guidelines for monitoring and Nursing Programme
22.3.8 Government of India and the sick units
22.3.9 RBI Guidelines in respect of sick SSI units
22.3.10 Recommendations of working group
22.3.1 Sick Industrial Unit
The first attempt to define a sick industrial unit was made in the year 1962 by
the Committee on Rationalisation of Returns in respect of small scale industrial
advances. The committee defined sick unit as one whose accounts were chronically
irregular and required a study to evolve a nursing programme and a close follow-
up. Later on in 1975 State Bank of India Study Team on Sick Units defined a sick
unit as a unit which fails to generate internal surplus on continuing basis and
depends for its survival on frequent infusion of external funds.
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According to Sick Industrial Companies (Special Provisions) Act, 1985 the sick
industrial undertaking means “an industrial company (being a company registered
for not less than five years) which has at the end of any financial year accumulated
losses equal to or exceeding its entire net worth”. In other words, according to the
Act, a company may be taken as a sick company if
a) It has been, in existence for the last five years.
b) It has completely lost its net worth i.e. the sum total of the paid up capita
and free reserves.
Weak Unit
The Reserve Bank of India has given the following definition of a weak unit: "A
unit which has at the end of any accounting year:
a) Accumulated losses equal to or exceeding 50% of its peak net worth: for
the immediately preceding four accounting years;
b) A current ratio of less than 1:1; and
c) Suffered a cash loss in the immediately preceding accounting year.
Thus, a weak unit is a potential sick unit. Hence, adequate measures should
be taken in time by the concerned authorities to prevent the weak unit from
becoming sick.
22.3.2 Causes of Sickness
The causes of sickness of an industrial unit can be classified into three
categories:
i) Environmental factors e.g. power cut, dearth of raw materials, change in
Government policies etc.
ii) Internal factors e.g. mismanagement, family feuds, labour unrest, faulty
production/marketing programme.
iii) Commitment of premeditated frauds or dishonest attitude of management
e.g. unscrupulous sales/purchase practices, diversion of funds etc.
According to a study conducted by RBI the share of various causes in
industrial sickness has been found as follows:
Cause Percentage share in sickness
Management 52%
Faulty Planning 14%
Market Recession 23%
Shortage of inputs 9%
Labour Trouble/Unrest 2%
100%
Signals of Sickness
A unit does not become sick overnight. Before becoming finally sick a unit
starts giving signals of sickness. A prudent banker will take measures to safeguard
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his interest before the unit becomes finally sick. We are giving below a list of the
symbols or signals which taken together tell about the possibility of the industrial
unit becoming sick.
1. Continuous cash losses
2. Manipulation on stock statements, accumulation of finished goods stock
3. Unexplained delay in submission of periodical statements to the banker
4. Frequent issue of post-dated cheques
5. Continued failure to meet fixed and current liabilities on due dates
6. Lay-off or retrenchment of workers
7. Extravagance in the personal life of the proprietor or directors.
8. Resignation or transfer of key managerial personnel
9. Closure of the factory
10. Raising of money against all assets of the undertaking
11. Borrowings from markets at excessive rate
12. Loss of major production or-distribution lines
13. Plant or product obsolescence
14. Non-payment of statutory dues-such as provident funds, taxes etc.
15. Unsatisfactory operations of the accounts; and
16. Incapacity of death of the key persons.
Stages of Sickness
An industrial unit passes through the following stages before becoming a sick
unit:
1. Healthy stage: This is a stage when a unit's all functional areas viz.,
production, marketing, finance, personnel, are working efficiently. The unit is
making profit, its debt equity ratio is satisfactory, its net worth is positive and the
current ratio is more than 1.
2. Tilt towards sickness: The unit is said to have a tilt towards sickness when
its profit starts declining and losses are projected in the years to come.
3. Incipient sickness: This is a stage when the unit has incurred a cash loss in
the previous year and expected to suffer a cash loss in the current year also. Its
current ratio and debt equity ratio will deteriorate.
4. Sickness: This is a stage when all functional areas of the unit become
inefficient. The unit has completely lost its net worth.
22.3.3 Rehabilitation of Sick Unit
The rehabilitation of a sick unit is undertaken in those cases where the
concerned banks/financial institutions are of the opinion that the unit is viable.
According to the decision taken on September 15, 1980 by the Standing Coordination
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Committee, “a unit can be considered as viable, if it is in a position to service its

debts in about 8 to 10 years.”
In case a unit is found to be viable, a nursing programme for rehabilitating the
sick unit is drawn up by the concerned institutions. While drawing the nursing
programme, the problems of the sick unit are identified and taken care of in the
programme.
22.3.4 Problems in Rehabilitation of Sick Units
The rehabilitation of a sick unit is not an easy task. A number of problems
crop up when such task is undertaken. Some of the problems are as follows:
(i) Sometimes the cash losses continue. This results in an increased burden on
the company's financial resources. There are, more irregularities on part of the
company in payments to its creditors, banks, etc.
(ii) Mere nursing may not revive a sick unit, in case the unit does not have an
efficient and competent management.. In most cases, the officers handling the
rehabilitation process lack the basic skill in dealing with the sick unit. The financial
institutions rarely use the “convertibility clause” in their loan agreements for getting
rid of inefficient management.
(iii) In case of consortium advances, it has been often found that institutions;
adopt conflicting approaches. For example, the bank may agree to finance the
working capital requirement of the sick unit but term 'tending institution may
refuse to grant or postpone the release of the term loan, when required. Moreover, it
has also, been noticed that the decisions taken in the consortium meeting are
either not faithfully implemented or inordinately delayed.
(iv) A unit may become sick not only because of financial difficulties but also
on account of inadequate supply of raw materials or non-availability of marketing
facilities. Usually the banks/financial institutions are in a position to arrange for
the finance but are not in a position to provide other facilities.
22.3.5 Nursing Programme for Sick Unit
The formulation and implementation of a nursing programme can be studied
under the following three heads:
i) Basic factors to be kept in mind while preparing a nursing programme.
ii) Steps to be taken for preparing a nursing programme,
iii) Guidelines for monitoring a nursing programme.
Basic factors
The following are the basic factors which must be kept in mind while preparing
a nursing programme:
i) No margin for errors: There is no margin for errors in decision-making on the
part of the bank or on the part of the borrower as these margins have been
exhausted. All decisions, therefore, have to be well calculated and supported by a
sound basis,
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ii) Considerable debt burden: A sick unit usually has a considerable debt
burden which hangs like a milestone round its neck. Because of this, the break-
even point would have gone up. To undertake a nursing programme in such
circumstances would require the unit to operate at higher levels than before so that
a surplus is generated.
iii) Additional finance: A nursing programme, which involves operating at a
higher level of activity, will require additional input of finance and, in most eases,
the source of finance will be the bank, as the borrower’s resources would have been
exhausted. However, the input of additional funds must be adequate to achieve the
increased level of activity. Moreover, steps must betaken to monitor the use of these
funds and the results obtained.
iv) Gradual liquidation of irregularity: The irregularity in the account can be
liquidated only gradually out of the internal generation of surplus. The repayment
programme, therefore, has to be carefully worked out; enough funds should be
available in the business to operate at the desired level, with a view to ensuring
continued internal generation of surplus. This process would be helped if penal
interest rate is not levied and, where possible, recovery of interest is rescheduled,
v) No delay: A nursing programme can bear no delay. The longer a decision
takes, the greater becomes the magnitude of the problem.
22.3.6 Steps to be taken
The object of a nursing programme is to improve the capability of the unit to
generate internal surplus. In view of the adverse factors affecting a sick unit, a
systematic approach is necessary to achieve this objective. Following are the
important steps to be taken for preparing an effective nursing programme for
rehabilitating a sick unit.
(i) Analysis of the past operations: Such an analysis is necessary to identify
unit's strengths and weaknesses. It is more important to identify all weaknesses.
(ii) Determination of a viable level of operations: This is the level which will
generate a reasonable internal surplus. The new breakeven point must be
determined and this level must be substantially higher than the previous break-
even point.
(iii) Investigation of the feasibility of operating at this level within the prevailing
business environment. For this purpose the following points will need to be studied
carefully:
i) Is the plant capable of operating at this level on a continuing basis?
ii) Can the market absorb this output?
iii) Is the prevailing price level remunerative?
iv) Are any changes required in the method of selling or distribution to handle
the increased quantity?
v) Are the necessary raw materials available to support this level of activity?
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vi) Can the present organisation cope with the increased level of activity? If not,
in what manner does it need to be strengthened?
vii) Is the borrower prepared to submit himself to the financial discipline
required for this exercise?
viii) Are there other constraints such as power, transport, space„ etc.?
(iv) Determination of the magnitude of the working funds require to initiate
and maintain the operation at this level. In estimating this, norms for the particular
industry for inventory, processing cycle times, credit terms, etc. will have to be
taken into account.
(v) Determination of the sources of funds. The following are typical sources:
a) Further capital contribution from the borrower or his friends.
b) Disposal of excess stocks or assets.
c) Rapid collection of outstanding bills.
d) Internal generation.
e) Enhancement, readjustment of limits or rescheduling interest payments
and/or term loan instalments.
(vi) Drawing up an action plan which will effectively overcome the weaknesses
and capitalized on the strengths. Each weakness identified must have a
corresponding action to overcome it. The plan must indicate in detail the results
that can be expected over a period of time. It must also indicate the phased
liquidation of the bank's outstandings.
(vii) Identifying the key performance indicators for close monitoring. The
monitoring system should pay particular attention to the areas of weaknesses
which brought about the initial sickness.
22.3.7 Guidelines for Monitoring a Nursing Programme
The details of the monitoring system for each unit will depend on the nature of
the industrial activity and the sophistication of the manufacturing process. The
following, however, will serve as a general guide for this purpose:
i) Management information system: Such a system should be set up
immediately. Without this system, neither the borrower nor the bank will be able to
assess the progress of the nursing programme.
ii) End-use of additional funds: Since the nursing programme usually involves
outlays of additional funds, it is necessary to ensure that these funds are properly
used for the purpose intended.
iii) Monitoring areas of weakness: The action plan would have indicated the
areas of weakness and the strategy for overcoming them. It is necessary that this
aspect is given particular attention, as otherwise the success of the nursing effort
will remain in doubt.
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iv) Monitoring meeting: There must be monthly meetings between the borrower
and the bank to assess the progress of implementation. Where a Management
Consultant is associated with the nursing programme, he should preferably be
present at monthly meetings.
The objective of these monthly meetings is to review the progress achieved. If
any adverse variances are observed, suitable corrective actions could be taken up
for review at these meetings in respect of the following:
a) Production and sales,
b) Profitability and internal surplus,
c) Working capital management (e.g. collections, inventory,-creditors etc.),
and
d) Position of Bank borrowings.
Use of Management Consultant, in Nursing Programme
Management of finance is an area of weakness in many small-scale units. The
sickness of the unit Is directly attributable to lack of proper management in these
cases. The nursing programme must, therefore, ensure that this weakness is
rectified. In other words, apart from the additional financial input, where necessary,
the nursing programme must also ensure the requisite input of management
expertise.
Concluding a Nursing Programme
By its very nature,: a nursing programme is only of a short duration. The,
success of a nursing programme le., capacity to generate internal surplus^ should
be evident within the estimated period. When this, situation established, it would
be desirable to end the close monitoring procedure adopted during the nursing
programme and apply the normal follow-up procedure recommended.
22.3.8 Government of India and the Sick Units
The Government of India in collaboration with the Reserve Bank of India, has
taken a number of steps for rehabilitation of sick units. These step are as follows:
1. Setting up of Sick Industrial Undertakings Cell: A Sick Industrial Undertaking
Cell has been set up in the Reserve Bank of India to functions as a clearing house
for information relating to sick units and also to as a coordinating agency as
between the Government, banks, finance institutions and other agencies for
tackling the various related issue This cell has been closely monitoring the banks
performance in indentifying sick units and taking remedial action. With a view to
checking industrial sickness, the cell has issued suitable instructions to the banks
in matter.
2. Setting up of Coordination Committees: The committees have been set up at
all the Regional Offices of the Department of Banking Operations and Development
of Reserve Bank of India for the purpose of ensuring better coordination between
the banks, Central and State Level financial institutions, the State Government and
other organisations involved in promoting industrial growth.
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3. Setting up of Standing Coordination Committee: A Standing Coordination

