Financial Management II 605 v1

Financial Management - II
Sub Code 605
Developed by
Prof. Abasaheb Chavan
On behalf of
Prin. L.N. Welingkar Institute of Management Development & Research
!  
Advisory Board
Chairman
Prof. Dr. V.S. Prasad
Former Director (NAAC)
Former Vice-Chancellor
(Dr. B.R. Ambedkar Open University)
Board Members
1. Prof. Dr. Uday Salunkhe  2. Dr. B.P. Sabale  3. Prof. Dr. Vijay Khole  4. Prof. Anuradha Deshmukh 
Group Director  Chancellor, D.Y. Patil University, Former Vice-Chancellor  Former Director 
Welingkar Institute of Navi Mumbai  (Mumbai University) (YCMOU)
Management Ex Vice-Chancellor (YCMOU)
Program Design and Advisory Team
Prof. B.N. Chatterjee Mr. Manish Pitke

Dean – Marketing Faculty – Travel and Tourism
Welingkar Institute of Management, Mumbai Management Consultant
Prof. Kanu Doshi Prof. B.N. Chatterjee

Dean – Finance Dean – Marketing
Welingkar Institute of Management, Mumbai Welingkar Institute of Management, Mumbai
Prof. Dr. V.H. Iyer Mr. Smitesh Bhosale

Dean – Management Development Programs Faculty – Media and Advertising
Welingkar Institute of Management, Mumbai Founder of EVALUENZ
Prof. B.N. Chatterjee Prof. Vineel Bhurke

Dean – Marketing Faculty – Rural Management
Prof. Venkat lyer Dr. Pravin Kumar Agrawal

Director – Intraspect Development Faculty – Healthcare Management
Manager Medical – Air India Ltd.
Prof. Dr. Pradeep Pendse Mrs. Margaret Vas

Dean – IT/Business Design Faculty – Hospitality
Welingkar Institute of Management, Mumbai Former Manager-Catering Services – Air India Ltd.
Prof. Sandeep Kelkar Mr. Anuj Pandey

Faculty – IT Publisher
Welingkar Institute of Management, Mumbai Management Books Publishing, Mumbai
Prof. Dr. Swapna Pradhan Course Editor

Faculty – Retail Prof. Dr. P.S. Rao
Welingkar Institute of Management, Mumbai Dean – Quality Systems
Welingkar Institute of Management, Mumbai
Prof. Bijoy B. Bhattacharyya Prof. B.N. Chatterjee

Dean – Banking Dean – Marketing
Mr. P.M. Bendre Course Coordinators

Faculty – Operations Prof. Dr. Rajesh Aparnath
Former Quality Chief – Bosch Ltd. Head – PGDM (HB)
Welingkar Institute of Management, Mumbai
Mr. Ajay Prabhu Ms. Kirti Sampat

Faculty – International Business Assistant Manager – PGDM (HB)
Corporate Consultant Welingkar Institute of Management, Mumbai
Mr. A.S. Pillai Mr. Kishor Tamhankar

Faculty – Services Excellence Manager (Diploma Division)
Ex Senior V.P. (Sify) Welingkar Institute of Management, Mumbai
COPYRIGHT © by Prin. L.N. Welingkar Institute of Management Development & Research.

Printed and Published on behalf of Prin. L.N. Welingkar Institute of Management Development & Research, L.N. Road, Matunga (CR), Mumbai - 400 019.
 
ALL RIGHTS RESERVED. No part of this work covered by the copyright here on may be reproduced or used in any form or by any means – graphic,
electronic or mechanical, including photocopying, recording, taping, web distribution or information storage and retrieval systems – without the written
permission of the publisher.
NOT FOR SALE. FOR PRIVATE CIRCULATION ONLY.
1st Edition, july 2017

ABOUT THE AUTHOR
ABOUT THE AUTHOR
Abasaheb Chavan is a Professional Banker currently working with one of

the fastest growing private sector banks as Head–Trade Compliance. He is
handling International Trade Compliance, Advisory and Regulatory matters
of the bank. He is a professional banker with more than 39 years of rich
banking experience. He has served 23 years with Canara Bank, 12 years
with India's first private sector bank. His areas of expertise include
International Trade; Corporate and Retail Banking; Rupee Drawing
Arrangements with International Banks and Exchange Houses for foreign
inward remittances business originating from GCC countries, Hong Kong
and Singapore. He is expert in handling NRI business too. The External
Commercial Borrowings (ECB); inbound and outbound capital investment
flow, viz., Foreign Direct Investment in India (FDI); Overseas Direct
Investment (ODI); Setting up of offices in India by overseas entities such
as Liaison Office (LO), Branch Office (BO), Project office (PO) and also
establishing Office overseas are his areas of interest.
Mr. Chavan is experienced in the establishing and centralization of Banks’

Trade Finance operations, preparation of policies and issuance of
procedural guidelines for various trade products and other regulatory
matters which include project finance, mergers, acquisitions,
amalgamation, takeover, etc. and other capital account deals pertaining to
venture capital and crowd funding.
! !3
ABOUT THE AUTHOR
Mr. Chavan was an Executive Committee Member of International Chamber

of Commerce (ICC), Paris Delhi Chapter, Managing Committee Member of
Foreign Exchange Dealers Association of India, Mumbai (FEDAI), and
Examiner for Indian Institute of Banking and Finance (IIBF), Foreign
Exchange and Risk Management and a Nodal Officer to the Reserve Bank of
India.
Mr. Chavan holds a Master’s degree in Science (M.Sc.) and is a Certified

Associate of Indian Institute of Banking and Finance (CAIIB). He is also a
professional trainer and is providing training to bank employees at various
levels on various subjects. He provides advisory services and conducts
seminars for Importers, Exporters and investors and participated in the
conferences organized by renowned bodies and government/semi-
government organizations.
! !4
CONTENTS
Contents
Chapter No. Chapter Name Page No.
1 Financial Management Decisions: Overview 7-17

2 Investment Decisions: Capital Budgeting Process 18-32
3 Investment Decisions: Capital Budgeting Techniques 33-63
4 Capital Expenditure Decisions 64-94
5 Methods for Taking the Investment Decisions 95-114
6 Financial Decisions 115-137
7 Factors Affecting Dividend Decisions 138-151
8 Measuring and Managing Investment Risk 152-170
9 Cost of Capital 171-185
10 Working Capital Investment Decisions 186-205
11 Term Loans, Leasing and Hire Purchase in Financial 206-223
Management
12 Financial Management in Debentures, Bonds and 224-243

Securitisation
13 Financial Management in Derivatives 244-259

14 Commercial Paper 260-276
15 Portfolio Management 277-294
16 Factoring and Forfaiting 295-312
17 Hybrid Financing 313-327
18 Hire Purchase Financing 328-342
19 Lease Financing 343-359
20 Long-term Finance and Small Business Finance 360-381
21 Venture Capital 382-398
! !5
CONTENTS
22 Foreign Venture Capital Investment in India 399-413

23 Corporate Governance 414-436
24 Corporate Restructuring 437-457
25 Business Valuation and Techniques 458-482
26 Financial Management in Public Enterprises 483-502
! !6
FINANCIAL MANAGEMENT DECISIONS: OVERVIEW
Chapter 1
Financial Management Decisions: Overview
Objectives
After studying this chapter, you should be able to understand some of the
basic requirements of decision-making process in financial management by
taking an overview of:
• Definition and Objectives of Financial Decision-making

• Investment Decisions
• Financial Decisions
• Dividend Decision
• Liquidity Decision
Structure:
1.1 Definition and Objectives

1.2 Prerequisites
1.3 Investment Decision
1.4 Financial Decision
1.5 Dividend Decision
1.6 Liquidity Decision
1.7 Other Decisions
1.8 Summary
1.9 Questions
! !7
1.1 Definition and objectives
Financial Decisions is comprehensive financial planning and wealth

management of firm that helps high-net-worth individuals and businesses
to achieve their financial objectives. Investment advisory services are
offered through Financial Decisions.
The general objective of Finance Management team in any organisation is

to take decision considering organisation’s goal, objective and policies in
respect of following areas:
1. Investment Decision: There are 2 types of investment decisions:
a. Capital Investment Decision

b. Working Capital Investment Decision
2. Financing Decision
3. Dividend Decision
4. Liquidity/Assets Management Decision
! !8
1.2 Prerequisites
Before taking any decisions, a Finance Manger should have clear view on
some of the following points:
• Where to invest the scarce resources of business?

• What makes for a good investment?
• Where do you raise the funds from for these investments?
• What mix of owner’s money (equity) or borrowed money (debt) do you
use?
• How much of a firm’s funds should be reinvested in the business and how
much should be returned to the owners?
• How much should a firm invest in current assets and what should be the
components with their respective proportions?
• How to manage the working capital?
These are some of the questions that a finance manager is expected to

answer and satisfy the owner/management/Board of the company before
taking an action or decision. Finance functions call for skillful planning,
control and execution of a firm’s activities. Let us note at the outset that
shareholders are made better off by a financial decision that increases the
value of their shares, thus while performing the finance function, and while
taking decision the finance manager should strive to maximize the market
value of shares. Whatever decisions a manger takes need to result in
wealth maximization of the shareholder and indirectly to Company.
Let us take an overview of major areas where critical Financial decisions

are required to be taken by the Finance Manager.
! !9
1.3 Investment Decision
Investment decision or capital budgeting involves the decision of allocation

of capital or commitment of funds to long-term assets that would yield
benefits in the future.
Two important aspects of the investment decision are:
a. the evaluation of the prospective profitability of new investments, and
b. the measurement of a cut-off rate against that of the prospective return

of new investments could be compared.
Future benefits of investments are difficult to measure and cannot be

predicted with certainty. Because of the uncertain future, investment
decisions involve risk. Investment proposals should, therefore, be
evaluated in terms of both expected return and risk. Besides the decision
for investment, managers do see where to commit funds when an asset
becomes less productive or non-profitable. There is a broad agreement
that consists of correct cut-off rate, required rate of return or the
opportunity cost of capital.
However, there are problems in computing the opportunity cost of capital in

practice from the available data and information.
A decision-maker should be aware of capital in practice from the available

data and information. A decision-maker should be aware of these
problems.
1.4 Financing Decision
Financing decision is the second important function to be performed by the

finance manager. Broadly, he or she must decide when, where and how to
acquire funds to meet the firm’s investment needs. The central issue before
him or her is to determine the proportion of equity and debt. The mix of
debt and equity is known as the firm’s capital structure. The finance
manager must strive to obtain the best financing mix or the optimum
capital structure for his or her firm. The firm’s capital structure is
considered to be optimum when the market value of shares is maximized.
! !10
The use of debt affects the return and risk of shareholders; it may increase
the return on equity funds but it always increases risk. A proper balance
will have to be struck between return and risk.
When the shareholders’ return is maximized with minimum risk, the

market value per share will be maximized and the firm’s capital structure
would be considered optimum.
Once the finance manager is able to determine the best combination of

debt and equity, he or she must raise the appropriate amount through the
best available sources. In practice, a firm considers many other factors
such as control, flexibility, loan convenience, legal aspects etc. in deciding
its capital structure.
1.5 Dividend Decision
Dividend decision is the third major financial decision. The finance manager
must decide whether the firm should distribute all profits, or retain them,
or distribute a portion and retain the balance. Like the debt policy, the
dividend policy should be determined in terms of its impact on the
shareholders’ value. The optimum dividend policy is one that maximizes
the market value of the firm’s shares. Thus, if shareholders are not
indifferent to the firm’s dividend policy, the finance manager must
determine the optimum dividend-payout ratio. The payout ratio is equal to
the percentage of dividends to earnings available to shareholders.
The finance manager should also consider the questions of dividend

stability, bonus shares and cash dividends in practice. Most profitable
companies pay cash dividends regularly. Periodically, additional shares,
called bonus shares (or stock dividend), are also issued to the existing
shareholders in addition to the cash dividend.
1.6 Liquidity Decision
This is the function of Asset Management. Current asset management that

affects a firm’s liquidity is yet another important finance function, in
addition to the management of long-term assets. Current assets should be
managed efficiently for safeguarding the firm against the dangers of
illiquidity and insolvency.
! !11
Investment in current assets affects the firm’s profitability, Liquidity and

risk. A conflict exists between profitability and liquidity while managing
current assets.
If the firm does not invest sufficient funds in current assets, it may become
illiquid. But it would lose profitability, as idle current assets would not earn
anything. Thus, a proper trade-off must be achieved between profitability
and liquidity.
In order to ensure that neither insufficient nor unnecessary funds are

invested in current assets, the finance manager should develop sound
techniques of managing current assets. He or she should estimate firm’s
needs for current assets and make sure that funds would be made
available when needed.
It would thus be clear that financial decisions directly concern the firm’s
decision to acquire or dispose of assets and require commitment or
recommitment of funds on a continuous basis. It is in this context that
finance functions are said to influence production, marketing and other
functions of the firm. Thus, in consequence, finance functions may affect
the size, growth, profitability and risk of the firm, and ultimately, the value
of the firm.
1.7 Other Decisions
The function of finance management is to review and control decisions to

commit or recommit funds to new or ongoing uses. Thus, in addition to
raising funds, financial management is directly concerned with production,
marketing and other functions, within an enterprise whenever decisions are
about the acquisition or distribution of assets.
Various financial functions are intimately connected with each other. For
instance, decision pertaining to the proportion in which fixed assets and
current assets are mixed determines the risk complexion of the firm. Costs
of various methods of financing are affected by this risk. Likewise, dividend
decisions influence financing decisions and are themselves influenced by
investment decisions.
! !12
In view of this, finance manager is expected to call upon the expertise of

other functional managers of the firm particularly in regard to investment
of funds. Decisions pertaining to kinds of fixed assets to be acquired for the
firm, level of inventories to be kept in hand, type of customers to be
granted credit facilities, terms of credit should be made after consulting
production and marketing executives.
However, in the management of income, finance manager has to act on his

own. The determination of dividend policies is almost exclusively a finance
function. A finance manager has the final say in decisions on dividends
than in asset management decisions.
Financial management is looked on as cutting across functional even

disciplinary boundaries. It is in such an environment that finance manager
works as a part of total management. In principle, a finance manager is
held responsible to handle all such problems that involve money matters.
But in actual practice, he has to call on the expertise of those in other
functional areas to discharge his responsibilities effectively.
! !13
1.8 Summary
From the above overview, you will understand that Financial management
is the development and implimentation of financial principles to position
the company to achieve a for-profit’s primary goal – increasing owners
value. Financial management does this through utilizing resources
appropriately and collecting and using information effectively to make
sound decisions. A financial management system enables companies to
leverage the financing, management and investment in new and current
assets to attain its operational and financial and operational goals by
managing, financing and investing in a variety of assets. Financial
management includes cash flow management and debt financing also
One role of financial management is to raise funds from external entities,

typically lenders and investors, to cover the costs of expansion. If a
company intends to grow at a pace that requires more money than
operational cash flow can provide, it must adopt a strategy for identifying
and pursuing additional sources of funds. Companies must establish
specific goals and weigh the pros and cons of debt and equity. Debt to
equity ratio targets, expansion rates and available assets will impact this
expansion and financing strategy.
Small business owners and managers make decisions on a daily basis,
addressing everything from day-to-day operational issues to long-range
strategic planning. The decision-making process of a manager can be
broken down into six distinct steps (Identify Problems, Seek Information,
Brainstorm Solutions, choose an Alternative, Implement the Plan and
Evaluate Outcomes). Although each step can be examined at length,
managers often run through all of the steps quickly when making
decisions. Understanding the process of managerial decision-making can
improve your decision-making effectiveness.
! !14
1.9 Questions
A. Answer the following Questions:
1. What types of decisions are required to be taken by a Finance Manager?
2. Explain your understanding on: Investment Decisions
3. Is the working capital requirement decision forming the part of

investment decision? Please explain.
4. Write short notes on:

a. Liquidity Decision
b. Financing Decision
5. Explain the steps involved in process of decision-making.
B. Multiple Choice Questions: (Mark X against the most appropriate

alternative)
1. Whatever decision a manager takes need to result in wealth

maximization of a _____________ indirectly to Company.
a. Finance Manager
b. Shareholder
c. Company Management
d. Board of Directors
2. Investment decision or capital budgeting involves the decision of

allocation of capital or commitment of funds to _____________ that
would yield benefits in the future.
a. Medium-Term Assets
b. Short-term assets
c. long-term assets
d. All assets acquired
 
! !15
3. What do you understand by term “Firms Capital structure”?
a. Equity
b. Debt
c. Equity and debt
d. Net worth
4. In order to ensure that neither insufficient nor unnecessary funds are

invested in current assets, the financial manager should develop sound
techniques of managing_____________.
a. Current assets
b. Fixed Assets
c. All assets
d. Floating assets
5. The finance manager is expected to call upon the expertise of other

functional managers of the firm particularly in regard to
_____________.
a. Investment into assets
b. Investment of funds
c. Raising the Finance
d. Declaring the dividend
Answers: 1. (b), 2. (c), 3. (c), 4. (a), 5. (b)
! !16
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
! !17
INVESTMENT DECISIONS: CAPITAL BUDGETING PROCESS
Chapter 2
Investment Decisions: Capital Budgeting
Process
Objectives
After studying this chapter, you should be able to understand the capital
Budgeting process, steps involved in capital budgeting starting from idea
generation till the implementation and completion of project. There are
Verities of industry-wise decision-making processes for computing the
budgeting. You will also understand the steps involved and principles of
capital budgeting alongside evaluation and selection of project.
Structure:
2.1 Introduction
2.2 Steps in Capital Budgeting Process
2.3 Categories of Capital Budgeting Projects
2.4 Principles of Capital Budgeting
2.5 Evaluation and Selection of Capital Projects
2.6 Summary
2.7 Questions
! !18
Capital Budgeting Process:
2.1 Introduction
Capital budgeting is the most important decision for a finance manager.

Since it involves buying expensive assets for long-term use, capital
budgeting decisions may have a role to play in the future success of the
company. The right decisions made in capital budgeting process will help
the manager and the company to maximize the shareholder value which is
the primary goal of any business.
The capital budgeting process includes identifying and then evaluating

capital projects for the company. Capital projects are the ones where the
cash flows are received by the company over longer periods of time which
exceed a year. Almost all the corporate decisions that impact future
earnings of the company can be studied using this framework. This process
can be used to examine various decisions like buying a new machine,
expanding operations at another geographic location, moving the
headquarters or even replacing the old asset. These decisions have the
power to impact the future success of the company. This is the reason the
capital budgeting process is an invaluable part of any company.
2.2 Steps in Capital Budgeting Process
The capital budgeting process has the following five steps:
1. Generation of Ideas
The generation of good quality project ideas is the most important capital
budgeting step. Ideas can be generated through a number of sources like
senior management, employees and functional divisions or even from
outside the company.
In this step of proposal, identify best investment projects. For example,

investment of funds in Health industry, media industry or any other. But, if
you have more than 20 years’ experience in education industry, ideally it is
best to invest in education industry. Like this, you can select the best area
where you have to invest your money. Otherwise, it will be just gambling.
So you have to identify the investment project first.
! !19
2. Analysis of Proposals
The basis of accepting or rejecting a capital project is the project’s

expected cash flows in the future. Hence, all the project proposals are
analyzed after forecasting their cash flows to determine the expected
profitability of each project.
This is also called evaluation of investment project. As mentioned above,

once again after selecting industry, you will have to go more deeply to
screen the proposal of investment. In education industry, if one is investing
to open school or educational institute, he can also invest to start own
publishing company or company for selling the books. So, before actual
investment, screening the proposal and then focusing on any one of other
projects is essential.
3. Creating the Corporate Capital Budget
Once the profitable projects are shortlisted, they are prioritized according
to the available company resources, the timing of the cash flows of the
project and the overall strategic plan of the company. Some projects may
be attractive on their own, but may not be a fit to the overall strategy.
After evaluation through capital budgeting methods, you can select best
investment project, in which they invest their money for getting return.
4. Monitoring and Post-Audit:
A follow-up on all decisions is equally important in the capital budgeting

process. The analysts compare the actual results of the projects to the
projected ones and the project managers are responsible if the projections
match or do not match the actual results. A post-audit to recognize
systematic errors in the cash flow forecasting process is also essential as
the capital budgeting process is as good as the inputs’ estimates into the
forecasting model.
This is 4th step in which you can start to monitor the performance by
keeping its accounts. If performance is not coming as per your estimation,
you can change the project at the initial stage itself.
! !20
5. Feedback
Feedback is the controlling process of capital budgeting in which you can
check the investment from time to time, if there is any default anywhere in
the investment, you can try to correct it for long-term for better return on
investment.
2.3 Categories of Capital Budgeting Projects:
As a small-business owner, your strategic budgeting process is vital so that

you can properly allocate your resources. A capital budget allows you to
accurately predict the best way to grow your business to meet your short-
and long-term goals. It helps you evaluate your future projects to
determine as to which the most feasible and profitable are. Capital budget
contains four basic components. They are as under.
1. Replacement Projects for Maintaining Business
Such projects are implemented without any detailed analysis. The only
issues pertaining to these types of projects are first whether the existing
operations continue and, if yes, whether the existing processes should be
changed or maintained.
Equipment that wears out or breaks down must be replaced. When you
spend more time and money on repairing equipment, it’s usually best to
replace it, because the costs end up exceeding the resources you need to
purchase new equipment. Improvements on your workspace also may be
included in the replacement category of your capital budget. Repairs and
other maintenance costs that exceed your normal operating budget also go
into the more long-term outlay projected in a capital budget. Replacements
usually don’t require the same level of analysis and consideration you put
into additions to your business.
2. Replacement Projects for Reducing Cost
The replacement of projects for reducing cost are implemented after a

detailed analysis, because these determines whether the existing is
obsolete, but still operational, and equipment requires to be replaced or
not.
! !21
Mandatory additions, adjustments, improvements or repairs required by

state or city government codes serve to form another category of your
capital budget plan. In US Federal regulations or environmental industry
changes must be included in your planning so that you can stay in business
and avoid fines and shutdowns. In India Govt. of India approval is
necessary to protect the environment/pollution control etc. Any
requirements of insurance carriers mandate go into the mandatory
requirement category of the budget. This category is another step that
can’t be ignored or debated and includes those costs that are not recurring
in your operational budget.
3. Expansion Projects
Such projects require a very detailed analysis. These projects are

undertaken to expand the business operations and involve a process of
making complex decisions as they are based on an accurate forecast of
future demand.
Before adding new services or products to your business, expansions and

improvements of existing equipment and facilities must be considered. The
category in the capital budget is reserved for adding onto existing product
lines and increasing the purchasing levels of those products proving to be
most successful. This category might include renovations to your building
or converting existing space to be more functional. It includes those
expenditures that make your business better without adding new
structures, equipment or products. Unlike repairs, replacements and
government requirements, expansions and improvements require
extensive consideration before adding them to your capital budget.
4. New Product/Market Development
Such projects also consist of making complex decisions that require a

detailed analysis as there is a great amount of uncertainty involved.
Making additions to your buildings, adding new product lines and the
equipment needed to produce it, and creating additional services are all
part of the capital budget for growth. This category includes acquisition of
new land and buildings. Additions to your business require resources and
planning and should coincide with your strategic growth plans. The capital
budget process allows you to consider all the ramifications of growth that
! !22
include the costs associated with the additional resources you will need to
achieve that growth. The capital budgeting process does not just include
making list of your additional needs, but considering how those additions
fit in with your strategic goals.
5. Mandatory Projects
Such projects are required by an insurance company or a governmental

agency and often involve environmental or safety-related concerns. These
projects will not generate any revenue, but they surely accompany new
projects started by the company to produce revenue.
6. Other Projects
Some projects that cannot be easily analyzed fall into this category. A pet
project involving senior management or a high-risk project that cannot be
analyzed easily with typical assessment methods are included in such
projects.
2.4 Principles of Capital Budgeting
Capital budgeting is the process of evaluating and implementing a firm’s

investment opportunities, by virtue of properly identifying such
investments that are likely to enhance a firm’s competitive advantage and
increase shareholder wealth. A typical capital budgeting decision involves a
large up-front investment followed by a series of smaller cash inflows.
A typical capital budgeting process is focused around following basic

principles:
i. Decisions are based on potential cash flows and not accounting

income
If a project is undertaken and subsequently some relevant incremental

cash flows are to flow out, by virtue of such a capital budgeting plan, the
relevant cash flows are to be considered as a part of the budgeting
process, and the decisions on capital budgeting have to take such
incremental cash flows into consideration, before properly evaluating such
a capital budgeting plan. However, the sunk costs can’t be avoided even by
! !23
overlooking or avoiding such a capital budgeting plan, and should not be

considered for acceptance or rejection of the project.
However, while finalizing a capital budgeting decision, one needs to

examine the impact of implementing such a plan on the cash flows of
related activities undertaken by the same group, which has some synergy
with the proposal for which the capital budgeting is being undertaken. If
the sales of some related company within the same group are likely to face
shrinkage following the implementation of such a plan, the capital
budgeting plan should take such a potential cash inflow loss into account,
before going for the proposed plan. In other words, if potential cash flows
are likely to have a detrimental effect on the cash flows emerging out of
existing business, both of them need to be examined carefully before
finalizing the capital budgeting plan. Such a typical case, where an existing
cash flow may suffer due to potential cash flow of the new/improved facility
is called cannibalization or externality.
For example, if a day-care centre decides to open another branch within a

distance of 10 km from the existing one, the impact of customers who
decide to move from one facility to the new facility that is now closer to
their workplace must be considered.
A project could have a conventional cash flow pattern, which typically

means a cash flow at the time of undertaking such a capital budgeting
plan, to be followed by a series of cash inflows over the years to follow.
However, at times, there could be cases where the project may also have
more than one cash outflow, like the one at the start, which could follow at
the time of retirement of project. Such cases are called non-conventional
cash flow patterns.
ii. Cash flows are based on opportunity costs
Any firm that undertakes an analysis of taking up a project may end up

finding that there may be alternate plans available to boost its potential
cash flows out of the funds it is deploying in the capital budgeting. Such
cash flows which need to be foregone, for undertaking the capital
budgeting plan, and typically considered as the opportunity costs for the
firm and are key parameters before making a choice on whether to
implement the project, or forego it. Such opportunity costs should be duly
! !24
considered while making a final choice on whether or not to implement the

new project.
iii. Timing of Cash Flow
It should be kept in mind that the timing of cash flows subsequent to the
capital budgeting (when the cash outflows move out of system), are
important for undertaking a project. Typically, the earlier the cash inflow
starts to plough back into the business, the higher is its value.
iv. Post-tax analysis
It is important to note that all cash flows accruing into the business should
be considered only after taking into account the tax implication of such
cash inflows or only on a post-tax basis.
Financing costs reflected in project’s required rate of return: Once the

opportunity costs are considered to evaluate the project, it is widely
accepted that the project no longer requires considering the financing
costs, which get built into the system automatically, once the entire project
is examined with a perspective from the required rate of return.
Thus, the capital budgeting process is based on the following five

principles:
i. All the capital budgeting decisions are based on the incremental cash
flows of the project, and not on the accounting income generated by
it. Sunk costs are not considered in the analysis. The external factors
that can impact the implementation of the project and eventually the
cash flow of company have to be fully considered while preparing/
planning the capital budgeting.
ii. All the cash flows of the project should be based on the opportunity
costs. Opportunity costs account for the money that the company will
lose by implementing the project under analysis. These are the existing
cash flows already generated by an asset of the company that will be
forgone if the project under analysis is undertaken.
! !25
iii. The timing of the receipt of the cash flows is important. As per the time
value of money concept, cash flows of the project received earlier have
more value than the cash flows received later.
iv. All the cash flows from the project should be analysed on an after-tax
basis. The company should evaluate only those cash flows that they will
keep, not those that they will pay to the government.
v. The financing costs pertaining to a project should not be considered

while evaluating incremental cash flows. These costs are already
reflected in the project’s required rate of return.
2.5 Evaluation and Selection of Capital Projects:
Capital projects involve the commitment of large outlays of capital assets

for an investment project. These projects tend to be large scale and more
complex than usual transactions. Examples of a capital project include a
business organization's allocation of monetary resources to expand
production capacity or a city's capital budgeting plan to build a bridge or
public facility. Including milestone and final evaluation stages in the capital
project plan gives the project manager or sponsor an opportunity to assess
whether predetermined targets related to costs, time and quality have
been achieved
Therefore, all the capital projects are thoroughly analysed on the basis of
their cash flows forecast. However, the evaluation and selection of capital
projects are also affected by the following categories:
1. Independent versus Mutually Exclusive Projects: Independent

projects are unrelated to each other and are thus, evaluated
independently based on the individual profitability of each project. For
example, assume both projects X and Y are independent and are
profitable as well, then there is a probability that the company will
accept both the projects. However, mutually exclusive implies that only
one of the projects from a set will be accepted and that there is a
competition among the projects itself. For example, if projects X and Y
are mutually exclusive, the company cannot select both but only either
X or Y.
! !26
2. Project Sequencing: Some projects are implemented in a certain

sequence or order so that the investment in one project today generates
the opportunity to invest in other future projects. If a project
implemented today is profitable, it will create the option to invest in the
second project next year. However, if the same current project becomes
unprofitable, the company won’t invest in the next project.
3. Unlimited Funds versus Capital Rationing: If a company has

unlimited funds, it can execute all the projects where expected returns
are in excess of the cost of capital. However, many companies have
capital constraints and have to use capital rationing. If the company’s
profitable projects exceed the funds available for investing, the company
resorts to rationing or prioritizing the capital expenditures. This helps
the company to achieve the goal of maximum increase in the
shareholders’ value given the available capital.
In addition to above Capital project evaluations include a quality

assessment. Project managers use a number of techniques to assess
quality. As an example, Six Sigma is a quality control technique used by
companies to achieve and assess quality standards. Sigma is a Greek letter
used in mathematics to represent a standard deviation or variance. A Six
Sigma evaluation for a capital project can assess for waste and poor
production outputs or the quality performance of teams and suppliers.
Capital project evaluations include comparing projected budgets against

actual budget costs. This entails reviewing costs such as those associated
with labor expenses, equipment, supplies and other general operating
costs. Additionally, capital budgeting techniques – used to assess
alternative investments option – can be an effective tool in evaluating
large-scale investments. For example, the capital budgeting payback
approach involves calculating how many years it will take to recover initial
investment outlays. Another capital budgeting approach calculates the
average rate of return on a given capital investment.
Thus, the capital budgeting process is an amalgamation of very complex

decisions and their assessments. A single project can easily harm or enable
the company to a large extent. Hence, an analyst needs to understand all
the steps involved as well as the basic principles of the capital budgeting
process.
! !27
2.6 Summary
Capital budgeting refers to the process we use to make decisions

concerning investments in the long-term assets of the firm. The general
idea is that the capital, or long-term funds, raised by the firms are used to
invest in assets that will enable the firm to generate revenues several
years into the future. Often the funds raised to invest in such assets are
not unrestricted, or infinitely available; thus the firm must budget how
these funds are invested.
Importance of Capital Budgeting — because capital budgeting decisions

impact the firm for several years, they must be carefully planned. A bad
decision can have a significant effect on the firm’s future operations. In
addition, the timing of the decisions is important. Many capital budgeting
projects take years to implement. If firms do not plan accordingly, they
might find that the timing of the capital budgeting decision is too late, thus
costly with respect to competition.
Generating Ideas for Capital Budgeting—ideas for capital budgeting

projects usually are generated by employees, customers, suppliers, and so
forth, and are based on the needs and experiences of the firm and of these
groups.
The sales representative presents the idea to management, who in turn

evaluates the viability of the idea by consulting with engineers, production
personnel, and perhaps by conducting a feasibility study.
Project Classifications—capital budgeting projects usually are classified

using the Replacement decision—a decision concerning whether an existing
asset should be replaced by a newer version of the same machine or even
a different type of machine that does the same thing as the existing
machine. Such replacements are generally made to maintain existing levels
of operations, although profitability might change due to changes in
expenses (that is, the new machine might be either more expensive or
cheaper to operate than the existing machine).
Project Classification can be classified into Expansion decision, —where a

decision concerning whether the firm should increase operations by adding
new products, additional machines, and so forth. Such decisions would
expand operations. It can also be by way of Independent project—where
! !28
the acceptance of an independent project does not affect the acceptance of

any other project—that is, the project does not affect other projects.
In case of mutually exclusive projects, the decision to invest in one project

affects other projects because only one project can be purchased.
When there are similarities between Capital Budgeting and Asset Valuation
of a capital budgeting decision, you need to compare the cost of the
project to the value the project will provide to the firm. To determine the
value of an asset, you need to compute the present value of the cash flows
the asset is expected to generate over its life. Once the value of the asset
is determined, the firm can determine whether to invest in the asset by
comparing its computed value to how much the asset costs to purchase.
Following this, decision-making procedure helps ensure that the firm will
maximize its value—that is, if an asset has a value to the firm that is
greater than its cost, the firm’s value would be increased if the firm
purchases the asset.
2.7 Questions
A. Answer the following questions:
1. What are the steps involved in capital budgeting?
2. What are the principles of capital budgeting?
3. What is the impact of Timing of Cash Flow in capital budgeting?
4. Write short notes on:
a. Sunk Cost
b. Opportunity Cost
5. Explain: Project sequencing.
! !29

alternative)
1. A capital budget allows you to accurately predict the best way to grow
your business to meet your short- and long-term goals as well as it
helps you evaluate your _____________ to determine which are most
feasible and profitable.
a. Future projects
b. Current Project
c. Completed project
d. Project under process
2. All the capital budgeting decisions are based on the _____________ of

the project, and not on the accounting income generated by it.
a. Existing Cash flow

b. Incremental cash flows
c. Expected cash flow
d. Other expected income
3. If a project implemented today is profitable, it will create the option to

invest in the second project next year, this process is called
_____________.
a. Project Selection
b. Project Budgeting
c. Project sequencing
d. Project identification
4. If the company’s profitable projects exceed the funds available for

investing, the company resorts to rationing or prioritizing the capital
expenditures. This process is called as _____________
a. Capital sunk
b. Capital rationing
c. Capital Restriction
d. Capital filtering
! !30
5. Capital budgeting is the process of evaluating and implementing a firm’s

_____________, by virtue of properly identifying such investments that
are likely to enhance a firm’s competitive advantage and increase
shareholder wealth.
a. Investment opportunities
b. Expansion opportunity
c. Investment in other activities
d. New project opportunity
Answers: 1. (a), 2. (b), 3. (c), 4. (b), 5. (a).
! !31
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !32
INVESTMENT DECISIONS: CAPITAL BUDGETING TECHNIQUES
Chapter 3
Investment Decisions: Capital Budgeting
Techniques
Objectives
After studying this chapter, you should be able to understand use of capital
Budgeting techniques which provide precise means to choose most useful
project for enterprise. In this chapter, we are going to discuss various
techniques used for capital budgeting. Most of the techniques are based on
the marginal principle wherein marginal revenue derived from the
investment matched with marginal cost.
You will also understand various ratios that are used and applied to
carefully choose techniques while doing the capital budgeting exercise.
Structure:
3.1 Introduction
3.2 Evaluation Techniques
3.3 Investment Profile
3.4 Capital Budgeting in Practice
3.5 Summary
3.6 Questions
! !33
3.1 Introduction
Capital budgeting is a technique of evaluating big investment projects. Net

Present Value (NPV), Benefit to Cost Ratio, Internal Rate of Return (IRR),
Payback Period and Accounting Rate of Return are some prominent capital
budgeting techniques widely used in the finance arena. A project is passed
for implementation after it is approved by applying these techniques.
Capital budgeting techniques are utilized by the entrepreneurs in deciding

whether to invest in a particular asset or not. It has to be performed very
carefully because a huge sum of money is invested in fixed assets such as
machinery, plant etc. The analysis is always based on the stream of
expected cash flows generated by using those assets and initial or future
outlays required for acquisition of the asset. Such investment techniques or
capital budgeting techniques are broadly divided into two criteria:
3.1.1 Discounting Cash Flow Criteria
Discounting cash flow criteria has three techniques for evaluating an

investment.
1. Net Present Value (NPV)
Net present value (NPV) technique is a well known method for evaluating
investment projects or proposals. In this technique or method, present
values of all the future cash flow whether it is negative (expenses) or
positive (revenues) is calculated by using an appropriate discounting rate
and adding. From this sum, the initial outlay is deducted to find out the
profit in present terms. If the figure is positive, the techniques show green
signal to the project and vice versa. This figure is called net present value
(NPV).
Suppose, you proposed investment of Rs. 100 Cr. and present value (PV) of
future cash flows come to be Rs. 120 Cr., the NPV would be Rs. 20 Cr. and
hence, the project should be undertaken. If the PV is Rs. 80 Cr., the NPV
would be negative by Rs. 20 Cr., the project is not advisable in this case.
! !34
2. The benefit to Cost Ratio
Benefit to cost ratio presents the analysis in a proportion or ratio format.

Here, just like in the NPV method, the present value of future cash flows is
calculated and a ratio of this sum to the initial outlay is seen. If this ratio is
more than 1, the project should be accepted and if it is less than 1, it
should be rejected.
Let us assume the same example as taken in NPV method. Benefit to cost
ratio would be 1.2 in the first case and as per the rule, the project should
be executed and in the second example, the ratio is 0.8 which is less than
1, so the project should be rejected.
3. Internal Rate of Return
This method is also a well-known method of evaluation. This has a direct

connection with the first method i.e. Net Present Value (NPV). In the NPV
method, the discounting rate is assumed to have known to the evaluator.
On the contrary, the rate of discounting is not known in this method of
Internal Rate of Return (IRR). IRR is found out by equating the NPV equal
to 0 with an unknown variable as the discounting rate. This discounting
rate is found out using trial and error method or extrapolating and
interpolating methods and it is known as Internal Rate of Return (IRR).
For evaluation purpose, IRR is compared with the cost of capital of the
organization. If the IRR is greater than a cost of capital, the project should
be accepted and vice versa.
3.1.2 Non-Discounting Cash Flow Criteria
Non-discounting cash flow criteria have two techniques for evaluation of

investment.
i. Payback Period: Payback period is the method of evaluation where no

discounting of cash flow comes into play. The term ‘payback period’ is
the period in which the initial outlay is covered with the revenues.
! !35
Suppose an initial outlay is Rs. 100 Cr. and the revenue stream is Rs. 40
Cr. for the first 4 years. Then, the payback period is 2.5 years. Essentially,
in 2.5 years, the entrepreneur gets his investment back and revenue after
this period is the profit for him.
ii. Accounting Rate of Return: Accounting rate of return is calculated

with the help of accounting data. The ratio of profit after tax and book
value of investment is the accounting rate of return. If the book value of
investment is Rs. 100 and profit after tax isRs. 25, then the ratio results
into 25%. Hence, accounting rate of return is 25%.
Value of the firm
The value of a firm today is the present value of all its future cash flows.
These future cash flows come from assets which are already in place and
from future investment opportunities. These future cash flows are
discounted at a rate that represents investors' assessments of the
uncertainty that they will flow in the amounts and when expected:
Value of the firm = !
where CFt is the cash flow in period t and r is the required rate of return.
The objective of the finance manager is to maximize the value of the firm.
In a company, the shareholders are the residual owners of the firm, so
decisions that maximize the value of the firm also maximize shareholders'
wealth.
The finance manager makes decisions regarding long-lived assets; this

process is referred to as capital budgeting. The capital budgeting decisions
for a project require analysis of:
• its future cash flows,
• the degree of uncertainty associated with these future cash flows, and
• the value of these future cash flows considering their uncertainty.
! !36
We have seen how to estimate cash flows where we were concerned with a
project's incremental cash flows, comprising changes in operating cash
flows (change in revenues, expenses, and taxes), and changes in
investment cash flows (the firm's incremental cash flows from the
acquisition and disposition of the project's assets).
And we know the concept behind uncertainty. The more uncertain a future
cash flow, the less it is worth today. The degree of uncertainty, or risk, is
reflected in a project's cost of capital. The cost of capital is what the firm
must pay for the funds to finance its investment. The cost of capital may
be an explicit cost (for example, the interest paid on debt) or an implicit
cost (for example, the expected price appreciation of its shares of common
stock).
Now, let us focus on evaluating the future cash flows. Given estimates of
incremental cash flows for a project and given a cost of capital that reflects
the project's risk, we look at alternative techniques that are used to select
projects.
For now, all we need to understand about a project's risk is that we can
incorporate risk in either of two ways:
1. we can discount future cash flows using a higher discount rate, the
greater the cash flow's risk, or
2. we can require a higher annual return on a project, the greater the risk
of its cash flows.
3.2 Evaluation Techniques
Look at the incremental cash flows for Project X and Project Y shown in
Exhibit 1. Can you tell by looking at the cash flows for Investment A
whether or not it enhances wealth? Or, can you tell by just looking at
Investments A and B which one is better? Perhaps with some projects you
may think you can pick out which one is better simply by gut feeling or
eyeballing the cash flows. But why does it that way when there are precise
methods to evaluate investments by their cash flows?
! !37
Exhibit-1
End of period cash flows (Rs)
Year Project X Project Y
2006 10,00,000 10,00,000
2007 0 3,25,000
2008 2,00,000 3,25,000
2009 3,00,000 3,25,000
2010 9 00,000 3,25,000
(Estimated cash flows for Investments X and Y)
Therefore, we must first determine the cash flows from each investment
and then assess the uncertainty of all the cash flows in order to evaluate
investment projects and select the investments that maximize wealth.
We look at six techniques that are commonly used by firms to evaluate

investments in long-term assets:
1. Payback period
2. Discounted payback period
3. Net Present Value
4. Profitability Index
5. Internal rate of Return and
6. Modified Internal rate of Return
We are interested in how well each technique discriminates among the

different projects, steering us toward the projects that maximize owners'
wealth.
An evaluation technique should:
• Consider all the future incremental cash flows from the project;
• Consider the time value of money;
• Consider the uncertainty associated with future cash flows, and
• Have some objective criteria by means of which projects can be selected.
! !38
Projects are selected using a technique that satisfies all four criteria and
will, under most general conditions, maximize owners' wealth.
In addition to judging whether each technique satisfies these criteria, we

will also look at which ones can be used in special situations, such as when
a certain amount of Rupees limit is placed on the capital budget.
3.2.1 Payback Period
The payback period for a project is the time from the initial cash outflow to
invest in it until the time when its cash inflows add up to the initial cash
outflow. In other words, how long it takes to get your Money back.
The payback period is also referred to as the payoff period or the capital
recovery period. If you invest Rs. 10,000 today and are promised Rs. 5,000
one year from today and Rs. 5,000 two years from today, the payback
period is two years -- it takes two years to get your Rs. 10,000
investments back.
Suppose you are considering Investments X and Y, each requiring an

investment of Rs. 1,000,000 today (we're considering today to be the last
day of the year 2006) and promising cash flows at the end of each of the
following years through 2010. How long does it take to get your
Rs. 1,000,000 investments back? The payback period for Project X is four
years:
Year Project X Accumulated cash flows
2006 -Rs. 1,000,000
2007 Rs. 0 -Rs. 1,000,000
2008 2,00,000 -800,000
2009 3,00,000 -500,000
2010 9,00,000 +400,000
By the end of 2009, the full Rs. 1,000,000 is not paid back, but by 2010
the accumulated cash flow hits (and exceeds) Rs. 1,000,000. Therefore,
the payback period for Project X is four years.
! !39
The payback period for Project Y is four years. It is not until the end of
2010 that Rs. 1,000,000 original investment (and more) is paid back.
Let us assume that the cash flows are received at the end of the year. We
always arrive at a payback period in terms of a whole number of years. If
we assume that the cash flows are received, say, uniformly, such as
monthly or weekly, throughout the year, we arrive at a payback period in
terms of years and fractions of years.
For example, assuming we receive cash flows uniformly throughout the

year, the payback period for Project X is 3 years and 6.6 months (assuming
Rs. 75,000 cash flow per month). Our assumption of end-of-period cash
flows may be unrealistic, but it is convenient to use this assumption to
demonstrate how to use the various evaluation techniques. We may
continue to use this end-of-period assumption throughout the coverage of
capital budgeting techniques.
Is Project X or Y more attractive? A shorter payback period is better than a

longer payback period. Yet there is no clear-cut rule for how short is better.
If we assume that all cash flows occur at the end of the year, Project X
provides the same payback as Project Y. Therefore, we do not know in this
particular case whether quicker is better.
In addition to having no well-defined decision criteria, payback period

analysis favors investments with "front-loaded" cash flows. That means, an
investment looks better in terms of the payback period the sooner its cash
flows are received no matter what its later cash flows look like. Payback
period analysis is a type of "break-even" measure. It tends to provide a
measure of the economic life of the investment in terms of its payback
period. The more likely the life exceeds the payback period, the more
attractive is the investment. The economic life beyond the payback period
is referred to as the post-payback duration. If post-payback duration is
zero, the investment is worthless, no matter how short the payback. This is
because the sum of the future cash flows is no greater than the initial
investment outlay. And since these future cash flows are really worthless
today than in the future, a zero post-payback duration means that the
present value of the future cash flows is less than the project's initial
investment.
! !40
The payback method should only be used as a coarse initial screen of

investment projects. But it can be a useful indicator of some things.
Because a Rupee of cash flow in the early years is worth more than a
Rupee of cash flow in later years, the payback period method provides a
simple, yet crude measure of the liquidity of the investment.
The payback period also offers some indication on the risk of the
investment. In industries where equipment becomes obsolete rapidly or
where there are very competitive conditions, investments with earlier
payback are more valuable. That's because cash flows farther into the
future are more uncertain and therefore have lower present value. In the
personal computer industry, for example, the fierce competition and rapidly
changing technology requires investment in projects that have a payback
of less than one year since there is no expectation of project benefits
beyond one year.
Because the payback method doesn't tell us the particular payback period
that maximizes wealth, we cannot use it as the primary screening device
for investment in long-lived assets.
3.2.2 Discounted Payback Period
The discounted payback period is the time needed to pay back the original
investment in terms of discounted future cash flows.
Each cash flow is discounted back to the beginning of the investment at a

rate that reflects both the time value of money and the uncertainty of the
future cash flows. This rate is the cost of capital -- the return required by
the suppliers of capital (creditors and owners) to compensate them for
time value of money and the risk associated with the investment. The more
uncertain the future cash flows, the greater the cost of capital.
The cost of capital, the required rate of return, and the discount rate
We discount an uncertain future cash flow to the present at some rate that
reflects the degree of uncertainty associated with this future cash flow. The
more uncertain, the less the cash flow is worth today -- this means that a
higher discount rate is used to translate it into a value today.
! !41
This discount rate is a rate that reflects the opportunity cost of funds. In
the case of a corporation, we consider the opportunity cost of funds for the
suppliers of capital (the creditors and owners). We refer to this opportunity
cost as the cost of capital.
The cost of capital comprises the required rate of return (RRR) (that is, the
return suppliers of capital demand on their investment) and the cost of
raising new capital if the firm cannot generate the needed capital internally
(that is, from retaining earnings). The cost of capital and the required rate
of return are the same concept, but from different perspectives. Therefore,
we will use the terms interchangeably.
• Calculating the discounted payback period
Returning to Projects X and Y, suppose that each has a cost of capital of 10

percent. The first step in determining the discounted payback period is to
discount each year's cash flow to the beginning of the investment (the end
of the year 2006) at the cost of capital:
Project X Project Y
Discounted Discounted
Year Cash flows Cash flows Cash flows Cash flows
2006 -Rs.1,000,000.00 -Rs. -Rs. -Rs.