Committee has been constituted by the Reserve Bank of India under the
chairmanship of its Deputy Governor to consider issues relating to coordination
between commercial banks and term-lending institutions on an 'on-going' basis.
4. Setting up of Special Cell in IDBI: A special cell has been set up within the
Rehabilitation Finance Division of IDBI for attending to references received from
banks in respect of units being sick or in problem.
5. Setting-up of a Screening Committee: In order to coordinate, Government
action in respect of cases of sick units, a Screening Committee has been
constituted under the Chairmanship of the Secretary, Department of Industrial
Development; Secretary, Department of Company Affairs
6. Submission of quarterly progress reports by commercial banks: All scheduled
commercial banks are required to submit to the Reserve Bank of India quarterly
progress reports giving separate information on all sick units with separate date on
sick units in the small-scale industries sector.
7. Setting up of Board of Industrial and Financial Reconstruction (BIFR): With
the objective of detecting incipient sickness of industrial units and rehabilitating
viable sick units, the government has passed the Sick Industrial Companies
(Special Provisions) Act, 1985, which provides for the establishment of a board for
industrial and financial reconstruction.
8. Setting up Industrial Investment Bank of India Ltd: The Industrial Investment
Bank of India Ltd. (IIBI) was set up on March 27, 1997 to takeover, the business of
Industrial Reconstruction Bank of India (IRBI), set up in 1984. IRBI was essentially
required to function as a principal reconstruction agency for industrial revival
22.3.9 RBI Guidelines in Respect OP Sick SSI Units
The small industries play a significant role in the country's economy.
According to the revised guidelines issued by RBI on March 1, 2005 for
rehabilitation of sick SSI units (based on Kohli Working Group Recommendations) a
small scale unit is considered as sick when any of the borrowal accounts of the unit
remains substandard for more than 6 months or there is erosion in the net worth
due to accumulated cash losses to the extent of 50% of its net worth during the
previous accounting year and the unit has been in commercial production for at
least two years. The revised criteria will enable banks to detect sickness at an early
stage and facilitate corrective action for revival of the unit.
The following are the basic features in respect of rehabilitation of sick small
scale units:
1. Time frame for Implementation of Rehabilitation Package
As per the revised guidelines the rehabilitation package should be fully
implemented within six months from the date the unit is declared as potentially
viable/viable.
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2. Parameters for Relief

Following are broad parameters for grant of relief and concessions for revival of
potentially viable sick SSI units:

(i) Interest on Working Capital Interest 1.5% below the prevailing

fixed/prime lending rate, wherever
applicable.
(ii) Funded Interest Term Loan Interest Free.
(iii) Working Capital Term Loan Interest to be charged 1.5% below the
prevailing fixed/prime lending rate,
wherever applicable.
(iv) Term Loan Concessions in the interest to be
given not more than 2% (not more
than 3% in the case of tiny/
decentralised sector units) below the
document rate.
(v) Contingency Loan Assistance The Concessional rate allowed for
Working Capital Assistance.
3. State Level Inter-Institutional Committee
In order to deal with the problems of co-ordination for rehabilitation of sick
small scale units, State Level Inter-Institutional Committees (SLIICs) have been set
up in all the States.
4. Technology Upgradation
Banks have been advised to develop schemes to encourage investment by SSI
units in technology upgradation. Government of India has also introduced the
scheme of Credit Linked Capital Subsidy for the upgradation of the Small Scale
Industries!)
5. Cluster Approach
60 clusters have been identified by the Ministry of SSI, Government of India
for focused development of SSIs. All SLBC Convener banks have been advised to
incorporate in their Annual Credit Plans, the credit requirement in the clusters
identified by the Ministry of SSI, Government of India.
22.3.10 Recommendations of Working Group on Rehabilitation of Sick SMEs
A working group was constituted by Reserve Bank of India with
Dr. K.C. Chakrabarty as Chairman, to suggest measures for improving the Credit
flow to the SME2 sector. The Group submitted its report in April 2008. The major
recommendations of the group are as under:
(i) A simplified application cum sanction form (printed in the regional language
as well) should be introduced for sanction of loans up to Rs. 1 crore to all micro
enterprises,
(ii) A current ratio of 1.25 should be acceptable in the accounts where bank
finance was provided under the Nayak Committee norms,
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(iii) The rate of interest on loans should be completely deregulated and should
be determined by the lenders based on the competitive market forces.
(iv) Banks that had sanctioned term loan singly or jointly must also sanction
working capital limit singly (or jointly, in the ratio of the term loan) to avoid delay in
commencement of commercial production of the MSME.
(v) Banks could focus on opening more specialised MSME branches, while
RRBs and co-operative banks could be asked to undertake more MSME financing.
(vi) A Rehabilitation Fund, with a corpus of Rs. 1,000 crore, should be created
as many sick units could not be rehabilitated due to non-availability of promoters'
contribution,
(vii) A Marketing Development Fund to provide, inter alia, financial assistance
to MSMEs in setting up distribution and marketing infrastructure/outlets should
be set up.
(viii) Banks should finance, on an average, at least 10 MSME accounts per
semi-urban/urban branches per year.
(ix) State Governments should have separate department for MSMEs as also
short and long term policies for development/promotion of the MSME sector.
(x) Banks should set up credit counselling centres (whether singly or jointly
with other banks or with large corporates) exclusively for MSMEs in major
industrial towns/clusters.
(xi) A micro or small enterprise (as defined-in the MSMED Act, 2006) could be
defined as sick, if any of the borrowal account of the enterprise remained a non-
performing asset (NPA) for three months or more, or, accumulated losses led to a 50
per cent erosion of its net worth.
22.4 REVISION POINTS
• Sick Industrial Company: An industrial company which has (a) accumulated
losses in any financial year equal to 50% or more of its average net worth during
four years immediately preceding such financial year or (b) failed to repay its debt
within any three consecutive quarters on demand made in writing for its repayment
by a creditor or creditors pf such company.
• Weak Unit: A unit which has at the end of any accounting year: (a) accumulated
losses equal to or exceeding 50% of its peak net worth for the immediately preceding
four accounting years; (b) a current ratio of less than 1:1; and (c) suffered a cash loss
in the immediately preceding accounting year.
22.5 INTEXT QUESTIONS
1. Define a sick unit.
2. What is industrial Sickness?
3. What do you Mean by weak Unit?
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22.6 SUMMARY
According to RBI, an Industrial unit is sick, it has incurred cash loss for one
year and in the judgement of the bank, it is likely to continue to incur loss in two
following years and it has imbalance in its financial structure such as current ratio
being less than 1:1 and worsening debt equity ratio. Industrial sickness does not
occur suddenly. The causes of sickness can be classified onto two categories.
External causes and internal causes. The government India is collaboration with
RBI has taken a number of steps for rehabilitation of sick units.
22.7 TERMINAL EXERCISE
1. The term ……………………………. in banking means the unsatisfactory
working of industrial units resulting in non-payment of bank dues.
2. ……………………………….as one whose accounts were chronically irregular
and required a study to evolve a nursing programme and a close follow-up.
22.8 SUPPLEMENTARY MATERIAL
1. https://www.scribd.com
2. http://siva8622kalvi.blogspot.in/
3. http://etabu.com/
4. http://docslide.us/
5. http://www.authorstream.com/
22.9 ASSIGNMENTS
1. Define a 'sick unit'. Suggest the steps that you will take for preparing and
implementing a nursing programme for rehabilitation of a sick unit.
2. What is industrial sickness? What are the problems faced by the
commercial banks and financial institutions in rehabilitating sick units financed by
them?
3. Under what circumstances an industrial unit financed by bank is classified
as sick unit? What controls would you suggest under nursing programme adopted
for this unit?
4. What is a nursing programme? What should the financing bank do before
adopting nursing programme for any industrial unit?
5. Discuss the norms prescribed by the Reserve Bank of India to determine
industrial sickness and mention the important steps to be taken to make a sick
unit viable.
6. Mention briefly the symptoms of incipient industrial sickness.
7. What are the causes of industrial sickness?
8. State the main recommendations of the working group on rehabilitation of
sick SMEs.
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22.10 SUGGESTED READINGS

Vasanti Desui, Small scale Industries and Entrepreneurship, Himalaya
Publishing House, Mumbai (2006).
Gordon, Natarajan, Entrepreneurship Development, Himalaya Publishing House,
Mumbai (2008).
22.11 LEARNING ACTIVITIES
What are the reasons for industrial sickness? Discuss the steps that should be
taken to turn around a sick company.
22.12 KEYWORDS
Industrial Sickness, Sick Industrial Unit, Weak Unit, Cluster Approach.

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LESSON – 23

ECONOMIC VALUE ADDED

23.1 INTRODUCTION
Economic Value Added (EVA) is the financial performance measure that comes
closer than any other to capturing the true economic profit of an enterprise. Thus,
in modern economics and finance area, EVA holds an important part that has less
debate among practitioners. It is the performance measure most directly linked to
the creation of shareholders wealth over time. Shareholders are very much choosy
for their interest into the business and they like management to come up with very
specific solution. By the time, it is established that the very logic of using EVA is to
maximize the value for the shareholders. More explicitly, EVA measure gives
importance on how much economic value is added for the shareholders by the
management for which they have been entrusted with. EVA is exceptional from
other traditional tools in the sense that all other tools mostly depend on
information generated by accounting. And we know, accounting, more often
produces historical data or distorted data that may have no relation with the real
status of the company. But, EVA goes for adjustments to accounting data to make
it economically viable.
Under conventional accounting, most companies appear profitable but many
in fact are not. As Peter Drucker put the matter in a Harvard Business Review
article, "Until a business returns a profit that is greater than its cost of capital, it
operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The
enterprise still returns less to the economy than it devours in resources…until then
it does not create wealth; it destroys it." Company may intentionally pay tax to
prove that they have made profit for their shareholders and thus a falsification is
done with owners that is not a rare corporate practice. EVA corrects this error by
explicitly recognizing that when managers employ capital they must pay for it, as if
it were a wage. It also adjusts all distortions that are very much prevalent in the
information generated by conventional accounting. Thus, it is the most demanded
tool for the owners in every situation. It has been implemented in numerous large
companies to motivate managers to create shareholder value (Dodd and Chen,
1996). The decision role is very simple; if the EVA is positive, the company creates
shareholder wealth. Negative EVA indicates that shareholder wealth is destroyed
(Stewart, 1991). De facto, EVA is the same as residual income (RI) that has been in
existence for several decades. The only significant difference between the two lies in
the handling of accounting distortions (Dodd and Chen, 1997). EVA removes
existing distortions by using up to 164 adjustments to traditional accounting data
(Stewart, 1991; Blair, 1997). These distortions are disregarded in the RI calculation.
In this paper, an earnest effort has made to introduce EVA as a value based
performance measurement tool.
23.2 OBJECTIVES
After completing this lesson you must be able to
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 Explain the meaning and evolution of EVA

 Discuss the features of EVA
 Analyze EVA as a management tool
 Describe the 4Ms of EVA
 List steps in EVA computation
 Highlight the adjustments to be made while calculation EVA
 State the advantages and disadvantages of EVA
23.3 CONTENT
23.3.1 Historical background of EVA
23.3.2 Features of EVA
23.3.3 EVA as a Management tool
23.3.4 4Ms of EVA
23.3.5 Steps in EVA computation
23.3.6 EVA Calculation and Adjustments
23.3.7 Advantages of EVA
23.3.8 Limitations of EVA
23.3.1 Historical background
EVA is not a new discovery. An accounting performance measure called
residual income is defined to be operating profit subtracted with capital charge.
EVA is thus one variation of residual income with adjustments to how one
calculates income and capital. According to Wallace (1997, p.1) one of the earliest
to mention the residual income concept was Alfred Marshall in 1890. Marshall
defined economic profit as total net gains less the interest on invested capital at the
current rate. According to Dodd & Chen (1996, p. 27) the idea of residual income
appeared first in accounting theory literature early in this century by e.g. Church in
1917 and by Scovell in 1924 and appeared in management accounting literature in
the 1960s. Also Finnish academics and financial press discussed the concept as
early as in the 1970s. It was defined as a good way to complement ROI-control
(Virtanen, 1975, p.111). In the 1970s or earlier residual income did not got wide
publicity and it did not end up to be the prime performance measure in great deal
of companies. However EVA, practically the same concept with a different name,
has done it in the recent years. Furthermore the spreading of EVA and other
residual income measures does not look to be on a weakening trend. Onthe
contrary the number of companies adopting EVA is increasing rapidly. We can only
guess why residual income did never gain a popularity of this scale. One of the
possible reasons is that Economic value added (EVA) was marketed with a concept
of Market value added (MVA) and it did offer a theoretically sound link to market
valuations. The origins of the value added concepts date all the way back to the
early 1900's. Stern Stewart & Co trademarks EVA in 1990’s when the tool is
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introduced and subsequently adopted by several major corporations that lead EVA
to have successful stories at the very beginning. Mainly professional literature
mostly aimed at presenting, promoting or discussing the EVA concepts in relation
to consulting work. While most of this, partly anecdotal, literature looks at the
advantages of the concept with a few critical views also. Subsequent sources are too
numerous for an extensive listing, but for instance there is material such as
Milunovich & Tsuei (1996), Anctil, Jordan & Mukherji (1998), Damodaran (1999),
Mouritsen (1998), Bowen & Wallace (1999), and Dodd & Johns (1999). Therealso is
much WWW based material such as Mäkelä (1998), Weissenrieder (1999), and
Stern Stewart & Co. (2000).Empirical research literature measuring the strength of
the relation between market returns (or market value) and EVAcompared to the
relation between market returns and the traditional income measures. O'Byrne
(1996, p.125) concludes, "EVA, unlike NOPAT [net operating profit after taxes] or
other earnings measures like net income or earnings per share, is systematically
linked to market value. It should provide a better predictor of market value than
other measures of operating performance." Besides the theoretical discussion,
understanding is needed about the numerical behavior of the EVA under different
conditions and about EVA's numerical relationship to the accounting measures like
Return on Investments (ROI), Return on Equity (ROE) and to economic profitability
measures like the Internal Rate of Return (IRR).
23.3.2 Important Features of EVA
 It acts as performance measure which is linked to share holder value
creation in all directions.
 It is useful in providing business knowledge to everyone.
 It is an efficient method for communicating to investors.
 It transforms the accounting information into economic quality which can be
easily understood by non financial managers.
 It is useful in evaluating Net Present Value(NPV) of projects in capital
budgeting which is contradictory to IRR.
 Instead of writing the value of firm in terms of discounted cash flow, it can
be expressed in terms of EVA of projects.
23.3.3 EVA as a Management Tool
EVA is superior to accounting profits as a measure of value creation because it
recognizes the cost of capital and, hence, the riskiness of a firm’s operations (Lehn
& Makhija, 1996, p.34). It is used as a value based performance measure tool more
widely. In this context, EVA is compared with some traditional measures and with
some other value based measures as well.
EVA vs. Traditional Measures
EVA is based on the common accounting based items like interest bearing
debt, equity capital and net operating profit. It differs from the traditional measures
mainly by including the cost of equity. Salomon and Laya (1967) studied the
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accounting rate of return (ARR) and the extent to which it approximates the true
return measured with IRR. Harcourt (1965), Solomon and Laya (1967), Livingston
and Solomon (1970), Fischer and McGowan (1983) and Fisher (1984) concluded
that the difference between accounting rate of return (ARR) and the true rate of
return is so large that the former cannot be used as an indication of the later.
Among all traditional measures, return on capital is very common and
relatively good performance measure. Different companies calculate this return
with different formulas and call it also with different names like return on
investment (ROI), return on invested capital (ROIC), return on capital employed
(ROCE), return on net assets (RONA), return on assets (ROA) etc. The main
shortcoming with all these rates of return is in all cases that maximizing rate of
return does not necessarily maximize the return for shareholders. Observing rate of
return and making decisions based on it alone is similar to assessing products on
the "gross margin on sales" -percentage. The product with the highest "gross
margin on sales" percentage is not necessary the most profitable product. The
difference between EVA and ROI is actually exactly the same as with NPV (Net
present value) and IRR (Internal rate of return). IRR is a good way to assess
investment possibilities, but we ought not to prefer one investment project to the
other on the basis of IRR only.
Mathematically EVA gives exactly the same results in valuations as Discounted
Cash Flow (DCF) or Net Present Value (NPV) (Stewart, 1990, p. 3; Kappi, 1996),
which are long since widely acknowledged as theoretically best analysis tools from
the stockholders’ perspective (Brealey & Mayers, 1991, pp. 73-75). In the corporate
control, it is worth remembering that EVA and NPV go hand in hand as also ROI
and IRR. The formers tell us the impacts to shareholders wealth and the latters tell
us the rate of return. There is no reason to abandon ROI and IRR. They are very
good and illustrative measures that tell us about the rate of returns. IRR can
always be used along with NPV in investment calculations and ROI can always be
used along with EVA in company performance. However, we should never aim to
maximize IRR and ROI and we should never base decisions on these two metrics.
IRR and ROI provide us additional information, although all decisions could be done
without them. Maximizing rate of returns (IRR, ROI) does not matter, when the goal
is to maximize the returns to shareholders. EVA and NPV should be in the
commanding role in corporate control and ROI & IRR should have the role of giving
additional information.
EVA vs. Other Value-based Measures
EVA is not the only value-based measure rather we have a good number of
tools that are also used for the same. Some are developed by consulting industries
and others are by academics. Consultants like to use their particular acronym to
establish it as their personal brand though it would not differ very much of the
competitors’ measures. Thus the range of these different acronyms is wide. Some of
such measures are mentioned here in a tabular format so that readers can grasp
them easily.
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23.3.4 4 Ms of EVA
As a mnemonic device, Stern Stewart describes four main applications of EVA
with four words beginning with the letter M.
Measurement
EVA is the most accurate measure of corporate performance over any given
period. Fortune magazine has called it "today's hottest financial idea," and Peter
Drucker rightly observed in the Harvard Business Review that EVA is a measure of
"total factor productivity" whose growing popularity reflects the new demands of the
information age.
Management System
While simply measuring EVA can give companies a better focus on how they
are performing, its true value comes in using it as the foundation for a
comprehensive financial management system that encompasses all the policies,
procedures, methods and measures that guide operations and strategy. The EVA
system covers the full range of managerial decisions, including strategic planning,
allocating capital, pricing acquisitions or divestitures, setting annual goals-even
day-to-day operating decisions. In all cases, the goal of increasing EVA is
paramount.
Motivation
To instill both the sense of urgency and the long-term perspective of an owner,
Stern Stewart designs cash bonus plans that cause managers to think like and act
like owners because they are paid like owners. Indeed, basing incentive
compensation on improvements in EVA is the source of the greatest power in the
EVA system. Under an EVA bonus plan, the only way managers can make more
money for themselves is by creating even greater value for shareholders. This
makes it possible to have bonus plans with no upside limits. In fact, under EVA the
greater the bonus for managers, the happier shareholders will be.
Mindset
When implemented in its totality, the EVA financial management and incentive
compensation system transforms a corporate culture. By putting all financial and
operating functions on the same basis, the EVA system effectively provides a
common language for employees across all corporate functions. EVA facilitates
communication and cooperation among divisions and departments, it links
strategic planning with the operating divisions, and it eliminates much of the
mistrust that typically exists between operations and finance. The EVA framework
is, in effect, a system of internal corporate governance that automatically guides all
managers and employees and propels them to work for the best interests of the
owners. The EVA system also facilitates decentralized decision making because it
holds managers responsible for-and rewards them for-delivering value.
23.3.5 Steps in EVA Computation
EVA computation requires some basis steps. The common steps are
exemplified here that may be modified due to the typical nature of business or
processes where it has been used.
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Step 1: Collect and Review Financial Statements