1,000,000.00 1,000,000.00 1,000,000.00
2007 Rs. 0.00 -Rs. Rs. -Rs. 704,545.45

1,000,000.00 295,454.55
2008 Rs. 165,289.26 -Rs. 834,710.74 Rs. -Rs. 435,950.41

268,595.04
2009 Rs. 225,394.44 -Rs. 609,316.30 Rs. -Rs. 191,773.10

244,177.31
2010 Rs. 614,712.11 Rs. 5,395.81 Rs. Rs. 30,206.27

221,979.37
How long does it take for each investment's discounted cash flows to pay
back its Rs. 1,000,000 investment? The discounted payback period for both
X and Y is four years.
! !42
• Discounted Payback Decision Rule
It appears that the shorter the payback period, the better, whether using
discounted or non-discounted cash flows. But how short is better? We don't
know. All we know is that an investment "breaks-even" in terms of
discounted cash flows at the discounted payback period -- the point in time
when the accumulated discounted cash flows equal the amount of the
investment.
Using the length of the payback as a basis for selecting investments,

Projects X and Y cannot be distinguished. But we've ignored some valuable
cash flows for both investments, those beyond what is necessary for
recovering the initial cash outflow.
3.2.3 Net Present Value
If offered an investment that costs Rs. 5,000 today and promises to pay
you Rs. 7,000 two years from today and if your opportunity cost for
projects of similar risk is 10 percent, would you make this investment? To
determine whether or not this is a good investment you need to compare
your Rs. 5,000 investments with the Rs. 7,000 cash flow you expect in two
years. Because you determine that a discount rate of 10 percent reflects
the degree of uncertainty associated with the Rs. 7,000 expected in two
years, today it is worth:
Present value of Rs. 7,000 to be received in 2 years =
!
By investing Rs. 5,000, today you are getting in return, a promise of a cash
flow in the future that is worth Rs. 5,785.12 today. You increase your
wealth by Rs. 785.12 when you make this investment.
Another way of stating this is that the present value of the Rs. 7,000 cash
inflow is Rs. 5,785.12, which is more than the Rs. 5,000, today's cash
outflow to make the investment. When we subtract today's cash outflow to
make an investment from the present value of the cash inflow from the
investment, the difference is the increase or decrease in our wealth
referred to as the net present value.
! !43
The net present value (NPV) is the present value of all expected cash flows.
Net present value = Present value of all expected cash flows.
The word "net" in this term indicates that all cash flows -- both positive
and negative -- are considered. Often the changes in operating cash flows
are inflows and the investment cash flows are outflows. Therefore, we tend
to refer to the net present value as the difference between the present
value of the cash inflows and the present value of the cash outflows.
We can represent the net present value using summation notation, where t
indicates any particular period, CFt represents the cash flow at the end of
period t, i represents the cost of capital, and N the number of periods
comprising the economic life of the investment:
NPV= (Present value of cash inflow) - (Present value of Outflow) =
!
Cash inflows are positive values of CFt and cash outflows are negative
values of CFt. For any given period, t, we collect all the cash flows (positive
and negative) and net them together. To make things a bit easier to track,
let’s just refer to cash flows as inflows or outflows, and not specifically
identify them as operating or investment cash flows.
Take another look at Project X. Using a 10 percent cost of capital, the

present values of inflows are:
Project X
Year Cash flow(Rs) Discounted cash
Flow (`)
2006 10,00,000 10,00,000.00
2007 0 0.00
2008 2,00,000 1,65,289.26
2009 3,00,000 2,25,394.44
2010 9,00,000 6,14,712.11
NPV = +5,395.81
! !44
This NPV tells us that if we invest in X, we expect to increase the value of

the firm by Rs. 5,395.81. Calculated in a similar manner, the net present
value of Project Y is Rs. 30,206.27. We can use a financial calculator to
solve for the NPV as well, inputting the cash flows in order, making sure
that the Rs. 0 cash flow for year 2007 is included in the list of cash flows.
We can also use Microsoft Excel to solve for the net present value. The
Excel spreadsheet entries for the data would be:
A B
1 Year Project X
2 2006 -Rs. 1,000,000
3 2007 Rs. 0
4 2008 Rs. 200,000
5 2009 Rs. 300,000
6 2010 Rs. 900,000
• Net Present Value Decision Rule
A positive net present value means that the investment increases the value
of the firm -- the return is more than sufficient to compensate for the
required return of the investment. A negative net present value means that
the investment decreases the value of the firm -- the return is less than
the cost of capital. A zero net present value means that the return just
equals the return required by owners to compensate them for the degree
of uncertainty of the investment’s future cash flow and the time value of
the Money. Therefore,
! !45
if... this means that... and you...
NPV > Rs. the investment is expected should accept the project.
0 to increase shareholder
wealth
NPV < Rs. the investment is expected should reject the project.
0 to decrease shareholder
wealth
NPV = Rs. the investment is expected should be indifferent between

0 not to change shareholder accepting or rejecting the project
wealth
Project X is expected to increase the value of the firm by Rs. 5,395.81,

whereas Project Y is expected to increases add Rs. 30,206.27 in value. If
these are independent investments, both should be taken on because both
increase the value of the firm. If X and Y are mutually exclusive, such that
the only choice is either X or Y, then Y is preferred since it has the greater
NPV. Projects are said to be mutually exclusive if accepting one precludes
the acceptance of the other.
3.2.4 Profitability Index
The profitability index uses some of the same information we used for the
net present value, but it is stated in terms of an index. Whereas the net
present value is;
NPV= (Present value of cash inflow) - (Present value of Outflow) =
The profitability Index, PI = ! =
! !46
Where CIF and COF are Cash Inflow and Cash Outflow, respectively.
Project X
Year Cash flow Discounted cash flow
2007 Rs. 0 Rs. 0.00
2008 2,00,000 1,65,289.26
2009 3,00,000 2,25,394.44
2010 9,00,000 6,14,712.11
PI = ! = Rs. 1,005,395.81
Therefore, the profitability index is: PIX = !
= 1.0054
The index value is greater than one, which means that the investment
produces more in terms of benefits than costs.
The decision rule for the profitability index therefore depends on the PI
relative to 1.0:
PI > 1.0 the investment is expected to should accept the project.

increase shareholder wealth
PI < 1.0 the investment is expected to should reject the project.
decrease shareholder wealth
PI = 1.0 the investment is expected not should be indifferent between

to change shareholder wealth accepting or rejecting the
project
There is no direct solution for PI on your calculator; what you need to do is
calculate the present value of all the cash inflows and then divide this value
by the present value of the cash outflows. In the case of Project X, there is
! !47
only one cash out flow and it is already in present value terms (i.e., it
occurs at the end of 2006).
3.2.5 Internal Rate of Return
Suppose you are offered an investment opportunity that requires you to

put up Rs. 50,000 and has expected cash inflows of Rs. 28,809.52 after
one year and Rs. 28,809.52 after two years. We can evaluate this
opportunity using a time line, as shown in Exhibit below.
Time Line of Investment Opportunity
0 1 2
------------------- ----------------- ------------
Rs. 50,000 Rs. 28,809.52 Rs. 28,909.52
The return on this investment is the discount rate that causes the present
values of the Rs. 28,809.52 cash inflows to equal the present value of the
Rs. 50,000 cash outflow, calculated as:
Rs. 50,000 = ! =!
Another way to look at this is to consider the investment's cash flows

discounted at the IRR of 10 percent. The NPV of this project if the discount
rate is 10 percent (the IRR in this example), is zero:
Rs. 50,000 = ! = !
An investment's internal rate of return (IRR) is the discount rate that

makes the present value of all expected future cash flows equal to zero.
We can represent the IRR as the rate that solves:
Rs. 0 = !
The IRR for X is the discount rate that solves:
! !48
!
After calculation (on calculator or computer), we get the more precise
answer of 10.172 % per Year.
Looking back at the investment profiles of the projects X and Y, you will
notice that each profile crosses the horizontal axis (Where NPV= Rs. 0) at
the discount rate that corresponds to the investment’s internal rate of
return. This is no coincidence: by definition, the IRR is the discount rate
that causes the project's NPV which is equal to zero.
• Internal Rate of Return Decision Rule
The internal rate of return is a yield -- what we earn, on average, per year.
How do we use it to decide which investment, if any, to choose? Let's
revisit Investments A and B and the IRRs we just calculated for each. If, for
similar risk investments, owners earn 10 percent per year, then both A and
B are attractive. They both yield more than the rate owners require for the
level of risk of these two investments:
Investment IRR Cost of capital
X 10.172% 10%
Y 11.388% 10%
The decision rule for the internal rate of return is to invest in a project if it
provides a return greater than the cost of capital. The cost of capital, in the
context of the IRR, is a hurdle rate -- the minimum acceptable rate of
return. For independent projects and situations in which there is no capital
rationing, then 
! !49
IRR > cost of capital the investment is should accept the

expected to increase project.
shareholder wealth
IRR < cost of capital the investment is should reject the project.
expected to decrease
shareholder wealth
IRR = cost of capital the investment is should be indifferent

expected not to change between accepting or
shareholder wealth rejecting the project
• The IRR and Mutually Exclusive Projects
What if we were forced to choose between projects X and Y because they

are mutually exclusive? Project Y has a higher IRR than Project X -- so at
first glance we might want to accept Project Y. What about the NPV of X
and Y? What does the NPV tell us to do? If we use the higher IRR, it tells
us to go with Y. If we use the higher NPV if the cost of capital is 5 percent,
we go with X. Which is correct? Choosing the project with the higher net
present value is consistent with maximizing owners’ wealth. Why? Because
if the cost of capital is 10 percent, we would calculate different NPVs and
come to a different conclusion.
When evaluating mutually exclusive projects, the one with the highest IRR
may not be the one with the best NPV. The IRR may give a different
decision than NPV when evaluating mutually exclusive projects because of
the reinvestment assumption:
• NPV assumes cash flows reinvested at the cost of capital.

• IRR assumes cash flows reinvested at the internal rate of return.
This reinvestment assumption may cause different decisions in choosing

among mutually exclusive projects when:
• the timing of the cash flows is different among the projects,

• there are scale differences (that is, very different cash flow amounts), or
• the projects have different useful lives.
! !50
With respect to the role of the timing of cash flows in choosing between
two projects: Project Y's cash flows are received sooner than X's. Part of
the return on either is from the reinvestment of its cash inflows. And in the
case of Y, there is more return from the reinvestment of cash inflows. The
question is "What do you do with the cash inflows when you get them?" We
generally assume that if you receive cash inflows, you'll reinvest those cash
flows in other assets.
With respect to the reinvestment rate assumption in choosing between

these projects: Suppose we can reasonably expect to earn only the cost of
capital on our investments. Then for projects with an IRR above the cost of
capital we would be overstating the return on the investment using the
IRR.
Thus, If we evaluate projects on the basis of their IRR, it is possible that

we may select one that does not maximize value.
With respect to the NPV method: if the best we can do is reinvest cash
flows at the cost of capital, the NPV assumes reinvestment at the more
reasonable rate (the cost of capital). If the reinvestment rate is assumed to
be the project's cost of capital, we would evaluate projects on the basis of
the NPV and select the one that maximizes owners' wealth.
• The IRR and Capital Rationing
What if there is capital rationing? Suppose Investments A and B are

independent projects. Projects are independent if that the acceptance of
one does not prevent the acceptance of the other. And suppose the capital
budget is limited to Rs. 1,000,000. We are therefore forced to choose
between A or B. If we select the one with the highest IRR, we choose A.
But A is expected to increase wealth less than B. Ranking investments on
the basis of their IRRs may not maximize wealth.
We saw this dilemma earlier pertaining to projects X and Y when we looked

at their investment profiles. The discount rate at which X's NPV is Rs. 0.00
is X's IRR = 10.172 percent, where X's profile crosses the horizontal axis.
Likewise, the discount rate at which Y's NPV is Rs. 0.00 is B's IRR = 11.388
percent. The discount rate at which X's and Y's profiles cross is the cross-
over rate, 7.495 percent. For discount rates less than 7.495 percent, X has
the higher NPV. For discount rates greater than 7.495 percent, Y has the
! !51
higher NPV. If Y is chosen because it has a higher IRR and if Y's cost of
capital is less than 7.495 percent, we have not chosen the project that
produces the greatest value.
The source of the problem in the case of capital rationing is that the IRR
percentage, not a Rupee amount. Because of this, we cannot determine
how to distribute the capital budget to maximize wealth because the
investment or group of investments producing the highest yield does not
mean they are the ones that produce the greatest wealth.
• Multiple Internal Rates of Return
The typical project usually involves only one large negative cash flow
initially, followed by a series of future positive flows. But that's not always
the case. Suppose you are involved in a project that uses environmentally
sensitive chemicals. It may cost you a great deal to dispose of them. And
that will mean a negative cash flow at the end of the project.
Suppose we are considering a project that has cash flows as follows:
Period End of period cash flow (`)
0 -100
1 +260
2 +260
3 -490
What is this project's IRR? One possible solution is IRR = 14.835 percent,
yet another possible solution is IRR = 191.5 percent.
! !52
!
We can see this graphically in Exhibit, where the NPV of these cash flows
are shown for the discount rates from 0% to 250%. Remember that the
IRR is discount rate that causes the NPV to be zero.in terms of this graph
this means that the IRR is the discount rate where the NPV is Rs. 0, the
point at which the present value changes sign -- from positive to negative
or from negative to positive. In the case of this project, the present value
changes from negative to positive at 14.835 percent and from positive to
negative at 250 percent.
Thus, we can’t use the internal rate of return method if the sign of the cash
flows changes more than once during the project’s life.
3.2.6 Modified Internal Rate of Return
The internal rate of return method assumes that cash flows are reinvested
at the investment’s internal rate of return. Consider Project X. The IRR is
10.17188 percent. If we take each of the cash inflows from Project X and
reinvest them at 10.17188 percent, we will have Rs. 1,472,272.53 at the
end of 2010:
! !53
Number of periods earning a Future value of cash flow reinvested

return at 10.17188%
3 Rs. 0.00
2 2,42,756.88
1 3,30,515.65
0 9,00,000.00
Rs. 1,473,272.53
The Rs. 1,473,272.53 is referred to as the project’s terminal value. The
terminal value is how much the company has from this investment if all
proceeds are reinvested at the IRR. So what is the return on this project?
Using the terminal value as the future value and the investment as the
present value,
FV = Rs. 1,473,272.53
PV = Rs. 1,000,000.00
N = 4 years
i = !
= 10.17188%
In other words, by investing Rs. 1,000,000 at the end of 2006 and
receiving Rs. 1,473,272.53 produces an average annual return of 10.1718
percent, which is the project’s internal rate of return.
The modified internal rate of return is the return on the project assuming
reinvestment of the cash flows at a specified rate. Consider Project X if the
reinvestment rate is 5 percent:
Number of periods earning a Future value of cash flow

return reinvested at 5%
3 Rs. 0.00
2 2,20,500.00
1 3,15,000.00
0 9,00,000.00
! !54
Rs. 1,435,500.00
The modified internal rate of return is 9.4588 percent:

FV = Rs. 1,435,500
PV = Rs. 1,000,000
N = 4 years
i =! = 9.4588%
The MIRR is therefore a function of both the reinvestment rate and the
pattern of cash flows, with higher the reinvestment rates leading to greater
MIRRs. You can see this in Exhibit 5, where the MIRR of both Project X and
Project Y is plotted for different reinvestment rates. Project Y’s MIRR is
! !55
more sensitive to the reinvestment rate because more of its cash flows are
received sooner, relative to Project X’s cash flows.
If we wish to represent this technique in a formula,
MIRR = N !
Where the CIFt are the cash inflows and the COFt are the cash outflows. In
the previous example, the present value of the cash outflows is equal to
the Rs. 1,000,000 initial cash outlay, whereas the future value of the cash
inflows is Rs. 1,435,500.
If... this means that... and you...
MIRR > cost of capital the investment is should accept the

expected to return more project.
than required
MIRR < cost of capital the investment is should reject the project.
expected to return less
than required
MIRR = cost of capital the investment is are indifferent between

expected to return what accepting or rejecting the
is required project
Scale Differences
Scale differences -- differences in the amount of the cash flows -- between

projects can lead to conflicting investment decisions among the discounted
cash flow techniques. Consider two projects, Project Big and Project Little,
that each have a cost of capital of 5 percent per year with the following
cash flows: 
! !56
End of period Project Big Project Little
0 -Rs. 1,000,000 -Rs. 1.00
1 + 400,000 + 0.40
2 + 400,000 + 0.40
3 + 400,000 + 0.50
Applying the discounted cash flow techniques to each project,
Technique Project Big Project Little
NPV Rs. 89,299 Rs. 0.1757
PI 1.0893 1.1757
IRR 9.7010% 13.7789%
MIRR 8.0368% 10.8203%
Mutually Exclusive Projects
If Big and Little are mutually exclusive projects, which project should a firm
prefer? If the firm goes strictly by the PI, IRR, or MIRR criteria, it would
choose Project Little. But is this the better project? Project Big provides
more value -- Rs. 89,299 versus Rs. 0.18. The techniques that ignore the
scale of the investment -- PI, IRR, and MIRR -- may lead to an incorrect
decision.
Capital Rationing
If the firm is subject to capital rationing -- say a limit of Rs. 1,000,000 --

and Big and Little are independent projects, which project should the firm
choose? The firm can only choose one -- spend Rs. 1 or Rs. 1,000,000, but
not Rs. 1,000,001. If you go strictly by the PI, IRR, or MIRR criteria, the
firm would choose Project Little. But is this the better project? Again, the
techniques that ignore the scale of the investment -- PI, IRR, and MIRR --
leading to an incorrect decision.
! !57
3.3 The investment Profile
We may want to see how sensitive is our decision to accept a project to

changes in our cost of capital. We can see this sensitivity in how a project's
net present value changes as the discount rate changes by looking at a
project's investment profile, also referred to as the net present value
profile. The investment profile is a graphical depiction of the relation
between the net present value of a project and the discount rate: the
profile shows the net present value of a project for each discount rate,
within some range.
Let's impose X's NPV profile on the NPV profile of Project Y, If X and Y are
mutually exclusive projects -- we invest in only one or neither project --
this clearly shows that the project we invest in depends on the discount
rate. For higher discount rates, B's NPV falls faster than A's. This is
because most of B's present value is attributed to the large cash flows four
and five years into the future. The present value of the more distant cash
flows is more sensitive to changes in the discount rate than is the present
value of cash flows nearer the present.
3.4 Capital budgeting techniques in practice
Among the evaluation techniques in this chapter, the one we can be sure
about is the net present value method. NPV will steer us toward the project
that maximizes wealth in the most general circumstances. But whether
evaluation technique really helps financial decision makers?
We learn about what goes on in practice by anecdotal evidence and

through surveys. We see that:
• there is an increased use of more sophisticated capital budgeting

techniques;
• most financial managers use more than one technique to evaluate the
same projects, with a discounted cash flow technique (NPV, IRR, PI) used
as a primary method and payback period used as a secondary method;
and
• the most commonly used is the internal rate of return method, though
the net present value method is gaining acceptance.
! !58
• IRR is popular most likely because it is a measure of yield and therefore

easy to understand. Moreover, since NPV is expressed in Rupees the
expected increment in the value of the firm and financial managers are
accustomed to dealing with yields, they may be more comfortable
dealing with the IRR than the NPV.
The popularity of the IRR method is troublesome since it may lead to

decisions about projects that are not in the best interest of owners in
certain circumstances. However, the NPV method is becoming more widely
accepted and, in time, may replace the IRR as the more popular method.
And is the use of payback period troublesome? Not necessarily. The

payback period is generally used as a screening device, eliminating those
projects that cannot even break-even.
Further, the payback period can be viewed as a measure of a yield. If the

future cash flows are the same amount each period and if these future
cash flows can be assumed to be received each period forever --
essentially, a perpetuity -- then 1/payback period is a rough guide to a
yield on the investment. Suppose you invest Rs. 100 today and expect Rs.
20 each period, forever. The payback period is 5 years. The inverse, 1/5=
20 percent per year, is the yield on the investment.
Now let's turn this relation around and create a payback period rule.
Suppose we want a 10 percent per year return on our investment. This
means that the payback period should be less than or equal to 10 years.
So while the payback period may seem to be a rough guide, there is some
rationale behind it.
Use of the simpler techniques, such as payback period, does not mean that
a firm has unsophisticated capital budgeting. Remember that evaluating
the cash flows is only one aspect of the process:
• cash flows must first be estimated,
• cash flows are evaluated using NPV, PI, IRR, MIRR or a payback method;
and
• project risk must be assessed to determine the cost of capital.
! !59
3.5 Summary
The payback period and the discounted payback period methods give us an
idea of the time it takes to recover the initial investment in a project. Both
of these methods are disappointing because they do not necessarily
consider all cash flows from a project. Further, there are no objective
criteria that we can use to judge a project, except for the simple criterion
that the project must pay back.
The net present value method and the profitability index consider all of the
cash flows from a project and involve discounting, which incorporates the
time value of money and risk. The net present value method produces an
amount that is the expected added value from investing in a project. The
profitability index, on the other hand, produces an indexed value that is
useful in ranking projects.
The internal rate of return is the yield on the investment. It is the discount
rate that causes the net present value to be equal to zero. IRR is
hazardous to use when selecting among mutually exclusive projects or
when there is a limit on capital spending.
The modified internal rate of return is a yield on the investment, assuming

that cash inflows are reinvested at some rate other than the internal rate
of return. This method overcomes the problems associated with unrealistic
reinvestment rate assumptions inherent with the internal rate of return
method. However, MIRR is hazardous to use when selecting among
mutually exclusive projects or when there is a limit on capital spending.
Each technique we look at offers some advantages and disadvantages. The

discounted flow techniques -- NPV, PI, IRR, and MIRR -- are superior to the
non-discounted cash flow techniques -- the payback period and the
discounted payback period.
To evaluate mutually exclusive projects or projects subject to capital

rationing, we have to be careful about the technique we use. The net
present value method is consistent with owners' wealth maximization
whether we have mutually exclusive projects or capital rationing.
! !60
Looking at capital budgeting in practice, we see that firms do use the

discounted cash flow techniques, with IRR the most widely used. Over
time, however, we see a growing use of the net present value technique.
3.6 Questions
1. Explain Discounting cash flow method.

2. What is net present value?
3. What is the scale of difference?
4. Explain Capital Budgeting techniques in practice.
5. Write short Notes on:
a. Profitability Index
b. Internal rate of return decision rule

alternatives)
1. Cash flows are evaluated using _____________ Method

a. NPV,
b. PI, IRR, MIRR
c. payback
d. any one of the above
2. The payback period is also referred to as the _____________

a. payoff period
b. capital recovery period
c. time required to pay
d. a or b
3. Whether we can’t use the internal rate of return method if the sign of
the cash flows changes more than once during the project’s life?
_____________Yes or No
a. No
b. Yes
! !61
4. The MIRR is a function of both the reinvestment rate and the pattern of
cash flows, with higher the reinvestment rates leading to
_____________.
a. Greater MIRRs
b. Less MIRRs
c. Constant MIRRs
d. Fluctuating MIRRs
5. Under Scale differences -- differences in the amount of the cash flows

between projects can lead to conflicting investment decisions among the
_____________ Techniques
a. MIRRs
b. Benefit cost ratio
c. Discounted cash flow
d. NPV
Answers: 1. (d), 2. (d), 3. (b), 4. (a), 5. (c).
! !62
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !63
CAPITAL EXPENDITURE DECISIONS
Chapter 4
Capital Expenditure Decisions
Objectives
After studying this chapter, you will understand various factors contributing
to the significance of the capital expenditure decision, various categories of
the decisions and their importance etc. Capital expenditure decision is
single most important financial decision inasmuch as it affects the financial
health of the enterprise for a long period of time. The very fact of this kind
of decision deals with capital expenditure projects involving considerably
large volume of capital, return on which will be flowing in the enterprise
over a number of years bears testimony to its significance. These aspects
need to be understood by the finance manager while taking the
expenditure decisions.
Therefore, in this chapter it is attempted to develop an analytical

understanding as well as the process.
Structure:
4.1 Introduction
4.2 Quantitative Estimates
4.3 Decision Models
4.4 Administration of Capital Expenditure Decisions
4.5 Summary
4.6 Questions
! !64
4.1 Introduction
Capital expenditures are defined as investments to acquire fixed or long

lived assets from which a stream of benefits is expected. Such
expenditures represent an organization's commitment to produce and sell
future products and engage in other activities. Capital expenditure
decisions, therefore, form a foundation for the future profitability of a
company. Ccapital expenditure activities are made up of two distinct
processes: (a) making the decision and (b) implementing it, which may
include performing a post-appraisal. This Practice deals only with the first
process.
This chapter prescribes procedures to follow in making the capital

expenditure decision. For purposes of convenience and to understand this
is divided in to 3 parts
• Development of quantitative estimates

• Decision models
• Administration of the capital expenditure decision process
The capital expenditure decision is derived from and is closely associated

with strategic planning which is an effort by an organization to define its
mission and goals and the policies and strategies it will follow to attain
them.
4.2 Quantitative Estimates
Reliable estimates and forecasts are vital to the capital investment

decision. A sophisticated process of analysing financial information and
managing the decision related to a project is of little value if a casual
approach is taken to development of these estimates. The foundations for
good capital planning are reliable forecasts of marketing opportunities,
competitive technology, likely actions by competitors and governments,
sales volumes, selling prices, operating costs, changes in working capital,
taxes payable and capital costs of equipment. Effective management of
capital expenditure decisions, therefore, requires that controls be designed
and operated to ensure that projections are realistic at the time decisions
are made.
! !65
The estimate of the costs and benefits of a capital project should show the
difference that results from making the investment. The important
information is the change in cash flows as a result of undertaking the
project, i.e., the differential principle.
The degree of precision necessary for the estimates related to the capital
expenditure decision depends on:
a. the stage of evaluation of the project (i.e., in early stages less precision
is needed),
b. the sensitivity of the project's economics to the level of accuracy and

timing of each of the elements within the estimates, and
c. the similarity of the project to others already undertaken.
4.2.1 Fixed Investment Estimates
Fixed investments consist of all the costs necessary to bring the project to
full operation. These include the equipment costs, installation, training,
commissioning, initial spoilage, spare parts inventory, etc. The capital
investment in a project can usually be estimated with greater precision
than the other factors required for the capital expenditure decision,
primarily because capital investments occur in the near future whereas
operating costs and revenues are incurred over the life of the project.
The simplest means of estimating capital costs is to adjust the known

investment of a project of similar nature. The most complex means of
estimation requires a detailed project plan from which the costs of
individual items and other costs are developed. In between, various
yardsticks may provide adequate approximations of investment required.
For example, the cost of a building may be approximated by the estimated
cost per square foot to construct the building times the estimated square
footage of the building.
In lieu of firm bids from manufacturers and suppliers, quick estimates can
often be obtained without involving a great deal of their time as published
information is often available. If the project will result in the replacement
of existing equipment, the net cash inflows or outflows from the removal
! !66
and disposal of that equipment, including the tax implications, should be

taken into account.
4.2.2 Working Capital Estimates
The analysis includes estimates of all investments required for a project.

The project may require increases (or decreases) in cash, accounts
receivable, accounts payable, or inventory. These changes in working
capital should be included in the calculation as should the changes to these
at the end of the economic life of the project.
4.2.3 Planning Horizon - Economic Life
It is often difficult to estimate the life of a project (i.e., its planning

horizon). The criterion is the continued ability to generate satisfactory cash
flows or other intangible benefits. The economic life of a project is the
lesser of its physical life, technological life or product-market life.
• Physical Life
Physical life represents the time taken for an asset to become physically
worn out so that it can no longer be efficiently maintained and must be
replaced. However, equipment will often be disposed of before its physical
life has expired.
• Technological Life
Technological life is the period of time that elapses before an even newer
machine or process becomes available which would make the proposed
machine or process obsolete. Improvements will almost certainly be made
sometime in all machines or processes now in existence, but questions of
which machines or processes will be improved, and how soon they will be
on the market are most difficult to answer. To ignore a process' or
machine's technological life is to imply that the technological life is the
same as the physical life.
! !67
• Product - Market Life
Although a machine may be in excellent physical condition, and although

there may be no better machine in the market, its economic life has ended
for the organization as soon as it ceases to market the product. The
product-market life of the machine may end because the particular
operation performed by the machine is made unnecessary by a change in
style or because the market for the product itself has disappeared.
The projected economic life of the return on investment is particularly

important if the project lasts for a relatively short period, say ten years or
less, and is less important for longer projects. It is therefore particularly
important that special consideration be given to estimates of economic life
if there is a high probability that the economic life may be short.
Because of the inherent uncertainties of making estimates in distant years,

especially estimates related to sales volumes, some organizations set an
arbitrary limit on the planning horizon to be used in the analysis. This
planning horizon can be shorter than the estimated economic life of the
project; in some organizations, it is ten years. In some organizations, cash
flows beyond this planning horizon are disregarded in the interest of
conservatism or if not significant to the project. Other organizations apply
an arbitrary estimate of value for the benefits beyond the planning horizon.
4.2.4 Market Estimates
Some methods of developing market estimates are discussed as under:
• Market Study
A market study forecasts sales revenue through the life of a project. It

should describe fully all aspects of the company's position in the market
and estimate the degree of marketing risk associated with the venture. It
provides information on demand, supply and price trends in the overall
market, and specific forecasts of market share, sales volume, net returns
and selling costs, as well as what competitors are or may be doing in the
marketplace.
! !68
Usually, this forecast proceeds from stated assumptions regarding the

economic environment and general business conditions, to estimates of
total market, subdivided by end-use, region, and major customer, and then
concludes with estimates of specific sales potential available within that
market.
When developing sales forecasts, consideration should be given to the

possible obsolescence of products or services. Such items have a life of
only a few years, so that organizations must compete, not necessarily on
the basis of being the low-cost producer, but by being product innovators.
The demand forecast must, therefore, consider: frequent introduction of
new products, timely delivery, and flexibility in the production process to
adapt to customer preferences. Such considerations must also be factors in
the selection process for capital equipment.
Significant relationships between an organization's sales and economic

indicators for the market as a whole, or other industry statistics, may be
determined by using correlation analysis.
An alternative way of projecting sales is to use internal sources of data,

such as information supplied through salesmen's call reports,
supplementary information developed through interviews of market
researchers, credit statistics, and general knowledge of the customer and
his or her competitive situation.
Either method may produce a set of possible outcomes to which a

probability figure could be developed. The appropriate figure to use is a
weighted average1 of the possible outcomes. It is known as the expected
value. However, in many projects such a probability distribution is either
not feasible or not worthwhile.
• Competitive Factors
The demand forecast should indicate the competitors and their market
share. The productive capacity in existence and potentially available would
then be assessed in relation to the forecasted demand to show the volume
and timing of expansion needs. Competitors' expansion possibilities and
economics should also be considered along with their product and
technology life cycles.
! !69
• Price Estimation
The estimation of price trends is frequently the most difficult area of

market forecasting. However, analysis of the supply/demand balance and
estimation of competitors' economics can provide a guide. The elasticity of
demand in relation to the price may also be considered. A careful study of
the product life cycle is often needed as, in the early development stages
of a new product, the price is often high and it falls when demand levels off
at maturity, and then declines further when new substitutes appear in the
market.
• The Organization's Position in the Market
The analyses of supply, demand and price are consolidated into specific
forecasts of market share, sales volume and annual cash inflow through
the project's expected life. In addition, it is important to state the major
assumptions, the reliability of the market data and, if worthwhile, attach
confidence limits to the forecasts. By doing so, the degree of marketing
risk associated with the project is conveyed, and the sensitivity of the
project to inaccuracies in the marketing appraisal can be evaluated.
4.2.5 Operating Cost Estimates
When estimating operating costs for capital expenditures, the following

should be kept in mind:
a. Only cash costs after the payment of tax on income are relevant; non-
cash expenses such as depreciation are excluded except to the extent
they affect taxable income.
b. Only future costs are relevant. Historical costs may be useful in terms of
providing a basis for prediction, but they do not represent what future
costs will be.
c. Only differential costs are relevant. This means that only the difference
in cash operating costs between implementing or not implementing a
proposal need be considered.
! !70
• Labour - Associated Payments, etc.
Labour costs should include, in addition to the direct wage rate, overtime
and all associated payments and benefits.
• Labour - Savings from Reducing Time Required of Individuals
Labour savings often result from the saving of part of several individuals'
time.
Over the long run, it would normally be expected that the time set free for
these individuals could be productively utilized elsewhere or that the
aggregate saving in time will cause reduction in the number of employees.
• Efficiency Improvement
Cost reduction projects often include improvements in efficiency which

either reduce material consumption or increase output. The additional
output should be valued at the probable profit which can be realized.
• Services
The differential cost of services, (e.g., utilities, transport, computer

services) often present problems. An investment proposal may result in the
consumption of fewer services due to efficiency improvements. In such a
case, the effect on a project's differential cost depends upon what can be
done with the unused service. If any cash costs associated with keeping
the service at the level prior to the investment can be eliminated, then the
amount involved can be treated as a cash cost saving (negative cost). If
the freed-up service can be used elsewhere and would have to be bought
for this other use, then the amount saved by not having to buy for this
other purpose would be a cost saving of the investment. If the freed-up
service cannot be used elsewhere and must still be paid for, then there
would be no incremental cost saving for the investment (the cost would
continue whether or not the investment was made).
! !71
• Maintenance
Maintenance costs should normally be the cost expected to be incurred in

each year of the life of a project. Sometimes the use of an average may be
justified. An average will sometimes be a greater amount than the
maintenance cost in the initial years. Provision should also be made, as
appropriate, for periodic overhauls. Estimates should also be made of the
incremental costs for maintenance material and operating supplies.
• Depreciation
No amount for depreciation should be included in calculating the cash flow

since this is an allocation of the investment cost required to match
expenses against revenues over the life of the investment. It does not
require a cash outflow each year. In capital budgeting, the cost of the
investment is taken into account when cash outlays or their equivalent take
place. If depreciation were counted in determining cash flows, the
investment cost would be inappropriately double counted. However, in the
determination of taxes on income allowances for depreciation should be
considered.
• Property-Related Costs
Certain insurances and taxes are related to investment costs and should be
estimated accordingly.
• Plant Administration, Service Departments, etc.
If an organization is expanding, plant administration and service

departments also expand, but such expansion may not be directly
attributed to individual capital investment projects. Nevertheless, some
allowance for the cost of expansion is needed. It is suggested that general
ratios may be applicable to most appropriations being prepared at a time.
Periodic revision of these ratios is necessary.
! !72
4.2.6 Estimating Terminal Values (Salvage, Trade-in or Disposal

Values)
The terminal value of a capital asset at the end of its useful life should
include disposal values less the dismantling and/or site restoration costs
plus the release of any associated working capital.
4.2.7 Estimating the Effects of Inflation
The effect of inflation on a capital project is to reduce the purchasing

power of net cash flows over time. Several techniques for recognizing the
effect of inflation are used in practice. They include:
a. use of a discount rate that is high enough to incorporate inflation,
b. adjusting all cash flows by a single percentage that allows for inflation,
or
c. adjusting individual cash flows by rates that include the effect of

inflation on each of them.
The first technique is perhaps the most common. Care must be taken to
ensure that the effect of inflation is not double counted, which can happen
if two of the above methods are used together.
4.2.8 Risk Analysis
Risk exists in capital budgeting when more than one outcome may occur. A
quantitative evaluation of a capital expenditure proposal requires that
several predictions be made, often far into the future. As a general rule,
the risk associated with achieving an expected cash inflow or outflow in a
given year increases as one moves further into the future as there are
more factors in the long term which cannot be foreseen but which will
affect cash flows.
Most organizations do not make a specific allowance for risk. Some,

however, provide the following information:
! !73
a. the range of accuracy for the estimate stated as a plus or minus

percentage,
b. the expected value of the estimate based on a weighted average of all

possible outcomes, and
c. the effect on the appraisal results using the widest range of error of
particular interest is the amount by which a key variable can be varied
before the project fails to meet its decision criterion, all other things
being held constant.
4.3 Decision Models
4.3.1 Evaluation Techniques
Several techniques are available to arrive at a financial decision regarding a

capital expenditure project. These include:
i. the net present value method. This method discounts all cash flows
to the present using a predetermined minimum acceptable rate of
return as the discount rate. If the net present value is positive, the
financial return on the project is greater than this minimum acceptable
rate and indicates the project is economically acceptable. If the net
present value is negative, the project is not acceptable on economic
grounds.
ii. the internal rate of return method. The internal rate of return is
defined as the discount rate that makes the net present value of a
project equal to zero. It is the highest rate of interest that a company
could incur to obtain funds without losing money on the project.
iii. the equivalent annual cost method. When considering alternative

proposals, it may be that only costs are involved. In such situations, a
choice of alternatives can be made by determining which has the lowest
equivalent annual cost. Under this method, capital expenditures are
converted to their "equivalent annual cost" and added to the annual
"operating" costs. Equivalent annual cost is the annual amount that
would repay the capital over the life of the project at a specified
discount rate. It is similar to an annual, level repayment schedule for a
! !74
mortgage. The alternative with the lowest total cost would be the most
attractive (ignoring intangibles).
iv. the payback method. This method estimates the time taken to
recover the original investment outlay. The estimated net cash flows
from a proposal for each year are added until they total the original
investment. The time required to recoup the investment is called the
payback period. Projects with a shorter payback period are preferred to
those with longer periods.
v. the discounted payback method. The discounted payback period is

the number of years for which cash inflows are required to (a) recover
the amount of the investment and also (b) earn the required rate of
return on the investment during that period. In this method, each year's
cash inflow is discounted at the required rate of return, and these
present values are cumulated by year until, their sum equals, the
amount invested. Projects with a shorter discounted payback period are
preferable to those with longer periods.
vi. the accounting rate of return method. The accounting rate of return
is a measure of the average annual income after tax over the life of a
project divided by the initial investment or the average investment
required to generate the income. It is important to note that this
method assesses net income and not cash flows which are used in the
other methods.
The internal rate of return, discounted payback, net present value and
equivalent annual cost methods use discounted cash flows (D.C.F.). The
D.C.F. concept considers the time value of money in making investment
decisions, whereas the other methods do not.
The payback method (or discounted payback method) is useful where:
a. preliminary screening of many proposals is necessary;
b. a weak cash position has an important bearing on the selection of

projects;
c. the proposed project is extremely risky; or
! !75
d. projects, such as routine replacement projects, have similar economic

lives.
When the payback method is used, the required payback period should be
consistent with that developed by applying the required rate of return on
projects with similar characteristics.
The accounting rate of return method is useful when management is

especially concerned with the effect of a large capital investment on
reported financial results.
4.3.2 Ranking of Capital Expenditure Projects
Many organizations have several proposed capital projects which are

economically acceptable, but they have only limited financial resources.
Thus the entity must rank the projects and select those that promise the
higher returns.
At any given time, management is likely to be considering several projects

at various stages of refinement. At each stage in the evaluation process,
proposals are assessed and accepted into the next stage, referred back to
the sponsor for further work or rejected. A ranking procedure should be
used at each stage. Ranking projects on the basis of quantitative criteria
may be established by specifying a minimum desired rate of return on a
project. This minimum rate is called the required rate of return (also the
discount rate or the hurdle rate). This rate is used to calculate the net
present value of each project and to rank them accordingly.
The internal rate of return and net present value methods are also used to
resolve the capital rationing problem. If the internal rate of return method
is used, the higher the rate of return, the better the project. If the net
present value is used, it is necessary to first divide the present value of the
cash inflows by the amount of the investment. The higher the resulting
number, called the profitability index, the better the project.
! !76
4.3.3 Selection of the Required Rate of Return
In selecting the required rate of return to evaluate capital expenditure

proposals, two approaches are widely used: calculating a cost of capital, or
use of a number generally accepted by the industry.
In theory, the required rate of return on a project of average risk should be

at least as high as the organization's cost of capital.
4.3.4 Non-Quantitative Evaluation Considerations
Qualitative or policy considerations may override quantitative criteria in the

ranking or acceptance of projects. Some examples of qualitative
considerations are:
a. relationship to business strategy;
b. product line or location and its significance to the enterprise;
c. timing of fund flows from the project versus the timing of fund flows
required;
d. management, technical engineering and marketing capacities or

constraints; and
e. balance desired in spending by product classification.
Projects may be worthy of approval on such non-financial grounds as

protection of company property, employee health and welfare or to comply
with government regulations in such areas as pollution.
4.3.5 Government and Non-profit Organisations
The capital expenditure process for government and non-profit

organizations is conceptually similar to that of the for profit organizations,
and although the method of estimating costs and benefits is also similar,
there are important differences in measuring benefits.
! !77
If feasible, government and non-profit organizations attempt to measure

both financial and social benefits. Social benefits can be difficult to quantify
but include:
• direct benefits that accrue to the taxpayer or member, and
• indirect benefits that accrue to individuals or groups that may or may not
be taxpayers or members.
The required rate of return on government or non-profit funds is the return

on alternative uses of these funds. The methods used to evaluate capital
expenditure proposals are the same as the ones described above.
4.4 ADMINISTRATION OF THE CAPITAL EXPENDITURE

DECISIONS
Figure below depicts, in general terms, the process which an organization

may use in making the capital expenditure decision. This Practice describes
only the decision-making process (i.e., up to the "final approval" decision).
! !78
!
Fig. 4.1: The Capital Expenditure Decision
4.4.1 Policy Manual
Each proposed capital expenditure competes for, and should justify, its
share of the limited resources available. Formal procedures and rules
should be established to assure that all proposals are reviewed fairly and
consistently. Managers and supervisors who make proposals need to know
what the organization expects the proposals to contain, and on what basis
their proposed projects will be judged. Those managers who have the
authority to approve specific projects need to exercise that responsibility in
! !79
the context of an overall organizational capital expenditure policy [as

approved by the Board of Directors or senior managers where appropriate].
The management accounting function, which has the task of developing the
internal controls in an enterprise, also has the responsibility for
coordinating the input of the various functional groups and obtaining
approval of this policy manual.
The policy manual should include specifications for:
a. an annually updated forecast of capital expenditures. This project

by project forecast should cover a period of three to five years and
should include: previous expenditures for approved projects,
expenditures for the current budget year, a forecast of the capital
expenditures required for the following two to four years, and the
supply (both internal and external) of funds in the ensuing year.
b. the appropriation steps. These should be sufficiently detailed to

ensure that the proposal and approval procedures are identified in a
consistent and orderly manner. The procedure for a revision to a
previously approved capital expenditure application should also be
specified.
c. the appraisal method(s) to be used to evaluate proposals.
d. the minimum acceptable rate(s) of return on projects of various

risk. Normally, this provides guidelines rather than an absolute
requirement, because not all projects are evaluated solely in terms of
financial benefits.
e. the limits of authority. Here, the specification of the appropriate

managers attesting to the desirability of the project in relation to the
responsibility of these managers should be required as the basis for
their accountability.
f. the control of capital expenditures. The manual should indicate who

is responsible for controlling capital expenditures once the project is
approved and authorizing capital expenditures against authorized
amounts.
! !80
g. the procedure to be followed when accepted projects will be

subject to an actual performance review after
implementation. As a minimum, the policy manual should specify the
expenditure limit above which a review will be required; the time it will
commence after completion of the project; and by whom it will be
undertaken.
4.4.2 Preliminary Project Review
The first formal step in the capital expenditure decision is a preliminary

project review. This assessment is often needed:
a. to give early consideration of and guidance to a project which could

result in an appropriation request and to provide an early screen for
ideas not worthy of pursuit,
b. to minimize the lead time to implement a promising project, and
c. to coordinate activities associated with a project.
An appropriate project sponsor should be identified who should ensure that

all required documentation contains the information needed to reach a
decision on the preliminary proposal. The organization's policy regarding
the preparation of estimates for capital expenditure proposals should
encourage managers to seek out and use the expertise of others who can
help in the derivation of cash flows.
! !81
4.4.3 The Appropriation Request
Of all the documentation required in the capital expenditure decision, the

appropriation request is the most important since it is from this document
that a decision is to be made. It is the request for authorization to spend
money. The appropriation request is also used to provide information as to
the expected timing and amount of cash inflows and out-flows.
Management accounting personnel are usually responsible for coordinating

and compiling information with the aim of prompt completion and issue of
the appropriation request. Marketing, technical, production and engineering
staff, and others may make a considerable contribution. While sponsors of
projects must take ultimate responsibility for preparation of the
appropriation request, the responsibility for development of the report on
their behalf should be defined. The management accountant, as an
objective member of management is well placed to fill this role.
Decisions on major appropriations are taken at senior management levels,

and by the Board of Directors, as they have far-reaching implications on
the future profitability of the company. These persons who are involved in
the final decision cannot be expected to have an intimate knowledge of all
aspects of a project. Consequently, they rely heavily on the facts,
estimates, and appraisal contained in an appropriation request.
Appropriation requests should be prepared for all capital expenditures

above a minimum amount and should also be required for major expense
items such as non-routine repairs.
In addition, appropriation requests are required for supplemental funding

when original estimates have been exceeded, and for retirement requests
for assets no longer required.
! !82
• Appropriation Request Documentation
The information included in an appropriation request should be designed to

show:
a. the purpose, by a brief description of the project;
b. the timing and amount of the operating cash flows expected;
c. the timing and amount of the investment required and expected net
salvage value, if any, at the end of its useful life and the degree of
accuracy of the estimates;
d. the major assumptions that bear on the accuracy of the cash flow
estimates;
e. the economic desirability of the project, and the sensitivity of the

discounted cash flow rate of return after tax to changes in the basic
data;
f. a review, if appropriate, of the alternatives to the project and the impact

on the economics of the project;
g. implications of not proceeding with the project;
h. the financing method or availability of internally generated funds to

underwrite the project; and
i. the actions recommended.
The appropriation request would give a concise, readable picture of the

whole project. It would indicate why the project was proposed, why it
should be carried out at the present time, and why it should be done in the
way proposed. It should also show linkages to the strategy, goals and
objectives of the enterprise and to any concurrent projects or programs
which bear on the project.
! !83
Examples of reasons for capital expenditures are:

1. expansion,
2. maintenance of the current level of activity,
3. cost reduction and/or quality achievement,
4. replacement,
5. modernization,
6. research and development,
7. protection of property,
8. to meet legal requirements, and
9. safety and health.
The classification would be tailored to each organization's needs. The first

five examples lend themselves to a D.C.F. analysis while expenditures for
the last four are often assessed on more qualitative grounds.
There is generally more than one method of carrying out a project, and
alternatives should be examined to assess the effect of differences in cash
flows, investment costs and other factors. The report should show that the
best alternative has been selected. Also the carrying out of the project
under review may pre-empt the carrying out of another project and this
should be clearly stated.
The report should be logically arranged so that facts lead to conclusions

and arguments are progressively developed. Evidence should be given of
the adequacy and completeness of the facts and the degree of accuracy of
the estimates.
The appropriation request should include a market report when
a. a change in quantity or quality of product is involved,
b. an investment is required to maintain the existing quantity or quality of

a product, or
c. there is a change in the market for an existing product.
The appropriation request should include an engineering and production

report for projects involving installation of plant facilities. It should contain
all data necessary for assessment of the physical nature of the
undertaking, the investment involved and the yields, efficiency and cost of
! !84
the output from the new facilities. Capacity to be installed by the project
under review should be shown. Where an addition to existing capacity
results, the total installed capacity before and after the expenditure should
be indicated. One should be able to accurately assess the extent of any
technological risk associated with any new equipment involved in the
project.
When appropriate, a research and development report should accompany

the appropriation request. It should present a concise summary of the
status of the organization's knowledge and define the uncertainties with
regard to technology related to product or processes involved in the
project.
Where new appropriations free existing assets, a retirement request should

accompany and form part of the appropriation request.
Retirement requests should clearly indicate if the asset is to be sold or

retained for future use. If retained, a justification is required for retention
compared to disposing of the asset for cash. Sound financial management
requires that assets no longer required be sold and the cash obtained used
to earn a return elsewhere in the organization.
A retirement request should state why the assets were no longer required,
and should indicate their original cost, age, dismantling costs and expected
salvage value. This would guide the decision maker on the reasonableness
of the value to be obtained on disposal. The value on disposal also presents
problems in determining the levels of authority for approval. Practice
seems to favour use of original cost for determining the level of approval.
• Review and Approvals
Certifying signatures are used to assist the ultimate decision maker in

determining whether to approve the expenditure. Certification may be
partial or complete; a partial certification contains any qualification on the
project's desirability. For example, the engineering department certifies
that the proposal will meet the organization's engineering standards, and
that the capital cost estimate is accurate. The production manager similarly
certifies the physical production data, capacities, yields, efficiencies and
production costs. The sales manager certifies the market data, sales
volume and selling prices. Signatures of controllers, treasurers, general
! !85
managers and presidents certify their opinion as to the total financial and
overall desirability of the proposed expenditure.
• Benefits of Documentation
Formal procedures for initiating, preparing, reviewing and approving

appropriation requests have several advantages:
• Standard terminology, estimating techniques and methods of appraisal

enhance the comparability of appropriations originating in different parts
of the organization.
• The requirement that certain facts appear in support of each type of

appropriation, that the reasons for the appropriation are set forth in a
report and that the report is to be reviewed by the principal managers of
an organization, all tend to promote increased objectivity.
• Encourage decisions to be made in the same manner throughout the

organization and that authorities for approving expenditures can be
delegated with greater confidence.
• Standardization of appraisals enables senior management to concentrate

on the strategic and intangible aspects of major expenditures as it is
these aspects which often have the greatest impact on the long-term
future of the organization.
! !86
Exhibit 4.1
The Appropriation Request (Cover Page)
! !87
Exhibit 4.2
The Appropriation Request (Cover Page)
! !88
Footnote:
1. The weighted average is found by multiplying each outcome by its

probability, calculating the total and then determining the average.
2. Taxes on income can have a significant influence on the decision as they

impact on the amount and timing of cash inflows or outflows. Variations
in tax laws throughout the world prevent discussion of this topic in this
practice. However, the reader should be aware of its significance and
adjust calculations accordingly.
3. For the capital expenditure decision, it is important that the project be

comprehensively and fully defined. This is intended to prevent
avoidance of approval limits or making relatively low initial investments
which require larger follow-up investments for which no yes/no decision
can be made at the time.
4. Smaller or routine capital expenditure projects may not require such a

formal approach.
5. In some systems this document is labelled ‘Project Proposals’.
! !89
4.5 SUMMARY
The Capital expenditure decisions are just the opposite of operating

expenditure decisions. It is the planning, evaluation and selection of capital
expenditure proposals, the benefits of which are expected to accrue over
more than one accounting year. The capital expenditure decisions have the
features like they involve large amounts of funds, involve greater amount
of risk, Capital expenditure decisions which are irreversible, Cash outflows
and inflows occur at different points of time.
The capital expenditure decision is the process of making decisions

regarding investments in fixed assets which are not meant for sale such as
land, building, plant & machinery, etc. Thus it refers to long-term planning
for proposed capital expenditures and includes raising of long-term funds
and their utilization. The key function of the finance manager is selection of
the most profitable project for investment. This task is very crucial because
any action taken by the manager in this area affects the working and
profitability of the firm for many years to come.
Capital expenditure decisions involve acquisition of assets that have a long
life span and which provide benefits spread over a long period of time.
The nature of capital expenditure decisions can be briefed as under:
• Substantial Investments: Capital expenditure decisions involve large

amounts of funds. Such decisions have its effect over a long span of
time.
• Irreversible Decision: Capital expenditure decisions once approved

represent long-term investments that cannot be reversed or withdrawn
any time. Withdrawal or reversal of such decisions may lead to
considerable financial losses to the firm.
• Estimation of Future Cash Inflows: Preparation of capital expenditure

budget involves forecasting of cash inflows over several years for
evaluating the profitability of projects.
• Maximization of Shareholders’ Wealth: It helps protect the interest

of the shareholders as well as of the firm because it avoids over-
investment and under-investment in fixed assets.
! !90
The capital expenditure decision or capital budgeting is a process that

plans to ascertain the long-term investments of the firm. The main purpose
of capital budgeting is to recognize as well as prioritize capital investments
on the basis of maximum returns to the business. It is also considered as a
managerial tool required for efficient management of collected capital of
the firm.
There are a number of objectives of capital expenditure decisions, some of

which are:
• Increasing Output: Output may be increased by utilizing existing

facility or through expansion by installing new plant and machinery.
• Cost Reduction: The existence of a firm depends on profitability, which

in turn depends on the production of goods or services at a reasonable
price. This is possible if over/under-investment in fixed assets is avoided.
• Providing Contemporary Goods: Consumer tastes change every day.