EVA is based on the financial data produced by traditional accounting system.
Most of the data come from either income statement or balance sheet both of which
are available from general-purpose financial statements.
Step 2: Identify the distortions and adjustments required to make it distortion
free
Stern Stewart has identified around 164 potential adjustments to GAAP and to
internal accounting treatments, all of which can improve the measure of operating
profits and capital. As financial statements are mandatorily prepared under GAAP,
distortions will be there and identification of distortions is an art that requires a
sound understanding of EVA technicalities to identify and to adjust them as well.
Now the question comes, to what extent it can be adjusted.
Step 3: Identify the company’s capital structure (CS)
A company’s capital structure (CS) comprises all of the money invested in the
company either by the owner or by borrowing from outsiders formally. It is the
proportions of debt instruments and preferred and common stock on a company’s
balance sheet (Van Horne, 2002). Stewart (1990) defined capital to be total assets
subtracted with non-interest bearing liabilities in the beginning of the period.
However, it can be computed under anyone of the following methods:
Direct Method: By adding all interest bearing debts (both short and long term)
to owner’s equity.
Indirect Method: By subtracting all non-interest bearing liabilities from total
liabilities (or total assets).
Step 4: Determine the company’s weighted average cost of capital (WACC)
Estimation of cost of capital is a great challenge so far as EVA calculation for a
company is concerned. The cost of capital depends primarily on the use of the
funds, not the source (Ross et. al., 2003). It depends on so many other factors like
financial structures, business risks, current interest level, investors expectation,
macro economic variables, volatility of incomes and so on. It is the minimum
acceptable rate of return on new investment made by the firm from the viewpoint of
creditors and investors in the firms’ securities (Schall & Haley, 1980). Some
financial management is available in this case to calculate the cost of capital. A
more common and simple method is Weighted Average Cost of Capital (WACC)
(Copeland et. al., 1996).
For calculating WACC, we have to know a lot of other issues like
1. Components of capital employed like equity, debt etc;
2. Respective weight of various components into total amount of capital
employed;
3. Factors that affect the risk and return of various components in a capital
structure;
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4. Standalone cost of all such components in a capital structure.

The overall cost of capital is the weighted average of the costs of the various
components of the capital structure. The cost of each component of the firm’s
capital – debt, preferred stock, or common stock equity – is the return that
investors must forgo if they are to invest in the firm’s securities (Kolb & DeMong,
1988). The Capital Asset Pricing Model (CAPM) is a common method in estimating
the cost of equity (Copeland et. al., 1996).
Step 5: Calculate the company’s Net Operating Profit after Tax (NOPAT)
NOPAT is a measure of a company’s cash generation capability from recurring
business activities and disregarding its capital structure (Dierks and Patel, 1997).
NOPAT is derived from NOP simply by subtracting calculated taxes from NOP
[NOPAT = NOP � (1 – Tc)]. But adjustments should be made to the accounting profit
to convert it into economic profit.
NOPAT � Net operating profit - {(Net operating profit +excess depreciation
+other increase reserves X tax rate)
Step 6: Calculation of Economic Value Added
Finally, the EVA can be calculated by subtracting capital charges from NOPAT
EVA � NOPAT � Capital Employed � WACC .......... .......... .......... ..........
.......... If the EVA is positive, the company created value for its owner. If the EVA is
negative, owner’s wealth gets reduced.
23.3.6 EVA Calculation and Adjustments
As stated above, EVA is measured as NOPAT less a firm's cost of capital.
NOPAT is obtained by adding interest expense after tax back to net income after-
taxes, because interest is considered a capital charge for EVA. Interest expense will
be included as part of capital charges in the after-tax cost of debt calculation.
Other items that may require adjustment depend on company-specific
activities. For example, when operating leases rather than financing leases are
employed, interest expense is not recorded on the income statement, nor is a
liability for future lease payments recognized on the balance sheet. Thus, while
interest is implicit in the yearly lease payments, an attempt is not made to
distinguish it as a financing activity under GAAP.
Under EVA, however, the interest portion of the payment is estimated and the
after-tax amount from it is added back into NOPAT because the interest amount is
considered a capital charge rather than an operating expense. The corresponding
present value of future lease payments represents equity equivalents for purposes
of capital employed by the firm, and an adjustment for capital is also required.
If a company wants to adopt the EVA philosophy it must be able to measure
EVA down through the organization. Although this seems obvious, it is something
that Stern Stewart does not dwell on. Young and O’Byrne (op. cit.) suggest that
units or divisions could be grouped together to measure EVA when there are
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difficulties in obtaining a finer measurement. However, they note that there are
potential drawbacks to this solution, including the addition of another layer of
management and the free-rider problem. Corporate structure is another important
factor in the feasibility of the measure of EVA. If the firm reorganizes frequently,
there is no history for the calculation and monitoring of EVA growth over time.
What happens to any positive or negative EVA? Does it follow the manager since
there is no longer a unit in which it can reside?
Factors to consider
There must be agreement as to:
 The adjustments to GAAP to obtain the EVA figure;
 The cost of capital;
 Jointness over revenues, costs, assets and liabilities;
 Allocated costs; and
Appropriate value drivers for each unit or sub-unit.
Adjustments
Measurement can have an impact on managerial behaviour and affect the way
business is conducted. For these reasons, Stern Stewart recommends adjusting
conventional GAAP figures to remove ‘distortions’ that they create. It says that more
than 160 adjustments can be made to the financial accounting numbers although
that, in reality, only around 20 adjustments will be made for a particular firm.
Adjustments must be consistently applied further down through the
organization if EVA is to be calculated at lower levels. However, as soon as you start
making adjustments to accounting numbers and there is discretion over the nature
of those adjustments, the measure is no longer objective. It would be easy to lose
confidence in the measure if individuals within the firm couldn’t see how it was
calculated or where the adjustments came from.
The cost of capital
The cost of capital should be calculated as a weighted average cost of debt and
equity, with the cost of equity derived from a model such as the capital asset
pricing model.
For EVA measurement there are two issues:
 Should the cost of capital be time varying?
 Should the cost of capital vary across business units to take account of
possible differences in risk (and leverage)?
A general rise in interest rates or the market means a rise in the cost of
capital. With rewards based on EVA, this potentially affects managerial
compensation. One way to avoid this problem is to use a constant cost of capital
over time. The estimate could be a company-wide cost of capital. However, this may
not adequately reflect the risk of business units or the projects in which they
invest. The cost of capital may be regarded as subjective if it is believed that risk is
 367

not adequately reflected. However, if the cost of capital varies across business
units, it may create tensions within the firm.
Jointness over revenues and costs, assets and liabilities
Jointness over costs and revenues will inevitably arise in a decentralised
organisation, particularly a network business. Shared revenues include, for
example, revenue from bundling goods or services that go across business units.
Similarly, costs may also be bundled, for example, advertising. Unless these costs
and benefits can be broken down and priced separately for all units of the
company, a satisfactory means of allocating these costs and benefits has to be
devised. Any allocation will inevitably involve judgement, leading to subjectivity in
the measure. Capital must be allocated to business units in order to measure
business unit EVA. While this may be a simple enough exercise when units
maintain essentially separate assets, it can become more difficult when there is
jointness, for example, if products map to multiple assets in multiple business
units or assets map to multiple products. Shared assets and liabilities will
inevitably be the case down the hierarchy, particularly for network businesses.
Allocated costs
There is a standard problem of allocating costs and deciding on the
appropriate measure of performance. Should managers’ performance be measured
before or after the allocation of such costs? There are arguments on both sides but
the important point is that it is difficult to see how EVA can resolve this problem.
Value drivers
Value drivers for performance measurement are important, particularly as we
move down through the organisation since this is where the secondary objectives
lie. There must be agreement for each unit or sub-unit over:
 The appropriate value drivers;
 The key number of drivers on which to focus; and
 How often the value drivers will be reviewed
The use of value drivers is a dynamic process, with the possibility of all of the
above factors changing between reporting periods.
Other items that may require adjustment depend on company-specific
activities. For example, when operating leases rather than financing leases are
employed, interest expense is not recorded on the income statement, nor is a
liability for future lease payments recognized on the balance sheet. Thus, while
interest is implicit in the yearly lease payments, an attempt is not made to
distinguish it as a financing activity under GAAP.
Under EVA, however, the interest portion of the payment is estimated and the
after-tax amount from it is added back into NOPAT because the interest amount is
considered a capital charge rather than an operating expense. The corresponding
present value of future lease payments represents equity equivalents for purposes
of capital employed by the firm, and an adjustment for capital is also required.
 368

R & D expense items call for careful evaluation and adjustment. While GAAP
generally requires most R & D expenditures to be expensed immediately, EVA
capitalizes successful R & D efforts and amortizes the amount over the period
benefiting the successful R & D effort.
Other adjustments recommended by Stern Stewart include the amortization of
goodwill. The annual amortization is added back for earnings measurement, while
the accumulated amount of amortization is added back to equity equivalents.
Goodwill amortization is handled in this manner because by "unamortizing"
goodwill, the rate of return reflects the true cash-on-yield. In addition, the decision
to include the accumulated goodwill in capital improves the real cost of acquiring
another firm's assets regardless of the manner in which the acquisition is
accounted.
While the above adjustments are common in EVA calculations, according to
Stern Stewart, those items to be considered for adjustment should be based on the
following criteria:
 Materiality: Adjustments should make a material difference in EVA.
 Manageability: Adjustments should impact future decisions.
 Definitiveness: Adjustments should be definitive and objectively determined.
 Simplicity: Adjustments should not be too complex.
If an item meets all four of the criteria, it should be considered for adjustment.
For example, the impact on EVA is usually minimal for firms having small amounts
of operating leases. Under these conditions, it would be reasonable to ignore this
item in the calculation of EVA. Furthermore, adjustments for items such as
deferred taxes and various types of reserves (i.e. warranty expense, etc.) would be
typical in the calculation of EVA, although the materiality for these items should be
considered. Unusual gains or losses should also be examined and eliminated if
appropriate. This last item is particularly important as it relates to EVA-based
compensation plans.
How Companies Have Used EVA
Name Timeframe Use of EVA
The Coca-Cola Co. Early 1980s Focused business managers on increasing
shareholder value
AT&T Corp. 1994 Used EVA as the lead indicator of a
performance measurement system that
included "people value added" and "customer
value added"
IBM 1999 Conducted a study with Stern Stewart that
indicated that outsourcing IT often led to
short-term increases in EVA
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Herman Miller Inc. Late 1990s Tied EVA measure to senior managers' bonus
and compensation system
23.3.7 Advantages of EVA
1. It helps the company in monitoring the problem areas and hence taking
corrective action to resolve those problems.
2. It can also improve the corporate governance of the company because since
a higher EVA implies higher bonuses to the managers they will be working hard
and also honestly which in turn augurs well for the company.
3. Unlike accounting profit, such as EBIT, Net Income and EPS, EVA is
Economic and is based on the idea that a business must cover both the operating
costs as well as the capital costs and hence it presents a better and true picture of
the company to the owners, creditors, employees, shareholders and all other
interested parties.
4. It also helps the owners of the company to identify the best person to run
the company effectively and efficiently.
5. Using EVA company can evaluate the projects independently and hence
decide on whether to execute the project or not
22.3.8 Limitations of EVA
EVA has a lot of advantages though it is not free of limitations. Some of the
limitations are pointed out below:
1. EVA is criticized to be a short-term performance measure. Some companies
have concluded that EVA does not suit them because of their focus on long-term
investments. An example is offered by American company GATX (Glasser, 1996),
which leases transportation equipment and makes fairly long-term investments.
2. The true return or true EVA of long-term investments cannot be measured
objectively because future returns cannot be measured; they can only be
subjectively estimated.
3. EVA is probably not a suitable primary performance measure for companies
that have invested heavily today and expect positive cash flow only in a distant
future. The periodic EVA fails to estimate the value added to shareholders, because
of the inflation and other factors.
5. EVA suffers from wrong periodizing. A company may have a lot of
undepreciated new assets in its balance sheet and it might show negative EVA even
if the business would be quite profitable in the long run.
6. Traditional financial ratios are commonly used for distress prediction. It was
observed that EVA does not have incremental value in the predicting.
23.4 REVISION POINTS
 EVA: Value based measure that was intended to evaluate business strategies,
capital projects, and to maximize long-term shareholders wealth.
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 NOPAT: Net Operating profit after depreciation and taxes

 Cost of Capital: Minimum expected returns from investments
 WACC: Weighted Average Cost of Capital is the overall cost of capital of all
securities.
23.5 INTEXT QUESTIONS
1. Define EVA.
2. What do you mean by value drivers?
3. What do you meant by value based measure?
23.6 SUMMARY
During the 1990's value based management has made a strong entry in the
assortment of management tools in the form of EVA as marketed in particular by
Stern Stewart & Co. Since then, it has successfully taken an important place in
corporate world and we have seen maximum utilization of it. The central idea of
EVA is subtracting the cost of capital from the firm's profits to measure, as the term
indicates, the economic additional value produced by the firm to its owners over the
weighted cost of the capital employed. It is well accepted from both side of the coin,
i.e., owners and management. Owners are happy to see the amount of value added
and management is happy to get reward proportionately. But, the challenge is to
implement it for the first time. If the tool is not welcomed at the very beginning it
will produce nothing. Keeping EVA simple is also viewed as an important feature in
successful implementation EVA has some inherent limitations also. Major
limitations are generated due to the conventional accounting system that produces
time-barred data. Thus, calculating true EVA becomes a challenge. But, we can
make it tailored through EVA team, formed for successful implementation of the
tool. The team will be responsible to find out all distortions and the way to adjust
them to convert accounting profit into economic profit. EVA has both advantages
and limitations. Thus, using EVA only is no case a good decision. Rather, it should
be used with other to take decisions more effectively. Companies may go for
simulations over past several years’ performance to find out the areas where EVA as
a managerial tool is stronger over others. And where other tools show important
correlations. Then, a set of tools can be used simultaneously in line with the
philosophy of management.
23.7 TERMINAL EXERCISE
1. ………………………….is the financial performance measure that comes closer
than any other to capturing the true economic profit of an enterprise.
23.8 SUPPLEMENTARY MATERIAL
1. https://www.controlling.wi.tum.de
2. http://www.evanomics.com/
3. http://i.investopedia.com/
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23.9 ASSIGNMENTS
1. Define EVA and state its significance as a management tool in decision
making.
2. Explain the role of Cost of capital and WACC in calculating the EVA
3. List the steps involved in computing the EVA
4. Explain the major adjustments to be made while calculating EVA.
5. State the advantage and disadvantages of EVA.
23.10 SUGGESTED READINGS
Anctil, R. M., Jordan, J. S., & Mukherji, A. (1998). Activity-based costing for
Economic Value Added®. Review of Accounting Studies, 2(3), 231-264.
Bacidore, J. M., Boquist, J. A., Milbourn, T.T., & Thakor, A.V. (1997). The Search
for the Best Financial Performance Measure. Financial Analysts Journal, 11-20.
Biddle, G. C., Bowen, R. M., & Wallace, J. S. (1997). Does EVA beat earnings?
Evidence on associations with stock returns and firm values. Journal of Accounting
and Economics, 24(3), 301-336.
Blair, A. (1997). EVA Fever. Management Today, 42 - 45.
23.11 LEARNING ACTIVITIES
In the present context how companies have used EVA . Explain with suitable
example.
23.12 KEYWORDS
EVA, WACC, Cost of Capital, Value Drivers,NOPAT.


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LESSON - 24

VALUATION OF SHARES
24.1 INTRODUCTION
As observed in Lesson 1, the objective of a firm is to maximise shareholder's
wealth. Further, it was explained that the shareholder's wealth is represented by
the product of number of shares and the current market price per share. Given the
number of shares that the shareholder owns, the higher the stock price per share,
the greater will be the shareholder's wealth. Thus, the financial objective of a firm is
to maximize the market value per share in the market. To maximise the stock price,
we have to develop a valuation model and identify the variables that determine the
stock price. Generally speaking, the value of the firm depends upon two things:
(i) the rate of return arid (ii) the element of risk. As the return and risk
characteristics of a firm are influenced by the three financial decisions, namely, (a)
Investment decisions, (b) Financing decision, and (c) Dividend decision.
24.2 OBJECTIVES
After reading this lesson you should be able to:
 Know the different concepts of valuation
 Understand the necessity for and relevance of valuation
 Ascertain the general and. specific factors influencing the valuation of
shares;
 Explain and evaluate the different methods of valuation of shares.
 Calculate fair market value of shares
24.3 CONTENT
24.3.1 Valuation Concept
24.3.2 Factors Influencing the Share Value
24.3.3 Necessity for Valuation
24.3.4 Relevance of Valuation
24.3.5 Asset Backing Method
24.3.6 Earning Capacity Method
24.3.7 Valuation of shares on the basis of Actual market Price
24.3.1 Valuation Concepts
The term 'value' has been used to convey a variety of meanings. The different
meanings of value are useful for different purposes. The various concepts of value
are discussed below:
1. Present Value: A business enterprise keeps or uses various assets because
they generate cash inflows. Value is the function of cash inflows and their timing
and risk. When cash inflows are discounted at the required rate of return to
account for their timing and risk, we get the value or the present value of the asset.
 373

In financial decision making, such as valuation of securities, the present value

concept is relevant.
2. Going Concern Value: In the valuation process the valuation of shares is
done on the going concern basis. In a going concern, we assess the value of an
existing mixture of assets which provide a stream of income. The going concern
value is the price which a firm could realise if it is sold as an operating business.
The going concern value will always be higher than the liquidation value. The
difference between these two values will be due to value of organisation, reputation
etc. We may command goodwill if the concern is sold as a going concern.
3. Liquidation Value: If a firm decides to go out of business it will sell its assets.
After terminating the business, the amount which will be realised from sale of
assets is known as liquidation value. Since the business will be terminated, the
organisation will be valueless and intangibles will not fetch any price. The
liquidation value will be die lowest value of a firm. Generally, the true value of the
firm will be greater than the liquidation value.
The liquidation value is useful from the creditors' point of view. If the concern
is running then the creditors will be paid out of cash inflows. On the other hand if
the concern is terminated, the creditors will be paid out of the amount realised from
various assets. The creditors will try to ensure that the realisable value of the
assets is more than their claims so that they get fully paid.
4. Replacement Value: The assets are shown on historical cost in the balance
sheet. This cost may not be relevant in the present context. This problem may be
solved by showing assets on replacement value basis. Replacement value is the cost
which a firm will have to spend if it were to replace the assets under present
conditions.
Though replacement value method is an improvement over book value concept
but still it has certain limitations. It is very difficult to ascertain the present value of
similar assets which the firm is using. It may so happen that this type of assets
may no longer be manufactured as present. This will create a problem of finding out
the replacement cost of the assets. Moreover, it is not certain that the assets of
business would be worth its replacement cost. The Value of intangibles is also
ignored in this method.
5. Market Value: The market value of an asset or security is the value at which
it can be sold at present. It is argued that actual market prices are appraisals of
knowledgeable buyers and sellers who are willing to support their opinions with
cash. Market price is a definite measure that can readily be applied to a particular
situation and it minimises the subjectivity of other methods in favour of a known
yardstick of value.
6. Book Value: The book value of assets can be ascertained from the firm's
balance sheet which is prepared according to the accounting concepts and
conventions. The assets are shown in the balance sheet at cost less depreciation.
 374