To satisfy the new demands from customers, either proper utilization of
existing facility or installation of the latest machinery is necessary—which
is not possible without proper capital expenditure decision.
4.6 QUESTIONS
1. What are the different types of quantitative estimates? Explain.
2. Write short notes on “Working capital Estimates”.
3. What are the elements involved in Operating Cost Estimates? Describe.
4. How you will estimate the Effects of Inflation? Explain.
5. Write short notes on: Administration of capital investment Decision.
! !91

alternatives)
1. The degree of precision necessary for the estimates related to the

capital expenditure decision depends on:
a. the stage of evaluation of the project

b. the sensitivity of the project's economics to the level of accuracy and
timing of each of the elements within the estimates
c. the similarity of the project to others already undertaken.
d. All of the above
2. A market study forecasts sales revenue through the life of a project and
it should describe fully all aspects of the _____________
a. company's position in the market

b. estimate the degree of marketing risk associated with the venture
c. both a and b
d. none of the above
3. In selecting the required rate of return to evaluate capital expenditure

proposals, the approaches widely used are calculating a cost of capital
or use of a number generally accepted by the industry.
a. Cost of capital
b. Cost of investment
c. Return on investment
d. Generation of Cash flow
4. If feasible, government and non-profit organizations attempt to

measure both financial and social benefits. Social benefits can be
difficult to quantify but include:
a. direct benefits that accrue to the taxpayer or member, and

b. indirect benefits that accrue to individuals or groups that may or may
not be taxpayers or members.
c. Both a and b
d. Only a
! !92
5. “Certifying signatures are used to assist the ultimate decision maker in

determining whether to approve the expenditure or not”
_____________ True or false.
a. True
b. False
Answers: 1. (d), 2. (c), 3. (a), 4. (c), 5. (a)
! !93
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture Part 1
Video Lecture Part 2 
! !94
METHODS FOR TAKING THE INVESTMENT DECISIONS
Chapter 5
Methods For Taking The Investment
Decisions
Objectives
After studying this chapter, you will be able to understand various methods
used for capital investment decisions and also brief on types of investment
that that company may look into.
Structure:
5.1 Introduction
5.2 Types of Capital Investments
5.3 Objectives of Capital Investment
5.4 Methods for Taking Investment Decisions under Risk
5.5 Summary
5.6 Questions
! !95
5.1 Introduction
Capital investment refers to commodity or money paid in return for any

kind of asset, non-fixed or fixed. Thus, simply put, capital investment is the
money that is used for buying things in the market.
Acquisition of fixed assets like land and buildings are considered to be

capital investment which can be used for long period of time before
requiring any kind of repairs or replacements. Similarly, capital investment
is made while a company purchases items like machinery and other goods
that would prove to be beneficial to the operation of the business but is not
directly linked to day to day operations of the business. Capital investment
need not necessarily be all about land or machinery, capital investment can
be as simple as the amount of money in bank or in the interest bearing
account. In other words, this money or capital investment can be used or
set aside to generate additional revenue. Thus the first principle amount
that is used for opening a savings account can be considered as capital
asset that would turn into capital investment when interest would be
realized from it every year.
General conception of capital investment to be an asset or item of great

initial worth does not hold true. Factually, irrespective of its original worth,
assets that can generate additional revenue are all capital investments.
Current value does not in any way decide the eligibility of an amount or
machinery to be a capital investment, but the fact that this item or money
is not used for normal regular business operations or daily living,
categorises it into capital investment. Accruing interest also is not
mandatory for assets to be considered as capital investment. Money in the
bank is capital investment since it has a long usable life and is not used for
meeting daily monetary requirements.
! !96
5.2 Types of Capital Investment
Capital investment is not just buying things with money. There are many
more components that need to be looked into prior to indulging in
resources that are valuable.
• In business management, both tangible and intangible items can be

considered to be capital investment. While machinery, buildings,
equipment, supplies, manpower etc. are tangible assets,
securities, capital investment bonds, stock options etc. that extend
financial influence over venture are intangible assets.
• Acquisition of liquid assets and various forms of monetary securities etc.

are the main focus of venture capital investment.
• Capital investment in real estate involves buying of properties, leasing

out properties for productive use etc. Market shifts have a large bearing
on value of real estate investments. Residential real estate holdings are
relatively less risky real estate capital investment.
There are many avenues for capital investment. Each area is governed by
laws, provisions and guidelines. A little bit of time and research would be
necessary to master the tricks of each path of capital investment but rest
assured that all the efforts would certainly pay off.
5.3 Objectives of Capital Investment
There are various investment avenues in the market today. Nevertheless,

the main objectives behind any kind of capital investment remain more or
less the same – growth, income and safety. Investors can have more than
one of these objectives in mind while investing but success usually comes
with the expense of one of these objectives.
i. Safety: Safety of capital investment depends largely on the type of

investment. Even though there is no hundred percent safe investment,
government-issued securities, corporate bonds etc. are some that fall in
the relatively safe categories. These securities can usually preserve your
capital and at the same time provide you with a specific return rate.
! !97
ii. Income: A certain amount of safety would have to be sacrificed if

income from capital investment is the main aim. Increase in yields is
associated with a certain degree of risk, thus as yield increases, safety
decreases. Safest investments in the markets are usually the ones that
have the lowest income returns. It is generally seen that all investors
look for income generation too in their portfolios.
iii. Growth: Capital gain on the capital investment comprises growth of

capital and this is different from yield. Capital gains occur when security
bought is sold at a higher price than its original purchase price. On
similar lines, if security is sold at a lower price, capital loss occurs. Thus,
long-term growth occurs at the expense of ongoing investment returns.
Apart from these three main objectives, there can be secondary objectives
too while considering capital investment. These usually include;
• Tax minimizations and certain degree of liquidity
Capital investment that gives tax exemptions can reduce overall income
tax burden. Likewise, liquidity of investment is highly desired by investors.
Many investments are illiquid and cannot be converted to cash
immediately. Shares are relatively the most liquid investment since they
can be sold in a day or two.
Thus capital investment with any of the above mentioned five objectives
usually becomes a success when one or two of the objectives are sacrificed
for the benefits of the others. Mostly, income and safety have to be shown
the way out if growth is desired, thus most of the investment portfolios
should be guided by one predominant objective. Other objectives would
occupy less significant positions in the investment scheme of things.
Hence investments must be planned accordingly, with appropriate

weightings assigned to each objective. The choice of objective should
largely depend on factors like:
• temperament of investor
• stage of life
• family situation
• marital status
• income etc.
! !98
The investor would be able to find the right mix of investment opportunities
from the myriads of avenues available in the market. The investor should
keep in mind to do ample research and due diligence prior to investing. The
choice of the right kind of investment in accordance with all variables in
connection with investor is vital for the success of any investment venture.
The effort spent in finding, deciding and studying the various investment
opportunities would pay off in the long run.
5.4 Methods for Taking Investment Decisions under Risk
Some of the most important methods that are used for taking investment
decisions under risk are as under:
1. Sensitivity Analysis
2. Scenario Analysis
3. Decision Tree Analysis
4. Break-Even Analysis
5. Risk-Adjusted Discount Rate Method
6. Certainty-Equivalent Analysis.
Risk refers to the deviation of the financial performance of a project from

the forecasted performance. One needs to forecast the cash flows and
other financial aspects while selecting a project.
However, the actual financial performance of a project may not be in

accordance with the forecasted performance. These risks can be decline in
demand, uneven cash flow, and high inflation. For example, an
organization is planning to install a machine that would increase the
production level of the organization.
However, the demand of the product may vary with the economic
environment, for example, the demand may be very high in economic
boom and low if there is recession. Therefore, the organization may earn
high income or incur huge loss, depending on the business environment.
However, different kinds of risks can be assessed up to a certain limit.
! !99
The risks can be assessed by using various methods that are shown
in Figure below:
Now Let us understand each method in brief:
5.4.1 Sensitivity Analysis
Forecasting plays an important role in project selection. For example, a

project manager needs to forecast the total cash flow of a project. The
cash flow depends on the revenue earned and cost incurred in a project.
The revenue earned from the project depends on various factors, such as
sales and market share. Similarly, if we want to find out the NPV or IRR of
the project, we need to make the accurate predictions of independent
variables.
Any change in the independent variables can change the NPV or IRR of the
project.
In sensitivity analysis, we analyse the degree of responsiveness of the

dependent variable (here cash flow) for a given change in any of the
dependent variables (here sales and market share).
In other words, sensitivity analysis is a method in which the results of a

decision are forecasted, if the actual performance deviates from the
expected or assumed performance.
! !100
Sensitivity analysis basically consists of three steps, which are as

follows:
i. Identifying all variables that affect the NPV or IRR of the project
ii. Establishing a mathematical relationship between the independent and

dependent variables
iii. Studying and analysing the impact of the change in the variables
Sensitivity analysis helps in providing different cash flow

estimations in three circumstances, which are as follows:
a. Worst or Pessimistic Conditions: Refers to the most unfavourable

economic situation for the project
b. Normal Conditions: Refers to the most probable economic environment

for the project
c. Optimistic Conditions: Indicates the most favourable economic

environment for the project
Let us consider the example given in Table:
Particulars Project A Project -B
Initial Cash outlay 200000 300000
Cash Inflow Estimates
Most Optimistic 50000 80000
Expected Most Likely E 40000 60000
Most Pessimistic 20000 40000
Required rate of return 0.10 0.10
Economic Life 10 years 10 years
Now, the NPV of each of the projects can be calculated by using the
formula of NPV.
! !101
The calculation of the NPV of project A is shown in Table:
Expected Cash Inflow Present Value NPV
Most Likely 245782 45782
Most Pessimistic 122891 -77109
Similarly, the calculation of NPV of project B is shown in Table:
Expected Cash Inflow Present Value NPV
Most Likely 368674 68674
Most Pessimistic 245782 -54218
Therefore, we can see that the extent of loss in project B is less than that
of project A but the extent of profit in project B is more than that of project
A. Therefore, the project manager should select project B.
5.4.2 Scenario Analysis
Scenario analysis is another important method of estimating risks involved

in a project. It involves assessing future uncertainties associated with a
project and their outcomes. In this method, different probable scenarios
are analysed and the associated outcomes are also determined.
For example, you are going to undertake an important project and have
forecasted your cash flows accordingly. If your forecast goes wrong
substantially, the future of the whole project can be jeopardized. As
discussed earlier, in sensitivity analysis, different factors of a project are
interdependent.
Therefore, if any of the factors are disrupted, the whole forecast can be
wrong. Scenario analysis helps a project manager in preparing a
framework where he/she can explore different kinds of risks associated
with a project. It is more complex as compared to sensitivity analysis.
! !102
Scenario analysis needs sophisticated computer techniques to effectively

calculate a large number of probable scenarios and their respective
outcomes. Scenario analysis is more useful to a project manager than the
sensitivity analysis as the former is more comprehensive and gives more
insight about a project.
However, there are a few disadvantages of this method, which are

as follows:
a. Complex Process
Involves difficult calculations as calculating the NPV of a project is not easy

by following this method. The complexity of the method makes it both
costly and time consuming.
b. Difficulty in Assessing the Probability
Implies that it is very difficult to estimate the possibility of different

outcomes. Sometimes, in practical life, assessing future uncertainties is not
accurate.
5.4.3 Decision Tree Analysis
Decision tree analysis is one of the most effective methods of assessing

risks associated with a project. In this method, a decision tree is drawn for
analysing the risks associated with a project. A decision tree is the
representation of different probable decisions and their probable outcomes
in a tree-like diagram.
This method takes into account all probable outcomes and makes the
decision-making process easier.
Let us understand decision tree analysis with the help of an example, X&Y
Manufacturers has two projects, project A and project B. The two projects
need the initial investment of Rs. 25000 and Rs. 32000, respectively.
According to an estimation, 35% probability of project A to give a return is

Rs. 46000 in next five years and 65% probability is that it may give a
return of Rs. 42000 in the same period. Similarly, 20% probability of
! !103
project B to give a return of Rs. 55000 in next five years and 80%
probability is that it may give a return of Rs. 50000 in the same period.
Now, if we express the problem in a decision tree, we will get a

tree-like diagram, which is shown in below Figure:
Now, the net value of each of the projects can be easily calculated.
The net value of the project A would be (46000×0.35) + (42000×0.65)

-25000 = (16100+27300-25000) =18400
Similarly, the net value of the project B would be (55000×.20) + (50000×.

80)-32000 = 19000
Now, it is obvious that the project B is more profitable for the organization.
Therefore, the organization should continue with project B.
! !104
The advantages of decision tree analysis are as follows:
a. Detailed Insight
Provide a detailed view of all the probable outcomes associated with a

project
b. Objective in Nature
Provides a clear evaluation of different alternative decisions
Following are the disadvantages of decision tree analysis:
a. Difficulty in a Large Number of Decisions
Signifies that if the expected life of the project is long and the number of
outcomes is large in numbers, it is quite difficult to draw a decision tree
b. Difficulty in Interdependent Decisions
Indicates that the calculation becomes very time-consuming and

complicated in case the alternative decisions are interdependent
5.4.4 Break-Even Analysis
Break-even analysis is a widely used technique in project management.

Break-even is a no profit and no loss situation for a project. In break-even
analysis, all costs associated with a project are divided into two heads,
fixed costs and variable costs.
The total fixed cost and the total variable cost are then compared with the
total return or revenue of the project. In a break-even scenario, the total of
all fixed costs or variable costs in a project is equal to the total revenue or
return from the project. Therefore, a project can be said to have reached
its break-even when it does not have any profit or loss.
! !105
The concept of breakeven point is explained in below Figure:
The different costs used in break-even analysis are explained as follows:
a. Fixed Costs
Refer to the costs incurred at the initial stage of the project and do not
depend on the production level or operation level of the project. For
example, cost of a machinery and rent.
b. Variable Costs
Refer to the costs that depend on the volume of production. Wages and
raw materials are the examples of variable costs.
c. Total Cost
Refers to the sum total of fixed costs and variables costs.
As shown in Figure-9, at point P, the total cost is equal to the total

revenue. Therefore, the project can be said to have achieved break-even at
point P.
! !106
5.4.5 Risk-Adjusted Discount Rate Method
Risk-adjusted discount rate method refers to the adjustment of risk in

valuation model that is NPV.
Risk-adjusted discount rate can be expressed as follows:
d = 1/ 1 + r + µ
Where, r = risk-free discount rate
µ = risk probability
The preceding formula can be used for calculating risk-adjusted present

value.
For example, if the expected rate of return after five years is equal to R5,
then the risk-adjusted present value can be determined with the help of
the following formula.
Present Value (PV) = 1/ (1+r+µ)5 R5
The calculation of risk-adjusted NPV for nth year can be done with the help
of the following formula:
NPV = !
Where, Rn = return in nth year and Co = original cost of capital
By substituting the value of d, we get the following equation:
NPV = !
Let us understand the calculation of risk-adjusted discount rate with the

help of an example.
! !107
For example, a project, ABC cost Rs. 100 million to an organization. The
project is expected to give a return of Rs. 132 million in one year. The
discount rate for project is 18% and probability of risk is 0.12. Find out
whether the organization should accept the project ABC or not?
Solution:
The risk-adjusted NPV for project ABC can be calculated as follows:
NPV = !
Where, R = Rs. 132 million
Co = Rs. 100 million
r = 0.08
H = 0.12
After substituting the given values of different variables, we get the risk-
adjusted NPV that is equal to:
NPV = 132/1 + 0.08 + 0.12 = 100
NPV = 10 million
Therefore, the organization is getting risk-free return of Rs. 10 million.
If we calculate NPV for the same project, it would be equal to:
NPV = !
NPV = 132/1+0.08 = 100
NPV = 22.22 million
! !108
NPV and risk-adjusted NPV both are greater than zero. Therefore, project is
profitable and should be accepted.
The advantages of risk-adjusted discount rate method are as follows:
a. Changing discount rate by changing risk factor (µ) for different time
periods and amount of risk
b. Adjust the high risk of future by increasing the time duration for risk
adjusted rate. For example, the risk-adjusted discounted rate for
50th year is equal to:
c. Regarded as the easiest method for evaluating projects in risk

conditions
However, the disadvantage of risk-adjusted discount rate method is that it

fails to provide a tool for measuring risk factor. Therefore, it is required to
be supplemented with the method to calculate risk factor.
5.4.6 Certainty-Equivalent Analysis
Certainty-equivalent analysis is also used for the adjustment of NPV, thus,

selecting or rejecting a project. It is similar to risk-adjusted discount rate
analysis. However, there is one difference between them. In risk-adjusted
discount rate analysis, the discount rate is adjusted while in certainty-
equivalent analysis, expected return is adjusted.
Certainty-equivalent NPV can be calculated with the help of the following

formula:
NPV= aRn/ (1+ r)n – C0
Where, a = certainty – equivalent coefficient
The value of a can be determined with the help of following formula:
α = Rn/Rn*
Where, Rn = Expected certain return
! !109
Rn* = Expected risky return
For example, between two projects P and Q, P is risky but gives Rs. 100
million of return after one year. However, Q is risk-free but gives Rs. 90
million of return after one year. The investment for project P is Rs. 70
million and for Q it is Rs. 73 million. The risk-free discount rate is 10%. In
such a case, two projects are equal for the investor. This implies that risk-
free project Q is equivalent to risky project P.
Therefore, certainty-equivalent coefficient would be:
α = 90/100
α = 0.9
The certainty-equivalent NPV for project P would be:
NPV= α Rn/ (1 + r)n –C0
NPV = 0.9* 100/ (1+ 0.1) –70
NPV = 12 million
The certainty-equivalent NPV for project Q would be:
NPV = Rn/ (1+r)n – C0
NPV = 90/ (1+ 0.1) – 73
NPV = 9 million
The project P yields more with less investment as compared to project Q.

Therefore, project P would be selected.
! !110
5.5 Summary
The capital investment decisions can also be termed as capital budgeting in

finance. The purpose of the capital investment decisions includes allocation
of the firm’s capital funds most effectively in order to ensure the best
return possible. Evaluating the projects and allocating capital depending on
the requirements of the projects are the most important aspects of capital
investment decisions.
There may be various criteria for selecting the right and appropriate
decision for capital investment. For example, a firm may emphasize on the
projects that promise for the immediate return while some other firms may
insist on the projects that ensure long-term growth. The major goal of
capital investment decision is to increase the value of firm by undertaking
right project at right time.
The capital investment decisions are mainly governed by the process of

ranking and identifying the capital investments of the firm. The firm needs
to decide which of the given investments will ensure the most value to the
business.
The decisions of capital investment often suffer from a number of

constraints. The amount of capital that a firm collects is limited and it
brings down the constraint on the choice of the firm over various project
investments. As the debt of the firm is increased, the debt-equity ratio of
the firm also gets increased and hence it becomes difficult for the business
to raise more debts.
The decision of project ranking plays a significant role in the decisions of

capital investment. Depending on the various projects the firm is having at
a certain period of time, the firms prioritize the projects. The ranking of
projects depends on how much a project will return and which project will
be able to add maximum value to the business.
There are various measures that give the estimation of the return of the
firm over various investment projects. In order to determine the value of a
particular project, three most famous methods are – IRR methods, net
present value and payback method. These methods are applied while
taking decisions on capital investment.
! !111
5.6 Questions
1. What are the components that need to be looked into prior to indulging
in resources that are valuable?
2. Write short note on: Objectives of Capital Investment.
3. Describe in short “Methods for Taking Investment Decisions under Risk”.
4. Explain the process of sensitivity analysis.
5. What are the disadvantages of decision tree analysis? Explain in brief.

alternatives)
1. In business management, both tangible and intangible items can be

considered to be capital investment. While machinery, buildings,
equipment, supplies, manpower etc. are tangible assets, securities,
capital investment bonds, stock options etc. that extend financial
influence over venture are _____________.
a. Tangible Assets
b. Intangible assets
c. Both a & b
d. Capital assets
2. The main objectives behind any kind of capital investment consists of

_____________
a. Safety
b. Income
c. Growth
d. All of the above
3. “Any change in the independent variables can change the NPV or IRR of
the project” _____________ True or False
a. True
b. False
! !112
4. Which method involves assessing of future uncertainties associated with

a project and their outcomes?
a. Sensitivity Analysis
b. Scenario Analysis
c. Decision Tree Analysis
d. Break-Even Analysis
5. In break-even analysis, all costs associated with a project are divided

into _____________.
a. Fixed costs
b. Variable costs
c. Operating Cost
d. Both a and b
Answers: 1. (b), 2. (d) 3. (a), 4. (b), 5. (d)
! !113
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture
! !114
FINANCIAL DECISIONS
Chapter 6
Financial Decisions
Objectives
After studying this chapter, you will understand various factors that
influence the process of taking the Financial decisions considering the basic
concepts and external and internal factors which influence the decision-
making process.
Structure:
6.1 Introduction
6.2 Concept of Financial Decisions
6.3 Basic Factors Influencing Financial Decisions
6.4 Summary
6.5 Questions
! !115
FINANCIAL DECISIONS
6.1 Introduction
Financial decisions refer to decisions concerning financial matters to a

business concern. Decisions regarding magnitude of funds to be invested to
enable a firm to accomplish its ultimate goal, kind of assets to be acquired,
pattern of capitalization, pattern of distribution of firm’s income and similar
other matters are included in financial decisions.
These decisions are crucial for the well-being of a firm because they
determine the firm’s ability to obtain plant and equipment when needed to
carry the required amounts of inventories and receivables, to avoid
burdensome fixed charges when profits and sales decline and to avoid
losing control of the company.
Financial decisions are taken by a finance manager alone or in conjunction

with his other executive colleagues of the enterprise. In principle, finance
manager is held responsible to handle all such problems as involve money
matters.
But in actual practice he has to call on the expertise of those in other

functional areas: marketing, production, accounting and personnel to carry
out his responsibilities wisely. For instance, decision to acquire a capital
asset is based on expected net return from its use and on the associated
risk.
These cannot be given values by finance manager alone. Instead, he must

call on the expertise of those in charge of production and marketing.
Similarly, decision regarding allocation of funds as between different types
of current assets cannot be taken by a finance manager in vacuum.
In this chapter we are going to discuss these aspects in detail.
! !116
FINANCIAL DECISIONS
6.2 Concept of Financial Decisions:
Policy decision in respect of receivables—whether to sell for credit, to what

extent and on what terms is essentially a financial matter and has to be
handled by a finance manager. But at the operating level of carrying out
the policies, sales may also be involved since decisions to tighten up or
relax collection procedures may have repercussion on sales.
Similarly, in respect of inventory while determining types of goods to be

carried in stock and their size are a basic part of sales function, decision
regarding quantum of funds to be invested in inventory is the primary
responsibility of the finance manager since funds must be supplied to
finance inventory.
As against the above, the decision relating to acquisition of funds for

financing business activities is primarily a finance function. Likewise,
finance manager has to take decision regarding disposition of business
income without consulting other executives since various factors involved
in the decision affect the ability of a firm to raise funds.
In sum, financial decisions are looked upon as cutting across functional,

even disciplinary boundaries. It is in such an environment that a finance
manager works as a part of total management.
! !117
FINANCIAL DECISIONS
6.3 Basic Factors Influencing Financial Decisions
A finance manager has to exercise great skill and prudence while taking
financial decisions since they affect financial health of an enterprise over a
long period of time. It would, therefore, be in fitness of things to take
decisions in the light of external and internal factors. We shall now give a
brief account of the impact of these factors on financial decisions.
6.3.1 External Factors
External factors refer to environmental factors within which a business

enterprise has to operate. These factors are beyond the control and
influence of the management. A wise management adopts policies that will
be most suited to the present and prospective socio-economic and political
conditions of the country.
The following external factors enter into decision-making process:
1. State of Economy
At a time when the entire economy is enveloped into a state of uncertainty

and there is no ray of hope of recovery in the ensuing years, and
considerable amount of risk is associated with investment it would be
worthwhile on the part of a finance manager neither to take up new
investment activities nor to carry further the expansion programmes.
! !118
FINANCIAL DECISIONS
On the contrary, if it is found that the economy is likely to recover from the
current gloomy state of affairs, the finance manager should not miss the
chance of exploiting investment opportunities. For that matter, he should
after evaluating the economic viability of project in hand; select the most
profitable project in advance so that when the opportunity crops up the
same is seized upon.
Economic condition of the country influences financing decision also. In

times of prosperity, when investors have keen desire to invest more and
more savings, firms can garner desired amount of funds from the market
by floating securities. But it should be remembered that the firm will have
to offer higher interest rate (dividend rate) because interest rates tend to
harden under pressure of demand.
This would consequently increase cost of capital of the firm. To minimise

the cost of financing finance manager should insist more on debenture
financing as benefits on trading on equity would tend to minimise the cost.
In times of depression, raising outside capital poses a grave problem.
Under such condition, greater emphasis should be laid on internal financing
and for that purpose reserve position of the company will have to be
strengthened.
Dividend policy of a firm should also be attuned to changing economic

conditions. If it lurks that the business is entering upon a period of
depression, conservatism should be followed, for the business may need all
of its cash resources to carry it safely through the period of decline until its
! !119
FINANCIAL DECISIONS
sales soar. During boom period there is tendency among firms to offer
higher dividend rate to mobilise funds from the market.
The management is, therefore, constrained to declare dividend at higher

rate. This should not pose any financial problem before the management
since earning of the firm improves sharply in times of prosperity. There is
also a strong possibility for the management to adopt conservative
dividend policy during boom periods so that the firm may get sufficiently
large amount of resources to finance growth requirements.
2. Structure of Capital Market and Money Markets
Where institutional structure of capital and money markets is well

developed and organised with a multitude of financial institutions supplying
long-term as well as short-term financial assistance and investors are
venturesome evincing keen interest in security dealings in stock market,
business entrepreneurs will not have to encounter much problem in
procuring even a substantially large amount of capital.
Various alternate sources are available and businessmen have a freedom to

decide about the optimal financing mix so that the cost of capital is
reduced. Furthermore, the firm’s ability to adjust sources of funds in
response to major changes in need for funds increases.
Not only does it enable entrepreneurs to use the type of funds that is most
readily available at a given period of time but it also enhances their
bargaining power when dealing with a prospective supplier of funds.
In the absence of organised capital market entrepreneurs find it difficult to

procure large amount of resources from the market. They have to raise
capital from closely held circles. In such a state of affairs, policy of internal
! !120
FINANCIAL DECISIONS
financing is pursued so as to enable the firm to draw upon its resources in

times of need for funds.
3. State Regulations
A finance manager must take investment decisions within the legal

framework provided by the state. In a socialist country like India,
entrepreneurs are not free to take up any venture they like. For example,
in India, Industrial Policy Resolution 1956, spells out clearly the industrial
fields in which the Govt. will enter and those where private sector will have
freedom to operate.
Through industrial licencing system the Government seeks to ensure that

the private sector business entrepreneurs do not intrude into prohibited
areas. Under such circumstances a finance manager has to consider the
viability of only those projects which are permissible by the Government.
As per SEBI guidelines, a new company set up by entrepreneurs without a

track record is permitted to issue capital to public only at par. Other
companies have freedom in pricing their public issues, provided certain
conditions are fulfilled.
The equity capital to be subscribed, in any issue to the public, by

promoters should not be less than 25 percent of the total issue of equity
capital for amounts up to Rs. 100 crore and 20 percent of the issue for
amounts above Rs. 10 crore.
4. Taxation Policy
Taxation is the most predominant factor influencing business decisions

since it takes away bigger slice of business income. While deciding to
invest in projects, a finance manager has to keep in view the existence of
tax incentives.
For example, recently the Government of India decided to provide tax

holiday facility to entrepreneurs seeking to invest in roads, bridges,
airports, ports and rail systems for ten years. Tax holiday facility for five
years has also been provided to those engaged in providing
telecommunication services.
! !121
FINANCIAL DECISIONS
Further, a finance manager has to decide as to which method of

depreciation should be followed that may reduce tax burden. There are
numerous methods of charging depreciation, important being Straight Line
method, Diminishing Balance method and Annuity method.
From the stand point of taxation, Straight Line method is very useful since
in this method depreciation is charged at twice the normal depreciation
rate which ultimately reduces the tax liability. It may be argued in this
regard that tax savings generated in the initial years because of charging
depreciation at higher rate will be compensated by the increased tax
liability in the subsequent years when depreciation will be charged at lower
rate.
However, on a closer scrutiny it would appear that the present value of tax
savings in initial years would always be higher than the present value of
the additional tax liability in the subsequent years. Thus taxation influences
the choice of method of depreciation.
Likewise, tax liability of a firm fluctuates depending upon the method of

inventory valuation. There are different methods of inventory valuation,
viz., LIFO, FIFO. A finance manager must ascertain in advance as to which
method will be helpful in minimising the tax burden.
Taxation also influences the capital structure decision. Other things being
equal, debt financing is always cheaper from taxation point of view
because interest on debt is a tax deductible expenditure while dividends
are not.
Taxation enters into dividend decision too. High corporate tax rate lowers
the amount of earnings left for dividend distribution which, in consequence,
tend to lower dividend rate. However, recent studies have revealed that
high rates would not necessarily influence dividend rate particularly when
tax burden is shifted on consumers.
This tendency is widely prevalent in India. Very often the government in its
bid to promote corporate savings levies special tax on those companies
who declare dividend at a higher rate. For example, in India dividend tax @
7.5% was levied in 1964 and companies declaring dividend in excess of 10
per cent were required to pay this tax.
! !122
FINANCIAL DECISIONS
In 1968 this tax was taken back. Taxation also plays an important part in
deciding the form of dividend. Generally, dividend is distributed in the form
of cash and shares. Dividend distributed in shares is popularly known as
bonus shares.
While dividend received by shareholders in cash is subject to tax in their

hands, bonus shares are exempted from the tax. That is why shareholders
particularly those in the high income tax bracket prefer to receive
dividends in shares rather than in cash.
5. Requirements of Investors
While taking financing decision, a finance manager should also give due
consideration to the requirements of potential investors. There may be
different types of investors with varying degrees of safety, liquidity and
profitability notions.
Investors who are conservative and liquidity conscious would like to hold
such securities as may assure them certainty of return and return of
principal amount after the stipulated period of time. There may be, on the
other hand, investors who are not as liquidity conscious, venturesome and
who have greater preference for profitability.
Such type of investors would prefer to invest their savings in equities.

Thus, the management seeking to raise substantially large amount of
capital for this undertaking has to issue different types of securities so as
to cater to as large a number of investors as may be possible.
Further, investors’ psychology changes with the variation in economic and

business conditions. In times of economic turmoil and business depression
even venturesome investors would like to hold senior securities while
during the period of economic prosperity shares receive premium even at
the hands of those investors who are not so venturesome. Finance
manager should, therefore, be well aware of the prevailing temper of the
investing class.
Dividend policy must be geared to investors in general and existing

stockholders and potential stockholders in particular. This helps in
maximisation of the market value of the firm. Problem of ascertaining
optimum allocation of business earnings between retention and dividends
! !123
FINANCIAL DECISIONS
because of the diverse investment goals, tax brackets and alternate

investment opportunities of the current and potential investors may prompt
management to rationalize the soundness of such other factors as influence
dividend policy as risk avoidance or maintenance of market price.
6. Lending Policy of Financial Institutions
Lending policy of financial institutions may also influence investment

decisions of a firm. If financial institutions follow the policy of concessional
financing to priority projects and decide to grant loans to non-priority
projects on very strict terms and conditions, naturally the finance manager
while taking investment decisions would provide greater weightage to the
former group of projects in relation to the latter ones, if other things
remain the same.
Further, while deciding about the sources of funds that have to be tapped
for raising capital, lending policy of the financial institutions should be
carefully examined. Sometimes, financial institutions grant financial
assistance on such terms and conditions as may not be acceptable to the
management.
For instance, financial corporations in India usually insist on maintenance

of debt-equity ratio for medium and large scale project as 1.5:1 and
promoter’s contribution of 20-25 percent of the project cost while
considering loan application of a firm. Under such a condition, a firm
seeking loan from the financial institutions must maintain the ratio of debt
to equity at a level desired by them.
The finance manager must, therefore, make suitable adjustment in

financing mix of the firm in such ways as to conform to the desired pattern.
The finance manager will have, therefore, to examine into the expediency
of getting loans from the institutions under the afore-stated condition.
6.3.2 Internal Factors
Internal factors refer to those factors which are related with internal
conditions of the firm such as nature of business, size of business,
expected return, cost and risk, asset structure of business, structure of
ownership, expectations about regular and steady earnings, age of the
firm, liquidity in company funds and its working capital requirements,
! !124
FINANCIAL DECISIONS
restrictions in debt agreements, control factor and attitude of the

management.
The internal business environment comprises of factors within the company

which impact the success and approach of operations. Unlike the external
environment, the company has control over these factors. It is important
to recognize potential opportunities and threats outside company
operations. However, managing the strengths of internal operations is the
key to business success.
The role of company leadership is an essential internal factor. Your

leadership style and other management style impact organizational culture.
Often, firms provide a formal structure with its mission and vision
statements. Some cultural implications which result from leadership
approaches are:
• Value of employees
• The positive or negative nature
• Effectiveness of communication level of family-friendliness
Within the economic and legal environment of the country finance manager
must take financial decision, keeping in mind the numerous characteristics
of the firm. Impact of each of these factors upon financial decisions will
now be discussed in the following lines.
! !125
FINANCIAL DECISIONS
1. Nature of Business
Nature of business may influence the pattern of investment in a firm, firm’s

make-up of capitalisation and the firm’s dividend policy. In manufacturing
and public utility concerns bulk of the funds have to be employed in
acquiring fixed assets while in trading concerns substantially large amount
of funds is invested in current assets, and fixed assets claim a nominal
proportion.
As among manufacturing industries, fixed assets requirements in capital

goods industries would always be higher than in consumer goods
industries.
Impact of nature of business activities on make-up of capitalisation should

also be closely examined. It is generally found that firms engaged in
production of staple goods will have stability in their level of earnings as
demand of their products is very likely to be uniformly steady both in times
of business depression and boom. In view of this, they could place heavier
reliance on debt for acquiring additional funds for the business.
Contrary to this, level of business earnings is fluctuating in the case of

industrial undertakings engaged in production of non-essential products
because demand of their products changes in consonance with economic
oscillations. Management of such companies would not choose to burden
themselves with fixed charges.
Similarly, public utility concerns and industrial concerns manufacturing

essential products because of their steady and slow rising earnings may
pursue liberal dividend policy to declare higher dividend rate. But trading
concerns and those dealing in luxurious products would be committing
blunder in pursuing such dividend policy.
Prudent dividend policy in such concerns is one that lays more emphasis on
greater retention of earnings so that the firm could build huge reserves in
periods of prosperity and the same could be utilised to maintain dividend
rate at times when earnings of the firm nose-dive.
! !126
FINANCIAL DECISIONS
2. Size of Business
Firms engaged in the same line of activity may have different investment
patterns depending primarily on the scale of their operations. Relatively
larger amounts of funds are required to acquire fixed assets in larger
concerns because these companies automate their process of production
which smaller firms cannot afford.
Furthermore, small firms with their limited amount of capital can carry on
their affairs by renting or leasing plant and equipment and building while
larger firms usually construct their own buildings to house the factory and
acquire plant and machinery to carry on production work.
Smaller firms because of their poor credit position have limited access to
capital and money market in contrast to their larger counterparts.
Investors are usually averse to invest in shares and debentures of smaller
organisations. Furthermore, these smaller organisations do not have
adequate amount of fixed assets to offer as security for securing loan. This
is why management in the smaller organisations has to arrange capital
from closely held circles.
Even if smaller firms are in a comfortable position to raise equity share

capital, their owners would be hesitant to place issues for public offering
with a view to maintaining their control over the organisation. On the
contrary, larger concerns find it easier to procure needed funds from
different sources of capital and money markets.
Management in such concerns, therefore, considers it useful to employ

more and more doses of debt to meet business requirements since this
course of action would tend to reduce the cost of capital.
Dividend decision of a firm is also influenced by its size. Because of difficult

access to external sources of financing, smaller organisations have to
depend on internal sources of financing and for that matter the
management may pursue conservative dividend policy to retain larger
proportion of business earnings.
The management does not encounter any problem in persuading the

shareholders who are few in number to agree to their policy. The
shareholders should also have no objection in such policy because this will
! !127
FINANCIAL DECISIONS
help minimize their tax liability. However, in larger concerns having large
number of shareholders the management cannot always adopt a particular
policy because wishes of the shareholders would not be common.
3. Expected Return, Cost and Risk
Major factors influencing investment decision are expected return on the

project, its cost and the risk associated with the project. Where dispersion
of outcomes is known and all projects are equal in risk, finance manager
would naturally go for that investment proposal which leads to highest
revenues in relation to cost.
Where different projects have varying degrees of riskiness, allowance will

have to be made for the absorption of risk. This is usually done by
adjusting the discount rate, i.e., rate of interest which is employed to
discount future net cash flows of the project to present values.
Thus, the greater the dispersion of outcomes, higher the discount rate is
employed which means that returns will be reduced at a higher rate
because of the allowance made for the risk assigned to the eventuality of
their realisation.
For a risk-less investment, risk-free discount rate is employed. As risk

increases, higher and higher discount rates are employed. In this way after
making appropriate adjustments for risk factor final course of action is
chosen.
A finance manager should take into consideration earning prospects of

investment projects in hand while taking dividend decision. Supposing a
firm has a large number of investment projects with vast earning
potentialities sufficient to exhaust its earnings and the shareholders of the
firm have strong preference for current dividends a finance manager in
such situation must impress upon the shareholders about the strong need
to retain more and more earnings and pursue strict dividend policy.
However, where the projects in hand promise only normal return, the
management should follow liberal dividend policy to keep up with
preferences of shareholders. Contrary to this, if the shareholders are
indifferent between dividends and capital gains a finance manager must
accept all those investment projects that would carry income above the
! !128
FINANCIAL DECISIONS
break-even point and funds for these projects should be arranged out of
retained earnings.
4. Asset Structure of Firm
Firms with sufficient amount of fixed assets must rely on debt to take
advantage of cheaper source of financing. For example, public utilities and
steel companies can depend heavily on debentures for raising capital as
they can mortgage their assets for securing loan.
But trading concerns whose assets are mostly receivables and inventory
values which are dependent on the continued profitability of the firm
should place less reliance on long-term debt and should depend more on
short-term debt for their financial requirements.
5. Structure of Ownership
In private companies whose ownership is concentrated in a few hands the

management can find it easier to persuade the owners to accept strict
dividend policy in the interest of the firm. But in public limited companies
having a large number of shareholders with varying desires the finance
manager must insist on the pursuance of liberal dividend policy.
6. Probabilities of Regular and Steady Earnings
While planning about the make-up of capitalisation and deciding about the
relationship between debt and equity the finance manager must visualize
the trends of earnings of the firm for the past few years. Where the firm’s
past earnings have been reasonably stable and the same tendency is likely
to continue in future, reliance on debt may be desirable.
Where earnings of the firm have been irregular in the past but when
averaged over a period of years give a fair margin over the preferred stock
dividend, the management may issue preferred shares to raise funds.
When earnings of the firm fluctuated violently in the past and the future
earnings cannot be predicted with reasonable certainty, it will incur risk in
issuing debt.
! !129
FINANCIAL DECISIONS
Accordingly, common stock must be issued. When earning of the firm

fluctuated violently in the past and the future earnings cannot be predicted
with reasonable certainty, it will incur risk in issuing debt. Accordingly,
common stock must be issued.
Degree of stability in level of earnings is a potent factor influencing

dividend policy. But such a policy will prove dangerous to companies whose
earnings are subject to great fluctuations. In such companies it would be
prudent to declare lower dividend rate even when the business earnings
are fairly high in order to use them to maintain the dividend rate in times
of adversities.
7. Age of the Firm
Investors are generally loath to employ their funds in new ventures

because of relatively greater risks involved. Lenders too feel shy of lending
because of their poor capital base. Consequently, new enterprises have to
encounter considerable problems in assembling funds from the market.
They approach underwriters and stock brokers and pay them higher
commission and brokerage for sale of their securities.
Thus, a new firm will have a small share of debt in its total capitalisation.
Even if new enterprises are in a comfortable position to garner funds by
issue of debentures, a finance manager should, as far as possible, avoid
bringing in heavy dose of debt, for in that case a large chunk of business
income might be eaten away by interest on loans leaving a little amount
for dividend distribution and retention for further financing.
The company’s ability to raise funds by means of debt in the ensuing years
might be circumscribed by restriction in debt covenants. In sharper
contrast to this, existing ventures may not face considerable problem in
raising funds from the market because of high credit standing in market.
Such concerns usually float debentures for their additional long-term

financial requirements with a view to reaping benefit of trading on equity.
They also draw upon a part of the reserves built out of the past earnings
for covering their additional financial needs. Thus, there is every likelihood
of relatively greater amount of dilution of debt in the capitalisation of older
firms.
! !130
FINANCIAL DECISIONS
Age of the firm goes far to determine its dividend policy. A new and
growing concern whose access to capital market is limited must follow
strict dividend policy to keep away a larger portion of the business earnings
for financing growth requirements. Existing ventures, however, need not
follow such policy.
8. Liquidity Position of the Firm and Its Working Capital

Requirements
A finance manager must consider cash position of the firm and firm’s needs
for funds to meet maturing obligations and working and fixed capital
requirements while taking dividend decisions. Dividends are generally paid
out of cash. Care should, therefore, be exercised by the finance manager
to make sure that cash is readily available to distribute dividends.
Availability of large surplus does not always mean the availability of cash in
the firm particularly when a large amount of sale has been done on credit.
By the time sale proceeds tied in receivables are collected the firm may
need funds to buy materials to process production.
Thus, despite the presence of profit and even the availability of cash,
working capital requirements of the firm may be so imminent that may
warrant the pursuance of conservative dividend policy.
Again, if a company has sufficient amount of cash resources in hand at the

time when some loans taken in the past are due it would be advisable to
finance manager to conserve cash to meet the past obligations and adjust
the dividend pattern accordingly.
In many cases firms rely on their earnings for financing the acquisition of
fixed assets. In such circumstances too the management must not be
liberal in dividend distribution at least for some years even though a
sizeable profit has been earned.
9. Restrictions in Debt Agreements
The provisions of debt contracts should be carefully examined while

deciding about forms of raising capital and establishing dividend policy
since most indentures contain provisions that prevent the use of additional
debt or issue of debentures of the earlier type.
! !131
FINANCIAL DECISIONS
They also restrict the payment of dividends and sometimes disallow their
payment until certain conditions are fulfilled. Needless to say, finance
manager should make available to the Board of Directors a brief of all
contractual provisions that affect the capital structure and dividends in any
way.
10.Management Attitude
Above all, financial decisions are influenced by the attitude of the

management. Management attitudes that most directly influence the
choice of financing and dividend policy are those concerning control of the
enterprise and risk.
Management desiring to maintain control of the firm would like to raise

additional funds needed by means of debentures and preferred stock which
do not affect controlling position of the management in the firm.
However, if company borrows more than what can be serviced by it; there
is every risk of losing all control to creditors. It is, therefore, better to
sacrifice a measure of control by some additional equity financing rather
than running the risk of all control to creditors by bringing in additional
doses of debt. In such a situation, finance manager should not be very
much liberal in dividend distribution.
Management attitude towards risk also determines the pattern of

capitalisation of the firm. Conservative management would always prefer to
tread on beaten path and would always avoid incurring fixed obligations for
raising additional capital even though recourse to debt financing may be
advantageous.
! !132
FINANCIAL DECISIONS
6.4 Summary
There are two fundamental types of financial decisions that the finance
team needs to make in a business: investment and financing. The two
decisions boil down to how to spend money and how to borrow money.
Recall that the overall goal of financial decisions is to maximize shareholder
value, so every decision must be put in that context.
An investment decision revolves around spending capital on assets that will

yield the highest return for the company over a desired time period. In
other words, the decision is about what to buy so that the company will
gain the most value.
To do so, the company needs to find a balance between its short-term and
long-term goals. In the very short-term, a company needs money to pay
its bills, but keeping all of its cash means that it isn't investing in things
that will help it grow in the future. On the other end of the spectrum is a
purely long-term view. A company that invests all of its money will
maximize its long-term growth prospects, but if it doesn't hold enough
cash, it can't pay its bills and will go out of business soon. Companies thus
need to find the right mix between long-term and short-term investment.
The investment decision also concerns what specific investments to make.