No account is taken for the real value of the assets, which may change with the
passage of time. The assets are generally recorded at cost. In case the convention of
conservatism is used then assets are shown at cost or market price whichever less
is. The convention of conservatism is followed for current assets only not for fixed
assets. The value of intangibles is also included in the assets. The debts are shown
on the outstanding values and no account is taken for interest or payment of
principal amount. The book value per share can be determined by dividing the
common shareholders' equity (capital plus reserves and surpluses) by the number
of shares outstanding.
24.3.2 Factors influencing the share value
The factors influencing the valuation of shares can be classified as general
factors and specific factors.
General Factors: These factors are those which have an overall effect on the
price of shares in general:
i) Government's fiscal and monetary policies—Bank rate, direct and indirect
taxes,
ii) Political stability in the country,
iii) Economic climate i.e., depression or boom,
iv) Industrial Policy of the Government,
v) International political and economic climate also influence the market value
of shares. No country's economy is so isolated that it is immune to changes
in other parts of the world.
Specific Factors: These factors are those which apply to the particular company
and to the industry in which the company is operating:
i) The present position and future prospects of the industry of which the
company is a part.
ii) The amount and trend of dividends paid and expected, future dividends,
taking into consideration the dividend cover and the yield compared with
similar equity shares.
iii) Announcement by companies themselves may affect prices, for instance, if a
company increases or does not pay interim dividend.
iv) The capital structure of the company, which will lead to the study of
financial leverage i.e. the proportion of debt to equity.
v) An analysis of the company's cash flow to determine its ability to service
fixed charges.
vi) The amount and trend of the company' s profits and the net earnings i.e. the
profits available for distribution to the equity shareholders after meeting all
prior charges, expressed as a percentage of the market value of the equity
share capital.
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vii) The set up of the management to ensure that the company has got a
competent and broad-based, board of directors and also has within it
persons of sufficient standing with adequate technical, financial and
business experience.
viii) The net assets according to the balance sheet of the company
ix) Whether there is an active market in the equity shares and the amount of
the "turn" i.e., the difference between the higher and lower prices as quoted
on the stock exchange.
x) The possibility of bonus or rights issues.
24.3.3 Necessity for valuation
The necessity for valuation of shares arises inter alias in the following
circumstances.
i) Assessments under the Wealth Tax or Gift Tax Acts.
ii) Purchase of a block of shares which may or may not give the holder thereof
a controlling interest in the company.
iii) Purchase of shares by employees of the company where the retention of
such shares is limited to the period of their employment.
iv) Formulations of schemes like amalgamation, absorption, etc.
v) Acquisition of interest of disentitling shareholders under a scheme of
reconstruction.
vi) Compensating shareholders on the acquisition of their shares by the
Government under a scheme of nationalisation.
vii) Conversion of shares, say preference share, debentures/loan into equity.
viii) Advancing a loan on the security of shares.
ix) Resolving a deadlock in the management of a private limited company on
the basis of the controlling block of shares being given to either of the
parties.
x) Valuation of securities for Balance Sheet of trust and finance companies.
24.3.4 Relevance of Valuation
Valuation by expert is generally called for when parties involved in the
transaction/deal, etc., fail to arrive at a mutually acceptable value or the
agreements or Articles of Association, etc., do not provide for valuation by experts.
For isolated transactions of relatively small-blocks of shares which are quoted on
the stock exchanges, generally, the ruling stock exchange price provides the basis.
But valuation by values becomes necessary when: (i) Shares are unquoted, (ii)
Shares relate to private limited companies, (iii) Courts so direct, (iv) Articles of
Association or relevant agreements so provide, (v)Large blocks of shares is under
transfer, and (vi) Statutes as require (like Wealth Tax, Gift Tax Act).
 376

Limitation of Stock Exchange Prices as a Basis for Valuation: Stock exchange is

a place where shares and stocks are exchanged by the process of purchase and
sale, generally through brokers, who transact the business on a commission basis
on behalf of their clients. It may be stated that stock exchange price is a price pure
and simple and not a value based on valuation. Stock exchange price is, basically,
determined on the interactions of demand and supply and business cycles and may
not reflect a reasoned valuation on principal considerations of yield and safety of
capital.
Methods of Valuation
The different methods of valuing shares may be broadly classified into -1.
Asset backing method, 2.Eaming capacity valuation method. 3, Imputed Market
price of shares.
24.3.5 Asset Backing Method
This method is concerned with the asset backing per share and may be based
either(a)on the view that the company is a going concern, or (b)on the fact that the
company is being liquidated.
a) Company as a going concern
If this view is accepted, there are two approaches (i) to value the shares on die
net tangible assets basis (excluding the good will (ii) to value the shares on the net
tangible assets plus an amount for goodwill.
Net Tangible Assets Backing (Excluding the Goodwill)
Under this method, it is necessary to estimate net tangible assets of me
company (Net Tangible Assets=Assets-Liabilities) in order to value the shares. In
valuing (he figures by this method care must be exercised to ensure that the figures
representing me assets are sound, that intangible assets and preliminary expenses
are eliminated and all liabilities are taken into account.
Where both types of shares are issued by a company, the shares would be
valued as under:
1. If preference shares have priority as to capital and dividend, then me
preference shares are to be valued at par.
2. After the preference shareholders are paid, the net tangible assets are
divided by the number of equity shares to calculate me value of each shares. If at
the time of valuation there is an uncalled capital, then the uncalled equity share
capital is added with the net tangible assets in order to value me shares roily paid
up. The valuation of shares for me shareholder who have calls in arrears will be
valued as a percentage on their paid up value with me nominal -value of shares.
3. If the preference shares are non-participating and rank equally with the
equity shares, men the value per share would be in proportion of me paid up
capital.
 377

Illustration - 1
The following is me summarised Balance Sheet of XYZ company Ltd. as at
December 31.2015.

Liabilities Rs. Assets Rs.

Share capital 10,000 15% Fixed Assets 38,00,000
preference share of Rs.100 Investments 10,25,000
each fully paid.
10,00,000 Current Assets:
2,00,000 Equity shares Stock in trade 5,72,000
of Rs.10 each fully paid 20,00,000 Sundry Debtors 12,78,000
Reserves and surplus: Less: provision
General Reserve 15,00,000 Cash and Bank Balances 2,25,000
Profit and Loss A/c. (Cr) 12,00,000
Secured Loans 16%
Debentures 8,00,000
Current Liabilities:
Sundry Creditors 2,75,000
Liabilities for expenses 1,25,000
69,00,000 69,00,000

For purposes of valuation of shares fixed assets are to be depreciated by 10

per cent and investments are to be revalued at Rs. 10,80,000. Debtors will realize
Rs.12,14,000. Interest on Debentures is accrued doe for 9 .months —d preference
dividend for 2015 is also due; neither of these has been provided for in the Balance
Sheet. Calculate the value of each Equity Share.
Solution
Valuation of Shares of XYZ Company Ltd. By the Net Assets Method
Rs.
Fixed Assets 34,20,000
Investments as per revaluation 10,80,000
Stock in trade 05,72,000
Sundry Debtors 12,14,100
Cash and Bank Balances 02,25,000
65,11,100
Less: Liabilities of the Balances:
16% Debentures 08,00,000
Sundry Creditors 02,75,000
Liabilities for expenses 01,25,000
 378

Interest on Debentures(accrued for 9 months) 00,36,000

12,36,000
52,75,100
Less: Preference Share Capital 10,00,000
Preference Share dividend 00,50,000
10,50,000
Value of 2,00,000 Equity shares 42,25,100
42,25,100
Hence, value of 1 Equity share = = Rs. 21.13 (approx.)
2,00,000
Asset Backing (including Goodwill): In many cases goodwill may be worth the
figure at which it is stated in the balance sheet/or if there is no book value for
goodwill, it may nevertheless, exist. Further even if there is a book value, the actual
value of goodwill may be considerably higher than the book value. It is generally
considered that the value of fixed assets of the company depend on their ability to
earn profits i.e., on the goodwill attaching to them. In such a case goodwill should
be included with other tangible assets for valuation purposes. The various methods
of valuing the goodwill are: (i) Capitalisation of expected future net profits or
earnings, (ii) Assessment based on turnover, (iii) Super Profits method, and (iv)
Annuity Method.
Illustration - 2
Calculate Goodwill as per(a)Annuity Method(b)Five Years purchase of Super
Profits method; and (c) Capitalisation of super profits methods from the details
given hereunder:
i) Capital employed 1,50,000
ii) Normal rate of profit 10%
iii) Present value of Annuity of Re.1for Five years at 10% 3.78
iv) Net profits for five years: I Year – Rs.14,400; III Year – Rs.16,900;
II Year – Rs.15,400; IV Year – Rs.17,400;
V Year – Rs.17.900
The profits included non-recurring profits on an average basis of Rs.l,000. Out
of which it was deemed mat even non-recurring profits had a tendency of appearing
at the rate of Rs.600 p.a.
Solution
Normal rate of profit 10% of 1,50,000 = Rs.15,000
Average net profit for 5 years
=(l4,400+15,400+16.900+17,400+17,900)+ 5 = Rs.16,400
Super Profit=16,400-600(non-recurring)=15,800
15,800-15,000 =Rs. 800
 379

Value of goodwill
(a) Annuity Method = Rs.800 x 3.78 (present value factor) =Rs.3,024
(b) Five years purchase of super profits=800 x 5 = Rs.4,000
(c) Capitalisation of supper profit method:
average profit
Goodwill = - Net assets (i.e capital employed)
normal rate profit

15,800
-150,000 =158,000-150,000 = Rs. 8,000.
10%
Weakness of Assets Based Approach: This method has its own weaknesses:
1. There is no uniform method for assessing book value of assets. Such a
value is influenced by policies of the companies on the one hand and
accounting practices on the other.
2. There is no uniformity in assessing depreciation which is an essential
ingredient of valuation of assets.
3. Goodwill and patents count a lot in valuation but in so far as accounting
practice goes, there is considerable lack of standardisation in this regard.
4. It is usually very difficult or rather impossible to exactly bring at par and
compare the value of securities of one company with another.
5. Every company has certain conventions about valuing assets rather than
following any logic and this influences valuation.
6. Usually the understandings do not take fixed assets at current value, but
at old costs which is quite deceptive.
7. This approach also does not give any real idea about earning power of the
assets, which is another consideration in valuation.
Advantages of the approach: This approach has certain advantages as well.
This approach has proved very useful in so far as investing companies, insurance
companies and a bank are concerned and in the case of such companies whose
assets are largely liquid, provided such an approach are not exclusively expanded
upon.
b) Asset backing where company is being liquidated (Realisable Value Approach)
Asset backing method is sound if liquidation is contemplated though realizable
value should be taken into account. When realisation is imminent, it is desirable to
construct a statement of affairs supported, by independent valuations of the fixed
assets such as land and buildings, plant and goodwill. Provision should also be
made for the cost of liquidation and thus some indication may be obtained as to
how much per shares may be payable to members.
24.3.6 Earning Capacity Valuation Method
Capitalisation of earnings approach for valuation of shares is based on the
assumption that a shareholder values earning power on the one hand and income
 380