Since there is no guarantee of a return for most investments, the finance
department must determine an expected return. This return is not
guaranteed, but is the average return on an investment if it were to be
made many times.
The investments must meet three main criteria:
1. It must maximize the value of the firm, after considering the amount of
risk the company is comfortable with (risk aversion).
2. It must be financed appropriately (we will talk more about this shortly).
3. If there is no investment opportunity that fills (1) and (2), the cash
must be returned to shareholder in order to maximize shareholder
value.
! !133
FINANCIAL DECISIONS
All functions of a company need to be paid for one way or another. It is up

to the finance department to figure out how to pay for them through the
process of financing.
There are two ways to finance an investment: using a company's own

money or by raising money from external funders. Each has its advantages
and disadvantages.
There are two ways to raise money from external funders: by taking on
debt or selling equity. Taking on debt is the same as taking on a loan. The
loan has to be paid back with interest, which is the cost of borrowing.
Selling equity is essentially selling part of your company. When a company
goes public, for example, they decide to sell their company to the public
instead of to private investors. Going public entails selling stocks which
represent owning a small part of the company. The company is selling itself
to the public in return for money.
An investor should understand the past performance of the relevant assets

before making his investment decisions. He should consider his tolerance
for risk based on his responsibilities and his personality before investing in
assets that carry substantial risk. His decisions on how much money he
wants to invest each month or the amount of a lump sum should be guided
by the amount of money he expects once his investments mature. He
should use this amount to determine whether he should invest in equities,
bonds or other securities and assets.
An investor who wants to diversify his investments to include foreign

holdings must consider factors, such as the country's national economic
growth rate and the liquidity of its stock market. He must consider a
country's capital gains tax policy and the integrity of its dispute resolution
system. He must confirm that the country protects the rights of foreign
investors and that its central bank holds adequate currency reserves.
! !134
FINANCIAL DECISIONS
6.5 Questions
1. Write short Notes on Concept of Financial Decision.
2. Describe how Lending Policy of Financial Institutions affects the

decision-making.
3. Write short notes on Internal factors affecting financial decision.
4. Describe the influence of External Factors affecting financial Decisions
5. Does the size and nature of business affect the process of decision-
making? Explain.

alternatives)
1. Policy decision in respect of receivables, whether to sell for credit, to

what extent and on what terms is essentially a financial matter and has
to be handled by _____________
a. Finance Manager
b. Executive Director
c. Managing Director
d. Finance officer
2. To minimise cost of financing, finance manager should insist more on

_____________ as benefits on trading on equity would tend to
minimise cost.
a. In-house Funds
b. Debenture financing
c. Equity Financing
d. Borrowed funds
! !135
FINANCIAL DECISIONS
3. As far as age of the firm is concerned, Investors are generally not ready
to employ their funds in new ventures because of relatively greater risks
involved. Lenders too feel shy of lending because of
their_____________
a. Strong capital base
b. Poor capital base
c. Less chances of Returns
d. Increased cost of lending
4. If a company has sufficient amount of cash resources in hand at the

time when some loans taken in the past are due it would be advisable to
finance manager to conserve cash to meet the past obligations and
adjust _____________ accordingly.
a. Lending
b. Borrowing
c. Dividend pattern
d. Interest rate
5. Management desiring to maintain control of the firm would like to raise

additional funds needed by means of _____________ which do not
affect controlling position of the management in the firm.
a. debentures
b. preferred stock
c. Both a & b
d. Loans
Answers: 1. (a), 2. (b), 3. (b), 4. (c), 5. (c)
! !136
FINANCIAL DECISIONS
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !137
FACTORS AFFECTING DIVIDEND DECISIONS
Chapter 7
Factors Affecting Dividend Decisions
Objectives
After studying this chapter, you will understand the factors that influence or
affect the dividend decision of company. Also you will understand different
types of ratios that are useful and taken into consideration while taking the
decision on declaring the dividend.
Structure:
7.1 Introduction
7.2 Factors Affecting the Dividend decision
7.3 Summary
7.4 Questions
! !138
7.1 INTRODUCTION
Dividend is a widely researched arena but still its fathom has to be

explored as numerous questions remain unanswered. The question of “Why
do corporations pay dividends?” has puzzled researchers for many years.
Despite the extensive research devoted to solve the dividend puzzle, a
complete understanding of the factors that influence dividend policy and
the manner in which these factors interact is yet to be established. Allen et
al. (2000) stated that:
“Although a number of theories have been put forward in the literature to

explain their pervasive presence, dividends remain one of the thorniest
puzzles in corporate finance.”
The dividend decision is taken after due considerations to number of

factors like legal as well as financial. This is so because one set of dividend
policy cannot be evolved that can be applied to all firms rather the dividend
decision varies from firm to firm in light of the firm-specific considerations.
Lintner (1956) suggested that dividend depends in part on the firm's
current earnings and in part on the dividend for the previous year. He
found that major changes in earnings with existing dividend rates were the
most important determinants of the firm's dividend policy. Ramcharran
(2001) observed that:
“…dividend policy in the equity emerging markets from a corporate

finance perspective has not been empirically examined to date…
Continuing financial reforms in emerging markets, together with
the validity of more published data, will encourage further research
on other determinants of dividend policy, including the impact of
agency costs, information, and taxes as well as the capital
structure of firms”.
! !139
This suggested that much more research needed to be undertaken on

dividend policy in developing economies.
7.2 FACTORS AFFECTING DIVIDEND DECISION
Dividend decision, one of the important aspects of company’s financial

policy, is not an independent decision. Rather, it is a decision that is taken
after considering the various related aspects and factors. There are various
factors influencing a firm's dividend policy. For example, some studies
suggest that dividend policy plays an important role in determining firm’s
capital structure and agency costs. Many studies have provided arguments
that link agency costs with the other financial activities of a firm.
Easterbrook (1984) argued that firms pay out dividends in order to reduce
agency costs. Dividend payout keeps firms in the capital market, where
monitoring of managers is available at lower cost. If a firm has free cash
flows, it is better to share them with shareholders in the form of dividend
in order to reduce the possibility of these funds being wasted on
unprofitable (negative net present value) projects.
Crutchley and Hansen (1989) examined the relationship between

ownership, dividend policy, and leverage and concluded that managers
make financial policy tradeoffs to control agency costs in an efficient
manner. More recently, researchers have attempted to establish the link
between firm dividend policy and investment decisions. Smith and Watts
(1992) investigated the relations among executive compensation,
corporate financing, and dividend policies and concluded that a firm's
dividend policy is affected by its other corporate policy choices. Also,
Jensen, Solberg and Zorn (1992) linked the interaction between financial
policies and insider ownership to informational asymmetries between
insiders and external investors. Despite this rich literature, most prior work
recognizes differences in determinants of financial decisions between
different firms.
! !140
7.2.1 Basic Factors Affecting Dividend Decision
Theoretically, over the past number of years, it has been believed by the
academicians that the dividend decision is influenced by a number of
factors. Some of the factors that affect the dividend decision of a firm are
listed as follows:
1. Legal Provisions: Indian Companies Act, 1956 has given the

guidelines regarding legal provisions as to dividends. Such guidelines
are required to be followed by the companies whenever the dividend
policy is to be formulated. As per the guidelines, a company is required
to transfer a certain percentage of profits to reserves in case the
dividend to be paid is more than 10 percent. Further, a company is also
required to pay dividend only in cash only with the exception of bonus
shares.
2. Magnitude of Earnings: Another important aspect of dividend policy is

the extent of company’s earnings. It serves as the introductory point for
framing the dividend policy. This is so because a company can pay
dividends either from the current year’s profit or the past year’s profit.
So, if the profits of a company increase, it will directly influence the
dividend declaration as the latter may also increase. Thus, the dividend
is directly linked with the availability of the earnings with the company.
3. Desire of Shareholders: The decision to declare the dividends is taken

by Board of Directors but they are also required to consider the desire
of the shareholders, which depends on the latter’s economic condition.
The shareholders, who are economically weak, prefer regular dividend
policy while the rich shareholders may prefer capital gains as compared
to dividends. However, it is very difficult for the board to reconcile the
conflicting interests of different shareholders yet the dividend policy has
to be framed keeping in view the interest of all the interested parties.
4. Nature of Industry: The nature of industry in which a company is

operating, influences the dividend decision. Like the industries with
stable demand throughout the year are in a position to have stable
earnings, thus, should have a stable dividend policy and vice-versa.
! !141
5. Age of the Company: A company’s age also determines the quantum

of profits to be declared as dividends. A new company should restrict
itself to lower dividend payment due to saving funds for the expansion
and growth as compared to the already existing companies who can pay
more dividends. It is suggested that as firms mature, they experience a
contraction in their growth which results in a decline in their capital
expenditures. Consequently, these firms have more free cash flow to
pay as dividends. Similarly, it is also suggested that more mature firms
are more likely to pay dividends. In contrast, younger firms need to
build up reserves to finance the future growth opportunities, thus,
making them to retain the earnings.
6. Taxation Policy: The tax policy of a country also influences the

dividend policy of a company. The rate of tax directly influences the
amount of profits available to the company for declaring dividends.
7. Control Factor: Yet another factor determining dividend policy is the

threat to lose control. If a company declares high rate of dividend, then
there is the possibility that a company may face liquidity crunch for
which it has to issue new shares, resulting in dilution of control. Keeping
this threat in view, a company may go for lower level of dividend
payments and more ploughing back of profits in order to avoid any such
threat.
8. Liquidity Position: A company’s liquidity position also determines the

level of dividend. If a company does not have sufficient cash resources
to make dividend payment, then it may go for issue of bonus shares.
9. Future Requirements: A company while framing dividend policy

should also consider its future plans. If it foresees some profitable
investment opportunities in near future, then it may go for lower
dividend and vice-versa.
10.Agency Costs: The separation of ownership and control results in

agency problems. Agency costs can be reduced by distributing
dividends. In this stratum, dividends are paid out to stockholders in
order to prevent managers from building unnecessary empires to be
used in their own interest. In addition, dividends reduce the size of
internally generated funds available to managers, forcing them to go to
the capital market to obtain external funds. Firms with a larger
! !142
percentage of outside equity holdings are subject to higher agency

costs. The more widely spread is the ownership structure, the more
acute the free rider problem and the greater the need for outside
monitoring. Hence, these firms should pay more dividends to control the
impact of widespread ownership.
11.Business Risk: Business risk is a potential factor that may affect

dividend policy. High levels of business risk make the relationship
between current and expected future profitability less certain.
Consequently, it is expected that firms with higher levels of business
risk will have lower dividend payments. Many researchers argued that
the uncertainty of a firm’s earnings may lead it to pay lower dividends
because volatile earnings materially increase the risk of default. In
addition, field studies using survey data reported compelling evidence
that risk can affect dividend policy. In these surveys, managers
explicitly cited risk as a factor that influences their dividend choice.
7.2.2 Financial Factors Affecting Dividend Decision
The above mentioned factors are not limited and many more can be there
that affect the determination of dividend. Keeping in view the above-
mentioned factors and the review of literature, some variable has been
identified within the arena of the theoretical factors. Those variables
include both the dependent and independent variables. However, their
interpretation depends upon their measurement. The present study covers
the following set of variables:
1. DPS to Face Value: This ratio evaluates the relationship between

dividend per share and face value of the share. It is calculated as:
Dividend Yield ratio= Dividend per share/Face value per share
2. DPS to Market Value (Yield ratio): This ratio evaluates the

relationship between dividend per share and market value of the share.
It is calculated as:
Dividend Yield ratio=Dividend per share/Market value per share
3. Dividend Payout Ratio: It indicates the extent to which the earnings

per share have been retained by a company. It enables the company to
! !143
plough back the profits which will result in more profits in future and
hence, more dividends. It is calculated as:
Dividend Pay-Out Ratio = Dividend per equity share/Earnings per share
The higher the ratio, lower is the dividend payment and vice-versa.
4. Current Ratio: It is a measure of firm’s liquidity and is basically used

for measuring the short-term financial position or liquidity of the firm. It
indicates the ability of the firm to meet its current liabilities. It is
calculated as:
Current Ratio=Current assets/Current liabilities
A high ratio indicates that firm’s liquidity position is good and it has the
ability to honor its obligations while a low ratio implies that firm’s
liquidity position is not so good so as to honor all its obligations.
However, a ratio of 2:1 is considered satisfactory. The expected relation
between current ratio and dividend payment is positive.
5. Net Profit Ratio: This ratio establishes the relation between net profits
and sales and indicates the management’s efficiency. It is calculated as:
Net Profit ratio= (Net Profit/Net sales) *100
As dividends are declared from the net profits of a firm, so higher the net
profit ratio, higher will be the expected dividend payment.
6. Net Profit to Net worth: This ratio indicates the relation between net
profits earned by a company and the net worth which is represented by
shareholders’ capital. It is composed of equity share capital, preference
share capital, free reserves and surpluses, if any. It is also referred to as
return on investment and is calculated as:
Return on shareholders’ investment = Net Profit/Net Worth
This ratio is an indication of company’s ability to earn profits. If the

earning capacity of the company is more, more dividend payment can be
expected and vice-versa.
! !144
7. Debt Equity Ratio: This ratio measures the claims of outsiders and
owners against the firm’s assets. It indicates the relation between
outsider funds and shareholders’ funds. It is calculated as:
Debt-equity ratio = Outsiders funds / Shareholder’s funds
This ratio tells the solvency position of the firm. Higher the ratio, better
will be the solvency as well as the ability of firm to pay dividends. The
vice-versa will hold true in case of low ratio.
8. Lagged Profits: The dividend is not only influenced by the past year’s
dividend but also by the past year’s profits. This is so because a
company can follow the stable dividend policy if it has sufficient current
year’s profit or the past year’s profit.
9. Behavior of Share Prices: The prevailing share prices also influence

the dividend payment by a company. If the share prices of a company
are unfavorable, then it may increase the dividend in order to boost up
the share prices. It can be calculated as:
Behavior of share prices = !
10.Growth in Earnings: If the earnings of a company increase, then the

chances of increase in dividend payment are also there. Growth is a
must for the survival of a company. This ratio can be calculated as:
Growth in Earnings= EPSt – EPSt-1 / EPSt-1
Where, EPSt = Current earnings per share
EPSt-1 = Previous earnings per share
11.Growth in Working Capital: This ratio indicates increase in the

working capital of a company.
Growth in Working Capital= WCt – WCt-1 / WCt-1
Where, WCt = Current working capital
WCt-1= Previous working capital
! !145
Higher ratio indicates the increase in the capacity of a company to pay

dividends but this is interrelated with other factors also. Like, if a company
has increased the working capital to match the increased level of
operations, then this ratio will not be useful in studying the impact on the
dividend payments.
12.Lagged Dividends: A company may consider the past year’s dividend

as a benchmark. If a company prefers stability of dividend payments, it
may consider the past year’s dividend rate and can act accordingly.
13.Tobin’s Q: This variable represents the investment opportunities for a

company. It is measured as;
(MV of equity-BV of equity +Total Assets) /Total Assets
14.Investment Opportunity Set (Market to Book Value): It represents

the availability of investment opportunities to the company and
generally is believed to have negative relationship with dividend payout.
15.Free Cash Flow: This variable is used to measure the availability of

cash with the company. It is calculated as:
(Cash flow from Operations – Cash flow from investment activities) /Total
assets
16.Cash Holdings: It is another financial variable to analyze the liquidity

position of the firm. It is calculated as:
(Cash + Short-term investment)/Total assets
17.Uncertainty in Earnings: It refers to the variation in the earnings

from one year to another. Some companies might witness irregular
earnings and thus, may not have stable dividend policy. Uncertainty in
earnings can be measured as
a. = √ (∑x2/N)
A small value of standard deviation means high degree of uniformity in the

earnings and vice-versa.
! !146
18.Solvency Ratio: This ratio is a small variant of equity ratio. It indicates

the relationship between total liabilities to outsiders to total assets of a
firm. It can be calculated as:
Solvency ratio = Total Liabilities to Outsiders / Total Assets
19.Return on Net worth: This ratio is also termed as return on

investment. This ratio indicates the relationship between net profits
(after interest and tax) and the shareholders’ funds. It can be calculated
as
Net profit (after interest and taxes) / Shareholders’ funds
20.Return on Capital Employed: This ratio establishes the relationship

between profits and capital employed. It can be calculated as
(Adjusted Net Profits/Gross Capital Employed) *100
or
(Adjusted Net Profits/Net Capital employed) *100
! !147
7.3 Summary
We have seen that a firm's dividend policy is influenced by a large numbers

of factors. Some factors affect the amount of dividend and some factors
affect types of dividend. Some of the major factors which influence the
dividend policy of the firm can be summarized as under:
1. Legal requirements: There is no legal compulsion on the part of a

company to distribute dividend. However, there are certain conditions
imposed by law regarding the way dividend is distributed. Basically,
there are three rules relating to dividend payments. They are the net
profit rule, the capital impairment rule and insolvency rule.
2. Firm's liquidity position: Dividend payout is also affected by firm's

liquidity position. In spite of sufficient retained earnings, the firm may
not be able to pay cash dividend if the earnings are not held in cash.
3. Repayment need: A firm uses several forms of debt financing to meet

its investment needs. This debt must be repaid at the maturity. If the
firm has to retain its profits for the purpose of repaying debt, the
dividend payment capacity reduces.
4. Expected rate of return: If a firm has relatively higher expected rate

of return on the new investment, the firm prefers to retain the earnings
for reinvestment rather than distributing cash dividend.
5. Stability of earning: If a firm has relatively stable earnings, it is more

likely to pay relatively larger dividend than a firm with relatively
fluctuating earnings.
6. Desire of control: When the needs for additional financing arise, the
management of the firm may not prefer to issue additional common
stock because of the fear of dilution in control on management.
Therefore, a firm prefers to retain more earnings to satisfy additional
financing need which reduces dividend payment capacity.
7. Access to the capital market: If a firm has easy access to capital

markets in raising additional financing, it does not require more retained
earnings. So a firm's dividend payment capacity becomes high.
! !148
8. Shareholders’ individual tax situation: For a closely held company,

stockholders prefer relatively lower cash dividend because of higher tax
to be paid on dividend income. The stockholders in higher personal tax
bracket prefer capital gain rather than dividend gains.
7.4 Questions
1. What are the basic factors affecting the Dividend decision?
2. What are the financial factors that affect the dividend decision?
3. Explain in Brief:
a. Business Risk
b. Agency Cost
4. How will you calculate dividend payout ratio?
5. Explain: Uncertainty in earning affecting dividend decision.

alternatives)
1. Dividend decision, one of the important aspects of company’s

_____________ policy, is not an independent decision.
a. Industrial
b. Employee
c. Shareholders
d. Financial
2. As per the guidelines, a company is required to transfer a certain

percentage of profits to reserves in case the dividend to be paid is
_____________
a. More than 10%
b. Less than 10 %
c. As per companies Board
d. As per dividend policy
! !149
3. Which ratio indicates the relation between outsider funds and

shareholders’ funds?
a. Net profit to net worth
b. Debt equity
c. Cash Holding
d. Solvency Ratio
4. A high current ratio indicates that firm’s liquidity position is good and it
has the ability to honor its obligations while a low ratio implies that
firm’s liquidity position is not so good so as to honor all its obligations.
However, a ratio of _____________ is considered satisfactory.
a. 1:1
b. 2:1
c. 1:2
d. 2:2
5. Which ratio indicates the relationship between total liabilities to

outsiders to total assets of a firm?
a. Debt equity ratio
b. Solvency ratio
c. Return on capital employed
d. Return on net worth
Answers: 1. (d), 2. (a), 3. (b), 4. (b), 5. (b)
! !150
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture
! !151
MEASURING AND MANAGING INVESTMENT RISK
Chapter 8
Measuring And Managing Investment Risk
Objectives
After studying this chapter, you will understand various types of risks that
come across while investing in different portfolios. You can also understand
risk perception and risk tolerance level up to which you can take the risk on
investment. Managing the portfolio and risk mitigation is also discussed for
better understanding in measuring the risk on investment.
Structure:
8.1 Introduction
8.2 What is Risk?
8.3 Risk – Good, Bad and Necessary
8.4 Risk Perception and Tolerance
8.5 How Can You Change Your Risk Tolerance Level
8.6 Risk and Psychology
8.7 Risk Management: Measuring the risk
8.8 Risk Management: Manage your portfolio
8.9 What Investor has to do next – Mitigation
8.10 Summary
8.11 Questions
! !152
8.1 Introduction
Risk is something we live with every day. There are risks in everyday
activities like driving a car and trying a new restaurant or recipe, or
starting a business or accepting a new job. Most situations and endeavours
come with their own risks and rewards. Similarly, investing is all about
risks and returns. As many investors have learned the hard way, an
investment offering unusually high returns, such as rapid growth or rich
dividends, comes with higher risks. Conversely, if you find an investment
with almost no risk, its return is likely to be very low.
Financial professionals see a very close relationship between risk and

returns. Higher-risk investments (stocks, long-term bonds) must yield
higher returns over the long run to attract investors, while lower-risk
investments (bank accounts, Treasury bills) can pay lower returns.
Recognizing that risk is built into investing is the first step in knowing your
own capacity for accepting risk. As you begin forming an investment plan,
or make adjustments at key points in life, it is important to understand
that prices of most investments can rise and fall.
Of course, knowing intellectually that investing involves risks is not much

help when a monthly statement arrives and the value of your portfolio has
dropped. Avoid first impulse emotional reactions in cases like this. As long
as you are progressing toward long-term goals, there’s no need to panic or
abandon your long-term plan. You can assess what level of risk you are
comfortable taking, working on your own or with an advisor. But go beyond
the general questions of “Are you a conservative, moderate or aggressive
investor?” Also ask yourself the following:
• Do your long-term goals require that you use potentially higher-return

investments (with their risk level) to get from point A to point B? Or will
a focus on preserving assets provide what you need?
• How soon will you need to spend the money you are investing?
• Does your time horizon allow ample time to recover from short-term
losses in assets that fluctuate, such as stocks?
• Are you emotionally prepared to accept higher risk, some risk, or none at
all?
! !153
• What is your attitude toward the market? Is it: “I never want to see the
value of my funds go down” or “I can weather the impacts of the market
as long as I’m on track for the future”, or something in-between?
• Investors who fail to clarify their feelings about risk tend to get surprised
by the market, causing them to panic and bail out of sound financial
plans.
8.2 What is Risk?
Even though all human endeavours have a measure of risk, human beings
have a hard time understanding and quantifying “risk,” or what some call
“uncertainty.” Many of us understand that risk is the possibility of loss and
it is omnipresent. There is no certainty that you will live beyond the day,
drive to the grocery store without an accident, or have a job at the end of
the month. Risk exists when we take action or, conversely, when we fail to
act. It can be as obvious as driving while intoxicated, or as unforeseen as
an earthquake striking in the Midwest.
Most people are risk-averse. Essentially, we prefer the status quo, rather
than dealing with the unknown consequences of new endeavours or
experiences. This is particularly true in financial matters, and is evident in
the correlation of price and perceived risk: Investments considered to be
higher risk must pay higher returns in order to get people to buy them.
The degree of risk in a financial asset is generally measured by the asset’s

price variability or volatility over a period of time. In other words, a
common stock that ranges from Rs. 10 to Rs. 20 a share over a six-month
period would be considered to be a higher risk than a stock that varied
from Rs. 10 to Rs. 12 during the same period. Practically speaking, the
owner of the more volatile stock is likely to worry more about his
investment than the owner of the less volatile stock.
! !154
8.3 Risk – Good, Bad and Necessary
A common definition for investment risk is deviation from an expected

outcome. We can express this in absolute terms or relative to something
else like a market benchmark. That deviation can be positive or negative,
and relates to the idea of "no pain, no gain" — to achieve higher returns in
the long run you have to accept more short-term volatility. How much
volatility depends on your risk tolerance – an expression of the capacity to
assume volatility based on specific financial circumstances and the
propensity to do so, taking into account your psychological comfort with
uncertainty and the possibility of incurring large short-term losses.
In the investment world, however, risk is inseparable from performance

and, rather than being desirable or undesirable, is simply necessary.
Understanding risk is one of the most important parts of a financial
education. This article will examine ways that we measure and manage risk
in making investment decisions.
8.4 Risk Perception and Tolerance
How we perceive risk varies from person to person, and generally depends
upon an individual’s temperament, experience, knowledge, investment and
alternatives, and time for which he or she will be exposed to the risk. Risk
itself is generally categorized by its likely impact or magnitude if the
uncertain event happens, as well as its frequency or its probability of
occurring.
Many people purchase a Rs. 10 lottery ticket with a payoff of Rs. 1 million,
even though their loss is virtually certain (10,000,000 to 1) because the
Rs. 10 loss is not significant upon living standard or way of life. However,
few people would spend their month’s salary on lottery tickets since the
probability of winning would not significantly increase. When humans
exceed their risk tolerance, they show physical signs of discomfort or
anxiety. To a psychologist, anxiety is those unpleasant feelings of dread
over something that may or may not happen. Anxiety differs from actual
fear – a reaction when we encounter a real danger and our body
instantaneously prepares an immediate fight or flee response. To a lesser
degree, anxiety triggers similar physical reactions in our body, even though
the danger may be imagined or exaggerated.
! !155
Being anxious over any extended period is physically debilitating, reduces

concentration, and impairs judgment. For these reasons, it is important to
identify your personal risk tolerance as it applies to different investments,
since exceeding that tolerance is most likely to end with disappointing (or
even harmful) results. Reputable investment advisors frequently tell their
clients, “If an investment keeps you from sleeping at night, sell it.”
There are several questions you can ask yourself to help gain an
understanding of your personal risk tolerance. Remember that there is no
“right” level of tolerance or any necessity that you should be comfortable
with any degree of risk. People who appear to take extraordinary risk
financially or personally have most likely reduced the risk (unbeknownst to
observers) with training, knowledge, or preparation. For example, a stunt
car driver expecting to be in a high-speed chase will use specially
engineered autos, arrange for safety personnel to be readily available in
the event of a mishap, and spend hours in practice, driving the course over
and over at gradually increasing speeds, until he is certain he can execute
the maneuver safely.
8.5 How Can You Change Your Risk Tolerance Level?
The perception of risk is different for each person. Just as the stunt driver
prepares for an apparent dangerous action in a movie or an oil man selects
a place to drill an exploratory well, you can manage your discomfort with
different investment vehicles. Learning as much as possible about an
investment is the most practical risk management method – investors such
as Warren Buffett commit millions of dollars to a single company, often
when other investors are selling, because he and his staff do extensive
research on the business, its management, products, competitors, and the
economy. They develop “what if” scenarios with extensive plans on how to
react if conditions change. As they grow more knowledgeable, they become
more comfortable that they understand the real risks and have adequate
measures in place to protect themselves against loss.
Diversification is another popular risk management technique where the

assumption of risk is unavoidable. Investors can reduce the impact of a
potential disaster by limiting the potential of loss. Owning a single stock
magnifies the opportunity for gain and loss; owning 10 stocks in different
industries dilutes the effect of one’s stock movement upon the portfolio.
! !156
If you cannot reach your investment objective by limiting your investment

in only “safe” assets, you can limit the potential of loss while exposing your
portfolio to higher gains by balancing your investments between safe and
higher-risk investment types. For example, you might keep 80% of your
portfolio in U.S. Treasury bills and only 20% in common stocks. This
potentially provides a higher return than a portfolio invested solely in
Treasury bills, but protects against losses that might result in a 100%
equity portfolio. The proportion of safe to higher risk assets depends upon
your risk tolerance.
8.6 Risk and Psychology
While that information may be helpful, it does not fully address an

investor's risk concerns. The field of behavioural finance has contributed an
important element to the risk equation, demonstrating asymmetry between
how people view gains and losses. In the language of prospect theory, an
area of behavioural finance, investors exhibit loss aversion — they put
more weight on the pain associated with a loss than the good feeling
associated with a gain.
Thus, what investors really want to know is not just how much an asset
deviates from its expected outcome, but how bad things look way down on
the left-hand tail of the distribution curve. Value at risk (VAR) attempts to
provide an answer to this question. The idea behind VAR is to quantify how
bad a loss on an investment could be with a given level of confidence over
a defined period of time. The confidence level is a probability statement
based on the statistical characteristics of the investment and the shape of
its distribution curve.
Of course, even a measure like VAR doesn't guarantee that things won't be
worse. Spectacular debacles like hedge fund Long-Term Capital
Management in 1998 remind us that so-called "outlier events" may occur.
After all, 95% confidence allows that 5% of the time results may be much
worse than what VAR calculates.
Another risk measure oriented to behavioural tendencies is drawdown,

which refers to any period during which an asset's return is negative
relative to a previous high mark. In measuring drawdown, we attempt to
address three things: the magnitude of each negative period (how bad),
the duration of each (how long) and the frequency (how many times).
! !157
8.7 Risk Management: Measuring the risk
It’s a good idea to understand how to measure risk and how to assess the
impact of additions or alterations in your portfolio.
Risk and volatility are closely related. Volatility refers to the likelihood of
changes, up or down, in an investment’s value. High volatility means the
price can change quickly and dramatically in either direction. A fund with
low volatility is historically more stable, less prone to large swings.
Technically, risk also deals with up or down movements, but people tend to
take a practical view of risk: We do not like to lose money, so we try to
guard against downside risk.
i. A common measure of volatility is “beta”: A calculation that tells

you how closely a fund or security has historically tracked with
fluctuations in the broader market. If beta equals 1.0, the price of the
investment moves exactly in sync with a benchmark such as the
Standard & Poor’s 500 index. If beta is greater than 1.0, the fund or
security tends to rise (or fall) more than the market. If beta is less than
1.0, the investment does not fluctuate as much as the benchmark. Beta
is useful in choosing investments that tend to be more stable or more
volatile.
ii. Another measure of risk is the Sharpe Ratio. The Sharpe Ratio
analyses whether a portfolio’s returns were a result of smart investment
decisions or a result of excess risk. It also represents how well the
return of an asset compensates the investor for the risk taken. For
example, if you compare two assets against a common standard, the
asset with a higher Sharpe Ratio will provide a better return for the
same risk. This helps to distinguish a good investment from a “risky”
! !158
investment if the investments with higher returns do not come with too
much additional risk.
iii. Services such as Morningstar and Value Line also measure up-
versus-down behaviour of funds. When the market as a whole
drops, is the fund likely to decline more, or less, than the trend? And
when the market rises, does the fund really soar, or enjoy a slow-but-
steady increase?
Getting to know the various measures of risk helps you evaluate individual
investments and, more importantly, the mix of assets that together
represent your investment portfolio.
8.7.1 Absolute Measures of Risk
One of the most commonly used absolute risk metrics is standard

deviation, a statistical measure of diversion around a central tendency. For
example, during a 15-year period from August 1, 1992, to July 31, 2007,
the average annualized total return of the S&P 500 Stock Index was
10.7%. This number tells you what happened for the whole period, but it
doesn't say what happened along the way.
The average standard deviation of the S&P 500 for that same period was
13.5%. Statistical theory tells us that in normal distributions (the familiar
bell-shaped curve) any given outcome should fall within one standard
deviation of the mean about 67% of the time and within two standard
deviations about 95% of the time. Thus, an S&P 500 investor could expect
the return at any given point during this time to be 10.7% +/- 13.5% just
under 70% of the time and +/- 27.0% 95% of the time.
8.7.2 Risk: The Passive and the Active
In addition to wanting to know, for example, whether a mutual fund beat

the S&P 500 we also want to know how comparatively risky it was. One
measure for this is beta, based on the statistical property of covariance and
also called "market risk", "systematic risk", or "non-diversifiable risk". A
beta greater than 1 indicates more risk than the market and vice versa.
Beta helps us to understand the concepts of passive and active risk. The
graph below shows a time series of returns (each data point labelled "+")
! !159
for a particular portfolio R(p) versus the market return R(m). The returns
are cash-adjusted, so the point at which the x and y axes intersect is the
cash-equivalent return. Drawing a line of best fit through the data points
allows us to quantify the passive, or beta, risk and the active risk, which
we refer to as alpha.
The gradient of the line is its beta. For example, a gradient of 1.0 indicates
that for every unit increase of market return, the portfolio return also
increases by one unit. A manager employing a passive
management strategy can attempt to increase the portfolio return by
taking on more market risk (i.e. a beta greater than 1) or alternatively
decrease portfolio risk (and return) by reducing the portfolio beta below 1.
8.7.3 Influence of Other Factors
If the level of market or systematic risk were the only influencing factor,
then a portfolio's return would always be equal to the beta-adjusted
market return. Of course, this is not the case — returns vary as a result of
a number of factors unrelated to market risk. Investment managers who
follow an active strategy take on other risks to achieve excess returns over
the market's performance. Active strategies include stock, sector or
country selection, fundamental analysis and charting.
Active managers are on the hunt for alpha – the measure of excess return.
In our diagram example above, alpha is the amount of portfolio return not
explained by beta, represented as the distance between the intersection of
the x and y axes and the y axis intercept, which can be positive or
negative. In their quest for excess returns, active managers expose
! !160
investors to alpha risk – the risk that their bets will prove negative rather
than positive. For example, a manager may think that the energy
sector will outperform the S&P 500 and increase her portfolio's weighting in
this sector. If unexpected economic developments cause energy stocks to
sharply decline, the manager will likely underperform the benchmark – an
example of alpha risk.
A note of caution is in order when analysing the significance of alpha and

beta. There must be some evidence of a linear pattern between the
portfolio returns and those of the market, or a reasonably inclusive line of
best fit. If the data points are randomly dispersed, then the line of best fit
will have little predictive ability and the results for alpha and beta will be
statistically insignificant. A general rule is that an r-squared of 0.70 or
higher (1.0 being perfect correlation) between the portfolio and the market
reasonably validates the significance of alpha, beta and other relative
measures.
8.7.4 The Price of Risk
There are economic consequences to the decision between passive and

active risk. In general, the more active the investment strategy (the more
alpha a fund manager seeks to generate), the more an investor will need
to pay for exposure to that strategy. It helps to think in terms of a
spectrum from a purely passive approach. For example, a buy and
hold investment into a proxy for the S&P 500 – all the way to a highly
active approach such as a hedge fund employing complex trading
strategies involving high capital commitments and transaction costs. For a
purely passive vehicle like an index fund or an exchange trade fund ETF,
you might pay 15-20 basis points in annual management fees, while for a
high-octane hedge fund you would need to shell out 200 basis points in
annual fees plus give 20% of the profits back to the manager. In between
these two extremes lie alternative approaches combining active and
passive risk management.
The difference in pricing between passive and active strategies (or beta
risk and alpha risk respectively) encourages many investors to try and
separate these risks: i.e. to pay lower fees for the beta risk assumed and
concentrate their more expensive exposures to specifically defined alpha
opportunities. This is popularly known as portable alpha, the idea that the
alpha component of a total return is separate from the beta component.
! !161
For example, a fund manager may claim to have an active sector

rotation strategy for beating the S&P 500 and show as evidence a track
record of beating the index by 1.5% on an average annualized basis. To
the investor, that 1.5% of excess return is the manager's value - the alpha
- and the investor is willing to pay higher fees to obtain it. The rest of the
total return, what the S&P 500 itself earned, arguably has nothing to do
with the manager's unique ability, so why pay the same fee? Portable alpha
strategies use derivatives and other tools to refine the means by which
they obtain and pay for the alpha and beta components of their exposure.
8.8 Risk Management: Manage your portfolio
Most investors need to take some risk to achieve returns that will meet
their long-term goals. The best way to manage risk is through careful
attention to asset allocation and getting the right mix of investments to
match your stage of life, financial goals and risk tolerance. You can
assemble a portfolio that mixes different classes of stocks, bonds and cash
to provide an expected level of appreciation while also limiting risks.
Clearly, you want to avoid risk levels that could deliver a catastrophic
setback to your plans. Make asset allocation your No. 1 investing discipline,
either on your own or working with one of our investment advisors.
! !162
Monitoring your progress is important. Review your portfolio on a quarterly

basis and meet with your financial advisor once or twice a year to review
your financial plan and asset allocations. In examining your investments,
don’t just look at the returns but also check for any changes in risk levels
or the mix of risky and less-risky assets in your portfolio.
Additionally, if financial position or life situation changes significantly,

revisit the risk profile within the portfolio. An inheritance might cause to
scale back on risk, shifting in strategy from maximizing returns to
preserving wealth. Starting retirement, facing a health issue or losing a
spouse might cause you to reassess the proper level of risk and desired
returns.
Excessive risk may have you on an emotional roller coaster. On the other
hand, if your portfolio moves slowly but steadily year-after-year toward
long-term financial goals, that may be the level of risk with which you’re
more comfortable. Each investor is different, so it’s important to determine
what feels right for you when building your investment portfolio.
8.9 What Investor has to do next– Mitigation
• Consider risk important when assessing returns within your investment

planning.
• Make a serious evaluation of your attitudes toward risk, on your own or

with an investment advisor.
• Check the risk level of each investment and your overall mix of assets.
• Build your portfolio with an appropriate balance of risk levels and

expected returns.
• Review your portfolio on a quarterly basis and revisit your asset

allocation and risk profile at least twice a year.
The consequences of “financial risk” became apparent to many investors

during two-year period from 2007 to 2009. The stock market (as measured
by the Standard & Poor 500) plummeted from 1562.47 on October 10,
2007 to 752.44 on November 20, 2009. As a consequence, more than one-
half of the retirement savings of many people were lost.
! !163
Many investors had saved money for years in order to enjoy a comfortable
retirement – but as a result of the decline in stock values in that two-year
period, workers were forced to delay retirement or accept a significant
decrease in their expected standard of living. The S&P 500 did not regain
its previous high level until the first week of April 2013.
It has to be remembered that accumulating significant assets takes equal

measures of the following:
• Discipline. Diverting current income from the pleasures of today to

saving for tomorrow is not easy. Nevertheless, it is essential if you want
to reach your future objective.
• Knowledge. Expending the effort to understand different assets and

how they are likely to perform in changing economic environments is
necessary if you are to select those investments that will deliver the
highest return with the lowest risk.
• Patience. While “good things come to those who wait” is a popular

advertising slogan, it is especially applicable to investing. The benefit of
compounding interest accrues to those who can wait the longest before
invading the principal (spending any of the accumulated assets).
• Confidence. Being able to manage your risk tolerance effectively –

understanding which investments are worthwhile and which to avoid – is
required in a complex investment environment. Self-knowledge allows
you to understand why some investments make you anxious and how to
proceed to differentiate between perceived and real risk.
! !164
We live in a complex, confusing world that is constantly changing.

Fortunately, humans are especially adaptive to survive and thrive in the
chaos that surrounds us. While there are real dangers, there are also great
opportunities. Selecting investments may be less adventuresome than
fleeing from hungry lions, but managing your fear and selecting the best
strategy is critical for each.
8.10 Summary
When it comes to risk, all investments carry some degree of risk. Stocks,
bonds, mutual funds and exchange-traded funds can lose value, even all
their value, if market conditions sour. Even conservative, insured
investments, such as certificates of deposit (CDs) issued by a bank or
credit union, come with inflation risk. They may not earn enough over time
to keep pace with the increasing cost of living. When you invest, you make
choices about what to do with your financial assets. Risk is any uncertainty
with respect to your investments that has the potential to negatively affect
your financial welfare.
There are other types of risk. How easy or hard it is to cash out of an
investment when you need to is called liquidity risk. Another risk factor is
tied to how many or how few investments you hold. Generally speaking,
the more financial eggs you have in one basket, say all your money in a
single stock, the greater risk you take (concentration risk). In short, risk is
the possibility that a negative financial outcome that matters to you might
occur. There are several key concepts you should understand when it
comes to investment risk.
Risk and Reward. The level of risk associated with a particular investment
or asset class typically correlates with the level of return the investment
might achieve. The rationale behind this relationship is that investors
willing to take on risky investments and potentially lose money should be
rewarded for their risk.
Although stocks have historically provided a higher return than bonds and
cash investments (albeit, at a higher level of risk), it is not always the case
that stocks outperform bonds or that bonds are lower risk than stocks.
Both stocks and bonds involve risk, and their returns and risk levels can
vary depending on the prevailing market and economic conditions and the
manner in which they are used. So, even though target-date funds are
! !165
generally designed to become more conservative as the target date

approaches, investment risk exists throughout the lifespan of the fund.
Averages and Volatility. While historic averages over long periods can guide
decision-making about risk, it can be difficult to predict (and impossible to
know) whether, given your specific circumstances and with your particular
goals and needs, the historical averages will play in your favour. Even if
you hold a broad, diversified portfolio of stocks such as the S&P 500 for an
extended period of time, there is no guarantee that they will earn a rate of
return equal to the long-term historical average.
The timing of both the purchase and sale of an investment are key
determinants of your investment return (along with fees). But while we
have all heard the adage, “buy low and sell high,” the reality is that many
investors do just the opposite. If you buy a stock or stock mutual fund
when the market is hot and prices are high, you will have greater losses if
the price drops for any reason compared with an investor who bought at a
lower price. That means your average annualized returns will be less than
theirs, and it will take you longer to recover.
Based on historical data, holding a broad portfolio of stocks over an

extended period of time (for instance, a large-cap portfolio like the S&P
500 over a 20-year period) significantly reduces your chances of losing
your principal. However, the historical data should not mislead investors
into thinking that there is no risk in investing in stocks over a long period
of time.
Investors should also consider how realistic it will be for them to ride out
the ups and downs of the market over the long-term. The purpose of risk
management is to ensure that your investment losses never exceed
acceptable boundaries by following disciplined practices including position
sizing, diversification, valuation, loss prevention, due diligence, and exit
strategies. The first step in the risk management process is to acknowledge
the reality of risk. Denial is a common tactic that substitutes deliberate
ignorance for thoughtful planning. The reason risk management is essential
- not optional - is because the amount you lose during the tough times
determines how much you must make during the good times to meet your
financial goals.
! !166
You must preserve your capital during difficult periods so that your
offensive investment strategy has a larger base of capital to grow from
when profitable times return. Financial risk management controls the
investment game. The same is true with investing. It keeps the line of
scrimmage near breakeven so the offense doesn't have to make up for
losses when executing the next play.
In other words, investment risk management is the secret for safe,

consistent profits in any market condition. Few investors understand that
without a proper risk management plan they are literally one bad investor.
By managing risk, you can reduce the odds of financial destruction to as
close to zero as mathematically possible. If your objective is financial
security, then risk management should be your primary focus.
The risk mitigation advised should be taken into consideration while taking
the investment decision.
8.11 Questions
1. What is the Risk? Explain good / bad risk.
2. Write short notes on Risk Perception and Tolerance.
3. What are the tools for measuring the risk? Explain.
4. Write short notes on: Price of Risk
5. Explain the Risk mitigation in Investment Risk.
! !167

alternatives)
1. The degree of risk in a financial asset is generally measured by the

asset’s price variability or _____________ over a period of time.
a. Stability
b. Volatility
c. High price
d. Low price
2. Diversification is another popular risk management technique where the

_____________ of risk is unavoidable.
a. Measuring
b. Assumption
c. Activity
d. Fixing
3. What is the most commonly used absolute risk metrics in standard

deviation?
a. Statistical measure
b. Ideology measures
c. Influence of other factors
d. Price of Risk
4. The best way to manage risk is through careful attention to

_____________ and getting the right mix of investments to match your
stage of life, financial goals and risk tolerance.
a. Market research
b. Indexing
c. Asset allocation
d. Any one of the above
5. The benefit of compounding interest accrues to those who can wait the
_____________ before invading the principal (spending any of the
accumulated assets).
a. Shortest
b. Reasonable
c. Longest
d. Steady
! !168
Answers: 1. (b), 2. (b), 3. (a), 4. (c), 5. (c)
! !169
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !170
COST OF CAPITAL
Chapter 9
Cost Of Capital
Objectives
After studying this chapter, you will understand concept of cost of capital,
relating to the cost if you invest the funds of the company and when you
intend to borrow for the use of company. Various terms used, its meaning
is also defined at initial stage only for understanding the subject matter. In
addition, it is also attempted to provide the formulas used to determine the
cost of funds and cost of capital.
Structure:
9.1 Introduction
9.2 Terms and Definitions
9.3 Cost Matrix
9.4 Weighted Average Cost of Capital (WACC)
9.5 Cost of Debt
9.6 Cost of Equity
9.7 Cost of Borrowing
9.8 Cost of Funds/Cost of Funds Index (COFI)
9.9 Summary
9.10 Questions
! !171
COST OF CAPITAL
9.1 Introduction
The primary meaning of cost of capital is simply the cost an entity must
pay to raise funds. The term can refer, for instance, to the financing cost
(interest rate) a company pays when securing a loan. The cost of raising
funds, however, is measured in several other ways, as well, most of which
carry a name including "Cost of."
Capital refers to the funds invested in a business. The capital can come
from different sources such as equity shares, preference shares, and debt.
All capital has a cost. However, it varies from one source of capital to
another, from one company to another and from one period of time to
another.
Cost of capital may be defined as the company's cost of collecting funds.

This is equal to the average rate of return that an investor in a company
will expect for providing funds. It is the minimum rate of return that the
project must earn to keep the value of the company intact. The minimum
rate of return is equal to cost of capital.
The cost of capital is always expressed in terms of percentage. Proper

allowance is made for tax purposes. This is done to get a correct picture of
the cost of capital.
The concept of cost of capital is a major standard for comparison used in

finance decisions. Acceptance or rejection of an investment project
depends on the cost that the company has to pay for financing it. Good
financial management calls for selection of such projects, which are
expected to earn returns, which are higher than the cost of capital. It is
therefore, important for the finance manager to calculate the cost of
! !172
COST OF CAPITAL
capital, which the company has to pay and compare it with the rate of
return, which the project is expected to earn.
In capital expenditure decisions, finance managers go on accepting

projects arranged in descending order of rate of return. He stops at the
point where the cost of capital equals to the rate of return offered by the
project. That is, the finance manager finds out the break-even point of the
project. Accepting any project beyond the break-even point will cause
financial loss for the company.
The cost of capital is a guideline for determining the optimum capital
structure of a company.
9.2 Terms and definitions
Cost of capital is the cost an organization pays to raise funds, e.g., through
bank loans or issuing bonds. Cost of capital is expressed as an annual
percentage.
Weighted average cost of capital WACC is the arithmetic average (mean)

capital cost, where the contribution of each capital source is weighted by
the proportion of total funding it provides. WACC is usually expressed as an
annual percentage.
Cost of borrowing simply refers to the total amount paid by a debtor to

secure a loan and use funds, including financing costs, account
maintenance, loan origination, and other loan-related expenses. A cost of
borrowing sum will most likely be expressed in currency units such as
dollars, pounds, euro, or yen.
Cost of debt is the overall average rate an organization pays on all its
debts, typically consisting primarily of bonds and bank loans. Cost of debt
is expressed as an annual percentage.
Cost of equity COE is a part of a company's capital structure.

COE measures the returns demanded by stock market investors who will
bear the risks of ownership. COE is usually expressed as an annual
percentage.
Cost of Funds refers to the interest cost that financial institutions pay for
the use of money, usually expressed as an annual percentage.
! !173
COST OF CAPITAL
A Cost of Funds Index (COFI) refers to an established Cost of Funds rate

for a region. In the United States, for instance, a regional COFI might be
set by a Federal Home Loan Bank.
9.3 Cost Matrix
A firm's cost of capital is the cost it must pay to raise funds—either by

selling bonds, borrowing, or equity financing. Organizations typically define
their own cost of capital in one of two ways:
1. Cost of capital may be taken simply as the financing cost

the organization must pay when borrowing funds, either by securing a
loan or by selling bonds, or equity financing. In either case, cost of
capital would be expressed as an annual interest rate, such as 6%, or
8.2%.
2. Alternatively, when evaluating a potential investment (e.g., a major

purchase), the cost of capital is considered to be the return rate the
company could earn if it used money for an alternative investment with
the same risk. That is, the cost of capital is essentially the opportunity
cost of investing capital resources for a specific purpose.
In many organizations cost of capital (or, more often weighted average cost
of capital) serves as the discount rate for discounted cash flow analysis
of proposed investments, actions or business case cash flow scenarios.
Cost of capital (or weighted average cost of capital) is also used sometimes
to set the hurdle rate, or threshold return rate that a proposed investment
must exceed in order to receive funding.
Cost of capital percentages can vary greatly between different companies

or organizations, depending on such factors as the organization's credit
worthiness and perceived prospects for survival and growth. In 2011, for
example, a company with an AAA credit rating, or the US treasury, can sell
bonds with a yield somewhere between 4% and 5%, which might be taken
as the cost of capital for these organizations. At the same
time, organizations with lower credit ratings—organizations whose future
prospects are viewed as "speculative" by the bond market—might have to
pay 10% - 15%, or even more.
! !174
COST OF CAPITAL
9.4 Weighted average cost of capital (WACC)
A firm's cost of capital from various sources usually differs

somewhat between the different sources of capital used. Cost of capital
may differ, that is, for funds raised with bank loans, sale of bonds, or
equity financing. In order to find the appropriate cost of capital for the firm
as a whole, weighted average cost of capital (WACC) is calculated. This is
simply the arithmetic average (mean) capital cost, where the contribution
of each capital source is weighted by the proportion of total funding it
provides. WACC is not the same thing as cost of debt, because WACC can
include sources of equity funding as well as debt financing. Like cost of
debt, however, the WACC calculation is usually shown on an after-tax basis
when funding costs are tax deductible.
Calculating WACC is a matter of summing the capital cost components,

where each is multiplied by its proportional weight. For example, in
simplest terms:
WACC = (Proportion of total funding that is equity funding) x (Cost of

equity) + (Proportion of total funding that is debt funding) x (Cost of Debt) 
x (1 – Corporate tax rate)
In brief, WACC shows the overall average rate the company pays (average
interest rate) for funds it raises. In many organizations, WACC is the rate
of choice to use for discounted cash flow (DCF) analysis to evaluate
potential investments and business cash flow scenarios. However, financial
officers may choose to use a higher discount rate for DCF analysis of
investments and actions that are perceived riskier than the firm's own
prospects for survival and growth.
! !175
COST OF CAPITAL
9.5 Cost of debt
An organization's cost of debt is the effective rate (overall average

percentage) that it pays on all its debts, the major part of which typically
consists of bonds and bank loans. Cost of debt is a part of a
company's capital structure. (along with preferred stock, common stock,
and cost of equity).
Cost of debt is expressed as a percentage in either of two ways: Before tax

or after tax. In cases where interest expenses are tax deductible, the after
tax approach is generally considered more accurate or more appropriate.
The after-tax cost of debt is always lower than the before-tax version.
For a company with a marginal income tax rate of 35% and a before tax
cost of debt of 6%, the after tax cost of debt is found as follows:
After tax cost of debt = (Before tax cost of debt) x (1 – Marginal tax rate)
= (0.06) x (1.00 – 0.35)

= (0.06) x (0.65)
= 0.039 or 3.9%
As with cost of capital, cost of debt tends to be higher for companies with
lower credit ratings—companies that the bond market considers riskier or
more speculative. Whereas cost of capital is the rate the company must
pay now to raise more funds, cost of debt is the cost the company is
paying to carry all debt it has acquired.
Cost of debt becomes a concern for stockholders, bondholders, and

potential investors when a company is highly leveraged (i.e., debt financing
is large relative to owner equity). A highly leveraged position becomes
riskier and less profitable in a poor economy (e.g., recession), when the
company's ability to service its large debt load may be questionable.
The cost of debt may also weigh in management decisions regarding asset
acquisitions or other investments acquired with borrowed funds. The
additional cost of debt that comes with the acquisition or investment
reduces the value of investment metrics such as return on investment
(ROI) or internal rate of return (IRR).
! !176
COST OF CAPITAL
9.6 Cost of Equity
A company's cost of equity (COE) is a measure of the returns that the

stock market demands for investors who will bear the risks of
ownership. Cost of equity is a part of a company's capital structure. (along
with preferred stock, common stock, and cost of debt).
A high cost of equity indicates that the market views the company's future
as risky, thus requiring greater return rates to attract investments. A lower
cost of equity indicates just the opposite. Not surprisingly, cost of equity is
a central concern to potential investors applying the capital asset pricing
model (CAPM), who are attempting to balance expected rewards against
the risks of buying and holding the company's stock.
The two most familiar approaches to estimating cost of equity are

illustrated here:
9.6.1 Cost of equity and dividend capitalization approach
One approach to calculating Cost of equity is based on the equity

appreciation and dividend growth.
Cost of equity = (Next year's dividend per share + Equity appreciation per
share) / (Current market value of stock) + Dividend growth
Consider for example, a stock whose current market value is $8.00, paying
annual dividend of $0.20 per share. If those conditions hold for the next
year, the investor's return would be simply 0.20/8.00, or 2.5%. If the
investor requires a return of, say 5%, one or two terms of the above
equation would have to change:
• If the stock price appreciates 0.20 to 8.20, the investor would experience
a 5% return: (0.20 dividend + 0.20 stock appreciation) / (8.00 current
value of stock).
• If, instead, the company doubled the dividend (dividend growth) to 0.40,
while the stock price remained at 8.00, the investor would also
experience a 5% return.
! !177
COST OF CAPITAL
9.6.2 Cost of equity and Capital asset pricing model CAPM approach
An alternative approach to Cost of equity is based on Capital Asset Pricing

Model CAPM measures:
Cost of equity = (Market risk premium) x (Equity beta) + Risk-less rate
Consider a situation where the following holds for one company's stock:
Grande Company Common shares
Market Risk Premium: 4.0%

Equity beta for his stock: 0.60
Risk-free rate: $1,800
Using these CAPM data and the formula above, Cost of Equity is calculated
as:
Cost of equity = (4.0%) x (0.60) + 5.0% = 7.4%
In the CAPM, beta is a measure of the stock's historical price changes

compared to price changes for the market as a whole. A beta of 0 indicates
the stock tends to rise or fall independently from the market. A negative
beta means the stock tends to rise when the market falls and the stock
tends to fall while the market rises. A positive beta means the stock tends
to rise and fall with the market.
! !178
COST OF CAPITAL
9.7 Cost of Borrowing
The term Cost of borrowing might seem to apply to several other terms in
this article. As used in business and especially the financial industries,
however, the term refers the total cost a debtor will pay for borrowing,
expressed in currency units such as dollars, euro, pounds, or yen.
When a debtor repays a loan over time, the following equation holds:
Total payments = Repayment of loan principal + cost of borrowing
Cost of borrowing may include, for instance, interest payments, plus (in
some cases) loan origination fees, loan account maintenance fees,
borrower insurance fees, and still other fees. As an example, consider a
loan with the following properties:
Loan properties
Amount borrowed (loan principal): Rs. 100,000.00

Annual interest rate: 6.0%
Amortization time: 10 Years
Payment frequency: Monthly
Annual borrower insurance: Rs. 25.00
Such a loan calls for 120 monthly payments of Rs. 110.21. Thus, the
borrower who makes all payments on schedule ends up repaying a total of
120 x Rs. 1,110.21, or Rs. 133,225. The borrower will also pay Rs. 200 for
loan origination, Rs. 600 in account maintenance fees (120 x Rs. 5), and
Rs. 250 in borrower insurance. The cost of borrowing may be calculated as: 
! !179
COST OF CAPITAL
Cost of borrowing calculation
Total repayments: Rs. 133,225.20.00

Less principal repaid: (Rs. 100,000.00)
Total interest payments: 33,225.20
Loan origination fee: 200.00
Account maintenance: Rs. 600.00
Borrower insurance fees: 250.00
Total cost of borrowing: Rs. 34,255.20
Over the last few decades, lending institutions everywhere have begun to
face increasingly stringent laws requiring them to disclose total cost of
borrowing figures to potential borrowers, in clear, accurate terms, before
signing loan agreements.
9.8 Cost of funds / Cost of funds index (COFI)
The term cost of funds, like cost of borrowing might seem to apply to
several other terms in this article, but in practice the proper use of the
term refers to the interest cost that financial institutions pay for the use of
money. Whereas other kinds of businesses (for example, those in product
manufacturing or service delivery) raise funds that ultimately support more
production and/or service delivery in one way or another, financial
institutions make money essentially by making funds available to
individuals, firms, or institutions. The funds used for this purpose are
acquired at a cost—the cost of funds.
• For banks or savings and loan firms, cost of funds is the interest they pay
to their depositors on, for example, certificates of deposit, passbook
savings accounts, money market accounts, the bank uses depositor
funds for loans it issues, but the use of those funds comes with a cost.
• For a brokerage firm, cost of funds represents the firm's interest expense
for carrying its inventory of stocks and bonds.
! !180
COST OF CAPITAL
Besides interest expenses, the cost of funds may also include any non-
interest costs required for the maintenance of debt and equity funds. These
non-interest components of cost of funds may include such things as
labour costs or licensing fees, for instance.
A bank's cost of funds is related to the rates it charges for adjustable rate
loans and mortgages. Banks will set interest rates for borrowers based on
a cost of funds index (COFI) for their region.
9.9 Summary
Cost of Capital is the part of financial management. In cost of capital,

meaning of cost of capital, its measurement, cost of debt, equity and cost
of marginal capital will include. Cost of capital is the minimum rate of
investment which a company has to earn for getting fund. When any
company investor invests his money, he sees the rate of return. So, the
company has to mention, what the company will pay, if investors provide
their money to the company. That average cost on the investment is called
cost of capital.
Computation of cost of capital is a significant part of the financial

management to decide the capital structure of the business concern.
Capital budget decision mainly depends on the cost of capital of each
source. According to net present value method, present value of cash
inflow must be more than the present value of cash outflow. Therefore,
cost of capital is used for capital budgeting decision.
Capital structure is the mix or proportion of the different types of long-

term securities. Company uses particular type of sources if the cost of
capital is suitable. Therefore, cost of capital supports to take decision
regarding structure.
Cost of capital is imperative to determine which affects the capital

budgeting, capital structure and value of the firm. It helps to estimate the
financial performance of the firm.
Cost of capital is also used in some other areas such as, market value of
share, earning capacity of securities etc. Hence, it plays a major part in the
financial management.
! !181
COST OF CAPITAL
Cost of equity capital is the rate at which investors discount the expected
dividends of the firm to determine its share value. Theoretically, the cost of
equity capital is described as the "Minimum rate of return that a firm must
earn on the equity financed portion of an investment project in order to
leave unchanged the market price of the shares.”
To, summarize, cost of return is defined as the return the firm's investors
could expect to earn if they invested in securities with comparable degrees
of risk. The cost of capital signifies the overall cost of financing to the firm.
It is normally the relevant discount rate to use in evaluating an investment.
Cost of capital is important because it is used to assess new project of
company and permits the calculations to be easy so that it has minimum
return that investors expect for providing investment to the company.
9.10 Questions
1. What is cost of capital? Explain.
2. What is cost of borrowing? Explain.
3. Write short notes on Weighted average cost of capital (WACC).
4. What do you understand by Cost of equity and Capital asset pricing

model CAPM approach?
5. Write short notes on Cost of borrowing.
! !182
COST OF CAPITAL

alternatives)
1. What measures the returns demanded by stock market investors who

will bear the risks of ownership?
a. Cost of borrowing
b. Cost of Debt
c. Cost of equity
d. Cost of funds
2. An organization's cost of debt is the effective rate (overall average

percentage) that it pays on all its debts, the major part of which
typically consist of _____________
a. bonds
b. bank loans
c. Bank Deposit
d. Both a & b
3. The term cost of funds, like cost of borrowing might seem to apply to
several other terms, but in practice the proper use of the term refers to
the _____________ that financial institutions pay for the use of money
a. Interest cost
b. Dividend cost
c. Borrowing cost
d. Deposit cost
4. The term Cost of borrowing might seem to apply to several other terms.
As used in business and especially the financial industries, however, the
term refers the total cost a debtor will pay for _____________
a. Lending
b. Borrowing
c. Depositing
d. Investing in stock and securities
5. For banks or savings and loan firms, cost of funds is _____________

they pay to their depositors
a. Commission
b. Non-interest charges
c. Interest
d. Charges
! !183
COST OF CAPITAL
Answers: 1. (c), 2. (d), 3. (a), 4.( b), 5. (c)
! !184
COST OF CAPITAL
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !185
WORKING CAPITAL INVESTMENT DECISIONS
Chapter 10
Working Capital Investment Decisions
Objectives
taking overview of:
Structure:
10.1 Introduction
10.2 Types of Working Capital
10.3 Working Capital Cycle
10.4 Working Capital Management
10.5 Management of Working Capital
10.6 Working Capital Investment
10.7 Working Capital Policy
10.8 Summary
10.9 Questions
! !186
10.1 Introduction
Working capital (WC) is a financial metric which represents operating

liquidity available to a business, organization or other entity, including
governmental entity. Along with fixed assets such as plant and equipment,
working capital is considered a part of operating capital. Gross working
capital equals to current assets. Working capital is calculated as current
assets minus current liabilities. If current assets are less than current
liabilities, an entity has a working capital deficiency, also called a working
capital deficit.
A company can be endowed with assets and profitability but short

of liquidity if its assets cannot readily be converted into cash. Positive
working capital is required to ensure that a firm is able to continue its
operations and that it has sufficient funds to satisfy both maturing short-
term debt and upcoming operational expenses. The management of
working capital involves managing inventories, accounts receivable and
payable, and cash. Working capital is the difference between the current
assets and the current liabilities.
The basic calculation of the working capital is done on the basis of the
gross current assets of the firm. Current assets and current liabilities
include three accounts which are of special importance. These accounts
represent the areas of the business where managers have the most direct
impact:
• accounts receivable (current asset)

• Inventory (current assets), and
• Accounts payable (current liability)
! !187
The current portion of debt (payable within 12 months) is critical, because

it represents a short-term claim to current assets and is often secured by
long-term assets. Common types of short-term debt are bank loans and
lines of credit.
An increase in net working capital indicates that the business has either
increased current assets (that it has increased its receivables, or other
current assets) or has decreased current liabilities—for example has paid
off some short-term creditors, or a combination of both.
10.2 Types of working capital
The working capital can be classified on the basis of concept and on the
basis of time.
10.2.1 Types of working capital on the basis of concept
Generally, there are two concepts of working capital. They are gross
working capital and net working capital. But they are defined by different
names. They are explained below:
1. In broad sense: working capital refers to gross working capital. It is

also defined as financial concept or going concern concept. It means the
capital invested in the current assets of the firm. Current assets mean
the assets which can be converted into cash easily or within one
accounting period. It helps in determining the return on investment in
working capital and providing correct amount of working capital at the
right time.
2. In narrow sense: working capital refers to net working capital. It is

also defined as accounting concept. It means excess of current assets
over current liabilities. It helps in finding out firm’s capability to meet
short-+term liabilities as well as indicates the financial soundness of the
enterprise.
! !188
Net working capital = current assets – current liabilities
Net working capital can be +ve or –ve. When current assets are more than
the current liabilities then working capital is +ve and when current assets
are less than the current liabilities then working capital is –ve.
Both the working capitals are important but according to the suitability
gross working capital is suitable for companies having separate ownership
or management while net working capital is suitable for sole trader
companies or partnership firms.
10.2.2 Types of working capital on the basis of time
1. Permanent working capital: it is also called fixed working capital. It

means to carry on the day to day expenses the firm is required to
maintain the minimum amount of working capital. For example, the firm
is required to maintain the minimum level of raw material, finished
goods or cash balance etc.
a. Regular working capital: it means the minimum amount which the

firm has to keep with itself to carry on the day to day operations.
b. Reserve working capital: it means the excess amount over the

regular working capital for uncertain circumstances like strike, lockout,
depression etc.
2. Temporary working capital: it is also called variable working capital,

which is required to meet the seasonal demands as well as for special
purposes.
a. Seasonal working capital: it is required to meet the seasonal needs

of the enterprise.
b. Special working capital: it is required for some special purposes of

the enterprise. For example, advertising the product of the firm requires
special working capital.
Temporary working capital is for short period and fluctuates while

permanent working capital is stable and fixed.
! !189
To summarise, following are the types or classification of working capital.
10.3 Working capital cycle
Definition
The working capital cycle (WCC) is the amount of time it takes to turn the
net current assets and current liabilities into cash. The longer the cycle is,
the longer a business is tying up capital in its working capital without
earning a return on it. Therefore, companies strive to reduce their working
capital cycle by collecting receivables quicker or sometimes stretching
accounts payable.
Meaning
A positive working capital cycle balances incoming and outgoing payments

to minimize net working capital and maximize free cash flow. For example,
a company that pays its suppliers in 30 days but takes 60 days to collect
its receivables has a working capital cycle of 30 days. This 30-day cycle
usually needs to be funded through a bank operating line, and the interest
! !190
on this financing is a carrying cost that reduces the company's profitability.

Growing businesses require cash, and being able to free up cash by
shortening the working capital cycle is the most inexpensive way to grow.
Sophisticated buyers review closely a target's working capital cycle
because it provides them with an idea of the management's effectiveness
at managing their balance sheet and generating free cash flows.
As an absolute rule of funders, each of them wants to see a positive

working capital. Such situation gives them the possibility to think that your
company has more than enough current assets to cover financial
obligations. Though, the same can’t be said about the negative working
capital. A large number of funders believe that businesses can’t be
sustainable with a negative working capital, which is a wrong way of
thinking. In order to run a sustainable business with a negative working
capital it’s essential to understand some key components.
• Approach your suppliers and persuade them to let you purchase the
inventory on 1-2-month credit terms, but keep in mind that you must sell
the purchased goods, to consumers, for money.
• Effectively monitor your inventory management, make sure that it’s often
refilled and with the help of your supplier, back up your warehouse.
Plus, big companies like McDonald’s, Amazon, Dell, General Electric and
Wal-Mart are using negative working capital.
! !191
10.4 Working capital management
Decisions relating to working capital and short-term financing are referred

to as working capital management. These involve managing the
relationship between a firm's short-term assets and its short-term
liabilities. The goal of working capital management is to ensure that the
firm is able to continue its operations and that it has sufficient cash flow to
satisfy both maturing short-term debt and upcoming operational expenses.
A managerial accounting strategy focusing on maintaining efficient levels of

both components of working capital, current assets and current liabilities,
in respect to each other. Working capital management ensures a company
has sufficient cash flow in order to meet its short-term debt obligations and
operating expenses.
Decision criteria
By definition, working capital management entails short-term decisions—

generally, relating to the next one-year period—which are "reversible".
These decisions are therefore not taken on the same basis as capital-
investment decisions (NPV or related, ; rather, they will be based on cash
flows, or profitability, or both.
i. One measure of cash flow is provided by the cash conversion cycle—the

net number of days from the outlay of cash for raw material to receiving
payment from the customer. As a management tool, this metric makes
explicit the inter-relatedness of decisions relating to inventories,
accounts receivable and payable, and cash. Because this number
effectively corresponds to the time that the firm's cash is tied up in
operations and unavailable for other activities, management generally
aims at a low net count.
ii. In this context, the most useful measure of profitability is return on

capital (ROC). The result is shown as a percentage, determined by
dividing relevant income for the 12 months by capital employed; return
on equity (ROE) shows this result for the firm's shareholders. Firm value
is enhanced when, and if, the return on capital, which results from
working-capital management, exceeds the cost of capital, which results
from capital investment decisions as above. ROC measures are
! !192
therefore useful as a management tool, in that they link short-term

policy with long-term decision making.
iii. Credit policy of the firm: Another factor affecting working capital
management is credit policy of the firm. It includes buying of raw
material and selling of finished goods either in cash or on credit. This
affects the cash conversion cycle.
10.5 Management of working capital
Guided by the above criteria, management will use a combination of

policies and techniques for the management of working capital. The
policies aim at managing the current assets (generally cash and cash
equivalents, inventories and debtors) and the short-term financing, such
that cash flows and returns are acceptable.
• Cash management. Identify the cash balance which allows for the
business to meet day to day expenses, but reduces cash holding costs.
• Inventory management. Identify the level of inventory which allows

for uninterrupted production but reduces the investment in raw materials
—and minimizes reordering costs—and hence increases cash flow.
Besides this, the lead times in production should be lowered to
reduce Work in Process (WIP) and similarly, the Finished Goods should be
kept on as low level as possible to avoid overproduction.
• Debtors management. Identify the appropriate credit policy, i.e. credit

terms which will attract customers, such that any impact on cash flows
and the cash conversion cycle will be offset by increased revenue and
hence Return on Capital (or vice versa);
• Short-term financing. Identify the appropriate source of financing,

given the cash conversion cycle: the inventory is ideally financed by
credit granted by the supplier; however, it may be necessary to utilize a
bank loan (or overdraft), or to "convert debtors to cash" through
“factoring".
! !193
10.6 Working Capital Investment
Working capital is amount of liquid assets which an organization has at

hand. Working capital investments are required to pay for unexpected and
planned expenses, to build a business and meet the business’s short-term
duties and obligations. Working capital investment is the amount of money
you require to expand your business, meet short-term business
responsibilities and cover business expenses. A start-up capital, we can
say, is the amount money you require to begin a business till it yields
sufficient revenue so that it can pay for its own self. You can get working
capital investments and start-up capital from grants, loans, partners and
investors but a lot of business women put in to use their own personal
resources of finance for funding their businesses.
No working capital investment would make it difficult to lure investors or

even fetch credit or business loans. An organization has two types of
assets which are,
a. fixed assets like machinery, property etc. and,
b. current assets, which are the assets that would be used in one fiscal
year.
Current assets of an organization include accounts receivable, cash at

bank, cash in hand, inventory, pre-paid expenses as well as short term
investments.
We can define current liabilities as those liabilities that need to be cash

settled in the fiscal year. Current liabilities include the accounts payable
relating to services and goods that include short term payable loans in one
fiscal year. Working capital investment amount is what you get when you
subtract current liabilities from the current assets. The following is the
formula for deriving working capital investment:
Current Assets – Current Liabilities = Working Capital Investment
Working capital investment can be speculated as a negative or a positive

number, and it depends upon the quantity of debt a business has. How
much current assets are required depend upon the nature of the business
of the company, e.g., a manufacturing firm might need more stocks when
! !194
compared to a firm that is in the service sector. As a company volume of

output increases, amount of current assets that are required would
increase as well.
Even when you assume the procedures for debt collection, cash
management and effective stock holdings, there still is a certain level of
choice in the whole volume of the required current assets that are needed
to meet the output demand. Policies of minimum cash holding, tight credit,
low stock-holding levels etc. could be contrasted with high stock policies,
sizeable cash holding and easier credit.
10.6.1 Working Capital Investment Requirements
Net working capital investment requirement varies from one company to

another. Within the same company, the requirement of net working capital
investment could vary from one month to another. The requirement of net
working capital investment is dependent upon two factors: 1) what are the
earnings of the organization and the frequency of getting these earnings
and 2) the expenses of the organization and how often the payments
needed to be conciliated.
For knowing about calculating the working capital investment requirement

needed for a new business investment, the managers need to create
forecasts of earnings, which is inventory and accounts receivable and
expenses, which is accounts payable. Post you have made the projections;
you need to compare expenses with projections and the actual earning.
Then, you have to add the raise in inventory and accounts receivable and
minus from this amount, the accounts payable. The amount what you get
then would show the likely change in the working capital investment that
could be utilized for new investment. Any change in the working capital
investment can be also determined with the outflow and inflow of funds.
Thus, one should take these two things into consideration when calculating
working capital investment requirements.
10.6.2 Working Capital Investment Management
Working capital investment management is crucial to make sure that the

organization has sufficient funds for carrying out its everyday operations in
a smooth manner. Any business shouldn’t have a quiet a long cycle for
cash conversion. Cash conversion cycle assesses the period of time for
! !195
which an organization would be divested of funds in the case it raises its

investments, as a procedure of its strategies for business growth. The
organization needs to take some steps for the same, like reducing the
customer’s credit period, talking terms with suppliers and raising their
period of credit with the suppliers, preserving the apt inventory level that
lessens the costs of raw materials and right cash management that would
ensure reduced cash holding prices. If an organization follows these
measures, then the working capital investment requirement would come
down automatically.
There are some other things as well which one needs to consider in relation
to working capital investment requirements. If an organization’s current
liabilities are more than its current assets, then it shows a deficiency in the
working capital investment and might lead sometimes to a business related
debt. A shortfall in working capital investment has a damaging impact on
the image of an organization it shows that the firm is facing liquidity
problems and is unable to pay for costs related to short term periods. In
this instance, the investors might pull out of making investments of any
kind in the firm. Hence, financial planning, which includes planning of
working capital investment requirement is very important for running a
business expeditiously.
10.6.3 Working Capital Investment and Over-Capitalization
In case there are inordinate cash and stocks debtors and few creditors,
then there would be an excessive investment in current assets by the firm.
Working capital investment would be inordinate and the firm would in this
respect be over-capitalized. Return on investment (ROI) would be lesser
than it actually should be as well as long term funds would unnecessarily
be engaged when, instead they can be invested somewhere else to gain
profits.
With respect to working capital investment, over capitalization shouldn’t

exist in case the management is good but the warning since excessive
working capital be poor accounting ratios. The ratios that can help in
estimating if the working capital investment is reasonable or not, include: 
! !196
• Working capital investment: The sales volume as a product of working

capital investment ought to show weather, when compared with the
former year or with similar kind of firms, the whole amount of working
capital investment is very high.
• Liquidity Ratios: A quick ratio in surplus of 1:1 or a ratio in surplus of

2:1 might indicate a more than required working capital investment.
• Turnover periods: Inordinate periods of turnover for debtors and stocks

or a credit taken for a short period from supplies could indicate that the
debtors’ stocks volume is high unnecessarily or the creditors’ volume is
very low
10.7 Working Capital Policy
The working capital policy of a company refers to the level of investment in

current assets for attaining their targeted sales. It can be of three types
viz. restricted, relaxed, and moderate. The relaxed policy has higher and
restricted has lower levels of current assets whereas moderate places itself
between relaxed and restricted. Commonly, these policies are also named
as aggressive, conservative and hedging policy.
Working capital management has two main decisions at two consecutive

stages. They are as follows:
a. The level of Current Assets – How much to invest in Current Assets

to achieve the Targeted Revenue
b. Means of Financing Current Assets – How should the above Current

Asset Investment be financed i.e. the mix of long and short term
finance?
! !197
10.7.1 Difference between Working Capital Policies and Working

Capital Financing Strategies
Commonly, policies of working capital and strategies (approaches) of

working capital financing are interchangeably used and which is not
correct. There is a thin line of difference between the two. Working capital
management policy deals with the first decision and working capital
management strategies or approaches deal with the second decision.
Working capital policies are restricted, relaxed and moderate whereas the
working capital strategies are aggressive, conservative and hedging
(Maturity Matching).
10.7.2 Types of Working Capital Policies
Based on the attitude of the finance manager towards risk, profitability and
liquidity, the working capital policies can be divided into following three
types.
! !198
a. Restricted Policy: In restricted policy, the estimation of current assets

for achieving targeted revenue is done very aggressively without
considering for any contingencies and provisions for any unforeseen
event. After deciding, these policies are forcefully implemented in the
organization without tolerating any deviations. In the diagram, point R
represents the restricted policy which attains the same level of revenues
with lowest current assets.
Adopting this policy would result in an advantage of the lower working

capital requirement due to the lower level of current assets. This saves
the interest cost to the company and which in turn produces higher
profitability i.e. higher return on investment (ROI). On the other hand,
there is the disadvantage in the form of high risk due to very aggressive
policy. That is why; it is also called as aggressive working capital policy.
b. Relaxed Policy: Relaxed policy is just the opposite of restricted policy.

In this policy, the estimation of current assets for achieving the targeted
revenue is prepared after careful consideration of uncertain events such
as seasonal fluctuations, a sudden change in the level of activities or
sales etc. After the reasonable estimates also, a cushion to avoid any
unforeseen circumstances is left to avoid the maximum possible risk. In
the diagram, it represents the point Rx which uses the highest level of
current assets for achieving the same level of sales.
The companies having relaxed working capital policies assume an

advantage of almost no risk or low risk. This policy guarantees the
entrepreneur of the smooth functioning of the operating cycle. We know
that earnings are more important than higher earnings. On the other
hand, there is a disadvantage of lower return on investment because
higher investment in the current assets attracts higher interest cost
which in turn reduces profitability. Because of its conservative nature,
this policy is also called as conservative working capital policy.
c. Moderate Policy: Moderate policy is a balance between the two policies

i.e. restricted and relaxed. It assumes characteristics of the both the
policies. To strike a balance, moderate policy assumes risk which is
lower than restricted and higher than conservative. In profitability front
also, it lies between the two.
! !199
The biggest benefit of this policy is that it has reasonable assurance of

smooth operation of working operating capital cycle with moderate
profitability.
Working capital policies can be further framed for each component of net
working capital i.e. cash, accounts receivable, inventory and accounts
payable. Cash policies can be to maintain an appropriate level of cash.
When the level is high, it should be invested in liquid investments for
short term and vice versa. Accounts receivable policy may state about
payment terms, credit period, credit limit, etc. Inventory policy may
speak of minimizing the levels of inventory till the point it poses any risk
to the satisfaction of customer demands. Accounts payable policies
include policies of payment terms, quality terms, return policies, etc.
10.8 Summary
Working capital (WC) is a financial metric which represents operating

liquidity available to a business, organization or other entity, including
governmental entity. Along with fixed assets such as plant and equipment,
working capital is considered a part of operating capital. Gross working
capital equals to current assets. Working capital is calculated as current
assets minus current liabilities If current assets are less than current
liabilities, an entity has a working capital deficiency, also called a working
capital deficit. Working capital management entails short-term decisions—
generally, relating to the next one-year period—which are "reversible".
These decisions are therefore not taken on the same basis as capital-
investment decisions (NPV or related) rather, they will be based on cash
flows, or profitability, or both. Net working capital investment requirement
varies from one company to another. Within the same company, the
requirement of net working capital investment could vary from one month
to another. The requirement of net working capital investment is dependent
upon two factors: 1) what are the earnings of the organization and the
frequency of getting these earnings and 2) the expenses of the
organization and how often the payments needed to be conciliated.
Various Policies of working capital and strategies (approaches) of working

capital financing are interchangeably used and which is not correct. There
is a thin line of difference. Working capital management policy deals with
the first decision and working capital management strategies or
approaches deal with the second decision of Finance requirement
! !200
The trade-off between risk and return which occurs in policy decisions
regarding the level of investment in current assets is also significant in the
policy decision on the relative amounts of finance of different maturities in
the balance sheet, i.e. on the choice between short- and long-term funds
to finance working capital. To assist in the analysis of policy decisions on
the financing of working capital, we can divide a company’s assets into
three different types: non-current assets, permanent current assets and
fluctuating current assets. Non-current assets are long-term assets from
which a company expects to derive benefit over several periods, for
example factory buildings and production machinery. Permanent current
assets represent the core level of investment needed to sustain normal
levels of business or trading activity, such as investment in inventories and
investment in the average level of a company’s trade receivables.
Fluctuating current assets correspond to the variations in the level of
current assets arising from normal business activity. A matching funding
policy is one which finances fluctuating current assets with short-term
funds and permanent current assets and non-current assets with long-term
funds. The maturity of the funds roughly matches the maturity of the
different types of assets. A conservative funding policy uses long-term
funds to finance not only non-current assets and permanent current assets,
but some fluctuating current assets as well. As there is less reliance on
short-term funding, the risk of such a policy is lower, but the higher cost of
long-term finance means that profitability is reduced as well. An aggressive
funding policy uses short-term funds to finance not only fluctuating current
assets, but some permanent current assets as well. This policy carries the
greatest risk to solvency, but also offers the highest profitability and
increases shareholder value.
Further, trade receivables conversion period can be shortened by offering

incentives for early payment, by reducing the period of credit offered to
customers, by chasing slow or late payers, and by more stringent
assessment of the creditworthiness of customers to screen out slow
payers. The minimum trade receivables conversion period is likely to be the
credit offered by competitors. The trade payables deferral period is less
flexible as it is determined to a large extent by a company’s suppliers. If a
company delays payables payments past their due dates, it runs the risk of
paying interest on overdue accounts, losing its suppliers or being refused
credit in future.
! !201
Considering all above aspects and as discussed in this chapter you must
have understood following:
• an appreciation of the importance of working capital management in

ensuring the profitability and liquidity of a company;
• the ability to describe the cash conversion cycle and to explain its
significance to working capital management;
• an understanding of the need for working capital policies concerning the

level of investment in current assets, and of the significance of
aggressive, moderate and conservative approaches to working capital
management;
• an understanding of the link between the sources of short-term finance
available to a company and working capital policies concerning the
financing of current assets;
• the ability to describe and discuss a range of methods for managing

inventory, cash, trade receivables and trade payables;
• the ability to evaluate, at an introductory level, the costs and benefits of

proposed changes in working capital policies;
Based on the attitude of the finance manager towards risk, profitability and
liquidity, the working capital policies decision has to be taken for
investment in working capital finance out of the cash flow generated or
other sources as discussed in this chapter.
10.9 Questions
A. Answer the following Questions
1. What is working capital cycle? Define and explain
2. Write short notes on working capital Management
3. What is Working Capital Investment Management? Explain
4. Describe: Working Capital Investment and Over-Capitalization
! !202
5. Explain: Types of working capital policies

alternatives)
1. What is the common type of short-term debt?

a. bank loans
b. lines of credit
c. Debt instruments
d. Both a & b
2. In order to run a sustainable business with a negative working capital

it’s essential to understand some key component which may include
_____________
a. purchase the inventory on 1-2-month credit terms
b. Sell the purchased goods to consumers for money
c. Effectively monitor inventory management
d. All above
3. The requirement of net working capital investment is dependent upon

_____________
a. what are the earnings of the organization and the frequency of
getting these earnings
b. the expenses of the organization and how often the payments needed
to be conciliated
c. Both a & b
d. Demand for supply of finished goods
4. In which type of policy, the estimation of current assets for achieving

the targeted revenue is prepared after careful consideration of uncertain
events such as seasonal fluctuations, a sudden change in the level of
activities or sales etc.?
a. Relaxed policy
b. Restricted Policy
c. Moderate policy
d. Investment Policy
5. In restricted policy, the estimation of _____________ for achieving

targeted revenue is done very aggressively without considering for any
contingencies and provisions for any unforeseen event.
! !203
a. Fixed Assets
b. Current assets
c. Current Liabilities
d. Moving assets
Answers: 1. (d), 2. (d), 3. (c), 4. (a), 5. (b)
! !204
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !205
TERM LOANS, LEASING AND HIRE PURCHASE IN FINANCIAL MANAGEMENT
Chapter 11
Term Loans, Leasing And Hire Purchase In
Financial Management
Objectives
taking overview of:
Structure:
11.1 Introduction
11.2 Term Loans
11.3 Leasing
11.4 Cash Flow Analysis to Determine Lease and Borrowing
11.5 Decision on Lease Financing Vs. Term Loan Financing
11.6 Difference between Hire Purchase Vs. Term Loan
11.7 Decision on Hire Purchase (HP) Vs. Term Loan Financing
11.8 Summary
11.9 Questions
! !206
11.1 Introduction
A term loan is a monetary loan that is repaid in regular payments over a

set period of time. Term loans usually last between one and ten years, but
may last as long as 30 years also in some cases. A term loan usually
involves an unfixed interest rate that will add additional balance to be
repaid. Term loans can be given on an individual basis but are often used
for small business loans. The ability to repay over a long period of time is
attractive for new or expanding enterprises, as the assumption is that they
will increase their profit over time. Term loans are a good way of quickly
increasing capital in order to raise a business’ supply capabilities or range.
For instance, some new companies may use a term loan to buy company
vehicles or rent more space for their operations.
With a term loan, one can use the lump sum borrowed to pay for the asset
and take immediate possession whereas if one takes assets on hire, a
deposit is paid to take possession and the remainder of the purchase price
is repaid by fixed instalments over a fixed period. Legal ownership is
obtained only after payment of final instalment.
Leasing is an alternative to term loans and, again, generally covers an

intermediate (5-10 years) length of time. There are 2 types of lease,
Financial lease and operative lease.
Hire purchase is a type of contract of purchase in which the seller/financier

rents the asset for an agreed period of time in return for a set of monthly
instalments. The buyer obtains ownership only when the full amount of the
contract has been paid to the financier/seller of goods. So, the buyer
doesn’t own the asset until the last instalment.
11.2 Term Loans
The term loan is a type of financing, given by financial institutions such as

commercial banks, development banks and special institutions for lending
money. Normally, it is of two types: Long-Term and Short-Term. The
borrower takes the lump sum amount and agrees to return the amount
along with interest thereupon. The whole amount is repaid within the
stipulated time in instalments including both principal and interest. There is
a processing fee as a cost to acquire this type of financing. Generally, the
term loan is obtained for financing large expansion or diversification of an
! !207
organization. The borrower has to submit his financial statements and his
net worth capacity so that the lender can assess the ability of the borrower
in paying back the loan, on the assumption that their profit will increase
over time.
For raising a business’s supply capabilities, or for purchasing an asset, or

for any sort of expansion, the term loan is an easy option to arrange
finance in a short span of time.
Generally, bank loans are short-term in nature, while bonds are very long-
term. An intermediate type of loan exists that is referred to as a term loan.
Term loans are particularly important to medium-sized firms; those that
have become too big to obtain all of their financing from their commercial
bank, but are not large enough to issue publicly-traded bonds. The typical
term loan is also of medium duration, between five and fifteen years.
While banks will make term loans of up to five years, they generally prefer
to make only short-term loans. This is due to the nature of the source of
financing of banks. Banks’ financing generally comes from deposits, which
are short-term, so they do not want to make long-term loans. However,
some of their funds (equity and long-term certificates of deposit) are long-
term in nature and provide the means by which longer term loans can be
made.
The typical term loan is one that is said to be “self-amortizing”. That is, it is
made up of a series of equal payments, with each payment being
comprised of both interest and principal (just like a fixed rate mortgage on
a home). For tax purposes, we need to be able to break down each
payment into the portion that is interest and that which is principal since
the interest portion is tax-deductible.
Suppose, for instance, that we take a Rs. 5,000 loan at 12% rate of
interest payable in four equal annual installments. The first thing we need
! !208
to calculate is the annual payment. If we think in terms of a banker, we will

ask ourselves “What annual payment over four years will give me a present
value equal to Rs. 5,000 amount of the loan if it is discounted at 12% rate
of interest?” Then, solving for that payment, we obtain…
Rs.5,000
Payment = !
12%, 4
Rs.5,000
= !
3.0373
= Rs. 1646.20
The payment that will be due at the end of each of the next four years will
be Rs. 1,646.20 and will pay 12% interest on the outstanding balance as
well as paying the Rs. 5,000 in principal back. An amortization table would
appear as follows:
Year Payment Interest Principal Balance
0 -0- -0- -0- Rs. 5,000.00

1 Rs. 1,646.20 Rs. 600.00 Rs. 1,046.20 Rs. 3,953.80
2 Rs. 1,646.20 Rs. 474.46 Rs. 1,171.74 Rs. 2,782.06

3 Rs. 1,646.20 Rs. 333.85 Rs. 1,312.35 Rs. 1,469.71
4 Rs. 1,646.20 Rs. 176.36 Rs. 1,469.84 Rs. (0.13)
Note that thirteen cents too much was paid back. This is due to rounding
error and in practice the last payment would be for only Rs. 1,646.07 so
that everything worked out even.
Typically, a term loan will be secured by the general assets of the firm.
Oftentimes, the company will agree to maintain certain financial ratios
(current/quick ratio and times interest earned) as well as agreeing to
negative covenants regarding additional debt and dividend payments.
! !209
Term loans are available from numerous sources:
• Insurance companies
• Banks
• Venture capital companies
• Small Business Administration (SBA)
11.3 Leasing
Lease is defined as a contract under which one party i.e. the owner of the
asset, hereby called the LESSOR, provides the asset for usage to another
party i.e. The LESSEE for the period of time known as the term of lease
which is mutually agreed upon by the two parties, and charges a
consideration in the form of periodic lease rental payments, for the asset.
The ownership of the asset is retained by the lessor.
Leasing is an alternative to term loans and, again, generally covers an

intermediate (5-10 years) length of time.
11.3.1 Types of Lease
Two types of leases exist; an operating lease is one where the lease period
is short in comparison to the life of the equipment and maintenance is
generally provided (although oftentimes a separate maintenance contract
is required). A financial lease is where the lease period exceeds 75% of
the life of the equipment and generally has a purchase option at the end of
the lease period.
! !210
1. Financial Lease
The IRS is quite concerned with the distinction between the two types of
leases. A financial (or capital) lease is essentially a term loan packaged
together with the purchase of an asset. The reason to distinguish between
the two is because it does not want to see a company both depreciate the
asset (expense the cost) as well as deduct the entire lease payment
(expense the cost again). The entire lease payment of an operating lease
is tax-deductible. With a financial lease, the lease payment must be
broken down into the interest portion and the principal portion, just like a
term loan, and only the interest portion is deductible.
Characteristics of a financial (or capital) lease include the

following:
i. Asset is fully amortized to one lessee. The lessor plans to recoup his/her
investment and required return from one lessee.
ii. Not cancelable without substantial penalty, usually acceleration of the

remaining lease payments.
iii. Lessee is responsible for taxes, maintenance and insurance and Lessor
determines liability limits.
iv. Contract life approximates the useful economic life of the asset.
v. Lease contains a purchase option at the end of the lease.
vi. Lease does not expense the lease payments but rather records the asset
on the balance sheet and the lease as a liability. The interest portion of
each lease payment is deducted and then the asset is depreciated.
2. IRS requirements for a lease to be an operating lease are that
a. The lease term is less than 80% of the economic life of the asset
b. The estimated residual value of the asset at the end of the lease term is
at least 20% of its value at the beginning of the lease term
! !211
c. Cannot be a purchase option at the end for a fixed price (must be fair
market value)
d. Asset cannot be limited use (i.e., usable only by the lessee)
Characteristics of an operating lease include the following:
i. Lease is cancelable without substantial penalty.
ii. Lessor provides maintenance, taxes and insurance
iii. Contract life is less than the economic life of the asset
iv. Lessor to receive his investment and return from multiple lessees.
v. Lease payments are expensed by the lessee. Since the asset and the
lease are not recorded on the balance sheet, no depreciation is taken
and the lease payments are shown as an operating expense. Called off
balance sheet financing since lessee has use of the asset, can generate
income off the asset without recording the asset on the balance sheet,
leading to a misleading ROA calculation. Shows up as operating leverage
rather than financial leverage.
vi. Asset is depreciated by the lessor, sheltering the rental payment. At the
end of the lease, the lessor retain title (no purchase option). The lessor
can, release the asset, sell the asset, scrap the asset or use the asset
himself. Since this is not financing, no truth in lending is required and
typical required rates of return are 18% to 28%. Operating leases also
cause the lessee to lose the asset at the end of the lease and may
require replacement at a higher cost, loss of equity accumulation may
affect future financing, loss of residual value, and may lead to
inadequate valuation due to habitual leasing.
For purposes of our discussion, only an operating lease is considered (one

where the entire lease payment is tax-deductible).
! !212
11.3.2 The advantages of leasing
Permits the lessee to obtain the use of equipment that otherwise they
couldn’t get
• Provides equipment that is only temporarily needed
• Permits the disposal of obsolete equipment (although higher lease

charges generally cover this)
• Lessee doesn’t have to worry about maintenance service
• Provides an additional source of financing
• Lease payment is tax-deductible
Although long-term leases are supposed to be capitalized as both an asset

and a liability (FASB 13), few companies actually do so. Leasing is often
referred to as “off-balance sheet financing” as a consequence.
11.3.3 The disadvantages of leasing include
• High cost – the lease payment covers the cost of the equipment as well
as a profit for the lessor.
• The lessor gets to take the depreciation expense and receives any
residual value that exists at the end of the lease period.
In general, if equipment is needed for its entire useful life, it is more

economical to purchase the equipment rather than leasing it. On the other
hand, a company that is in the business of leasing equipment may have
access to secondary markets that the individual firm does not. For
example, the leasing company may be able to use older equipment as a
source of parts, have customers that buy used equipment, etc., that the
leasing firm does not have access to.
! !213
11.3.4 Sources of leasing funds
• Independent leasing companies

• Banks
• Insurance companies
• Pension funds
• Industrial development agencies
A Sale and Lease-back is where a company sells an asset to a financial

institution but leases it back over a period of time. The fixed amount of
the lease payments over the lease period are equivalent to the full
purchase price plus interest. Why would anyone want to do this? Because
it provides a source of cash to a firm that cannot obtain financing in any
other manner.
11.4 Cash Flow Analysis to determine Lease and borrowing
The occurrences on the time line above refer to the costs of purchasing the
asset assuming that a term loan must be taken out to finance the asset's
purchase. These costs are generally discounted into present value terms
at the after-tax cost of the term loan. For example, if the new debt carries
a coupon rate of 10% and the applicable tax rate is 40%, the discount rate
employed would be 10% * (1-.4) = 6%.
! !214
The gross lease cost of the asset is reduced by (1-t) since the lease
payments are tax-deductible. The cost of leasing is also generally
discounted into present value terms at the after-tax cost of borrowed
money since a long-term lease is considered debt for accounting purposes.
Hence, the discount rate for the leasing alternative would be 6% as well.
Since lease payments are generally due at the beginning of the lease
period, the lease alternative represents an annuity due.
Net Lease Cost = Gross Lease Cost * (1-t) + Gross Lease Cost * (1-t) *
PVIFA x %, n-1
Where < > indicates that the cash flow is an outflow. t = applicable tax
rate
11.5 Decision on Lease Financing Vs. Term Loan Financing
1. Down Payment: While taking an asset on a lease, down payment is

not required. Only a periodic lease rental payment is required which is
lower as compared to the percentage of down-payment. Whereas in the
case of a term loan, the borrower has to pay a small percentage in the
form of down-payment (margin money) at the beginning of the
transaction and an instalment amount at the required time and the
balance amount is financed by the loan.
2. The option of Buying the Asset: The lessee uses the asset up to the
lease period and pays the rentals. He has the option of buying the asset
at the end of the lease. Whereas in the case of loan financing, it is
compulsory for the user to buy the asset as soon as he gets the loan.
3. Security: No security, in any form, is required for lease financing.