rather than physical assets on the other. This method is also known as the Yield
method. Under this method, the valuation depends upon the comparison of the
company's earning capacity and the normal rate of interest or dividend that is
current on outside investment. The Earning capacity or yield basis of valuation may
take any of the following two forms: (i) valuation based on rate of return, and (ii)
valuation based on productivity factor.
(i) Valuation based on Rate of Return: The term rate of return refers to the
returns which a share holder earns on his investment. It may further be classified
as (a) rate of return and (b) rate of earnings. To ascertain the value of shares based
on profit earning capacity future maintainable profits and rate of interest at which
the profits are to be capitalised must be fixed. In arriving at the profit to show the
normal earning capacity generally the following adjustment are made: (i) Non-
recurring items should be allowed for, (ii)Income tax charges should be
appropriated to the particular year in which they are paid, and (iii) allocation to
reserve.
The main purpose for adjustment of profit is the determination of future
annual maintainable profit which must be capable of distribution as dividend. The
rate of interest for capitalising the average normal profit is fixed upon by the
circumstances of a particular case. In practice a rate of 10% or more may be
reasonable.
The following steps may be followed for calculating the value of shares
according to yield method:
i) Calculation of average expected future profits.
ii) Calculation of expected return by the following equation:
Expected Profits
Expected Returns = x100
Equity Capital
iii) Calculation of yield value of share as under:
Expected Rate
Value of share= x Paid up value of share
Normal Rate
Conclusion: Of course earning approach has its own advantages, hot it cannot
be denied that such an approach has own limitations It is primarily because profits
are influenced by many factors. Even due to various reasons, the companies having
same span of work, working under same conditions might show different profits.
Accordingly this method determining the value of shares has its own inherited
problems.
(ii) Valuation based on Productivity Factor: Productivity factor represents the
earning power of the company in relation to the value of the assets employed for
such earning. The factor is applied to the net worth of the company on the
valuation date to arrive at the projected earnings of the company. The projected
earnings after necessary adjustments are multiplied by the appropriate capitalisation
factor to arrive at the value of the company's business. Total value is divided by the
 381

number of equity shares to ascertain the value of each share. The productivity
factor-based valuation is merely a method for ascertaining a reliable figure of future
profits. The steps involved in such a method of valuation can be enumerated as
follows:
a) Average net worth of the business is ascertained by taking a number of
years whose results are relevant to the future. It will be appropriate to
determine the average net worth of each year on the basis of net worth of
the business at the commencement and at close of each of the accounting
years under consideration. The average net worth of the business of the
period under study would be calculated on the basis of the average net
worth calculated as above for each of the accounting years.
b) Net worth of the business on the valuation date is ascertained.
c) Average profit earned for the period under consideration is ascertained on
the basis of the profits earned by the business during the period by simple
or weighted average method as may be considered appropriate.
Average profit
d) The productivity factor is found out as follows: x 100
Average net worth

e) The productivity factor calculated as above is applied to the net worth of

the business in future.
f) The projected income so calculated is adjusted further by making of
appropriations for replacement, tax, rehabilitation of plant and
equipments, under utilisation of productive capacity, effects of restriction
on monopoly and divided on preference shares. Thus, the profits available
for the equity shareholders are ascertained.
g) The normal rate of return for the company is ascertained keeping in view
nature and size of the undertaking.
h) Appropriate capitalisation factor or multiplier based on normal rate of
return is ascertained, as explained earlier
i) The capitalisation factor obtained as above is applied to adjusted projected
profits available for the equity shareholders to ascertain the capitalised
value of the undertaking.
Illustration - 3
The following figure relate to a company which has Rs. 10,00,000 in Equity
Shares and Rs. 3,00,000 in 9 per cent Preference Shares, all of Rs. 100 each:

Average Net Worth

(excluding Adjusted Taxed Profit
investment)
Rs. Rs.
2013 18,60,000 1,90,000
2014 21,50,000 2,10,000
2015 21,90,000 2,50,000
 382

The company has investments worth Rs 2,80,000 (at market value) on the
valuation date, the yield in respect of which has- been excluded in arriving at the
adjusted tax profit figures. It is customary for similar types of companies to set
aside 25 percent of taxed profit for rehabilitation and replacement purposes. On the
valuation date, the net worth (excluding investments) amounts to Rs. 22,50,000.
The normal rate of return expected is 9 percent. The company has paid dividends
consistently within a range of 8 per cent to 10 per cent on equity shares over the
previous seven years and it expects to maintain the same.
You are required to ascertain the value of each equity share on the basis of
productivity, applying suitable weighted averaging.
Solution
Computation of Productivity Factor
Average Net Weighted Weighted
Adjusted Weights
Worth Net Worth adjusted taxed
Taxed Profits
profits

Rs. Rs. Rs. Rs. Rs.

2013 18,60,000 1,90,000 1 18,60,000 1,90,000
2014 21,50,000 2,10,000 2 43,00,000 4,20,000
2015 21,90,000 2,50,000 3 65,70,000 7,50,000
1,27,30,000 13,60,000
Average Net Worth and Adjusted Taxed Profits 21,21,667 2,26,667
2,26,667
Productivity factor: × 100 = 10.68%
21,21,667
(Profit as a percentage of Capital employed)
Maintainable Profit: 10,68% on Rs. 22,50,000 2,40,000
Less: Rehabilitation and Replacement Reserve @ 25% of
maintainable profits 60,075
1,80,225
Less: Preference Dividends 27,000
Profits available for equity shareholders 1,53,225
Capitalised value of Profits for Equity Shareholders
Rs.1,53,225 at 9 per cent 17,02,500
Add: Value of Investments 2,80,000
Value of Total assets. 19,82,500
19,82,500
Value of an equity share = = 198.25
10,000 198.25
 383

24.3.7 Valuation of Shares on the basis of Actual Market Price

Market price method is one of the old methods for the valuation of shares. In
fact there are many economists and analysts who attach more importance to this
rather than any other method. According to them, valuation of share is related to
actual market price and the prices at which transactions take place in the market
indicate the value of the shares. The real value is the verdict of the market.
Those who support this are of the view that this price is determined by the
investors and as such can be depended upon. Being a readily available measure
can also be applied to a particular situation. It is this method which minimises
subjectivity, which is the characteristic of other methods.
But the approach has its own problems as well. It is difficult to assess the
market because there are many fluctuations in its market and market is linked
with many factors. Some times fluctuations can be both violent as well as extreme,
which might disturb the whole system. Under such a situation it becomes doubtful
whether at all it is desirable to depend on this method, which is so undependable.
Then another problem with this method is that much of the speculative activity is
going on in the market which disturbs share valuation. Those who are working in
the market manipulate share prices in a manner which suits their convenience.
There are other problems involved in so far as market price is concerned. One
such important problem is that for many shares market quotations are not
available and as such their value is not listed in the share market. In the case of
such companies it becomes difficult to find out value of the shares. Trading in such
shares becomes rather deceptive both for the buyers as well as the investors. If any
undertaking decides to release some additional shares then in the case of any such
share, share market will suddenly come down, as it shall not he-possible for the
market to bear its reassure.
Still another difficulty with this method is that in many cases market price is
influenced not by real but by artificial means and when the market is under the
influence of such means then there is bound to be deception. Then comes the
problem of shares of closely held company. Obviously the shares of such a
company are not reflected through the market. In many cases shares of such
companies in the market might go up or come down when the members of the
family themselves begin to trade in the market and purchase or sell shares to
attract or detract the attention of some others concerned with it.
Fair Market Value: There are many problems in so far as market value is
concerned. Though the method might seem very acceptable, yet it is not because it
is linked with many problems. In order to avoid some of the problems the idea of
Fair Market Value, has been evolved. This value is based on the assumption that
there are both willing buyers as well as sellers in the market and that each is quite
well informed. It is also believed that each such buyer and seller is quite rational.
Accordingly, under this notion it is believed that whole market will smoothly and
rationality work. But as we know such an idea is difficult to follow in practice
 384

because in the market there are neither ready buyers nor ready sellers and equally
also in the market all the buyers and sellers are not rational or quite well informed.
Illustration - 4
Mr. Ram intends to invests Rs.66,000 in Equity Shares of a limited Company
and seeks your advice as to the maximum number of shares he can expect to
acquire based on a fair value of the shares to be determined by you. The following
information is available:
Rs.
Issued and Paid-up Capital:
6% preference Shares of Rs.100 each 11,00,000
Equity Shares of Rs. 10 each 7,00,000
18,00,000
Average net profit of the business is Rs. 1,50,000. Expected normal yield is 8%
in case of such equity shares. It is observed that net assets on revaluation are
worth Rs.l,40,000 more than the amount at which they are stated in the books.
Goodwill is to be calculated 5 years purchase of super profits, if any. Ignore
taxation.
Solution
1. Value on Yield basis
Rs.
Average net profit 1,50,000
Less: Preference dividend 6%on 11,00,000 66,000
Profit available to Equity Shareholders ,84,000
84,000
Earnings per share (EPS) = = Rs.1.20
70,000
Normal yield is 8%
100
Value of Equity Share = 1.20 x = Rs. 15
8
[or]
1.20
Actual Yield = x 100 = 12%
10
12%
Value of Equity Share = x Rs. 10 per share = Rs. 15
8%
66,000
No. of Equity Shares that he can acquire = = 4,400 Shares
15
 385

2. Intrinsic Value including goodwill

Rs.
Profit available to Equity Shareholders 84,000
Less: Normal return 8% on 7,00,000 + 1,40,000 67,200
16,800
Goodwill at 5 years purchase of Super Profits = 16,800 x 5 = 84,000
Add: Value of Equity Shares = 7,00,000+1,40,000 84,000
Funds belonging to Equity Shareholders 9,24,000
9,24,000
E.P.S.= = Rs.l3.20
70,000
66,000
No. of Equity Shares that he can acquire= = 5,000 Shares
13.20
3. Fair Value
15.00  13.20
Fair Value = =14.10
2
66,000
No. of Equity Shares that he can acquire = = 4,680 Shares
14.10
Illustration - 5
You are asked to value shares as on 31st March 2015 of a private Company
engaged in engineering business, with a view to floating it as a Public Company.
The following information is extracted from the audited accounts:

Year ended Net profit before Salary of Managing

31st March Taxation Director
2009 2,34,000 72,000
2010 3,24,000 72,000
2011 54,000 (loss) 36,000
2012 72,000 54,000
2013 3,42,000 1,08,000
2014 4,50,000 1,08,000
2015 2,52,000 1,08,000
The audited Balance Sheet as at 31st March, 2015 showed the following
position:

Shareholder’s Funds: Rs. Rs.