Whereas the borrower needs to pledge his existing assets as primary/
collateral security in case of a term loan.
! !215
4. Presentation in Financial Statements: In Lease, the value of the

asset is not included in the financial statements. Whereas in the case of
loan financing, the asset appears on the asset side and a corresponding
liability for loans appear on the liability side.
5. Tax Implication: In the case where the asset is purchased on loan, the
user can claim interest on loan payment (which decreases every year
due to part payment of principal also) and the depreciation of the asset
(which decrease every year due to written down value effect). Whereas
in the case of lease financing, the user can claim only lease rentals
which are uniform during the lease period.
6. Cash Flow: Since there is no purchase of an asset in lease financing,

the cash flow is limited up to the lease rentals. Whereas in case of term
loan, the cash flow includes down-payment, loan received purchase of
asset and instalment paid at the particular time.
7. Transfer of Risk Due to Asset Devaluation: In the case of lease

financing, the ownership of an asset is not attached to the user, so the
risk of asset devaluation is transferred to the lessor. Whereas in the
case of loan financing, the user of the asset has to bear all the risk of
asset devaluation due to change in technology.
In a nutshell, leasing makes it easier to get the usage of an asset for less
money. So, leasing sounds advantageous for the entrepreneurs who are
not cashing rich. But if we take the long-run view, we see that we will
always have a payment to make but no ownership. On the other hand, if
we consider buying an asset through term loan financing, after a few years’
instalment payments, the asset belongs to the owner and the periodic
payments also stop. The lease finance does not have the risk of asset
maintenance and devaluation whereas this risk exists in the case of a term
loan. It is the ultimate user to decide his needs, and to weigh the pros and
cons and what best suits to his organization.
! !216
11.6 Difference between Hire Purchase vs. Term Loan
Hire purchase is a type of contract of purchase in which the seller/financier

rents the asset for an agreed period of time in return for a set of monthly
instalments. The buyer obtains ownership only when the full amount of the
contract has been paid to the financier/seller of goods. So, the buyer
doesn’t own the asset until the last instalment.
Term loan is a financial assistance provided by banks and special

institutions for lending money. In case the buyer needs the ownership of
the asset as and when he purchases, then he can opt for “Term Loan
Financing”. After assessing his net worth and financial position, the banks
or special institutions provide the required amount to the borrower,
restricted to his financial credentials.
In return, the provider asks for interest at a certain rate upon the principal,
which the borrower has to pay together with the principal amount in
instalments. For purchasing an asset, or for any sort of expansion, the
term loan is an easy option to arrange finance in a short span of time.
11.7 Decision on Hire Purchase (HP) Vs. Term Loan

Financing
1. Ownership: In hire purchase, the seller/financier owns the asset until

the buyer makes the final payment and hence the word “Hire” is used.
Whereas in the term loan, the buyer borrows money, pays for the asset,
and own it immediately. So, in the case of hire purchase, one cannot sell
the asset if he runs into problems making periodic payments but in the
term loan, it can be sold.
2. Cost of the Asset: The cost of the asset in case of the term loan is the
cost at which the buyer purchases + installation cost if any, whereas, in
the case of hire purchase, the cost to the buyer is normal cash price +
HP Interest. The interest cost is incurred in case of term loan also but
that forms part of finance cost of the company and is not capitalized
with the asset.
! !217
3. Repossession of the Hired Asset: It may happen that the buyer is

unable to pay all the payments required under the agreement. Once the
buyer stops making the instalments, the seller/financier has the right to
take away the asset. This is called Repossession. In term loan, the
borrower can only take away the assets which are provided as security
against the loan. Normally, the purchased asset is the primary security
of the term loan along with the collateral security. So, the bank or
financial institution can take away the underlying asset as well as the
collaterals.
4. Mortgage of Assets in the Form of Security: No security, in any

form, is required for taking an asset on hire. Whereas the borrowers
need to pledge his assets as security in case of the term loan.
5. Financial Statements: In hire purchase, the value of the asset is not

included in the financial statements since the owner is the financier
company till the buyer pays the last hire charges instalment. Whereas in
the case of a loan, the value of asset appears on the asset side and a
corresponding liability for loans against such asset appears on the
liability side.
6. Effect of Taxation: In both the cases, i.e. when the asset is purchased
by loan, or if it is taken on hire, the user of the asset can take deduction
on the depreciation of the asset (which decreases every year due to
written down value effect) and also for interest on term loan or hire
purchase instalments. The only difference being in the quantitative
amount of interest.
7. Cash Flow: Since there is no purchase of an asset in hire purchase, the

cash flow is limited up to the hire purchase instalments. Whereas in a
case of the term loan, the cash flow includes down-payment, loan
received, purchase of asset and instalment paid at the required time.
! !218
8. The risk of Holding the Asset: In the case of hire purchase, there is
an option called “The Half-Rule” which states that the user can return
the asset and terminate the agreement at any time giving the seller/
financier a notice in writing. Whereas in the case of loan financing, the
user of the asset has to bear all the risk of asset devaluation due to
change in technology.
11.8 Summary
A term loan is a monetary loan that is repaid in regular payments over a

set period of time. Term loans usually last between one and ten years, but
may last as long as 30 years also in some cases. A term loan usually
involves an unfixed interest rate that will add additional balance to be
repaid. Term loans can be given on an individual basis but are often used
for small business loans. The ability to repay over a long period of time is
attractive for new or expanding enterprises, as the assumption is that they
will increase their profit over time. Term loans are a good way of quickly
increasing capital in order to raise a business’ supply capabilities or range.
For instance, some new companies may use a term loan to buy company
vehicles or rent more space for their operations.
Considerations: One thing to consider when getting a term loan is whether

the interest rate is fixed or floating. A fixed interest rate means that the
percentage of interest will never increase, regardless of the financial
market. Floating interest rates will fluctuate with the market, which can be
good or bad for you depending on what happens with the global and
national economy. Some student loans are essentially term loans.
On the contrary, “Lease is a contract whereby the owner of an asset

(lessor) grants to another party (lessee) the exclusive right to use the
asset usually for an agreed period of time in return for the payment of the
rent.” Owner of the Asset Lessor User of the Asset Lessee. The person who
wants to manufacture the product needs an equipment to do it but not the
ownership of an equipment. The concept of lease financing says ‘Eat the
mangoes rather than counting the trees.’ Lease financing denotes
procurement(buying) of assets through lease. The subject of leasing falls in
the category of finance. Leasing has grown as a big industry in USA and UK
and spread to other countries in the present century. In India, the concept
was started in 1973. It is a commercial arrangement whereby the
! !219
equipment owner conveys to the equipment user the right to use the
equipment in return for a rental.
There are different types of leases. Leasing Financial and operating lease
Sale and lease back Single investor and leveraged lease Domestic and
international lease. In Financial lease the lessor transfers to the lessee
substantially all the risks and rewards incidental to the ownership of the
asset. It is a long term non-cancellable lease. Types of assets included
under such lease are lands, building, heavy machinery, etc.
The Operating lease is one which is not a financial lease. It is a short-term

cancellable lease. The lessor provides services attached to the leased asset
such as maintenance, repairs and technical advice. It is also known as
service lease. Operating lease is primarily used for computers, office
equipment, trucks, etc. In this, the lessee is already the owner of the
asset. He, under the lease agreement, sells the asset to the buyer. The
buyer leases back the same asset to the owner (now the lessee) in
consideration of lease rentals. Under the sale and lease back, the lessee
not only retains the use of the assets but also gets funds from the sale of
the assets to the lessor.
In Single investor lease there are only two parties to the lease transaction,
the lessor and the lessee. Arrangement for assets of huge capital outlay. It
is a 3-sided arrangement. Lesser borrows a part of purchase cost of the
asset from the third party i.e. lender. In Domestic lease, a lease
transaction is classified as domestic if all the parties to the agreement are
domiciled(resided) in the same country. In International lease, parties to
the lease transaction are domiciled in the different countries, it is known as
international lease. In Import lease the lessor and the lessee are domiciled
in the same country but the equipment supplier is located in a different
country. In Cross-border lease (export lease) the lessor and the lessee are
domiciled in different countries, the lease is classified as cross-border
lease. The domicile of supplier is immaterial.
! !220
11.9 Questions
Answer the following Questions:
1. Define Term Loan and characteristic of term Loans.
2. Write Short Note on Lease Finance.
3. Explain the characteristic features of Hire purchase.
4. What is the difference between hire purchase and term loan? Explain.
5. What are the advantages and disadvantages of leasing? Describe in

brief.
Multiple Choice Questions: (Mark X against the most appropriate

alternatives)
1. Generally, the term loan is obtained for financing large expansion or

_____________ of an organization.
a. Winding up
b. Diversification
c. Giving on rent
d. Regular use
2. While banks will make term loans of up to five years, they generally
prefer to make only _____________ loans. This is due to the nature of
the source of financing of banks.
a. Long-Term
b. Medium-Term
c. Short-Term
d. Very long-term
3. The estimated residual value of the asset at the end of the lease term is
at least _____________ of its value at the beginning of the lease term
a. 10%
b. 20%
c. 90%
d. 80%
! !221
4. The Dis advantage of leasing includes _____________.

a. High cost – the lease payment covers the cost of the equipment as
well as a profit for the lessor.
b. The lessor gets to take the depreciation expense and receives any
residual value that exists at the end of the lease period.
c. The ownership is with lessee.
d. Both a and b
5. The contract of purchase in which the seller/financier rents the asset for
an agreed period of time in return for a set of monthly instalments is
called _____________.
a. Leasing
b. Hire purchase
c. On rent
d. Term loan
Answers: 1. (b), 2. (c), 3. (b), 4. (d), 5. (b) 
! !222
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !223
FINANCIAL MANAGEMENT IN DEBENTURES, BONDS AND SECURITISATION
Chapter 12
Financial Management In Debentures,
Bonds And Securitisation
Objectives
After studying this chapter, you should be able to understand the Definition
and objectives of Debenture, Bond and certain important facts about the
securitisation. They are of various types and classified as per its usage and
Financial Market demands.
Structure:
12.1 Introduction
12.2 Debentures
12.3 Bonds
12.4 Difference between Debentures and Bonds
12.5 Securitization of Bonds and Debentures
12.6 Advantages and Disadvantages of Debentures
12.7 Advantages and Disadvantages of Bonds
12.8 Summary
12.9 Questions
! !224
12.1 Introduction
Debentures and bonds are types of debt instruments that can be issued by
a company. In some markets (India, for instance) the two terms are
interchangeable, but in the United States they refer to two separate kinds
of debt-based securities. The functional differences centre around the use
of collateral, and they are generally purchased under different
circumstances.
Bonds are the most frequently referenced type of debt instrument, serving
as an IOU between the issuer and the purchaser. An investor loans money
to an institution, such as a government or business; the bond acts as a
written promise to repay the loan on a specific maturity date. Normally,
bonds also include periodic interest payments over the bond's duration,
which means that the repayment of principal and interest occur separately.
Bond purchases are generally considered safe, and highly rated corporate
or government bonds come with little perceived default risk.
Debentures have a more specific purpose than bonds. Both can be used to
raise capital, but debentures are typically issued to raise short-term capital
for upcoming expenses or to pay for expansions. Sometimes called
revenue bonds because they may be expected to be paid for out of the
proceeds of a new business project, debentures are never asset-backed
(they are not secured by any collateral) and are only backed by the credit
of the issuer.
These debt instruments provide companies and governments with a way to

finance beyond their normal cash flows. Some debentures and bonds are
convertible, which means that they can be converted into company stock.
In a sense, all debentures are bonds, but not all bonds are debentures.
Whenever a bond is unsecured, it can be referred to as a debenture.
! !225
12.2 Debentures
Types of Debentures
Debentures are classified into various types. These are redeemable,

irredeemable, perpetual, convertible, non-convertible, fully, partly, secured,
mortgage, unsecured, naked, first mortgaged, second mortgaged, the
bearer, fixed, floating rate, coupon rate, zero coupon, secured premium
notes, callable, puttable, etc.
The debenture classification is based on their tenure, redemption, mode of

redemption, convertibility, security, transferability, type of interest rate,
coupon rate, etc.
Following are the various types of debentures vis-a-vis their basis of

classification.
12.2.1 Redemption/Tenure
Redeemable and Irredeemable (Perpetual) Debentures: Redeemable

debentures carry a specific date of redemption on the certificate. The
company is legally bound to repay the principal amount to the debenture
holders on that date. On the other hand, irredeemable debentures, also
known as perpetual debentures, do not carry any date of redemption. This
means that there is no specific time of redemption of these debentures.
They are redeemed either on the liquidation of the company or when the
company chooses to pay them off to reduce their liability by issuing a due
notice to the debenture holders beforehand.
12.2.2 Types of Debentures Convertibility
Convertible and Non-Convertible Debentures: Convertible debenture

holders have an option of converting their holdings into equity shares. The
rate of conversion and the period after which the conversion will take effect
are declared in the terms and conditions of the agreement of debentures at
the time of issue. On the contrary, non-convertible debentures are simple
debentures with no such option of getting converted into equity. Their state
will always remain of a debt and will not become equity at any point of
time.
! !226
Fully and Partly Convertible Debentures: Convertible Debentures are

further classified into two – Fully and Partly Convertible. Fully convertible
debentures are completely converted into equity whereas the partly
convertible debentures have two parts. Convertible part is converted into
equity as per agreed rate of exchange based on an agreement. Non-
convertible part becomes as good as redeemable debenture which is repaid
after the expiry of the agreed period.
12.2.3 Security
Secured (Mortgage) and Unsecured (Naked) Debentures:

Debentures are secured in two ways. One when the debenture is secured
by the charge on some asset or set of assets which is known as secured or
mortgage debenture and another when it is issued solely on the credibility
of the issuer is known as the naked or unsecured debenture. A trustee is
appointed for holding the secured asset which is quite obvious as the title
cannot be assigned to each and every debenture holder.
First Mortgaged and Second Mortgaged Debentures: Secured/

Mortgaged debentures are further classified into two types – first and
second mortgaged debentures. There is no restriction on issuing different
types of debentures provided there is clarity on claims of those debenture
holders on the profits and assets of the company at the time of liquidation.
First mortgaged debentures have the first charge over the assets of the
company whereas the second mortgage has the secondary charge which
means the realization of the assets will first fulfill the obligation of first
mortgage debentures and then will do for second ones.
12.2.4 Transferability/Registration
Registered Unregistered Debentures (Bearer) Debenture: In the

case of registered debentures, the name, address, and other holding
details are registered with the issuing company and whenever such
debenture is transferred by the holder; it should be informed to the issuing
company for updating in its records. Otherwise, the interest and principal
will go to the previous holder because the company will pay to the one who
is registered. Whereas, the unregistered commonly known as bearer
debenture can be transferred by mere delivery to the new holder. They are
considered as good as currency notes due to their easy transferability. The
interest and principal are paid to the person who produces the coupons,
! !227
which are attached to the debenture certificate and the certificate

respectively.
12.2.5 Type of Interest Rates
Fixed and Floating Rate Debentures: Fixed rate debentures have fixed
interest rate over the life of the debentures. Contrarily, the floating rate
debentures have the floating rate of interest which is dependent on some
benchmark rate say LIBOR etc.
12.2.6 No Coupon Rate
Zero Coupon and Specific Rate Debentures: Zero coupon debentures

do not carry any coupon rate or we can say that there is zero coupon rate.
The debenture holder will not get any interest on these types of
debentures. Need not get surprised, for compensating against no interest,
companies issue them at a discounted price which is very less compared to
the face value of it. The implicit interest or benefit is the difference
between the issue price and the face value of that debenture. These are
also known as ‘Deep Discount Bonds’. All other debentures with specified
rate of interest are specific rate debentures which are just like a normal
debenture.
Secured Premium Notes/Debentures: These are secured debentures

which are redeemed at a premium over the face value of the debentures.
They are similar to zero coupon bonds. The only difference is the discount
and premium. Zero coupon bonds are issued at the discount and redeemed
at par whereas the secured premium notes are issued at par and redeemed
at the premium.
12.2.7 Mode of Redemption

Callable and Puttable Debentures/Bonds: Callable debentures have an
option for the company to buyback and repay to the investors whereas, in
the case of puttable debentures, the option lies with the investors. Puttable
debenture holders can ask the company to redeem their debenture and ask
for principal repayment.
! !228
12.3 Bonds
Types of Bonds
There are many types of bonds that can be issued, each of which is tailored
to the specific needs of either the issuer or investors. The large number of
bond variations is needed to create the best possible match of funding
sources and investment risk profiles.
A financial instrument issued by the government agencies, for raising

capital is known as Bonds. A financial instrument issued by the companies
whether it is public or private for raising capital is known as Debentures.
Bonds are backed by assets. Conversely, the Debentures may or may not
be supported by assets. The interest rate on debentures is higher as
compared to bonds.
The holder of bonds is known as bondholder whereas the holder of

debentures is known debenture holder.
The payment of interest on debentures is done periodically whether the

company has made a profit or not while accrued interest can be paid on
the bonds.
The risk factor in bonds is low which is just opposite in the case of
debentures. Bondholders are paid in priority to debenture holders at the
time of liquidation.
Internationally, when an issuing entity (usually a corporation) sells a fixed

obligation to investors, this is generally described as a bond. The typical
bond has a face value of $1,000, which means that the issuer is obligated
to pay the investor $1,000 on the maturity date of the bond. If investors
feel that the stated interest rate on a bond is too low, they will only agree
to buy the bond at a price lower than its stated amount, thereby increasing
the effective interest rate that they will earn on the investment.
Conversely, a high stated interest rate can lead investors to pay a premium
for a bond.
! !229
When a bond is registered, the issuer is maintaining a list of which

investors own its bonds. The issuer then sends periodic interest payments
directly to these investors. When the issuer does not maintain a list of
investors who own its bonds, the bonds are considered to be coupon
bonds. A coupon bond contains attached coupons that investors send to
the issuer; these coupons obligate the company to issue interest payments
to the holders of the bonds. A coupon bond is easier to transfer between
investors, but it is also more difficult to establish ownership of the bonds.
12.3.1 Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations
have a lot of flexibility as to how much debt they can issue: the limit is
whatever the market will bear. Generally, a short-term corporate bond has
a maturity of less than five years, intermediate is five to 12 years and
long-term is more than 12 years.
Corporate bonds are characterized by higher yields because there is a

higher risk of a company defaulting than a government. The upside is that
they can also be the most rewarding fixed-income investments because of
the risk the investor must take on. The company's credit quality is very
important: the higher the quality, the lower the interest rate the investor
receives.
Variations on corporate bonds include convertible bonds, which the holder

can convert into stock, and callable bonds, which allow the company to
redeem an issue prior to maturity.
12.3.2 Convertible Bonds
A convertible bond may be redeemed for a predetermined amount of the

company's equity at certain times during its life, usually at the discretion of
the bondholder. Convertibles are sometimes called “CVs."
Issuing convertible bonds is one way for a company to minimize negative

investor interpretation of its corporate actions. For example, if an already
public company chooses to issue stock, the market usually interprets this
as a sign that the company's share price is somewhat overvalued. To avoid
this negative impression, the company may choose to issue convertible
! !230
bonds, which bondholders will likely convert to equity should the company
continue to do well.
From the investor's perspective, a convertible bond has a value-added

component built into it: it is essentially a bond with a stock option hidden
inside. Thus, it tends to offer a lower rate of return in exchange for the
value of the option to trade the bond into stock.
12.3.3 Callable Bonds
Callable bonds, also known as "redeemable bonds," can be redeemed by

the issuer prior to maturity. Usually a premium is paid to the bond owner
when the bond is called.
The main cause of a call is a decline in interest rates. If interest rates have
declined since a company first issued the bonds, it will likely want to
refinance this debt at a lower rate. In this case, the company will call its
current bonds and reissue new, lower-interest bonds to save money.
12.3.4 Term Bonds
Term bonds are bonds from the same issue that share the same maturity
dates. Term bonds that have a call feature can be redeemed at an earlier
date than the other issued bonds. A call feature, or call provision, is an
agreement that bond issuers make with buyers. This agreement is called
an "indenture," which is the schedule and the price of redemptions, plus
the maturity dates.
Some corporate and municipal bonds are examples of term bonds that
have 10-year call features. This means the issuer of the bond can redeem
it at a predetermined price at specific times before the bond matures.
A term bond is the opposite of a serial bond, which has various maturity
schedules at regular intervals until the issue is retired.
12.3.5 Amortized Bonds
An amortized bond is a financial certificate that has been reduced in value

for records on accounting statements. An amortized bond is treated as an
asset, with the discount amount being amortized to interest expense over
! !231
the life of the bond. If a bond is issued at a discount – that is, offered for
sale below its par (face value) – the discount must either be treated as an
expense or amortized as an asset.
Amortization is an accounting method that gradually and systematically

reduces the cost value of a limited life, intangible asset. Treating a bond as
an amortized asset is an accounting method in the handling of bonds.
Amortizing allows bond issuers to treat the bond discount as an asset until
the bond's maturity.
12.3.6 Adjustment Bonds
Issued by a corporation during a restructuring phase, an adjustment bond

is given to the bondholders of an outstanding bond issue prior to the
restructuring. The debt obligation is consolidated and transferred from the
outstanding bond issue to the adjustment bond. This process is effectively
a recapitalization of the company's outstanding debt obligations, which is
accomplished by adjusting the terms (such as interest rates and lengths to
maturity) to increase the likelihood that the company will be able to meet
its obligations.
If a company is near bankruptcy and requires protection from creditors, it

is likely unable to make payments on its debt obligations. If this is the
case, the company will be liquidated, and the company's value will be
spread among its creditors. However, creditors will generally only receive a
fraction of their original loans to the company. Creditors and the company
will work together to recapitalize debt obligations so that the company is
able to meet its obligations and continue operations, thus increasing the
value that creditors will receive.
12.3.7 Junk Bonds
A junk bond, also known as a "high-yield bond" or "speculative bond," is a

bond rated "BB" or lower because of its high default risk. Junk bonds
typically offer interest rates three to four percentage points higher than
safer government issues.
! !232
12.3.8 Angel Bonds
Angel bonds are investment-grade bonds that pay a lower interest rate
because of the issuing company's high credit rating. Angel bonds are the
opposite of fallen angels, which are bonds that have been given a "junk"
rating and are therefore much more risky.
An investment-grade bond is rated at minimum "BBB" by S&P and Fitch,

and "Baa" by Moody's. If the company's ability to pay back the bond's
principal is reduced, the bond rating may fall below investment-grade
minimums and become a fallen angel.
12.3.9 Other types of bonds
In addition to above there are there are many types of bonds. The
following list represents a sampling of the more common types:
• Collateral trust bond. This bond includes the investment holdings of

the issuer as collateral.
• Convertible bond. This bond can be converted into the common stock
of the issuer at a predetermined conversion ratio.
• Debenture. This bond has no collateral associated with it. A variation is

the subordinated debenture, which has junior rights to collateral.
• Deferred interest bond. This bond offers little or no interest at the

start of the bond term, and more interest near the end. The format is
useful for businesses currently having little cash with which to pay
interest.
• Guaranteed bond. The payments associated with this bond are

guaranteed by a third party, which can result in a lower effective interest
rate for the issuer.
• Income bond. The issuer is only obligated to make interest payments

to bond holders if the issuer or a specific project earns a profit. If the
bond terms allow for cumulative interest, then the unpaid interest will
accumulate until there is sufficient income to pay the amounts owed.
! !233
• Mortgage bond. This bond is backed by real estate or equipment

owned by the issuer.
• Serial bond. This bond is gradually paid off in each successive year, so
the total amount of debt outstanding is gradually reduced.
• Variable rate bond. The interest rate paid on this bond varies with a
baseline indicator, such as LIBOR.
• Zero coupon bond. No interest is paid on this type of bond. Instead,

investors buy the bonds at large discounts to their face values to earn an
effective interest rate.
• Zero coupon convertible bond. This variation on the zero-coupon bond

allows investors to convert their bond holdings into the common stock of
the issuer. This allows investors to take advantage of a run-up in the
price of a company's stock. The conversion option can increase the price
that investors are willing to pay for this type of bond.
Additional features can be added to a bond to make it easier to sell to

investors at a higher price. These features can include:
• Sinking fund. The issuer creates a sinking fund to which cash is

periodically added, and which is used to ensure that bonds are eventually
paid off.
• Conversion feature. Bond holders have the option to convert their

bonds into the stock of the issuer at a predetermined conversion rate.
• Guarantees. The repayment of a bond may be guaranteed by a third

party.
The following additional bond features favour the issuer, and so may
reduce the price at which investors are willing to purchase bonds:
• Call feature. The issuer has the right to buy back bonds earlier than the
stated maturity date.
• Subordination. Bond holders are positioned after more senior debt

holders to be paid back from issuer assets in the event of a default.
! !234
12.4 Difference between Debentures and Bonds:
A debenture is a debt security issued by a corporation that is not secured

by specific assets, but rather by the general credit of the corporation.
Stated assets secure a corporate bond, unlike a debenture, but in India
these are used interchangeably.
Basis for Comparison Bonds Debentures

Meaning A bond is a financial A debt instrument used
instrument showing the to raise long-term finance
indebtedness of the is known as Debentures.
issuing body towards its
holders.
Collateral Yes, bonds are generally Debentures may be

secured by collateral. secured or unsecured.
Interest Rate Low High
Issued by Government Agencies, Companies

financial institutions,
corporations, etc.
Payment Accrued Periodical
Owners Bondholders Debenture holders

Risk factor Low High
Priority in repayment at First Second

the time of liquidation
Bonds are IOUs between a borrower and lender. The borrowers include
public financial institutions and corporations. The lender is the bond fund,
or an investor when an individual buys a bond. In return for the loan, the
issuer of the bond agrees to pay a specified rate of interest over a specified
period of time.
Typically, bonds are issued by PSUs, public financial institutions and

corporates. Another distinction is SLR (Statutory liquidity ratio) and non-
SLR bonds. SLR bonds are those bonds which are approved securities by
RBI which fall under the SLR limits of banks.
! !235
12.5 Securitization of bond and debentures
The Primary liability of Securitization is not with the issuing company as

the securities are bought by the public who will be paid from the long-term
assets as and when they mature. But the Primary liability of Bonds and
debentures is that of the issuing company.
• Repayment in Securitization vs. Bonds and debentures

There is classification of debt instruments as per the long-term assets
which are backing them in case of securitization. But in case of bonds and
debentures though there may be different types, the repayment is not
based on any asset. It is as per the liquidity position of the company.
• Risk factors in Securitization vs. Bonds and debentures

In Securitization, there is absolute safety and security for the debt
instruments as these are issued against certain illiquid assets. But Bonds
and debentures are issued not on the backing of any assets but on the
capacity of the company. Hence they carry more risks.
• Turnover of funds in Securitization against bonds and debentures

In Securitization, the turnover of funds will increase the earning capacity of
the institution. But in case of bonds and debentures, there is no such
possibility as these bonds or debentures are not subject to turnover.
• Backing of assets
In Securitization, the debt instruments may not have specific mention of
the backing of assets. But certain bonds and debentures will have specific
mention of assets against which they are issued. For example, mortgage
debenture with fixed charge.
! !236
12.6 Advantages and Disadvantages of Debentures
Debentures is a type of debt which is issued by the company, the person

who holds debentures receives regular interest and on maturity principal
amount is repaid to debenture holders. Given below are some of the
advantages and disadvantages of debentures –
12.6.1 Advantages of Debentures
When the company issues debentures it does not result in dilution of

ownership as is the case with the issue of equity shares and therefore
owners of company get funds without diluting the control of the company.
It also has the tax advantage because interest paid on debentures is a tax
deductible expense and hence company gets the tax benefit which leads to
more profits for the company because of lower tax payment.
Since debenture holders do not have any voting rights they do not interfere
with the working of the organization and hence does not create any
obstacles in the decision-making process of the organization.
If the firm makes good profits during the year then unlike equity shares
where you have to distribute that profit to the shareholders, debentures
holders’ payment of interest is fixed and hence the firm does not need to
share profits with them.
12.6.2 Disadvantages of Debentures
Payment of interest on debentures is mandatory and when company is

making low profits or losses then these payments can lead to more strain
on company’s balance sheet and non-payment of interest can even lead to
bankruptcy for the firm.
Since debentures are considered as loans or borrowings, the ability of the

company to borrow further in case of need of funds reduces considerably.
Since on maturity they have to be repaid, company needs to plan properly

and keep funds for the same because when they are repaid, it involves
substantial cash outflows and if company has not maintained enough funds
it is a recipe for disaster.
! !237
Unlike equity shares which are bought even by small retail investors,
debentures are bought by large institutional investors and hence at times it
may prove to be costly and difficult source of finance for the company.
As one can see that debentures have both advantages as well as

disadvantages and hence any company before deciding whether to issue
them or not must look at above points and introspect whether in the long
term such issue is profitable for the company or not.
12.7 Advantages and Disadvantages of Bonds
Governments and businesses issue bonds to raise funds from investors.

Bonds pay regular interest, and bond investors get the principal back on
maturity. Credit-rating agencies rate bonds based on creditworthiness.
Low-rated bonds must pay higher interest rates to compensate investors
for taking on the higher risk. Corporate bonds are usually riskier than
government bonds.
12.7.1 Advantages
Bonds offer safety of principal and periodic interest income, which is the
product of the stated interest rate or coupon rate and the principal or face
value of the bond. Bonds are ideal investments for retirees who depend on
the interest income for their living expenses and who cannot afford to lose
any of their savings. Bond prices sometimes benefit from safe-haven
buying, which occurs when investors move funds from volatile stock
markets to the relative safety of bonds. You can buy bonds directly through
your broker or indirectly through bond mutual funds.
12.7.2 Disadvantages
The disadvantages of bonds include rising interest rates, market volatility

and credit risk. Bond prices rise when rates fall and fall when rates rise.
Your bond portfolio could suffer market price losses in a rising rate
environment. Bond market volatility could affect the prices of individual
bonds, regardless of the issuers' underlying fundamentals. Credit risk
means that issuers could default on their interest and principal repayment
obligations if they run into cash-flow problems. Some bonds have call
provisions, which give issuers the right to buy them back before maturity.
Issuers are more likely to exercise their early-redemption rights when
! !238
interest rates are falling, so you then might have to reinvest the principal
at lower rates.
12.8 Summary
Generally, in the Indian context, you find the word debenture and bonds
being used interchangeably.
Bonds and Debentures both are types of borrowed capital. The major
difference between these two debt instruments is that bonds are more
secure as compared to debentures. The creditworthiness of the issuing
company is checked in both the cases. These are the liability of the
company that is why they get preference of repayment in the event of
winding up of the company.
A debenture is a debt instrument which is not backed by any specific

security; instead the credit of the company issuing the same is the
underlying security. Corporate treasury uses this as a tool to raise medium-
to long-term funds. The funds raised become part of the capital structure
but not share capital of the company.
A financial instrument issued by the government agencies, for raising

capital is known as Bonds. A financial instrument issued by the companies
whether it is public or private for raising capital is known as Debentures.
Bonds are backed by assets. Conversely, the Debentures may or may not
be supported by assets.
The interest rate on debentures is higher as compared to bonds.
The holder of bonds is known as bondholder whereas the holder of

debentures is known debenture holder.
The payment of interest on debentures is done periodically whether the

company has made a profit or not while accrued interest can be paid on
the bonds.
The risk factor in bonds is low which is just opposite in the case of
debentures. Bondholders are paid in priority to debenture holders at the
time of liquidation.
! !239
Bonds, however, in India are typically issued by financial institutions,

government undertakings and large companies. The interest rate is
assured and is paid at a fixed interval, i.e. on an annual or semi-annual
basis. On maturity, the principal is repaid. Bond is a form of loan. The
holder of the bond is the lender and the issuer of the bond is the borrower.
In today’s scenario, you see many government undertakings and
companies issuing bonds. These are done to fund their long-term capital
expenditure needs. In case of a government, raising the same helps in
funding its current expenditure.
There are many types of bonds, but only a few types are relevant to the
Indian markets.
Deep discount bonds, also known as zero-coupon bonds, wherein there is

no interest or coupon payment and the interest amount is factored in the
maturity value. So, the issue price of these bonds is inversely related to
their maturity period.
Corporate bonds are issued by companies and offer interest rates higher
than bonds issued by public sector units and other financial institutions.
The interest rate on these bonds is governed by their credit rating and
higher the rating, lower is the interest rate offered by them. Hence, an
investor needs to be careful before investing in them and should take a
decision after checking the credit ratings as well and not only the interest
being offered.
Sovereign bonds are issued by a government—in India, by the Reserve

Bank of India. These can be referred to as low-risk or even risk-free bonds.
Convertible bonds are another category wherein the bond holder has an
option to convert the bonds into equity after a fixed tenor. These may be
fully or partially convertible where only a part is converted and the other
part matures.
! !240
12.9 Questions
1. Write short notes on Types of debentures.
2. Explain the characteristic features of Bond and different types of bonds.
3. Write short note on: Securitization of bond and debentures
4. Compare the difference between debenture and bonds.
5. What are the advantages and dis advantages of debentures?

alternatives)
1. In which type of debentures, the company is legally bound to repay the

principal amount to the debenture holders on that date?
a. Redeemable
b. Convertible
c. Non-convertible
d. All of the above
2. Debentures is a type of debt which is issued by the company, the person

who holds debentures receives regular _____________ and on maturity
principal amount is repaid to debenture holders.
a. Dividend
b. Interest
c. Dividend and interest
d. Incentives
3. A bond is a financial instrument showing the _____________ of the

issuing body towards its holders.
a. Soundness
b. Strength
c. Indebtedness
d. Profitability
! !241
4. The Primary liability of Securitization is not with the _____________ as

the securities are bought by the public who will be paid from the long-
term assets as and when they mature.
a. Buyer
b. Holder
c. Seller
d. Issuing company
5. “Unlike equity shares which are bought even by small retail investors,
debentures are bought by large institutional investors and hence at
times it may prove to be costly and difficult source of finance for the
company”_____________True or False
a. True
b. False
Answers: 1. (a), 2. (b), 3. (c), 4. (d), 5. (a)
! !242
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !243
FINANCIAL MANAGEMENT IN DERIVATIVES
Chapter 13
Financial Management In Derivatives
Objectives
After studying this chapter, you should be able to understand the

derivatives and derivative market and you will be in a position to determine
whether you will be in a position to play in the derivative market.
Structure:
13.1 Introduction
13.2 Common Types of Derivatives
13.3 Types of Derivatives
13.4 Importance of Derivatives
13.5 Derivatives Markets in India
13.6 A General Rule
13.7 Advantages of Derivatives
13.8 Potential Pitfalls
13.9 Derivatives and Risk Management
13.10 Who Should Invest in Derivatives?
13.11 Summary
13.12 Questions
! !244
13.1 Introduction
As the world melted down during the 2007-2009 collapse, investors were
asking all kinds of questions about derivatives such as, "What is a
derivative?" and "How do derivatives work?". Let's start at the beginning
by answering the most fundamental question: What is a derivative?
The term derivative is often defined as something — a security, a contract

— that derives its value from its relationship with another asset or stream
of cash flows. There are many types of derivatives and they can be good
or bad, used for productive things or as speculative tools. Derivatives can
help stabilize the economy or bring the economic system to its knees in a
catastrophic implosion due to an inability to identify the real risks, properly
protect against them, and anticipate so-called "daisy-chain" events where
interconnected corporations, institutions, and organizations find themselves
instantaneously bankrupted as a result of a poorly written or structured
derivative position with another firm that failed; a domino effect.
A major reason this danger is built into derivatives is because of something

called counter-party risk.
Most derivatives are based upon the person or institution on the other side
of the trade being able to live up to the deal that was struck. If society
allows people to use borrowed money to enter into all sorts of complex
derivative arrangements, we could find ourselves in a scenario where
everybody carries these derivative positions on their books at large values
only to find that, when it's all unravelled, there's very little money there
because a single failure or two along the way wipes everybody out with it.
! !245
The problem becomes exacerbated because many privately written

derivative contracts have built-in collateral calls that require a counterparty
to put up more cash or collateral at the very time they are likely to need all
the money they can get, accelerating the risk of bankruptcy. It is for this
reason that billionaire Charlie Munger, long a critic of derivatives, calls
most derivative contracts "good until reached for" as the moment you
actually need to grab the money, it could very well evaporate on you no
matter what you're carrying it at on your balance sheet. Munger and his
business partner Warren Buffett famously get around this by only allowing
their holding company, Berkshire Hathaway, to write derivative contracts in
which they hold the money and under no condition can they be forced to
post more collateral along the way.
13.2 Common Types of Derivatives
In simple terms, Derivatives are nothing but a kind of security whose price
or value is determined by the value of the underlying variables. It is more
like a contract of future date in which two or more parties are involved to
alleviate future risk. Usually, derivatives enjoy high leverage. Its value is
affected by the volatility in the rates of the underlying asset. Some of the
widely known underlying assets are:
• Indexes (consumer price index (CPI), stock market index, weather

conditions or inflation)
• Bonds
• Currencies
• Interest rates
• Exchange rates
• Commodities
• Stocks (equities)
13.3 Types of Derivatives
The range of derivatives is wide. But some of the most commonly known
derivatives are:
i. Forwards: This is a tailor-made contract between two parties. In case

of this contract, a settlement is done on a scheduled future date at
today's pre-decided rate.
! !246
ii. Futures: When two entities decide to purchase or sell an asset at a

given time in the future at a given price, it is called futures contract.
Futures contracts can be said to be a special kind of forward contracts,
as they are customized exchange-traded agreements. Thus, futures
contract is an agreement between two parties to buy or sell an asset at
a certain time in the future at a certain price. Futures contracts are
special types of forward contracts in the sense that the former are
standardized exchange-traded contracts.
iii. Options: It is of two different kinds such as calls and puts. Those who
take calls option, they are not obligated to purchase given quantity of
the underlying variable, at a mentioned price on or prior to a scheduled
future date. On the other hand, buyers in case of puts option may not
necessarily sell a mentioned quantity of the underlying variable at a
mentioned price on or prior to a given date. Thus, Calls give the buyer
the right but not the obligation to buy a given quantity of the underlying
asset, at a given price on or before a given future date. Puts give the
buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date.
iv. Swaps: These are private contracts between two entities to deal in cash
flows in the future following a pre-decided formula. They are somewhat
like forward contracts' portfolios. Swaps are also of two types such as
interest rate swaps and currency swaps.
a. Interest rate swaps: in this case, only interest-related cash flows

can be exchanged between the entities in one currency.
b. Currency swaps: in this case of swapping, principal and interest can

be exchanged in one currency for the same in other form of
currency.
v. Warrants: Options generally have lives of up to one year, majority of

options traded on options exchanges are having a maximum maturity of
nine months. Longer-dated options are called warrants and are
generally traded over-the-counter.
vi. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation

Securities. These are options having a maturity of up to three years.
! !247
vii.Baskets: Basket options are options on portfolios of underlying assets.

The underlying asset is usually a moving average or a basket of assets.
Equity index options are a form of basket options.
viii.Swaptions: Swaptions are options to buy or sell a swap that will

become operative at the expiry of the options. Thus, a swaption is an
option on a forward swap. Rather than have calls and puts, the
Swaptions market has receiver Swaptions and payer Swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer
swaption is an option to pay fixed and receive floating.
13.4 Importance of Derivatives
Financial transactions are fraught with several risk factors. Derivatives are
instrumental in alienating those risk factors from traditional instruments
and shifting risks to those entities that are ready to take them. Some of
the basic risk components in derivatives business are:
• Credit Risk: When one of the two parties fails to perform its role as per
the agreement, this is called the credit risk. It can also be referred to as
default or counterparty risk. It varies with different sources.
• Market Risk: This is a kind of financial loss that takes place due to the
adverse price movements of the underlying variable or instrument.
• Liquidity Risk: When a firm is unable to devise a transaction at current

market rates, it can be referred to as liquidity risk. There are two kinds
of liquidity risks involved in the scenario. First is concerned with the
liquidity of separate items and second is related to supporting the
activities of the organization with funds comprising derivatives.
• Legal Risk: Legal issues related with the agreement need to be

scrutinized well, as one can deal in derivatives across the different
judicial boundaries.
! !248
13.5 Derivatives Markets in India
India had started with a controlled economic system and from there it
moved on to become a destination that witnesses constant fluctuation in
prices on a daily basis now. Persistent efforts of Reserve Bank of India
(RBI) in building currency forward market and liberalization process
provided the risk management agencies their much needed momentum.
Derivatives are the indispensable components of liberalization process to
handle risk. With National Stock Exchange (NSE) measuring the market
demands, the process of launching derivative markets in India got started.
In the year 1999, derivatives trading took place in India.
Indian derivatives markets can be divided into two types including
1. the transaction which depends on the exchange, and
2. the transaction which takes place 'over the counter' in one-to-one

scenario.
They can thus be referred to as:
• Exchange Traded Derivatives

• Over the Counter (OTC) Derivatives
• Over the Counter (OTC) Equity Derivatives
• Operators in the Derivatives Market
There are different kinds of traders in the derivatives market. These

include:
• Hedgers-traders who are interested in transferring a risk element of their

portfolio.
• Speculators-traders who deliberately go for risk components from

hedgers in a lookout for profit.
• Arbitrators-traders who work in various markets at the same time to gain

profit and do away with mispricing.
! !249
13.6 A General Rule
In Life for Individual Investors general rule is to avoid Speculative

Derivatives, both directly, in your own portfolio and on the Balance Sheets
of the companies in which you are Investing.
While individuals and families who have a substantial net worth might
intelligently deploy certain derivative strategies when working with a highly
qualified registered investment advisor — e.g., it might be possible to
lower taxes and hedge against market fluctuations when slowly disposing
of a concentrated stock position acquire over a long life or service for a
specific company or to generate additional income by writing covered call
options or selling fully secured cash puts, both of which are far beyond the
scope of what we are discussing here — a good rule in life is to avoid
derivatives at all cost in so far as you are talking about your stock portfolio.
It is observed that many people have become bankrupt or wipe decades of
savings off their books after buying call options to get rich quickly.
The same goes for investing in complex financial institutions or firms. If

you can't understand the derivative exposures of a business, do not invest
in its stock and do not buy its bonds.
13.7 Advantages of Derivatives
Derivatives are sound investment vehicles that make investing and

business practices more efficient and reliable.
Here are a few reasons why investing in derivatives is advantageous:
1. Non-Binding Contracts
When investors purchase a derivative on the open market, they are

purchasing the right to exercise it. However, they have no obligation to
actually exercise their option. As a result, this gives them a lot of flexibility
in executing their investment strategy. Some derivative classes (such as
certain types of swap agreements) are legally binding to investors, so it’s
very important to know what you’re getting into.
! !250
2. Leverage Returns
Derivatives give investors the ability to make extreme returns that may not
be possible with primary investment vehicles such as stocks and bonds.
When you invest in stock, it could take seven years to double your money.
With derivatives, it is possible to double your money in a week.
3. Advanced Investment Strategies
Financial engineering is an entire field based off derivatives. They make it

possible to create complex investment strategies that investors can use to
their advantage.
13.8 Potential Pitfalls
The concept of derivatives is a good one. However, irresponsible use by

those in the financial industry can put investors in danger. Famed investor
Wa r r e n B u f f e t r e f e r r e d t o t h e m a s “ i n s t r u m e n t s o f m a s s
destruction” (although he also feels many securities are mislabelled as
derivatives). Investors considering derivatives should be wary of the
following:
1. Volatile Investments
Most derivatives are traded on the open market. This is problematic for
investors, because the security fluctuates in value. It is constantly
changing hands and the party who created the derivative has no control
over who owns it. In a private contract, each party can negotiate the terms
depending on the other party’s position. When a derivative is sold on the
open market, large positions may be purchased by investors who have a
high likelihood to default on their investment. The other party can’t change
the terms to respond to the additional risk, because they are transferred to
the owner of the new derivative. Due to this volatility, it is possible for
them to lose their entire value overnight.
2. Overpriced Options
Derivatives are also very difficult to value because they are based off other
securities. Since it’s already difficult to price the value of a share of stock,
it becomes that much more difficult to accurately price a derivative based
! !251
on that stock. Moreover, because the derivatives market is not as liquid as

the stock market, and there aren’t as many “players” in the market to
close them, there are much larger bid-ask spreads.
3. Time Restrictions
Possibly the biggest reason derivatives are risky for investors is that they
have a specified contract life. After they expire, they become worthless. If
your investment bet doesn’t work out within the specified time frame, you
will be faced with a 100% loss.
4. Potential for Scams
Many people have a hard time understanding derivatives. Scam artists

often use derivatives to build complex schemes to take advantage of both
amateur and professional investors.
13.9 Derivatives and Risk Management
• Market risk
Market risk refers to the sensitivity of an asset or portfolio to overall
market price movements such as interest rates, inflation, equities,
currency and property. Pension funds are heavily exposed to interest and
inflation rate risks as these determine the present value of the scheme’s
liabilities; typically, these risks are referred to as ‘unrewarded’ risks as
these are intrinsic to the liabilities. While market risk cannot be completely
removed by diversification, it can be reduced by hedging. The use of
interest and inflation rate swaps can produce offsetting positions whereby
the risks are hedged.
• Market risk methodologies

When establishing a derivative overlay, it is essential for pension schemes
to measure their exposure to market risk and leverage. For any derivative
used within the netting/hedging; absolute any uncovered values that
remain.
• Value-at-Risk
Value-at-Risk (VaR) is a commonly used measure of risk. As a single
metric, it provides a single consolidated view which incorporates the
scheme’s exposure to risk sensitivities. ESMA recommends that UCITS
! !252
funds with more complex investment strategies use the Value-at-Risk

approach as a complement to the commitment approach.
❖ Definition: VaR calculates an expected loss amount that may not be

exceeded at a specified confidence interval over a given holding period,
assuming normal market conditions.
❖ Interpretation: The higher the portfolio’s VaR, the greater its expected
loss and exposure to market risks.
❖ Benefit: VaR is a composite risk measure that incorporates interest rate,

FX, credit, inflation, equity risks etc. into one figure. VaR gives a
consolidated view of different risks in a portfolio.
Pension schemes’ VaR typically considers both assets and liabilities. VaR
can be calculated using either historical or market-implied data.
• Counterparty risk
In addition to market risk, derivatives carry counterparty credit risk.

Counterparty risk arises when one of the parties defaults, resulting in a
replacement risk for the non-defaulting party. Replacement risk can be
broken down into:
❖ Mark-to-market exposure: The close out process may result in

realised mark-to-market exposure on the underlying contract
❖ Liquidity risk: Sourcing sufficient liquidity in the market (notional/

maturity) to replace the required position that has been closed out
following the counterparty’s default
❖ Operational risk: Managing the close-out of a portfolio of positions,

notifying the counterparty that an event of default has occurred,
replacing the transactions in the market, accurately margining
transactions, managing any on-going valuation disputes, meeting
required intra-day settlements
❖ Legal risk: Enforceability of netting/collateral enforcement

arrangements
! !253
❖ Collateral risk: Collateral posted may be ten-year government bonds.
However, on default there may be a requirement to reinvest cash into
new assets. There’s also the risk that the haircuts on the collateral are
insufficient or that the collateral is too closely correlated with the risk of
the counterparty (e.g. systemically important bank posting its
government’s bond)
❖ Settlement risk: The intra-day exposure to a counterparty, arising from

transfers of cash flows under a derivative transaction or returns of
collateral amounts following payments under a derivative contract (e.g.
cross-currency swaps, option purchases, etc.)
Additional considerations for counterparty risk management

include:
❖ Liquidity implications on portfolio allocations of using derivative

transactions and different eligible assets in collateral agreements
❖ Transfer pricing of the cost of credit and liquidity risk in derivative

contracts into strategic asset allocations
❖ Hedging tools for derivative exposure
❖ Valuation implications of derivatives of collateral arrangements,

clearing, credit and capital
13.10 Who Should Invest in Derivatives?
For the reasons listed above, this is a very tough market for novice
investors. Therefore, it is made up primarily of professional money
managers, financial engineers, and highly-experienced investors.
While any investor can no doubt dabble in derivatives to test things out,
beginners should not take high risks in this market given the potential
dangers. As you become more savvy and familiar with the various types of
derivatives and strategies that suit your investment style, you can start to
incorporate them further into your personal investment portfolio.
! !254
Having said that, it is important to note that regardless of your experience

and knowledge, derivatives should only make up a portion of your
investment portfolio. Because they can be so volatile, relying heavily on
them could put you at serious financial risk.
13.11 Summary
Derivatives are complicated financial instruments. They can be great tools

for leveraging your portfolio, and you have a lot of flexibility when deciding
whether or not to exercise them. However, they are also risky investments.
If you plan on purchasing a derivative, make sure that you are mindful of
the specified time frame and are prepared to deal with the fact that they
are volatile investment tools. In the right hands, and with the right
strategy, derivatives can be a valuable part of an investment portfolio.
A derivative is a financial contract with a value that is derived from

an underlying asset. Derivatives have no direct value in and of themselves
— their value is based on the expected future price movements of their
underlying asset.
Derivatives are often used as an instrument to hedge risk for one party of
a contract, while offering the potential for high returns for the other party.
Derivatives have been created to mitigate a remarkable number of risks:
fluctuations in stock, bond, commodity, and index prices; changes in
foreign exchange rates; changes in interest rates; and weather events, to
name a few.
As often is the case in trading, the more risk you undertake the more
reward you stand to gain. Derivatives can be used on both sides of the
equation, to either reduce risk or assume risk with the possibility of a
commensurate reward.
This is where derivatives have received such notoriety as of late in the dark
art of speculating through derivatives. Speculators who enter into a
derivative contract are essentially betting that the future price of
the asset will be substantially different from the expected price held by the
other member of the contract. They operate under the assumption that the
party seeking insurance has it wrong in regard to the future market price,
and look to profit from the error.
! !255
A derivative is traded between two parties – who are referred to as the

counterparties. These counterparties are subject to a pre-agreed set of
terms and conditions that determine their rights and obligations.
Derivatives can be traded on or off an exchange and are known as:
• Exchange-Traded Derivatives (ETDs): Standardised contracts traded

on a recognised exchange, with the counterparties being the holder and
the exchange. The contract terms are non-negotiable and their prices are
publicly available.
or
• Over-the-Counter Derivatives (OTCs): Bespoke contracts traded off-

exchange with specific terms and conditions determined and agreed by
the buyer and seller (counterparties). Thus, OTC derivatives are more
illiquid, e.g. forward contracts and swaps.
The most common types of derivatives are options, futures, forwards,

swaps and Swaptions.
In summary, derivative and portfolio structuring are becoming increasingly

complex – which in turn requires more sophisticated risk management and
reporting.
13.12 Questions
1. What are derivatives? Explain.

2. Write short notes on Types of derivatives.
3. Explain most common types of derivatives traded in India.
4. Write short Notes on: Risk Management in Derivatives
5. What is counterparty Risk in derivatives? Explain.
! !256

alternatives)
1. A major reason of danger is built into derivatives is because of

_____________
a. Market risk
b. Counter-party risk.
c. Trading Risk
d. Investment risk
2. Forward contract is a tailor-made contract between two parties and

settlement of this contract is done on a _____________ at today's pre-
decided rate.
a. Scheduled future Month
b. Scheduled future Week
c. Scheduled future Fortnight
d. Scheduled future date
3. What are the kinds of traders in the derivatives market?

a. Hedgers
b. Speculators
c. Arbitrator
d. All of the above
4. The intra-day exposure to other party, arising from transfers of cash

flows under a derivative transaction or returns of collateral amounts
following payments under a derivative contract is called as
_____________
a. Settlement Risk
b. Liquidity Risk
c. Collateral Risk
d. Counterparty Risk
5. When a firm is unable to devise a transaction at current market rates, it

can be referred to as _____________
a. liquidity risk.
b. Settlement Risk
c. VaR
d. Counterparty Risk
! !257
Answers: 1. (b), 2. (d), 3. (d), 4. (a), 5. (a)
! !258
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !259
COMMERCIAL PAPER
Chapter 14
Commercial Paper
Objectives
After studying this chapter, you should be able to understand more about
commercial paper, its growth and commercial paper market in India and
present regulatory framework for commercial paper.
Structure:
14.1 Introduction
14.2 What is Commercial Paper?
14.3 Eligibility for Issue of CP
14.4 Issue of CP – Credit Enhancement, Limits, etc.
14.5 Form of the Instrument, Mode of Issuance and Redemption
14.6 Trading and Settlement of CP
14.7 Buyback of CP
14.8 Duties and Obligations
14.9 Purpose of Issuance
14.10 Investment Characteristics
14.11 Commercial Paper Market
14.12 Commercial Paper Yields
14.13 Advantages and Disadvantages
14.14 Summary
14.15 Questions
! !260
COMMERCIAL PAPER
14.1 Introduction
The Commercial paper is the most prevalent form of security in the money
market, issued at a discount, with a yield slightly higher than Treasury
bills. The main issuers of commercial paper are finance companies and
banks, but also include corporations with strong credit, and even foreign
corporations and sovereign issuers. The main buyers of commercial paper
are mutual funds, banks, insurance companies, and pension funds.
Commercial paper are unsecured promissory notes for a specified amount
to be paid at a specified date, and are issued by finance companies, banks,
and corporations with excellent credit. They are issued at a discount. The
main purchasers are other corporations, insurance companies, commercial
banks, and mutual funds. Terms range from 7 days to 1 year.
14.2 What is commercial paper?
Commercial Paper (CP) is an unsecured money market instrument issued

in the form of a promissory note. CP, as a privately placed instrument, was
introduced in India in 1990 with a view to enable highly rated corporate
borrowers to diversify their sources of short-term borrowings and to
provide an additional instrument to investors. Subsequently, primary
dealers (PDs) and all-India financial institutions (FIs) were also permitted
to issue CP to enable them to meet their short-term funding requirements.
14.3 Eligibility for Issue of CP
In the Indian Scenario, issuer of CP would be,
a. Companies, PDs and FIs are permitted to raise short-term resources

through CP.
b. A company would be eligible to issue CP provided:
• the tangible net worth of the company, as per the latest audited balance
sheet, is not less than Rs. 4 crore;
• the company has been sanctioned working capital limit by bank/s or FIs;
and
! !261
COMMERCIAL PAPER
• the borrower account of the company is classified as a Standard Asset by

the financing bank/institution.
Thus, the eligible entities to invest in CP in India are Individuals,

banks, other corporate bodies (registered or incorporated in India) and
unincorporated bodies, Non-Resident Indians and Foreign Institutional
Investors (FIIs) shall be eligible to invest in CP.
FIIs shall be eligible to invest in CPs subject to (i) such conditions as may
be set for them by Securities Exchange Board of India (SEBI) and
(ii) compliance with the provisions of the Foreign Exchange Management
Act, 1999, the Foreign Exchange (Deposit) Regulations, 2000 and the
Foreign Exchange Management (Transfer or Issue of Security by a Person
Resident Outside India) Regulations, 2000, as amended from time to time.
In the international scenario, also issuers can be divided into financial and
nonfinancial companies, although most issuers are financial. There are 3
types of finance companies:
1. captive finance companies,

2. bank-related finance companies,
3. independent finance companies.
Captive finance companies are subsidiaries of manufacturers, with the

purpose of providing financing for the manufacturer. The largest selling of
commercial paper General Motors Acceptance Corporation (GMAC) is also a
captive finance company that provides financing for the customers of
General Motors. Other vehicle manufacturers also have captive finance
companies to promote the sale of their vehicles.
Bank holding companies generally use finance companies to cater to

customers with weaker credit. Independent finance companies are not
affiliated with any other company or bank hence, the name.
Generally, only corporations with the highest credit rating can issue
commercial paper. Some companies with weaker credit can get credit
enhancements, so that they can issue commercial paper. Asset-backed
commercial paper is backed by high quality collateral. Credit-supported
commercial paper is often guaranteed by an organization with excellent
credit, such as a bank. Often, a letter of credit is used for this purpose,
! !262
COMMERCIAL PAPER
which is referred to as LOC paper. The bank promises to pay the face value
of the paper if the issuer doesn't.
Other costs that the issuer must pay are agents' fees to a bank for doing
the paperwork necessary to issue commercial paper, and thousands of
dollars to have the issue rated by a credit rating organization, such as
Standard and Poor's and Moody’s.
14.4 Issue of CP – Credit enhancement, limits, etc.
a. CP shall be issued as a ‘stand-alone’ product. Further, it would not be

obligatory in any manner on the part of the banks and FIs to provide
stand-by facility to the issuers of CP.
b. Banks and FIs may, based on their commercial judgement, subject to

the prudential norms as applicable to them, with the specific approval of
their respective Boards, choose to provide stand-by assistance/credit,
back-stop facility etc. by way of credit enhancement for a CP issue.
c. Non-bank entities (including corporates) may provide unconditional and

irrevocable guarantee for credit enhancement for CP issue provided:
i. the issuer fulfills the eligibility criteria prescribed for issuance of CP;
ii. the guarantor has a credit rating at least one notch higher than the
issuer given by an approved CRA; and
iii. the offer document for CP properly discloses the net worth of the
guarantor company, the names of the companies to which the
guarantor has issued similar guarantees, the extent of the
guarantees offered by the guarantor company, and the conditions
under which the guarantee will be invoked.
d. The aggregate amount of CP that can be issued by an issuer shall

always be within the limit as approved by its Board of Directors or the
quantum indicated by the CRA for the specified rating, whichever is
lower.
e. Banks and FIs shall have the flexibility to fix working capital limits, duly
considering the resource pattern of company’s financing, including CP.
! !263
COMMERCIAL PAPER
f. An issue of CP by an FI shall be within the overall umbrella limit

prescribed in the Master Circular on Resource Raising Norms for FIs,
issued by the Reserve Bank of India, Department of Banking Operations
and Development, as prescribed/updated from time-to-time.
g. The total amount of CP proposed to be issued should be raised within a

period of two weeks from the date on which the issuer opens the issue
for subscription. CP may be issued on a single date or in parts on
different dates if in the latter case, each CP shall have the same
maturity date.
h. Every issue of CP, and every renewal of a CP, shall be treated as a fresh
issue.
14.5 Form of the Instrument, mode of issuance and

redemption
A. Form in which CP should be issued
i. CP shall be issued in the form of a promissory note and held in physical

form or in a dematerialized form through any of the depositories
approved by and registered with SEBI, if all RBI-regulated entities
can deal in and hold CP only in dematerialised form through such
depositories.
ii. Fresh investments by all RBI-regulated entities shall be only in

dematerialised form.
iii. CP shall be issued in denominations of Rs. 5 lakh and multiples thereof.

The amount invested by a single investor should not be less than Rs. 5
lakh (face value).
iv. CP shall be issued at a discount to face value as may be determined by

the issuer.
v. No issuer shall have the issue of CP underwritten or co-accepted.
vi. Options (call/put) are not permitted on CP.
! !264
COMMERCIAL PAPER
B. Tenor
i. CP shall be issued for maturities between a minimum of 7 days and a

maximum of up to one year from the date of issue.
ii. The maturity date of the CP shall not go beyond the date up to which
the credit rating of the issuer is valid.
C. Procedure for Issuance
a. Every issuer must appoint an IPA for issuance of CP.
b. The issuer should disclose to the potential investors, its latest

financial position as per the standard market practice.
c. After the exchange of confirmation of the deal between the investor

and the issuer, the issuer shall arrange for crediting the CP to the
Demat account of the investor with the depository through the IPA.
d. The issuer shall give to the investor a copy of IPA certificate to the
effect that the issuer has a valid agreement with the IPA and
documents are in order.
D. Rating Requirement
Eligible participants/issuers shall obtain credit rating for issuance of CP

from any one of the SEBI registered CRAs. The minimum credit rating shall
be ‘A3’ as per rating symbol and definition prescribed by the SEBI. The
issuers shall ensure at the time of issuance of the CP that the rating so
obtained is current and has not fallen due for review.
E. Investment / Redemption
a. The investor in CP (primary subscriber) shall pay the discounted

value of the CP to the account of the issuer through the IPA.
b. The investor holding the CP in physical form shall, on maturity,

present the instrument for payment to the issuer through the IPA.
! !265
COMMERCIAL PAPER
c. The holder of a CP in dematerialised form shall get the CP redeemed

and receive payment through the IPA.
F. Documentation Procedures
a. Standardised procedures and documentation for CPs are prescribed in

consultation with Fixed Income Money Market and Derivatives
Association of India (FIMMDA) in consonance with international best
practices.
b. Issuers/IPAs shall follow the operational guidelines issued by FIMMDA,

from time to time, with the approval of the RBI.
14.6 Trading and Settlement of CP
a. All OTC trades in CP shall be reported within 15 minutes of the trade to

the reporting platform of Clearcorp Dealing System (India) Ltd.(CDSIL).
b. OTC trades in CP shall be settled through the clearing house of the

National Stock Exchange (NSE), i.e., the National Securities Clearing
Corporation Limited (NSCCL), the clearing house of the Bombay Stock
Exchange (BSE), i.e., Indian Clearing Corporation Limited (ICCL), and
the clearing house of the MCX-Stock Exchange, i.e., MCX-SX Clearing
Corporation Limited (CCL), as per the norms specified by NSCCL, ICCL
and CCL from time to time.
c. The settlement cycle for OTC trades in CP shall either be T+0 or T+1.
14.7 Buyback of CP
i. Issuers may buyback the CP, issued by them to the investors, before
maturity.
ii. Buyback of CP shall be through the secondary market and at prevailing

market price.
iii. The CP shall not be bought back before a minimum period of 7 days
from the date of issue.
iv. Issuer shall intimate the IPA of the buyback undertaken.
! !266
COMMERCIAL PAPER
v. Buyback of CPs should be undertaken after taking approval from the

Board of Directors.
14.8 Duties and Obligations
The duties and obligations of the Issuer, IPA and CRA are as under:
(I)Issuer
The issuer shall ensure that the guidelines and procedures laid down for
the issuance of CP are strictly adhered to.
(II) IPA
a. The IPA shall ensure that the issuer has the minimum credit rating as
stipulated by the RBI and the amount mobilised through issuance of CP
is within the quantum indicated by CRA for the specified rating or as
approved by its Board of Directors, whichever is lower.
b. The IPA shall certify that it has a valid agreement with the issuer.
c. The IPA shall verify that all the documents submitted by the issuer, viz.,
copy of board resolution, signatures of authorised executants (when CP
is issued in physical form) are in order and shall issue a certificate to
this effect.
d. Certified copies of original documents, verified by the IPA, shall be held

in the custody of IPA.
e. All scheduled banks, acting as IPAs, shall report the details of issuance
of CP on the Online Returns Filing System (ORFS) module of the RBI
within two days from the date of issuance of the CP.
f. IPAs shall immediately report, on occurrence, full particulars of defaults

in repayment of CP to the Chief General Manager, Financial Markets
D e p a r t m e n t , Re s e r ve B a n k o f I n d i a , C e n t ra l O f f i c e , Fo r t ,
Mumbai-400001
! !267
COMMERCIAL PAPER
g. IPAs shall also report all instances of buyback of CPs undertaken by the
issuer to the Chief General Manager, Financial Markets Department,
Reserve Bank of India, Central Office, Fort, Mumbai–400001.
(III) CRA
a. CRAs shall abide by the Code of Conduct prescribed by the SEBI for
CRAs for undertaking rating of capital market instruments, which shall
be applicable for rating CPs.
b. The CRAs shall have the discretion to determine the validity period of
the rating depending upon their perception about the strength of the
issuer; and they shall, at the time of rating, clearly indicate the date
when the rating is due for review.
c. The CRAs shall closely monitor the rating assigned to issuers vis-à-vis
their track record at regular intervals and shall make their revision in
the ratings public through their publications and website.
14.9 Purpose of Issuance
While creditworthy corporations can borrow from banks for the prime
rate of interest, they may be able to borrow at a lower rate by selling
commercial paper. Commercial paper is also sold to provide seasonal and
working capital for corporations, to provide bridge financing until longer
term securities are sold or until money is expected to be received, such as
tax receipts, and to finance the purchase of other securities.
As an example of bridge financing, a corporation may project that interest

rates will be lower in the future, but, for business reasons, may want to
finance a project immediately. It can finance the project immediately by
issuing commercial paper with a maturity that coincides with the projected
lower interest rates. Then it can issue long-term bonds, and use the
proceeds to pay for the redemption of the commercial paper.
! !268
COMMERCIAL PAPER
14.10 Investment Characteristics
Most commercial paper has a maturity of about 45 days, and most are less
than 90 days, although some commercial paper has a maturity of up to 1
year. The terms of the commercial paper are determined by a number of
factors. One factor is the market. Buyers of commercial paper generally
buy the terms that they want to coincide with their need for money.
14.11 Commercial Paper Market
Most commercial paper is bought in the primary market. The primary

market consists of directly placed and dealer-placed paper. Directly placed
commercial paper is sold directly to the investor by the issuer without the
services of a securities firm. Most issuers of direct paper are finance
companies that sell a large amount of paper continually, and have
salespeople to sell the paper to investors.
Dealer paper is issued using the services of a securities firm, usually an

investment bank, but, increasingly, large commercial banks. Although
commercial paper is the most prevalent money market instrument,
the secondary market is very small, primarily because the terms of
commercial paper are very short, and because buyers of commercial paper
usually purchase paper with maturities that coincide with their need for
money. Hence, most holders of commercial paper hold it till maturity.
However, in many cases, if the holder of commercial paper needs the
money sooner, the commercial paper can usually be sold back to the issuer
of direct paper or to the dealer of dealer paper.
14.12 Commercial Paper Yields
Commercial paper is a discount instrument where interest earned is the

difference between the face value and the discounted purchase price.
Internationally, yields are calculated by using 360 days in a year.
The yields on commercial paper are usually 10 to 20 basis points above

Treasury bills of the same maturity, primarily because the interest earned
from commercial paper, unlike T-bills, is not exempt from state and local
taxes. Commercial paper also has lower liquidity than T-bills, where trading
in the secondary market is more active and bid/ask spreads, narrower.
! !269
COMMERCIAL PAPER
There is also some credit risk. The main credit risk stems from rollover
risk, when the issuer may not be able to sell new paper to pay for maturing
paper, either because the market has changed, or the credit rating of the
issuer has been downgraded.
To calculate the investment yield (bond equivalent yield) of commercial

paper to compare it to the rates of return of other investments:
1. calculate the interest rate for the period;
2. then compound the rate by the number of periods in a year.
Formula for Calculating the Investment Yield or Bond Equivalent Yield

(BEY)
Interest Rate Per Term Number of Terms per Year
Actual Number of Days in the

Face Value - Price Paid 
Year 
BEY = ───────────────  x
─────────────────── 
Price Paid
Term Length in Days
14.13 Advantages and disadvantages
Commercial paper is a lower-cost alternative to a line of credit with a bank.

Once a business becomes established, and builds a high credit rating, it is
often cheaper to draw on a commercial paper than on a bank line of credit.
Nevertheless, many companies still maintain bank lines of credit as a
"backup". Banks often charge fees for the amount of the line of the credit
that does not have a balance, because under the capital regulatory regimes
set out by the Basel Accords, banks must anticipate that such unused lines
of credit will be drawn upon if a company gets into financial distress. They
must therefore put aside equity capital to account for potential loan losses
also on the currently unused part of lines of credit, and will usually charge
a fee for the cost of this equity capital.
! !270
COMMERCIAL PAPER
A. Advantage of commercial paper
• High credit ratings fetch a lower cost of capital.

• Wide range of maturity provides more flexibility.
• It does not create any lien on assets of the company.
• Tradability of Commercial Paper provides investors with exit options.
B. Disadvantages of commercial paper
• Its usage is limited to only blue chip companies.
• Issuances of commercial paper brings down the bank credit limits.
• A high degree of control is exercised on issue of Commercial Paper.
• Stand-by credit may become necessary.
14.14 Summary
Commercial Paper in India is a new addition to short-term instruments in

Indian Money market since 1990. The introduction of Commercial paper as
the short-term monetary instrument was the beginning of a reform in
Indian Money market on the background of trend of Liberalization which
began in the world economy during 1985 to 1990. A commercial paper in
India is the monetary instrument issued in the form of promissory note. It
acts as the debt instrument to be used by large corporate companies for
borrowing short-term monetary funds in the money market. An
introduction of Commercial Paper in Indian money market is an innovation
in the Financial system of India. Prior to injection of Commercial Paper in
Indian money market i.e. before 1990, the corporate companies had to
depend upon the crude and traditional method of borrowing working capital
from the commercial banks by pledging the inventory of raw materials as
Collateral security. It involved more loss of time for the borrowing
companies in availing the short-term funds for day-to-day production
activities. The commercial paper has become effective instrument for
corporate companies to avail the short-term funds from the money market
within shortest possible time limit by avoiding the hassles of direct
negotiation with the commercial banks for availing the short-term
! !271
COMMERCIAL PAPER
The introduction of commercial paper as debt instrument has promoted

commercial paper market as one of the components of Indian money
market. In this commercial paper market, the issuers of commercial paper
create supply while the subscribers to commercial paper create demand for
these papers. The interaction between supply and demand for commercial
papers promotes the commercial paper market. The main issuers of
Commercial paper in this market are incorporated manufacturers and the
main subscribers to the Commercial papers are the banking companies.
Commercial Paper is issued by the issuers at a discount to face value of
Commercial paper. The face value of Commercial Paper is in the
denomination of Rs. 0.5 million and multiples thereof. The maturity period
of Commercial paper in the Commercial Paper market ranges between
minimum of 7 days and maximum of 1 year from the date of issue. The
subscriber to the commercial paper is the investor, and a single investor in
the Commercial paper market is not allowed to invest less than Rs. 0.5
million. The other issuers of Commercial paper in this market are Primary
dealers and All India Financial Institutions. The other investors or
subscribers to Commercial paper in this market are individuals, Non-
Resident Indians and Foreign Institutional Investors.
All eligible participants shall obtain the credit rating for issuance of
Commercial Paper either from Credit Rating Information Services of India
Ltd. (CRISIL) or the Investment Information and Credit Rating Agency of
India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the
FITCH Ratings India Pvt. Ltd. or such other credit rating agency (CRA) as
may be specified by the Reserve Bank of India from time to time, for the
purpose.
The minimum credit rating shall be A-2 [As per rating symbol and definition
prescribed by the Securities and Exchange Board of India (SEBI)].
The issuers shall ensure at the time of issuance of CP that the rating so
obtained is current and has not fallen due for review. Issuers of
Commercial Paper are classified into: Leasing and Finance Companies,
Manufacturing companies and Financial Institutions.
Commercial paper is a lower-cost alternative to a line of credit with a bank.

Once a business becomes established, and builds a high credit rating, it is
often cheaper to draw on a commercial paper than on a bank line of credit.
Nevertheless, many companies still maintain bank lines of credit as a
! !272
COMMERCIAL PAPER
"backup". Banks often charge fees for the amount of the line of the credit
that does not have a balance, because under the capital regulatory regimes
set out by the Basel Accords, banks must anticipate that such unused lines
of credit will be drawn upon if a company gets into financial distress. They
must therefore put aside equity capital to account for potential loan losses
also on the currently unused part of lines of credit, and will usually charge
a fee for the cost of this equity capital.
Short-term interest rate environment, credit rating and market liquidity

condition play an influential role in the Indian CP market activity. The
empirical finding shows that CP issuance yield depends on varying credit
quality across the CPs issuers and prevailing market liquidity. The short-
term risk premia also affect CP issuances activity depending on spread
between T-Bill yield and CPs issuance rates. A rise in risk premia limits
debt-paying capacity of the company and hence compresses the market
growth in CP segment because of the rise in default probability. Credit
rating and market liquidity condition are the most persuading factors in CPs
market dynamics. Comfortable market liquidity makes availability of funds
easy in the open market at lower borrowing costs and hence corporates
prefer CPs route for borrowing their working capital and vice versa. At
present, Indian commercial paper market is still in its nascent stage of
evolution in terms of borrowing activity in primary CPs market and trading
activity in the secondary CPs market. In the early phase, there was some
non-uniformity and fragility in the evolution process of Indian CP market.
The progressive standardization of the product (commercial paper) and
simplification of regulatory norms along with financial infrastructure
developments — like reporting platform (F-TRAC), specified clearing house
at NSE, BSE, and MCX-SX) are supporting the evolution process in the
Indian CP market. The market is growing slowly-but-steadily and is
expected to grow at a better growth pace on account of ongoing
liberalization and standardization in the CP market. Though, no significant
relationship between industrial production activity and CPs issuance has
been detected during the analysis period, the high growth potential in
productivity/business activity may drive the growth pace of CP market due
to its association with higher demand of operational funding even at
marginally higher cost.
! !273
COMMERCIAL PAPER
14.15 Questions
1. Define the commercial paper and explain the Characteristic features of

commercial paper.
2. What is the eligibility to issue commercial paper? Explain.
3. Write short note on commercial paper Market.
4. What is the methodology used to determine yield on commercial paper?

Explain.
5. Explain advantages and disadvantages of commercial paper.

alternatives)
1. Commercial Paper (CP) is an _____________ money market instrument

issued in the form of a promissory note.
a. Secured
b. Unsecured
c. Backed by Collateral
d. Backed by Deposit
2. A company would be eligible to issue CP provided _____________.

a. the tangible net worth of the company, as per the latest audited
balance sheet, is not less than Rs. 4 crore;
b. the company has been sanctioned working capital limit by bank/s or
FIs; and
c. the borrower account of the company is classified as a Standard
Asset by the financing bank/institution.
d. All of the above
 
! !274
COMMERCIAL PAPER
3. The aggregate amount of CP that can be issued by an issuer shall

always be within the limit as approved by its _____________ for the
specified rating, whichever is lower.
a. Board of Directors
b. The quantum indicated by the CRA
c. Regulators
d. a or b
4. Most commercial paper has a maturity of about 45 days, and most are
less than 90 days, although some commercial paper has a maturity of
up to _____________.
a. 1 year
b. 2 year
c. 3 year
d. 5 year
5. Commercial paper is a discount instrument the interest earned is the

difference between the face value and the discounted purchase price.
Internationally, yields are calculated using a banker's year of
_____________.
a. 366 days
b. 360 days
c. 365 days
d. Any one as agreed
Answers: 1. (b), 2. (d), 3. (d), 4. (a), 5. (b)
! !275
COMMERCIAL PAPER
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !276
PORTFOLIO MANAGEMENT
Chapter 15
Portfolio Management
Objectives
portfolio management and services provided by the portfolio managers in
India. In addition, you will also understand various schemes offered by
portfolio managers in India and charges levied by them vis-à-vis income
generation under portfolio management schemes.
Structure:
15.1 Introduction:
15.2 Portfolio and Portfolio Management
15.3 Need for Portfolio Management
15.4 Types of Portfolio Management
15.5 Portfolio Manager
15.6 Roles and Responsibilities of a Portfolio Manager
15.7 Various Models of Portfolio Management
15.8 Portfolio Management Services (PMS) in India
15.9 Investment in Portfolio Management Services (PMS)
15.10 Working of Portfolio Management Services (PMS)
15.11 Portfolio Management Services (PMS) Charges
15.12 Taxation for Portfolio Management Services (PMS)
15.13 How is PMS Different from a Mutual Fund?
15.14 Summary
15.15 Questions
! !277
15.1 Introduction
PMS (Portfolio Management Services) is used by high net worth investors

to invest in stocks. While there are products that also bet on fixed income
instruments, most are equity-linked. It is offered by brokerages and mutual
funds registered with the SEBI. There are two types of PMS: Discretionary
and Non-Discretionary.
In discretionary, the fund manager takes investment decisions on behalf of

the investor. In non-discretionary, the fund manager suggests investment
ideas, while the decision is taken by the client.
Let us understand first meaning of Portfolio and the portfolio management.
15.2 Portfolio and Portfolio Management
A portfolio refers to a collection of investment tools such as stocks, shares,

mutual funds, bonds, cash and so on depending on the investor’s income,
budget and convenient time frame. Following are the two types of Portfolio:
1. Market Portfolio
2. Zero Investment Portfolio
The art of selecting the right investment policy for the individuals in terms
of minimum risk and maximum return is called as portfolio management.
Portfolio management refers to managing an individual’s investments in the
form of bonds, shares, cash, mutual funds etc. so that he earns the
maximum profits within the stipulated time frame. Portfolio management
refers to managing money of an individual under the expert guidance of
portfolio managers.
In a layman’s language, the art of managing an individual’s investment is

called as portfolio management.
! !278
15.3 Need for Portfolio Management
• Portfolio management presents the best investment plan to the

individuals as per their income, budget, age and ability to undertake
risks.
• Portfolio management minimizes the risks involved in investing and also

increases the chance of making profits.
• Portfolio managers understand the client’s financial needs and suggest

the best and unique investment policy for them with minimum risks
involved.
• Portfolio management enables the portfolio managers to provide

customized investment solutions to clients as per their needs and
requirements.
15.4 Types of Portfolio Management
Portfolio Management is further of the following types:
• Active Portfolio Management: As the name suggests, in an active

portfolio management service, the portfolio managers are actively
involved in buying and selling of securities to ensure maximum profits to
individuals.
• Passive Portfolio Management: In a passive portfolio management,

the portfolio manager deals with a fixed portfolio designed to match the
current market scenario.
• Discretionary Portfolio management services: In Discretionary

portfolio management services, an individual authorizes a portfolio
manager to take care of his financial needs on his behalf. The individual
issues money to the portfolio manager who in turn takes care of all his
investment needs, paper work, documentation, filing and so on. In
discretionary portfolio management, the portfolio manager has full rights
to take decisions on his client’s behalf.
• Non-Discretionary Portfolio management services: In non-

discretionary portfolio management services, the portfolio manager can
! !279
merely advise the client what is good and bad for him but the client
reserves full right to take his own decisions.
15.5 Portfolio Manager
An individual who understands the client’s financial needs and designs a

suitable investment plan as per his income and risk-taking abilities is called
a portfolio manager. A portfolio manager is one who invests on behalf of
the client.
A portfolio manager counsels the client and advises him the best possible
investment plan which would guarantee maximum returns to the
individual.
A portfolio manager must understand the client’s financial goals and

objectives and offer a tailor-made investment solution to him. No two
clients can have the same financial needs.
15.6 Roles and Responsibilities of a Portfolio Manager
A portfolio manager is one who helps an individual invest in the best

available investment plans for guaranteed returns in the future. Let us go
through some roles and responsibilities of a Portfolio manager:
• A portfolio manager plays a pivotal role in deciding the best investment

plan for an individual as per his income, age as well as ability to
undertake risks. Investment is essential for every earning individual. One
must keep aside some amount of his/her income for tough times.
Unavoidable circumstances might arise any time and one needs to have
sufficient funds to overcome the same.
• A portfolio manager is responsible for making an individual aware of the

various investment tools available in the market and benefits associated
with each plan. Make an individual realize why he actually needs to
invest and which plan would be the best for him.
• A portfolio manager is responsible for designing customized investment

solutions for the clients. No two individuals can have the same financial
needs. It is essential for the portfolio manager to first analyse the
! !280
background of his client. Know an individual’s earnings and his capacity

to invest. Sit with your client and understand his financial needs and
requirement.
• A portfolio manager must keep himself abreast with the latest changes in
the financial market. Suggest the best plan for your client with minimum
risks involved and maximum returns. Make him understand the
investment plans and the risks involved with each plan in a jargon-free
language. A portfolio manager must be transparent with individuals.
Read out the terms and conditions and never hide anything from any of
your clients. Be honest to your client for a long-term relationship.
• A portfolio manager ought to be unbiased and a thorough professional.

Don’t always look for your commissions or money. It is your
responsibility to guide your client and help him choose the best
investment plan. A portfolio manager must design tailor-made
investment solutions for individuals that guarantee maximum returns and
benefits within a stipulated time frame. It is the portfolio manager’s duty
to suggest the individual where to invest and where not to invest. Keep a
check on the market fluctuations and guide the individual accordingly.
• A portfolio manager needs to be a good decision-maker. He should be

prompt enough to finalize the best financial plan for an individual and
invest on his behalf.
• Communicate with your client on a regular basis. A portfolio manager

plays a major role in setting the financial goal of an individual. Be
accessible to your clients. Never ignore them. Remember you have the
responsibility of putting their hard-earned money into something which
would benefit them in the long run.
• Be patient with your clients. You might need to meet them twice or even
thrice to explain them all the investment plans, benefits, maturity period,
terms and conditions, risks involved and so on. Don’t ever get hyper with
them.
• Never sign any important document on your client’s behalf. Never

pressurize your client for any plan. It is his money and he has all the
rights to select the best plan for himself.
! !281
15.7 Various Models of Portfolio Management
Portfolio management refers to the art of managing various financial

products and assets to help an individual earn maximum revenues with
minimum risks involved in the long run. Portfolio management helps an
individual to decide where and how to invest his hard-earned money for
guaranteed returns in the future.
15.7.1 Capital Asset Pricing Model
Capital Asset Pricing Model is also abbreviated as CAPM. When an asset

needs to be added to an already well-diversified portfolio, Capital Asset
Pricing Model is used to calculate the asset’s rate of profit or rate of return
(ROR). In Capital Asset Pricing Model, the asset responds only to:
• Market risks or non-diversifiable risks often represented by beta

• Expected return of the market
• Expected rate of return of an asset with no risks involved
What are Non-Diversifiable Risks?
Risks which are like the entire range of assets and liabilities are called non-
diversifiable risks.
Where is Capital Asset Pricing Model Used?
Capital Asset Pricing Model is used to determine the price of an individual

security through security market line (SML) and how it is related to
systematic risks.
What is Security Market Line?
Security Market Line is nothing but the graphical representation of capital

asset pricing model to determine the rate of return of an asset sensitive to
non-diversifiable risk (Beta).
SML: E(Ri) = Rf + βi [E(RM) – Rf ]
! !282
15.7.2 Arbitrage Pricing Theory
Stephen Ross proposed the Arbitrage Pricing Theory in 1976. Arbitrage

Pricing Theory highlights the relationship between an asset and several
similar market risk factors.
As per Arbitrage Pricing Theory, the value of an asset is dependent on

macro and company-specific factors.
15.7.3 Modern Portfolio Theory
Modern Portfolio Theory was introduced by Harry Markowitz.
According to Modern Portfolio Theory, while designing a portfolio, the ratio

of each asset must be chosen and combined carefully in a portfolio for
maximum returns and minimum risks.
In Modern Portfolio Theory, emphasis is not laid on a single asset in a

portfolio, but how each asset changes in relation to the other asset in the
portfolio with reference to fluctuations in the price.
Modern Portfolio theory proposes that a portfolio manager must carefully

choose various assets while designing a portfolio for maximum guaranteed
returns in the future.
15.7.4 Value at Risk Model
Value at Risk Model was proposed to calculate the risk involved in financial
market. Financial markets are characterized by risks and uncertainty over
the returns earned in future on various investment products. Market
conditions can fluctuate any time giving rise to major crisis.
The potential risk involved and the potential loss in value of a portfolio over
a certain period of time is defined as value at risk model. Value at Risk
model is used by financial experts to estimate the risk involved in any
financial portfolio over a given period of time.
! !283
15.7.5 Jensen’s Performance Index
Jensen’s Performance Index was proposed by Michael Jensen in 1968.

Jensen’s Performance Index is used to calculate the abnormal return of any
financial asset (bonds, shares, securities) as compared to its expected
return in any portfolio.
Also called Jensen’s alpha, investors prefer portfolio with abnormal returns
or positive alpha.
Jensen’s alpha = Portfolio Return – [Risk Free Rate + Portfolio Beta *

(Market Return – Risk Free Rate)
alphaJ = Ri – [Rf + βiM × (RM –Rf)]
15.7.6 Treynor Index
Treynor Index model, named after Jack.L Treynor, is used to calculate the
excess return earned which could otherwise have been earned in a portfolio
with minimum or no risk factors involved.
Where T-Treynor ratio
T= !
15.8 Portfolio Management Services (PMS) in India
Portfolio Management Services account is an investment portfolio in

Stocks, Debt and fixed income products managed by a professional money
manager that can potentially be tailored to meet specific investment
objectives. When you invest in PMS, you own individual securities unlike
a mutual fund investor, who owns units of the entire fund. You have the
freedom and flexibility to tailor your portfolio to address personal
preferences and financial goals. Although portfolio managers may oversee
hundreds of portfolios, your account may be unique.
! !284
As per the SEBI guidelines, only those entities who are registered with the
SEBI for providing PMS services can offer PMS to clients. There is no
separate certification required for selling any PMS product. So, this is a
case where mis-selling can happen.
As per the SEBI guidelines, the minimum investment required to open a

PMS account is ` 25 Lac. However, different providers have different
minimum balance requirements for different products. For example, Birla
AMC PMS is having min. amount requirement of Rs. 25 lac for a product.
Similarly, HSBC AMC is having minimum requirement of 50 lac for their
PMS and Reliance is having min requirement of Rs. 1 Crore.
I n I n d i a , Po r t f o l i o M a n a g e m e n t S e r v i c e s a r e a l s o p r o v i d e d
by equity broking firms & wealth management services.
1. Discretionary PMS – Where the investment is at discretion of the fund

manager & client has no intervention in the investment process.
2. Non-Discretionary PMS – Under this service, the portfolio manager

only suggests the investment ideas. The choice as well as the timings of
the investment decisions rest solely with the investor. However, the
execution of the trade is done by the portfolio manager.
The client may give a negative list of stocks in a discretionary PMS at the
time of opening his account and the Fund Manager would ensure that those
stocks are not bought in his portfolio. Majority of PMS providers in India
offer Discretionary Services.
15.9 Investment in Portfolio Management Services (PMS)
There are two ways in which an investor can invest in Portfolio

Management Services:
1. Through Cheque payment
2. Through transferring existing shares held by the customer to the PMS

account. The Value of the portfolio transferred should be above the
minimum investment criteria.
! !285
Besides this, the customer will need to sign a few documents like– PMS
agreement with the provider, Power of Attorney agreement, New demat
account opening format (even if the investor has a demat account, he is
required to open a new one) and documents like PAN, address proof and
Identity proof are mandatory.
NRIs can invest in PMS. The NRI needs to open a PIS account for investing
in PMS. The documentation required for an NRI, however, is different from
a resident Indian. A checklist of documents is provided by each PMS
provider.
15.10 Working of Portfolio Management Services (PMS)
Each PMS account is unique and the valuation and portfolio of each account
may differ from one another. There is no NAV for a PMS scheme; however
the customer will get the valuation of his portfolio on a daily basis from the
PMS provider. Each PMS account is unique from one another. Every PMS
scheme has a model portfolio and all the investments for a particular
investor are done in the Portfolio Management Services on the basis of
model portfolio of the scheme. However, the portfolio may differ from
investor to investor. This is because of:
1. Entry of investors at different times.

2. Difference in amount of investments by the investors
3. Redemptions/additional purchase done by investor
4. Market scenario – e.g. If the model portfolio has investment in Infosys,
and the current view of the Fund Manager on Infosys is “HOLD” (and
not “BUY”), a new investor may not have Infosys in his portfolio.
Under PMS schemes the fund manager interaction also takes place. The
frequency depends on the size of the client portfolio and the Portfolio
Management Services provider. Bigger the portfolio, frequency of
interaction is more. Generally, the PMS provider arranges for fund manager
interaction on a quarterly/half-yearly basis.
! !286
15.11 Portfolio Management Services (PMS) Charges
PMS charge following fees. The charges are decided at the time of
investment and are vetted by the investor.
Entry Load – PMS schemes may have an entry load of 3%. It is charged at
the time of buying the PMS only.
Management Charges – Every Portfolio Management Services scheme

charges Fund Management charges. Fund Management Charges may vary
from 1% to 3% depending upon the PMS provider. It is charged on a
quarterly basis to the PMS account.
Profit-Sharing – Some PMS schemes also have profit-sharing

arrangements (in addition to the fixed fees), wherein the provider charges
a certain amount of fees/profit over the stipulated return generated in the
fund. For example, PMS X has fixed charges of 2% plus a charge of 20% of
fees for return generated above 15% in the year. In this case, if the return
generated in the year by the scheme is 25%, the fees charged by the PMS
will be 2% + {(25%-15%)*20%}.
The Fees charged is different for every Portfolio Management Services

provider and for every scheme. It is advisable for the investor to check the
charges of the scheme.
Apart from the charges mentioned above, the PMS also charges the
investors on following counts as all the investments are done in the name
of the investor:
• Custodian Fee
• Demat Account opening charges
• Audit charges
• Transaction brokerage
! !287
15.12 Taxation for Portfolio Management Services (PMS)
Any income from Portfolio Management Services account is a business

income. Unlike MF, PMS is not required to remain 65%+ invested in equity
to get equity taxation benefit. Each Portfolio Management Services account
is in the name of additional investor and so the tax treatment is done on an
individual investor level.
Profit on the same can be considered as business income (i.e. slab-wise).