Equity shares of Rs.10 each 3,60,000
Reserves 3,06,000
Surplus in P & L Account 2,34,000 9,00,000
Current Liabilities and Provisions 12,60,000
 386

21,60,000
Fixed Assets:
Freehold land and building (at cost less depreciation) 6,48,000
Plant and Machinery (at cost less depreciation) 5,40,000
Factory and Office Fittings (at cost less depreciation) 1,80,000
13,68,000
Current Assets, Loans and Advances 7,92,000
21,60,000

The various assets were valued by and independent values as on 31-3-2015 as

under:

Freehold land and Building 7,92,000

Plant and Machinery 7,20,000
Factory and Office fittings 1,80,000
16,92,000

In lieu of salary to Managing Director, the Public Company would incur

director’s fees of Rs.18,000 per annum. Income Tax may be assumed at 60%.
You are required to value shares.
Solution
Valuation of Equity shares on net assets basis
Fixed Assets 16,92,000
Current Assets, Loans and Advances 7,92,000
24,84,000
Less: Current liabilities and provisions 12,60,000
Equity Shareholder’s funds 12,24,000
12,24,000
Value per Equity share=  Rs.34
36000shares
Valuation of Equity Shares on Earnings Basis
During the last 3 years, the profit position was stable and hence let us takes
last 3 years profits as follows:

Net profit before Tax 2013 2014 2015 10,44,000

Add: Salary of M.D 2013 2014 2015 3,24,000
13,68,000

Average for one year = 13,68,000  4,56,000

3
Less: Director’s Fees 18,000
 387

Additional depreciation:
(assumed) (on account of revaluation) 2=on Buildings i.e. 2%
× (792000 – 648000)2,800 +10% on
Plant and Machinery i.e. 10% ×( 7,20,000 – 5,40,000)
20,880
4,17,120
Less: Income Tax at 60%
i.e. 60% x (4,56,000-18,000 Directors Fees) 2,62,800
Average maintainable profit after tax 1,54,320
Capitalised value at 12% (assumed) 12,86,000
Number of Equity shares 36,000
12,86,000
Value per equity share =  Rs.35.72
36,000
Valuation of Preference Shares
In India preference share have a priority as to payment of dividend and
repayment of capital over equity shares in the event of company’s winding up. They
are taken as cumulative but non-participating unless otherwise stated. Their
valuation is generally on “Dividend Basis” according to the following formula:
Paid - up value x Average maintanable Dividendrate
Normal rate of return
For example, if the paid-up value of preference share is Rs.80, average
dividend rate 12 percent, normal rate of return 10 percent the value of a preference
share would be Rs.96 (m i.e. Rs. 80 x 12/10).
In case the dividend on cumulative preference shares is in arrears, the present
value of such arrears of dividend (if there is a possibility of their payment) should
be added to the value of a preference share calculated as above.
The dividend basis for valuation of preference share is useful only in those
cases where the preference share capital does not has adequate assets backing and
the company is a going concern. In case the preference share capital does not have
adequate assets backing or the company is going into liquidation it will be
appropriate to value preference shares according to the net assets method.
In case of participating preference shares of companies in liquidation, it will be
appropriate to take into account the share in the surplus assets remaining after
payment to the equity shareholders.
Illustration - 6
A Company has net assets of Rs.1lakh before payment to the shareholders.
The share capital consists of 5,000 equity shares of Rs.10 each and 2,000
preference share of Rs.10 each. The preference shares are entitled to share 25 per
cent of the surplus assets remaining after payment to the equity shareholders.
Calculate the value of a preference share.
 388

Solution
Rs.
Net assets before payment to shareholder 1,00,000
Less: Preference share capital 20,000
80,000
Less: Equity share capital 50,000
Surplus 30,000
Share of preference shareholders in the surplus 7,500
Total net assets available for preference shareholders 27,500
(20,000+7,500)
Number of preference shares 2,000
Value of a preference share 13.75
Illustration - 7
The following figures are extracted from the books of M/s. Prosperous Limited.

Share capital: Rs.

9 percent preference shares of Rs.100 each 3,00,000
1,000 Equity shares of Rs.100 each Rs.50 called up 50,000
1,000 Equity shares of Rs.100 each Rs.25 called up 25,000
1,000 Equity shares of Rs.100 each, fully called up 1,00,000
4,75,000
Reserve and Surplus:
General Reserve 2,00,000
Profit and Loss Account 50,000
7,25,000

On a fair valuation of all the assets of the company it is found that they have
an appreciation of Rs.75,000.
The articles of association provided that in case of liquidation the preference
shareholders will have a further claim to the extent of 10 percent of the surplus
assets. Ascertain the value of each preference and equity share, assuming
liquidation, Ignore expenses of winding up.
Solution
Valuation of preference and Equity Shares of M/s. Prosperous Ltd.
Paid-up Share of Per
Total
Value surplus share
Rs. Rs. Rs. Rs.
3,000 9% Preference shares 3,00,000 32,500 3,32,500 110.83
 389

1,000 Equity shares:

Rs.50 called up 50,000 97,500 1,47,500 147.50
Rs.25 called up 25,000 97,500 1,22,500 122.50
Rs.100 called up 1,00,000 97,500 1,97,500 197.50
Division of Surplus
Rs.
As per books 2,50,000
Appreciation in value of assets 75,000
3,25,000
10 per cent thereof to Preference Shareholders 32,500
Surplus of Equity Shareholders 2,92,500

Note: It is to be noted that values in the question are to be determined

assuming liquidation. In such a case the surplus is to be distributed among the
equity shareholders according to the nominal value of the shares held by them
(equal in this case). Uncalled capital is an asset of the company and, if one
presumes that uncalled money has been called up the truth of the statement made
above will be self-evident. It will be incorrect to distribute the surplus in the ratio of
paid-up amounts.
Practical problems
1. From the following figures calculate the value of a share of Rs.10 (i) on
yield on capital employed basis and (ii) dividend basis, the market
expectation being 12%.

Year Capital Employed Profit Dividend %

Rs. Rs.
2012 5,00,000 80,000 12
2013 8,00,000 1,60,000 15
2014 10,00,000 2,20,000 18
2015 15,00,000 3,75,000 20

(Ans: (i) Rs.17.29 (ii) 13.54)

2. Mr. Ashok wants to invest Rs.32,000 in equity shares of a company.
The following particulars are available:

Issued and Paid-up Capital: Rs.

12% preference shares of Rs.100 each 11,00,000
Equity shares of Rs.10 each 7,00,000
18,00,000
 390

The company is three years old and has earned an aggregate net profit of Rs.9
lakhs. The equity shares may yield 15%. If the net assets are re-valued, the
value thereof is Rs.1,40,000 more than the value stated in the books. What is the
maximum number of shares Mr. Ashok can purchase based in fair value of the
shares?
(Ans: Fair value=Rs.14, No. of shares to be purchased on the basis of fair value
2.286 Equity Shares)
3. Mr. X, who desires to invest Rs.33,000 in equity shares in public limited
company, seeks your advice as to the fair value of the shares. The
following information is made available:
Issued and Paid-up Capital: Rs.
6 per cent Preference shares of Rs.100 each 5,50,000
Equity shares of Rs.100 each 3,50,000
9,00,000

Average net profit of the business in Rs.75,000. Expected normal yield is 8 per
cent in case of such equity shares. It is observed that the net assets on revaluation
are worth Rs.70,000 more than the amounts at which they are stated in the books.
Goodwill is to be calculated at 5 years purchase of the super profits, if any, (Ignore
income-tax).
Give your working of the fair value of equity shares and determine the number
of shares which Mr. X should purchase.
(Ans: Goodwill Rs.42,000; Intrinsic value of Rs.13.20; Value on yield basis:
EPS based Rs.15 and Rate of Earnings basis Rs. 12.50 No. of shares to be
purchased 2,340)
The Balance Sheets of two companies A Ltd., as on 31st March, 1994 are:
(Rs. Lakh)

A Ltd. B Ltd.
Equity capital 3.00 4.00
Reserves 3.00 2.00
5 per cent Debentures --- ---
Sundry Creditors 2.00 2.50
8.00 8.50
Fixed Assets 5.00 4.00
Stock 1.25 1.30
Debtors 1.70 1.10
Cash at Bank 0.05 0.10
P & L.A/c --- 2.00
8.00 8.50
 391

A Ltd. proposes to take over B Ltd. For this purpose the assets were revalued
as:
Fixed Assets Rs. 6.15 lakhs
Stock 1.00 lakhs
Debtors 1.05 lakhs
The additional factor to be considered is that B Ltd., is an industry which is
not licensed under the current policy of the Government. Hence, there is an
advantage as an existing unit. For this premium of Rs.5 lakhs is assessed.
Calculate and suggest a share valuation of B for the takeover and suggest a
fair exchange ratio of shares.
(Ans: Break-up value of either more or less the same; Exchange Ration 1:1)
24.4 REVISION POINTS
Valuation Concepts: Present value, Going Concern Value, Liquidation Value,
Replacement value, Market Value, Book Value.
Factors Influencing the share value: General Factors, Specific Factors.
Methods of Valuation: Asset Backing Method, Earning Capacity Method,
Imputed Market Price of Shares.
24.5 INTEXT QUESTIONS
1. What do you mean by Going concern Value?
2. What do you mean by asset backing Method?
3. What do you mean by goodwill?
4. What do you mean by Fair Market Value?
24.6 SUMMARY
Valuation of shares mainly depends upon two things one is the rate of return
and another one is elements of risks. These characteristics of the firm are
influenced by investment decision, financing decision and divided decision. The
various concepts of value are present value. Going concern value, Liquidation
value, Replacement value, Market value and book value. The different methods of
valuing shares may be broadly classified into (i) Asset backing method, (ii) Earning
capacity valuation method, (iii) Imputed market Price of shares.
24.7 TERMINAL EXERCISE
1. Under ………………………………method, the valuation depends upon the
comparison of the company's earning capacity and the normal rate of interest or
dividend that is current on outside investment.
2. .Under…………………….. method , the value is based on the assumption
that there are both willing buyers as well as sellers in the market and that each is
quite well informed.
24.8 SUPPLEMENTARY MATERIAL
1. http://home.ku.edu.tr/
 392

2. http://people.stern.nyu.edu/
3. http://www.slideshare.net/lindyisabella/gsb711lecturenote04valuationofb
onds-and-shares
4. http://www.zeepedia.com/
24.9 ASSIGNMENTS
1. Briefly discuss some of the important purposes and methods of valuation
of shares.
2. What do you understand by asset based approach to valuation? What are
the main problems involved in this approach?
3. Critically evaluate capitalization of earnings approach for the valuation of
shares.
4. Explain the method of valuation of shares on the basis of actual market
price. State the main objections to this method.
5. Describe two methods of valuation of shares and discuss which method in
your view, most appropriate in valuing a minority and majority
shareholding.
24.10 SUGGESTED READINGS
1. Chowdhury : “Management Accounting”, Ludhiana Kalyani Publishers
2. Rathnam P.V: “Financial Adviser”, Allahabad Kitab Mahal.
3. Saravanavel.P : “Financial Management”, New Delhi, Dhanpat Rai & Sons.
24.11 LEARNING ACTIVITIES
What are the facts the influence the valuation of shares for the purposes of
amalgamation/merger of companies? Discuss with illustrations.
24.12 KEYWORDS
Present Value, Going Concern Value, Liquidation Value, Replacement Value,
Market Value, Book Value,Assets Backing Method, Goodwill,Earning Capacity
Valuation MethodActual Market Price.Instrinsic Value.

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346EN230 / 347EN130 / 348EN130 /349EN130

ANNAMALAI UNIVERSITY PRESS 2017 – 2018