Profit can be considered as Capital gains. [STCG (15%) or LTCG (Tax
free)]. It depends on the client’s Chartered Accountant or the assessing
officer how he treats this Income. The PMS provider sends an audited
statement at the end of the FY giving details of STCG and LTCG. it is on the
client and his CA to decide to treat it as capital gain or business income.
15.13 How is PMS different from a Mutual Fund?
Both PMS and Mutual Funds are types of managed Funds. The difference to
the investor in Portfolio Management Services over a Mutual Fund is:
• Concentrated Portfolio.
• Portfolio can be tailored to suit the needs of investor.
• Investors directly own the stocks, rather than the fund owning the
stocks.
• Difference in taxation
! !288
15.14 Summary
Portfolio management services (PMS) is a service offered by professional

money managers to the more discerning investors, which can potentially
be tailored to meet specific investment objectives. As per the SEBI
guidelines, only those entities that are registered with the regulator for
providing PMS can offer said services to the client. Additionally, the SEBI
has also provided that the minimum investment required to open a PMS
account should be Rs. 25 lakh. Portfolio management services are offered
by banks, brokerages, asset management companies, and independent
investment managers.
PMS providers can offer both standardised products as well as investments

that are tailor-made to adhere to client’s goals. The investor and the PMS
provider usually enter into a legally binding agreement which specifies the
nature of the service provided, the goals of the investor, risk profile of the
investor, investment strategy and other details. The client can then invest
the minimum stipulated amount either through cheque/money transfer or
by transferring existing shares held by the client to the PMS account. The
portfolio manager then creates a portfolio of stocks based on the client's
investment objective, which is held in a demat account opened in the name
of the client/investor and can be transferred back to him in the event that
he decides to close the PMS account.
There are broadly three kinds of PMS which basically differ in the degree of
participation in the investment process by the client.
• Discretionary PMS: In a discretionary PMS, the client gives the portfolio

manager the authority to undertake investment/trading decisions on his
behalf. In this case, the investment is at the discretion of the portfolio
manager and the client has no involvement in the investment process.
The client can, however, give the investment manager a list of negative
stocks or industries which are to be avoided.
• Non-discretionary PMS: Under this service, the primary role of the

manager is to act as an investment counsellor to the client. The portfolio
manager only provides the client with investment ideas while the final
choice and the timing of the investment rests solely with the client.
However, the actual execution of the trade is done by the portfolio
manager.
! !289
• Advisory PMS: In an advisory PMS, an investment manager only

provides the client with ideas, while the decision to trade as well as the
actual trade can be executed by the client.
Generally, the fee structure for portfolio management services is flexible in

nature and gives the client the advantage of choosing between a fixed
management fee and/or a performance-linked fee structure. The method of
charging is however decided at the inception and documented in the
agreement. The different types of charges are elucidated below:
PMS products have an option of charging the investor an entry load at the
time of purchasing the PMS.
Fixed management fees: In this type of structure, the portfolio manager

levies a fixed charge which may vary between different products. It is
usually charged on a quarterly basis and can also be charged annually.
Profit-sharing/performance-linked charges: In this type of structure,

along with a fixed fee, the portfolio manager charges a certain amount/
percentage of profits over and above the stipulated fund return. The fund
manager can claim a certain percentage of profit over and above a pre-
determined hurdle rate. In profit-sharing PMS, the percentage of fixed fee
is usually lower.
In addition to the above, all charges linked to equity investments like

custodian fees, demat account opening charges and transaction brokerage
is chargeable to the client.
Availing portfolio management services is the optimal way by which

investors’ investment decisions are designed to meet their wealth creation
goals with the help of expert advice and assistance.
Access to innovative and sophisticated strategies which can provide the

client with an opportunity to choose from an array of investment
opportunities. Higher degree of customisation usually takes into
consideration individual investment needs and goals, with the investment
philosophy to help clearly reflect the risk profile of the investor.
! !290
Ability to take focused positions in both stocks and sectors has the added
advantage of being beneficial once the true potential of the idea is realised
over a period of time.
Most PMS providers are technologically savvy and provide the client with
real-time access to portfolio positions and value. PMS managers are
directly accountable to the client, who can seek clarifications at will.
Choosing the right PMS provider is essential to maintaining long-term

portfolio discipline and in meeting an individual's financial goals. It should
be a logical decision based on an array of information relating to the risk-
adjusted performance of the portfolio manager, quality and experience of
the portfolio manager, fee structure and transparency in reporting and
communication.
While choosing a PMS provider, it is important to start with evaluating the

portfolio manager's past performance relative to a benchmark. As an
investor, one can take it one step further and compare various PMS
providers who have a similar investment mandate. While there is no
guarantee that historical performance can or will be replicated, it is a good
indicator of the manager’s skills and discipline. In addition to returns, it is
also imperative to evaluate the risk-adjusted return of the provider. Various
tools like the sharp ratio and portfolio beta can be employed to assess the
same.
Given the fiduciary nature of the relationship, an ideal portfolio manager

would be someone with whom one can maintain a collaborative
relationship. One can start with examining the quality and discipline of the
PMS providers and look at factors such as experience and qualifications of
both the portfolio manager and the support staff.
The investment philosophy and decision-making process should be clearly

outlined in the agreement. Additionally, the PMS providers should maintain
a high degree of transparency with timely and accurate reporting. To sum it
up, a PMS can provide investors with a transparent, highly skilled and
customised platform for investments, which are designed to help in long-
term wealth creation and help enhance risk-adjusted returns.
! !291
15.15 Questions
1. What is portfolio Management? Define and describe.
2. What are the roles and responsibilities of Portfolio Manager? Explain.
3. Write short Notes on: Models of Portfolio Management
4. Describe various charges levied to Portfolio Management Services

(PMS).
5. Write short notes on: Taxation for Portfolio Management Services (PMS)

alternatives)
1. The art of selecting the right investment policy for the individuals in
terms of _____________ is called as portfolio management.
a. minimum risk
b. maximum return
c. both a & b
d. any one of a or b
2. Portfolio management enables the portfolio managers to provide

_____________ to clients as per their needs and requirements.
a. Customized investment solutions
b. Risk involved in investment
c. Return on investment
d. Good and bad portfolios
3. The portfolio may differ from investor to investor. This is because of:
a. Entry of investors at different time.
b. Difference in amount of investments by the investors
c. Redemptions/additional purchase done by investor and Market
scenario
d. All of the above
! !292
4. The NRI needs to open a _____________ account for investing in PMS

a. Savings account
b. NRE account
c. PIS account
d. NRO account
5. As per the SEBI guidelines, the minimum investment required to open a

PMS account is _____________.
a. Rs. 5 lakh
b. Rs. 10 lakh
c. Rs. 15 lakh
d. Rs. 25 lakh
Answers: 1. (c), 2. (a), 3. (d), 4. (c), 5. (d)
! !293
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !294
FACTORING AND FORFAITING
Chapter 16
Factoring And Forfaiting
Objectives
After studying this chapter, you should be able to understand the factoring
and forfaiting and how it works, its major terms and conditions and how
these function in India. There are various advantages and disadvantages in
factoring and forfaiting which are also discussed in this chapter.
Structure:
16.1 Introduction
16.2 What is Factoring?
16.3 Factoring in India
16.4 Characteristics of Factoring
16.5 Different types of Factoring
16.6 Factoring Companies in India
16.7 NBFC-Factoring
16.8 What is Forfaiting?
16.9 Major Terms and Conditions of Forfaiting
16.10 Forfaiting – The Modus Operandi
16.11 Forfaiting Costs
16.12 Advantages and Disadvantages of Forfaiting
16.13 Forfaiting in India
16.14 Difference between Factoring and Forfaiting
16.15 Summary
16.16 Questions
! !295
16.1 Introduction
Proper financing is a crucial part of any business, more so in exports where

the cost of finance is affected by domestic as well as international factors.
Availability of a variety of suitable financing options can encourage small
and medium export businesses where raising of money to finance exports
is often more an issue than actual receipt of orders. Conventional financing
methods like bank loans, equity financing etc. come with a lot of conditions
and strings attached which new or small exporters find difficult to meet.
For instance, new firms may find it difficult to raise bank loans (since there
is no proof that business will be viable, no balance sheets to show healthy
profits). Equity participation implies a more long-term commitment and
accountability towards the shareholders.
In this context, the two financing methods of factoring and forfaiting could
provide viable options. Both provide immediate cash to the exporter that
virtually wipes out (for the exporter) the credit period extended to the
importer. This credit period extends from the time of shipment of goods to
the time of receipt of payment from the buyer abroad. The credit period
can extend from a couple of months to several years (in the case of
deferred payment contracts, project exports etc.) and hits the liquidity of
many export businesses. Forfaiting and factoring are similar in that a third
(factoring or forfaiting) agency takes over the accounts/trade receivables
of the exporter at a certain discount. The exporter in turn receives
immediate reimbursement of the receivables less the discount due to the
factoring or forfaiting agency. However, the conditions and stipulations
governing factoring and forfaiting are a little different.
A. FACTORING
16.2 What is factoring?
The Factoring Act, 2011 defines the ‘Factoring Business’ as “the business of
acquisition of receivables of assignor by accepting assignment of such
receivables or financing, whether by way of making loans or advances or in
any other manner against the security interest over any receivables”.
However, credit facilities provided by banks in the ordinary course of
business against security of receivables and any activity undertaken as a
commission agent or otherwise for sale of agricultural produce or goods of
! !296
any kind whatsoever and related activities are expressly excluded from the
definition of Factoring Business.
16.3 Factoring in India
Factoring is a financial option for the management of receivables. In simple

definition, it is the conversion of credit sales into cash. In factoring, a
financial institution (factor) buys the accounts receivable of a company
(Client) and pays up to 80%(rarely up to 90%) of the amount immediately
on agreement. Factoring company pays the remaining amount (Balance
20% minus finance cost minus operating cost) to the client when the
customer pays the debt. Collection of debt from the customer is done
either by the factor or the client depending upon the type of factoring. The
account receivable in factoring can either be for a product or service.
Examples are factoring against goods purchased, factoring in construction
services (in government contracts it is assured that the government body
can pay back the debt in the stipulated period of factoring and hence
contractors can submit the invoices to get cash instantly), factoring against
medical insurance etc. Let us see how factoring is done against an invoice
of goods purchased.
! !297
16.4 Characteristics of factoring
Usually, the period for factoring is 90 to 150 days. Some factoring

companies allow even more than 150 days.
Factoring is considered to be a costly source of finance compared to other

sources of short-term borrowings.
Factoring receivables is an ideal financial solution for new and emerging

firms without strong financials. This is because credit worthiness is
evaluated based on the financial strength of the customer (debtor). Hence
these companies can leverage on the financial strength of their customers.
• Bad debts will not be considered for factoring.
• Credit rating is not mandatory. But the factoring companies usually carry
out credit risk analysis before entering the agreement.
• Factoring is a method of off balance sheet financing.
• Cost of factoring=finance cost + operating cost. Factoring cost vary

according to the transaction size, financial strength of the customer etc.
Thes cost of factoring varies from 1.5% to 3% per month depending
upon the financial strength of the client's customer.
• For delayed payments beyond the approved credit period, penal charge
of around 1-2% per month over and above the normal cost is charged (it
varies like 1% for the first month and 2% afterwards).
! !298
16.5 Different types of Factoring
Following are major types of factoring:
• Disclosed and Undisclosed
• Recourse and Non-recourse
A single factoring company may not offer all these services.
• Disclosed Factoring
In disclosed factoring client's customers are notified of the factoring
agreement. Disclosed type can either be recourse or non-recourse.
• Undisclosed factoring
In undisclosed factoring, client's customers are not notified of the factoring
arrangement. Sales ledger administration and collection of debts are
undertaken by the client himself. Client has to pay the amount to the factor
irrespective of whether customer has paid or not. But in disclosed type
factor may or may not be responsible for the collection of debts depending
on whether it is recourse or non-recourse.
• Recourse factoring
In recourse factoring, client undertakes to collect the debts from the
customer. If the customer doesn't pay the amount on maturity, factor will
recover the amount from the client. This is the most common type of
factoring. Recourse factoring is offered at a lower interest rate since the
risk by the factor is low. Balance amount is paid to client when the
customer pays the factor.
• Non-recourse factoring
In non-recourse factoring, factor undertakes to collect the debts from the
customer. Balance amount is paid to client at the end of the credit period
or when the customer pays the factor whichever comes first. The
advantage of non-recourse factoring is that continuous factoring will
eliminate the need for credit and collection departments in the
organization.
! !299
16.6 Factoring companies in India
• Canbank Factors Limited

• SBI Global
• The Hong Kong and Shanghai Banking Corporation Ltd.
• IFCI Factors Limited
• Export Credit Guarantee Corporation of India Ltd.
• Citibank NA, India
• Small Industries Development Bank of India (SIDBI)
• Standard Chartered Bank
• YES BANK Limited
• India Factoring and Finance Solutions Pvt. Ltd.
16.7 NBFC-Factoring
• What is an NBFC-Factor?
NBFC-Factor means a non-banking financial company fulfilling the Principal
business criteria i.e. whose financial assets in the factoring business
constitute at least 75 percent of its total assets and income derived from
factoring business is not less than 75 percent of its gross income, has Net
Owned Funds of Rs. 5 crore and has been granted a certificate of
registration by the RBI under section 3 of the Factoring Regulation Act,
2011.
• Entry point norms for NBFC-Factor

Every company registered under Section 3 of the Companies Act, 1956
seeking registration as NBFC-Factor shall have a minimum Net Owned Fund
(NOF) of Rs. 5 crore. Existing companies seeking registration as NBFC-
Factor but not fulfilling the NOF criterion of Rs. 5 crore may approach the
Bank for time to comply with the requirement.
• What would happen with the existing companies registered with

the RBI as NBFCs and conducting factoring business that
constitute less than 75 percent of total assets / income?
Such a company shall have to submit to the RBI, a letter of its intention
either to become a Factor or to unwind the business totally, and a road
map to this effect. The company would be granted CoR as NBFC-Factor
only after it complies with the twin criteria of financial assets and income.
! !300
If the company does not comply within the period as specified by the Bank,
it would have to unwind the factoring business.
• Is it compulsory for all entities to get registered with the RBI to

conduct factoring business?
Yes. An entity not registered with the Bank may not conduct the business
of factoring unless it is an entity mentioned in Section 5 of the Act i.e. a
bank or any corporation established under an Act of Parliament or State
Legislature, or a Government Company as defined under section 617 of the
Companies Act, 1956.
• If a company does not fulfill the principal business criteria for

factoring and has no intention of getting itself registered as a
Factor with the Bank, can it continue to do factoring activities
with its group entities?
No. As per Section 3 of the Factoring Act, 2011, no Factor can commence
or carry on the factoring business without a) obtaining a CoR from the
Reserve Bank, b) fulfilling the principal business criteria.
• Can NBFC-Factors undertake Import and Export Factoring?
Yes, however, such NBFC-Factors will need to obtain the necessary

authorization from the Foreign Exchange Department of the Bank under
FEMA 1999 as amended and adhere to all the FEMA regulations in this
regard.
• Is it necessary for NBFC-Factors to register every factoring

transaction with the Central Registry?
Under Section 19 of the Factoring Act, 2011 every Factor is under

obligation to file the particulars of every transaction of assignment of
receivables in his favour with the Central Registry to be set-up under
section 20 of the Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest Act, 2002 (54 of 2002), within a period of
thirty days from the date of such assignment or from the date of
establishment of such registry, as the case may be.
! !301
• Do NBFC-Factors have to comply with a separate set of prudential

regulations?
No, The provisions of Non-Banking Financial (Non-deposit Accepting or

Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007 or
Non-Banking Financial (Deposit Accepting or Holding) Companies
Prudential Norms (Reserve Bank) Directions, 2007, as the case may be and
as applicable to a loan company shall apply to an NBFC-Factor.
• Is there a separate set of Returns that the NBFC-Factor has to

submit?
The submission of returns to the Reserve Bank will be as specified

presently in the case of registered NBFCs.
B. FORFAITING
The Government of India has recently permitted a new form of post-

shipment financing called Forfaiting as part of its efforts to promote
exports from the country.
16.8 What is Forfaiting?
Forfaiting in French means to give up one’s right. Thus, in forfaiting the

exporter hands over the entire export bill with the forfaiter and obtains
payments. The exporter has given up his right on the importer which is
now taken by the forfaiter. By doing so, the exporter is benefited as he
gets immediate finance for his exports. The risk of his exports is now borne
by the forfaiter. In case if the importer fails to pay, recourse cannot be
made on the exporter.
Forfaiting is the sale by an exporter of export trade receivables, usually

bank guaranteed, without recourse to the exporter. Such receivables
include Letters of Credit (with or without Bills of Exchange) Promissory
Notes with Aval (guarantee), Bill of Exchange with Aval, Bank Guarantees
Payable to an Exporter in one country from an Importer in another country.
Forfaiting as a financing concept has been in use across the world since the
1960s. The word forfait means to forgo one's right to something. In the
context of export finance, the exporter forgoes his right to receive payment
from the importer at later date and surrenders the right to collect payment
! !302
to a third party or agency (known as forfaiter). Instead the exporter

receives an immediate reimbursement of his payment less certain
discounts from the forfaiter. Normally, these payments are due at a later
date, forcing the exporter to bear the cost for the intervening period, as
well as being exposed to the risks of exchange rate fluctuations, political
situations etc. These are risks which expose a small or medium exporter to
significant erosion of profits. With forfaiting finance, the exporter passes on
his debts as well as attendant risks to the forfaiting agency. This form of
financing is referred to as without recourse financing (in case the debt
cannot be recovered there is no risk for the exporter). Forfaiting is a
medium-term financing option typically for the three to seven year time
frame.
16.9 Major Terms and conditions of forfaiting
• there is a discounting of the amount to be received from the importer
• discounting is on a fixed rate
• debt is in the form of bills of exchange or promissory notes guaranteed

by a bank
• such financing is without recourse to the seller
• 100% of the amount receivable can be financed in this manner
16.10 Forfaiting – The Modus Operandi
The parties/agencies involved in a forfaiting transaction include the

exporter, the importer, a forfaiting agency, a bank that stands guarantee
(aval) for the bills of exchange or promissory notes (this is normally the
importers bank) and the Exim bank in India acts as the facilitating agency
between the Indian exporter and the forfaiting agency.
Typically, the exporter negotiates terms like price, payment currency, credit
period and the like with their overseas buyer. The exporter then
approaches the Exim Bank with these terms.
! !303
The Exim Bank obtains a tentative forfaiting quotation from a forfaiting

agency. Armed with this quote the exporter can now finalise the contract
with the buyer.
The exporter should ensure that most of the forfaiting charges are passed
on to the buyer. Once the terms have been settled with the buyer, a final
forfaiting quote is obtained by the Exim Bank. If this quote is acceptable,
the exporter signs the contract with the buyer as well as a separate one
with the forfaiting agency.
Once shipment of goods has taken place the exporter obtains availed
(guaranteed) bills of exchange from the importer (through a bank) or
availed promissory notes. These bills of exchange or promissory notes are
endorsed by the exporter and are routed to the forfaiting agency through
the Exim Bank.
The forfaiting agency will then remit the payment due to the exporter to an
account of the exporter's bank in the country where the forfaiting agency is
based. This bank then transfers the amount to the exporter in India, and
the exporter will be provided with a Certificate of Foreign Inward
Remittance as proof. When the promissory notes/bills of exchange reach
maturity, the forfaiting agency collects the payment from the aval (the
bank or agency that stands guarantee irrespective of whether the importer
has paid the aval).
16.11 Forfaiting Costs
In a forfaiting transaction, the exporter should bear the following costs:
A commitment fee has to be paid to the forfeaiter for the period of time
from when the commitment is entered into up to the date of discounting or
date of expiry of the contract. The commitment fee typically ranges
between 0.5 to 1.5 per cent per annum of the utilised portion of the forfait
amount. This fee has to be paid irrespective of whether the export takes
place or not. The second is the actual discount fee which is the interest on
the receivable amount for the entire period of credit as well as a premium
for the various risks involved. This fee is based on prevailing market
interest rates including LIBOR (London Inter-Bank Offered Rate). These are
the two main costs involved. In addition, there could be documentation
costs in case of a lot of paperwork, penalties, handling charges, etc. The
! !304
Exim Bank which acts as the facilitator also charges a service fee which can
be paid in Indian rupees.
As per the RBI regulations it is mandatory that the discount fees and any
documentation fees charged by the forfaiter should be passed on to the
overseas buyer. During shipping, it is not necessary that any of the
forfaiting fees be shown separately, they can be included in the FOB value
indicated in the invoice. The export contract can be executed in any of the
major convertible currencies of the world, in order to be eligible for
forfeiting
16.12 Advantages and disadvantages of forfeiting
Commercial banks act a forfaiters by purchasing account receivables from

the exporter. There is not much risk involved for the forfaiter as the export
is done against the L/C (Letter of credit), issued by importer’s bank.
• Advantages of Forfaiting
The Following are some of the advantages of forfaiting:
1. It provides immediate funds to the exporter who is saved from the risk
of the defaulting importer.
2. It is an earning to commercial banks who by taking the bills of highly

valued currencies can gain on the appreciation of currencies.
3. The forfaiter can also discount these bills in the foreign market to meet
more demands of the exporters.
4. There is very little risk for the forfaiter as both importer’s bank and
exporter’s banks are involved.
5. Letter of Credit plays a major role for the forfaiter. Moreover, he enters
an agreement with the exporter on his terms and conditions and covers
his risks by separate charges.
6. As forfaiting provides 100% finance to exporter against his exports, he

can concentrate on his other exports.
! !305
• Disadvantages or Drawbacks of Forfaiting
The following are some of the disadvantages of forfaiting.
1. Forfaiting is not available for deferred payments especially while

exporting capital goods for which payment will be made on a deferred
basis by the importer.
2. There is discrimination between Western countries and the countries in

the Southern Hemisphere which are mostly underdeveloped (countries
in South Asia, Africa and Latin America).
3. There is no International Credit Agency which can guarantee for

forfaiting companies which affects long-term forfaiting.
4. Only selected currencies are taken for forfaiting as they alone enjoy
international liquidity.
16.13 Forfaiting in India
For a long time, Forfaiting was unknown to India. Export Credit Guarantee
Corporation was guaranteeing commercial banks against their export
finance. However, with the setting up of export-import banks, since 1994
forfaiting is available on liberalized basis.
The exim bank undertakes forfaiting for a minimum value of Rs. 5 lakh. For
this purpose, the exporter has to execute a special Pronote in favor of the
exim bank. The exporter will first enter into an agreement with the
importer as per the quotation given to him by the exim bank. The exim
bank on its part, gets quotation from the forfaiting agency abroad. Thus,
the entire forfaiting process is completed by exporter agreeing to the terms
of the exim bank and signing the Pronote.
Forfaiting business in India will pick up only when there is trading of

foreign bills in international currencies in India for which the value of
domestic currency has to be strengthened. This would be possible only with
increasing exports. At present, India’s share stands at 1.7 percent in the
world exports. Perhaps, this will bring a push to the forfaiting market.
! !306
16.14 Difference Between Factoring and Forfeiting
Points of Factoring Forfaiting

Difference
Extent of Finance Usually 75 - 80% of the 100% if invoice value
value of the invoice
Credit Worthiness Factor does the credit The Forfaiting Bank relies
rating in case of non- on the credit ability of the
resource factoring Availing Bank
transaction
Resource With or without recourse Always without resource
Risk Exporter bears some risk Exporter bears no risk

Sales Done Not Done
Administration
Term Short-Term Medium-Term
16.15 Summary
Factoring is a rather more general term for a concept similar to forfaiting.

Factoring is the non-recourse sale of accounts receivables of a business on
a daily, weekly, or monthly basis in exchange for payment.
It is a shorter-term financing based on accounts receivables of a business.

Factoring is prevalent in business in various ways. For instance, in retailing,
the credit card business is a clear example of factoring. Factoring is often
more short-term than forfaiting and is applicable where receivables are due
within around 180 days. Simply put, factoring is the process of purchasing
accounts receivable, or invoices, from a business at a discount. Factors
provide a vital financing service to mostly small and medium-sized
companies who are short of working capital. The factor fills the money gap
between the time a manufacturer or seller makes a sale and the time the
customer pays the bill. For this, the factor charges a fee equal to
percentage of the invoices purchased.
! !307
In the context of the export business, unlike forfaiting, factoring is often

with recourse. In a recourse agreement, the exporter has to repurchase or
pay for any invoices the factor cannot collect from the exporter's
customers. The factor still agrees to advance money, take on the collection
responsibility, and earn a fee for it. But if the customer doesn't pay, the
invoices are returned back to the exporter for payment. This eliminates any
financial risk for the factor, but unlike forfaiting increases the risk for the
exporter. Since the risk for the factor is less, factoring fees tend to be a
lower percentage as compared with forfaiting fees. Factoring does not
provide safety from non-payment, political risks and exchange rate
fluctuations. Factoring is not fixed rate discounting but depends on the
prevalent exchange rate and political conditions at time of maturity of
payment.
The need for cash is common to every business. Factoring rescues these
companies by providing them with the liquid assets, or cash, they need to
fuel their growth. Factoring can be particularly valuable for companies with
growth potential, but who need an accelerated cash flow to realize that
potential. It is additionally valuable for firms that are seeking new ways to
reduce bad debts, and small and mid-sized companies that require working
capital or are engaged in seasonal industries. At the same time, factoring is
not for all companies. While the advantages of factoring can be great, for
some companies the cost would outweigh the value of the services
extended by factoring companies. For example, a company serving a few
major customers with excellent credit ratings would probably not benefit
from factoring.
A company with no history, no assets, and no credit couldn't hope for a

bank loan, but as long as their customers are creditworthy, a factor or
forfaiter would be keen to do business with them. In essence the factor/
forfaiter is not extending credit to the exporter, but actually purchasing
their invoices.
As we have seen, factoring and forfaiting are two forms of post-shipment

financing that help exporters to overcome the hurdle of delay in
repatriation of export sale payments. This in turn increases liquidity and
cash flow for the exporter’s business. Forfaiting in particular does not
curtail other borrowing since it is without recourse to the seller and hence
does not increase debt. Hence this is an additional rather than an alternate
financing method. Forfaiting and factoring are thus means by which small
! !308
and medium businesses can raise short- to medium-term finance that will
help them extend credit to their customers with low or no risks to
themselves. This is yet another key to helping Indian exporters get
competitive in the international marketing arena where not just quality and
price but even payment terms can be deciding factors.
The parties/agencies involved in a forfaiting transaction include the

exporter, the importer, a forfaiting agency, a bank that stands guarantee
(aval) for the bills of exchange or promissory notes (this is normally the
importers bank) and the Exim bank in India acts as the facilitating agency
between the Indian exporter and the forfaiting agency …Typically the
exporter negotiates terms like price, payment currency, credit period and
the like with their overseas buyer. The exporter then approaches the Exim
Bank with these terms. The Exim Bank obtains a tentative forfaiting
quotation from a forfaiting agency. Armed with this quote, the exporter can
now finalise the contract with the buyer. The exporter should ensure that
most of the forfaiting charges are passed on to the buyer. Once the terms
have been settled with the buyer, a final forfeiting quote is obtained by the
Exim Bank. If this quote is acceptable, the exporter signs the contract with
the buyer as well as a separate one with the forfaiting agency. Once
shipment of goods has taken place, the exporter obtains availed
(guaranteed) bills of exchange from the importer (through a bank) or
availed promissory notes. These bills of exchange or promissory notes are
endorsed by the exporter and are routed to the forfaiting agency through
the Exim Bank. The forfaiting agency will then remit the payment due to
the exporter to an account of the exporter's bank in the country where the
forfaiting agency is based. This bank then transfers the amount to the
exporter in India, and the exporter will be provided with a Certificate of
Foreign Inward Remittance as proof. When the promissory notes/bills of
exchange reach maturity, the forfaiting agency collects the payment from
the aval (the bank or agency that stands guarantee irrespective of whether
the importer has paid the aval).
A commitment fee has to be paid to the forfaiter for the period of time
from when the commitment is entered into up to the date of discounting or
date of expiry of the contract. This fee has to be paid irrespective of
whether the export takes place or not. The second is the actual discount
fee which is the interest on the receivable amount for the entire period of
credit as well as a premium for the various risks involved. This fee is based
on prevailing market interest rates including LIBOR (London Inter-Bank
! !309
Offered Rate). These are the two main costs involved. In addition, there
could be documentation costs in case of a lot of paperwork, penalties,
handling charges, etc. The Exim Bank which acts as the facilitator also
charges a service fee which can be paid in Indian rupees.
As per the RBI regulations it is mandatory that the discount fees and any
documentation fees charged by the forfaiter should be passed on to the
overseas buyer. During shipping, it is not necessary that any of the
forfaiting fees be shown separately, they can be included in the FOB value
indicated in the invoice. The export contract can be executed in any of the
major convertible currencies of the world, in order to be eligible for
forfaiting.
16.16 Questions
1. Define and explain Factoring.

2. Describe the mechanism of factoring.
3. What is forfaiting? Explain.
4. Explain advantages and disadvantages of Forfaiting.
5. Compare: Factoring and forfaiting.

alternatives)
1. The conversion of credit sales into cash is called as _____________.

a. Forfaiting
b. Factoring
c. Reverse sale
d. Debt management
2. Every company registered under Section 3 of the Companies Act, 1956

seeking registration as NBFC-Factor shall have a minimum Net Owned
Fund (NOF) of Rs. _____________.
a. 10 Cr.
b. 5 Crore
c. 3 Crs.
d. 1 Cr.
! !310
3. The parties/agencies involved in a forfaiting transaction include

_____________ that stands guarantee (aval) for the bills of exchange
or promissory notes and the Exim bank in India acts as the facilitating
agency between the Indian exporter and the forfaiting agency.
a. The exporter
b. The importer
c. A forfaiting agency
d. All of the above
4. “There is no International Credit Agency which can guarantee for

forfaiting companies which affects long-term forfaiting”
_____________True or False
a. True
b. False
5. The exim bank undertakes forfaiting for a minimum value of Rs.

_____________.
a. 5 lakh
b. 10 lakh
c. 15 lakh
d. 20 lakh
Answers: 1. (a), 2. (b), 3. (d), 4. (a), 5. (a)
! !311
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !312
HYBRID FINANCING
Chapter 17
Hybrid Financing
Objectives
After studying this chapter, you should be able to understand what is

hybrid Financing, instruments under hybrid Financing, and types of hybrid
Financing. Characteristics of various instruments that are used in Hybrid
Finance, including advantages and disadvantages can also be understood
after studying this chapter.
Structure:
17.1 Introduction
17.2 Hybrid Financing
17.3 Purpose of Hybrid Financing
17.4 Types of Hybrid Financing
17.5 Summary
17.6 Questions
! !313
HYBRID FINANCING
17.1 Introduction
Hybrid Financing is the financial instrument that partakes some

characteristics of debt and some characteristics of equity. Simply, it is the
financial security that possesses the characteristics of both the debt and
equity.
The debt and equity are the two extreme points and in the mid-point lies
the hybrid financing that offers the investors the benefits of both the equity
and debt. Equity gives the right to have a residual claim on the cash flows
and assets of the firm and have control over the management. Whereas,
the debt represents the fixed claim over the cash flows and the assets of
the firm, but generally, does not give the right to control the management.
The important forms of Hybrid Financing are Preference Capital,

Convertible Debentures, Warrants, options, innovative hybrids and so on.
Hybrid securities are bought and sold on an exchange, through a

brokerage. Hybrids may give investors a fixed or floating rate of return,
and may pay returns as interest or as dividends. Some hybrids return their
face value to the holder when they mature, and some have tax
advantages.
In addition to convertible bonds, another popular type of hybrid security is

convertible preference shares, which pay dividends at a fixed or floating
rate before common stock dividends are paid and can be exchanged for
shares of the underlying company's stock.
Each type of hybrid security has unique risk and reward characteristics.
Convertible bonds offer greater potential for appreciation than regular
bonds, but pay less interest than conventional bonds, and still face the risk
that the underlying company could perform poorly and fail to make coupon
payments or not be able to repay the bond's face value at maturity.
Convertible securities offer greater income potential than regular
securities, but can still lose value if the underlying company
underperforms. Other risks of hybrid securities include deferred interest
payments, insolvency, market price volatility, early repayment and
illiquidity.
! !314
HYBRID FINANCING
New types of hybrid securities are being introduced all the time in an
attempt to meet the needs of sophisticated investors. Some of these
securities are so complicated that it is difficult to define them as either debt
or equity. In addition to being difficult to understand, another criticism of
some hybrid securities is that they require the investor to take more risk
than the potential return warrants.
17.2Hybrid Financing
Hybrid Financing can be defined as a combined face of equity and debt.

This means that the characteristics of both equity and bond can be found in
Hybrid Financing. There are several forms of Hybrid Financing like
preference capital, convertible debentures, warrants, innovative hybrids
and so on.
17.3 Purpose of Hybrid Financing
The concept of Hybrid Financing has been developed to enjoy the positive
factors of both the equities and debt instruments. The residual claim is
related to the equities. If someone is holding shares of a company, then it
is obvious that the person would enjoy some special rights regarding the
cash flow and the assets. At the same time, the shareholder of the
company is also entitled to play an important role while making business
decisions.
Debt instruments are totally different from equities. These instruments are
used by major companies to arrange a kind of loan for the development of
the company. The debt instruments do not provide the right to take part in
the management of the company. But at the same time, the debt
instruments confirm a permanent claim on the assets of the company.
Now these two are totally different and the purpose of Hybrid Financing is
to combine the qualities of both these investment instruments and to
develop something better for the investors.
! !315
HYBRID FINANCING
17.4 Types of Hybrid Financing
The purpose of hybrid financing is to offer the investors the combination of

positive factors of both the debt and equity instruments. Equity
instruments give the sense of ownership to the holder, and a residual claim
over the cash flows while the debt instruments are issued to raise capital in
the firm that could be used in its development. Following are the main
types of instruments in hybrid Financing.
1. Preference Capital
2. Convertible Debentures
3. Warrants
4. Options
1. Preference Capital
The Preference Capital is that portion of capital which is raised through the
issue of the preference shares. This is the hybrid form of financing that has
certain characteristics of equity and certain attributes of debentures. This
capital is always preferred at the time of distribution of the dividends.
Again, preference capital is paid first when the company is winding up its
activities. The equity capital always comes next.
! !316
HYBRID FINANCING
Advantages of Preference Capital
• There is no legal obligation on the firm to pay a dividend to the

preference shareholders.
• The redemption of preference shares is not distressful for a firm since the
shares are redeemed out of the profits and through the issue of fresh
shares (preference shares and equity shares).
• The preference capital is considered as a component of net worth and

hence the creditworthiness of the firm increases.
• Preference shareholders do not enjoy the voting rights, and thus, there is
no dilution of control.
Disadvantages of Preference Capital
• It is very expensive as compared to the debt-capital because unlike debt

interest, preference dividend is not tax deductible.
• Although there is no legal obligation to pay the preference dividends,

when the payment is made it is done along with the arrears.
• The preference shareholder can claim prior to the equity shareholders, in

case the dividends are being paid or at the time of winding up of the
firm.
• If the company does not pay or skips the preference dividend for some
time, then the preference shareholders could acquire the voting rights.
The preference capital is like the equity in the sense that the preference
dividend is paid out of the distributable profits, it is not obligatory on the
part of the firm to pay the preference dividend, these dividends are not
tax-deductible.
The portion of the preference capital resembles the debentures as the rate
of dividend is fixed, preference shareholders are given priority over the
equity shareholders in case of dividend payment and at the time of winding
up of the firm, the preference shareholders do not have the right to vote
and the preference capital is repayable.
! !317
HYBRID FINANCING
2. Convertible Debentures
Convertible debentures are those that can be transformed into the shares
of the same company. These debentures are also known as convertible
bonds. The ratio of conversion from bond to share is fixed by the company
and the bonds are usually converted to common stocks.
The Convertible Debentures are a type of loan that can be converted into
the stock of the company after a stipulated period at the option of the
holder or the issuer in special circumstances. These are issued with the
intent to raise money to expand or maintain the business operations at a
considerable low-interest rate.
The debentures are the long-term debt instruments on which the company
is obliged to pay interest to its holders. Sometimes, the debentures are
issued with an option of convertibility in which the debenture holder can
get his debentures converted into the stock of the company, either fully or
partly.
As per the SEBI, the following provisions apply in case the

debentures are converted into the stock either fully or partly:
1. The conversion time along with the conversion premium should be

stated in the prospectus.
2. The conversion, partial or full, must be at the disposal of the debenture

holder, provided the conversion takes place at or after 18 months but
before 36 months.
3. The conversion is to be made optional with “put” or “call” option in case

the debentures provide for conversion after 36 months.
4. In case the conversion period of fully convertible debentures exceeds 18

months, then a compulsory credit rating is required.
! !318
HYBRID FINANCING
Through above provisions, it is clear that convertible debentures could be

of three types:
a. Compulsory convertible debentures provide for the conversion within 18

months of the issue.
b. Optional convertible debentures provide for the conversion within 36

months of the issue.
c. Debentures with “call” or “put” option in case the conversion exceeds 36

months.
The convertible debentures are beneficial to the investor since they get an
opportunity to become the owner of the company and might leave in case
the company experiences loss. But however, the convertible debentures are
unsecured and in case the company goes bankrupt, the holder gets his
money only after all the secured creditors are paid.
The major disadvantage to the issuer is that, if the company makes huge
profits, then the investor would like to become the shareholder or the
owner which results in the dilution of ownership in the company.
3. Warrants
Warrant is a kind of hybrid financing and it is very close to security options.

Any person who is holding a warrant is guaranteed to be provided with
specific number of underlying instruments and the prices for those
instruments are fixed previously. This means that if the value of the
instrument is going up, the investor can make good amount of profit and if
the market is not favourable, the warrant-holder is not bound to use the
warrant. Like securities market, here also both the call and put warrants
are available.
The Stock Warrants are like the options that give the holder the right, but
not the obligation to buy or sell the security at a specific time and a
specific date. Unlike options, these are issued by the company itself and
are traded more over the counter than on an exchange.
! !319
HYBRID FINANCING
The stock warrants are issued to “sweeten the debt issues”, as with the
purchase or sale of these warrants, the company holding such stock can
raise money through equity, which is not possible in case of the options.
Also, the investors cannot write (put) the warrants as in the case of options
(except the employee stock options).
The warrants enjoy the benefits of elongated maturity period over the
options, as the former can last up to 15 years, whereas the latter generally
expires in two to three years.
The purpose of the issue of warrants is that the companies include these
into the debt or equity issues, as this helps in reducing the cost of
financing and getting the assurance of additional capital in case the stock
does well.
The stock warrant certificate comprises of the following:
• Type of Warrant: There are two types of warrants, viz., Call Warrant
and Put Warrant. The call warrant gives the holder a right to buy certain
shares at a specific time on or before the certain date while the Put
warrant gives the right to sell these.
• Exercise Price: The exercise price or the strike price is the amount that
needs to be paid either for the purchase of a call warrant or the sale of a
put warrant.
• Expiration Date: On the warrant certificate, the date on which the

warrant will get expired is clearly mentioned after which the holder
cannot exercise any rights.
• Underlying Asset: The underlying security for which the warrant seller
is obliged to deliver or purchase from the warrant buyer is clearly stated
in the warrant certificate.
• Warrant Style: It refers to the manner in which the warrants can be

exercised. There are two styles: American and European style. In the
former style, the warrants can be exercised any time before the
expiration date, whereas in the latter style the warrants can be exercised
on the expiration date itself.
! !320
HYBRID FINANCING
• Conversion Ratio: It refers to the number of warrants that are needed

to buy or sell one unit of investment.
The companies usually add the warrants with its new securities or offerings
and therefore whenever the investor exercises his warrant, he gets the
newly issued stock rather than the existing outstanding stock. Due to this,
the warrant causes the dilution as the company is obligated to issue new
shares whenever the investor exercises his warrant, which is not in the
case of options, where the investors get the stock from the existing
common shares of the company.
4. Stock Option
The Stock Option is a security that gives the right to its holder, but not the
obligation to buy or sell the outstanding stocks at a specific price and a
specific date. The stock options are traded on the securities exchange like
other shares. People purchase these stock options if they believe that the
stock price is likely to go up or down soon. For example, if today the stock
trades at Rs. 1000 per share and is expected to increase in the next month
to Rs. 1200 per share, then you will buy the call option today at Rs. 1000,
so that you can sell it at Rs. 1200 in the next month and make a profit of
Rs. 200 on each share purchased.
A stock option is a contract in which following terms are included:
• The type of stock option There are two types of options, call option
and put option. The call option gives the buyer the right not the
obligation to buy the underlying stock, while the put option gives the
right and not the obligation to sell them. One who buys the options are
called as holders, whereas the ones who sell these, are called as writers.
• Strike Price is the price at which the option holder can buy or sell the
underlying asset when the option is exercised.
• Option Premium, an amount paid to acquire the options. The option

buyer has to pay a premium to the option seller for carrying on the risk.
The amount of premium depends on the strike price, volatility of change
in the price of underlying assets and the time period till the option
expires.
! !321
HYBRID FINANCING
• In a contract, the date on which the option expires is clearly mentioned.

Thus, every option comes with an expiration date after which the options
become worthless, and the holder has no right to exercise it.
• There are two types of option styles according to which the options can
be exercised. The American Style and the European Style. The American-
style options can be exercised any time before the expiration date,
whereas the European style options can only be exercised on the
expiration date itself.
• The security for which the option seller has the obligation to deliver or
purchase from the option buyer is called the underlying asset. Thus, the
underlying asset for which the whole options contract is made is clearly
mentioned therein. For example, if there are stock options, then the
underlying asset is the shares of the specific company.
The contract must include the “multiplier” which means the quantity of the
underlying asset that needs to be delivered at the time option is exercised.
The stock options are also issued to the specified employees of the
company and are called as the Employee Stock Options.
! !322
HYBRID FINANCING
17.5 Summary
Hybrid financing instruments are those sources of finance which possess

characteristics of both equity and debt. Some well-known hybrid financing
instruments are preference shares, convertible debentures, warrants,
options etc.
Preference Shares: Preference share is also a long-term source of equity

finance. It is commonly known as hybrid financing instrument because it
shares certain characteristics of debt also.
Just like debt where these is fixed interest rate, preference shares has
fixed dividend and they also have a preference of payment at the time of
liquidation just as debt holders get. They do not have any voting rights
and also do not have any share in the residual profits in Hybrid Financing
Instruments also.
Certain attributes of preference shares resemble the equity shares. The

preference dividend is also paid out of net profits after taxes but the only
difference is that the dividend is fixed. In the weak financial situations,
management may consider not paying the dividend to preference
shareholders. If the shares are cumulative preference shares, the said
dividend may be postponed but will have to pay if the next year financials
are good. A specific type of preference share i.e. irredeemable preference
share does not have a certain maturity also.
Convertible Debentures: These are a different type of debentures which are

also categorized as hybrid financing. In addition to the normal debenture
features, these debentures have the option to convert the debenture into
equity on certain terms and conditions.
These debenture holders enjoy the regular income of interest till the time
they exercise their right or the option of converting it into equity shares.
Warrants: Like debentures, warrants also have the right to purchase equity
shares of a company. Warrants are not a debenture or equity till the time
they are exercised and equity is purchased. They are just a right or option
to purchase equity which the holder has.
! !323
HYBRID FINANCING
Options: These are debt instruments these may be either call or put
options. These options convert the debt into equity. This kind of
instruments remains debt at the time of issue until the time they are
exercised. When they are exercised, they become equity. A call option
allows the holder of the option to buy something at a certain price and on
or before a certain date whereas put option allows selling.
17.6 Questions
1. What is Hybrid Financing? Define.
2. What are the characteristics of Hybrid Financing and types of hybrid

financing?
3. Write short notes on Convertible debenture.
4. What are the terms included in stock option contract? Explain.
5. Explain in brief Advantages and disadvantages of preference capital.
! !324
HYBRID FINANCING

alternatives)
1. Hybrid Financing can be defined as a combined face of _____________

a. Equity
b. Debt
c. Both a & b
d. Debentures
2. Compulsory convertible debentures provide for the conversion within

_____________ months of the issue.
a. 12
b. 18
c. 36
d. As per agreement
3. The Stock Warrants are like the options that give the _____________
the right, but not the obligation to buy or sell the security at a specific
time and a specific date.
a. Issuing company
b. Trader
c. Holder
d. Acquiring company
4. In the stock option, the security for which the option seller has the
obligation to deliver or purchase from the option buyer is called the
_____________
a. Underlying asset
b. Underlying liabilities
c. Underlying contract
5. The contract must include the “multiplier” which means the quantity of
the _____________ that needs to be delivered at the time option is
exercised.
a. Underlying obligation
b. Liabilities
c. Underlying asset
d. Contract documents
! !325
HYBRID FINANCING
Answers: 1. (c), 2. (b), 3. (c), 4. (a), 5. (c)
! !326
HYBRID FINANCING
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !327
HIRE PURCHASE FINANCING
Chapter 18
Hire Purchase Financing
Objectives
the Concept of Hire Purchase Finance, Regulations related to Hire
purchase, legal structure of Hire purchase, difference between hire
purchase and leasing and various characteristic features of hire purchase
agreement.
Structure:
18.1 Introduction
18.2 Hire Purchase
18.3 Legal Framework
18.4 Features and Characteristics of Hire Purchase
18.5 Difference Between Leasing and Hire Purchase
18.6 Advantages of Hire Purchase
18.7 Disadvantages of Hire Purchase
18.8 Hire Purchase and Leasing
18.9 Cost of Hire Purchase
18.10 Time Frame and Other Options
18.11 Hire Purchase Agreement
18.12 Summary
18.13 Questions
! !328
18.1 Introduction
The Hire Purchase Act was passed in 1972, which is controlling the hire
purchase transactions. The hire purchase finance companies come under
non-banking finance companies (NBFCs) and are subject to the regulations
of the Reserve Bank of India Act (Section 45[i]).
Earlier, the non-banking finance companies were accepting deposits from

the public by offering attractive interest rates and were collecting higher
interest rates from the buyers of durable goods on hire purchase. But in
1998, certain restrictions were imposed on the acceptance of deposits by
non-banking finance companies involved in hire purchase finance. Since
then, the acceptance of deposits by these companies has been curtailed, as
a result of which there has been some decline in the hire purchase
activities in our country.
To overcome the above handicap, many automobile companies such as

Maruti Udyog Limited and Tatas have themselves promoted their own hire
purchase finance companies. Ashok Leyland Finance has been there
already in the market. The foreign banking companies are also undertaking
hire purchase finance and they are a big competitor to the Indian hire
purchase finance companies.
Of late, Housing Finance has been taken up on hire purchase by most of

the commercial banks and with the introduction of floating interest rate, it
is picking up both in urban and rural areas. The floating rate of interest is
beneficial to the customer as long as the interest rate is declining. Even
banks are allowing the swapping of the interest rate. By this, the old loan
with the higher interest rate is repaid and it is replaced by a new loan with
a lower rate of interest.
Thus, in India hire purchase finance is mainly encouraged by the middle-

income group consumers in the purchase of houses and durable goods,
whereas in industries, it is leasing which is becoming very popular.
! !329
18.2 Hire purchase
Hire Purchase is one of the most commonly used modes of financing for
acquiring various assets. It aids by spreading the huge cost of an asset
over a longer period. Thus, it frees a lot of capital to be directed to other
important purposes.
Hire Purchase is defined as an agreement in which the owner of the assets

lets them on hire for regular instalments paid by the hirer. The hirer has
the option to purchase and own the asset once all the agreed payments
have been made. These periodic payments also include an interest
component paid towards the use of the asset apart from the price of the
asset.
The term ‘Hire-Purchase’ is a UK term and is synonymous to ‘rent-to-own’

or ‘instalment plan’ in various other countries. Owning goods through hire
and purchase lets companies improve their earnings performance. Not just
beneficial to the hirer, this system is also the most effective and secure
form of credit sales for the current owner of the asset.
18.3 Legal Framework
There is no exclusive legislation dealing with hire purchase transactions in

India. The Hire purchase Act was passed in 1972. An Amendment bill was
introduced in 1989 to amend some of the provisions of the act. However,
the act has been enforced so far. The provisions of the act are not
inconsistent with the general law and can be followed as a guideline
particularly where no provisions exist in the general laws which, in the
absence of any specific law, govern the hire purchase transactions. The act
contains provisions for regulating: 1. the format/contents of the hire-
purchase agreement 2. warrants and the conditions underlying the hire-
purchase agreement, 3. ceiling on hire-purchase charges, 4. rights and
obligations of the hirer and the owner. In the absence of any specific law,
the hire purchase transactions are governed by the provisions of the Indian
Contract Act and the Sale of Goods Act. In the chapter relating to leasing
we have discussed the provisions related to Indian Contract Act, here we
will discuss the provisions of Sale of Goods Act.
! !330
18.4 Features and Characteristics of Hire Purchase:
Hire purchase (as per Hire Purchase Act 1972, India) is a typical
transaction in which the assets can be hired and the hirer is provided an
option to later purchase the same assets.
Following are the features of a regular hire purchase transaction:
• Rental payments are paid in instalments over the period of the

agreement.
• Each rental payment is considered as a charge for hiring the asset. This
means that, if the hirer defaults on any payment, the seller has all the
rights to take back the assets.
• All the required terms and conditions between both the parties involved
are documented in a contract called Hire-Purchase agreement.
• The frequency of the instalments may be annual, half-yearly, quarterly,

monthly, etc. as per the terms of the agreement.
• Assets are instantly delivered to the hirer as soon as the agreement is

signed.
• If the hirer uses the option to purchase, the assets are passed on to him
after the last instalment is paid.
• If the hirer does not want to own the asset, he can return the assets any
time and is not required to pay any instalment that falls due after the
return.
• However, once the hirer returns the assets, he cannot claim back any
payments already paid as they are the charges towards the hire and use
of the assets.
• The hirer cannot pledge, sell or mortgage the assets as he is not the
owner of the assets till the last payment is made.
• The hirer, usually, pays a certain amount as an initial deposit while

signing the agreement.
! !331
• Generally, the hirer can terminate the hire purchase agreement any time
before the ownership rights pass on to him.
18.5 Difference between Leasing and Hire Purchase
The lease is another popular way of financing your assets. However, the
following are the differences between leasing and hire purchase:
Points of Leasing Hire Purchase

Distinction
Ownership Lessor is the owner till the Hirer has the option of
end of the agreement purchasing the asset at the
end of the agreement
Duration Done for longer duration Done for shorter duration
Depreciation Lessor claims the Hirer claims the

depreciation depreciation
Payments Rental payments are the Payments include the
cost of using the asset principal amount and the
effective interest for the
duration of the agreement
Tax Impact Lease rentals categorized as Only interest component is

expenditure by the lessee categorized as expenditure
by the hirer
Extent of Financing Complete financing Partial financing
! !332
Repairs and Responsibility of the lessee Responsibility of the hirer

Maintenance in financial lease, and of the
lessor in operating lease
18.6 Advantages of Hire Purchase
Hire Purchase has the following advantages:
• Immediate use of assets without paying the entire amount.
• Expensive assets can be utilized as the payment is spread over a period.
• Fixed rental payments make budgeting easier as all the expenditures are
known in advance.
• Easy accessibility as it is a secured financing.
• No need to worry about the asset depreciating quickly in value as there is

no obligation to buy the asset.
18.7 Disadvantages of Hire Purchase
Hire Purchase suffers from the following disadvantages:
• Total amount paid towards the asset will be higher than the cost of the
asset.
• Long duration of the rental payments.
• Ownership only at the end of the agreement. The hirer cannot modify the
asset till then.
• The addition of any covenants increases the cost.
• If the hired asset is no longer needed because of any change in the

business strategy, there may be a resulting penalty.
! !333
Small scale companies and entrepreneurs can benefit from Hire Purchase.
Expensive and important assets can be hired and later owned. This ensures
that they can start using the asset from very first day and use the money
earned to later buy the same assets.
18.8 Hire purchase and leasing
Hire purchase (HP) or leasing is a type of asset finance that allows firms or
individuals to possess and control an asset during an agreed term, while
paying rent or instalments covering depreciation of the asset, and interest
to cover capital cost.
Assets are defined as anything of monetary value that is owned by a firm

or an individual. Assets listed on a firm’s balance sheet can include tangible
items such as inventories, equipment and real estate, as well as intangible
items such as property rights or goodwill.
Leases differ from term lending in that the lessee does not have ownership
rights to the asset. At the end of the lease contract, the lessee usually has
a choice of extending the lease, returning the asset, or introducing a buyer
for the asset. Some leasers are entitled to a refund of 95% of the sale
proceeds when they introduce a buyer. The refund amount will depend on
the contract between the original leaser and lessee.
HP is a financing solution suitable for businesses wishing to purchase

assets without paying the full value immediately. The customer pays an
initial deposit, with the remainder of the balance and interest paid over a
period of time. On completion, ownership of the asset transfers to the
customer.
It is important to note that the accounting and tax treatment of leases

varies according to the type of lease it is. For example, as a finance lease is
accounted for as a loan funding the asset, the tax treatment follows the
legal form of the transaction which is the hiring of an asset. More
specifically, the treatment of capital allowances differs, and tax treatment
should be taken into consideration when deciding how to finance an asset
purchase.
! !334
The use of HP or leasing is particularly common in industries where

expensive machinery is required, such as construction, manufacturing,
plant hire, printing, road freight, transport, engineering and professional
services.
It is also used to finance other capital requirements of a business, for

example:
• smaller items
• cars
• photocopiers.
The asset provider usually dictates this type of linked finance.
18.9 Cost of hire purchase
There are two main costs that need to be considered:
• interest rate charged for financing. Rates are favourable to assets with
higher resale value (i.e. machinery, agricultural equipment, vehicles
etc.). Assets that are considered ‘soft’ due to their low resale value (i.e.
printers, vending machines, office furniture etc.), will be given less
favourable rates
• fees charged by the financing company for loan processing and

administrative work meeting conditions. For example, a car purchased on
HP may need servicing at regular intervals and from a pre-approved
workshop.
18.10 Time frame and other options:
An HP or leasing facility can normally take up to a week to complete,

depending on the size and complexity of the deal. The right finance for
your business section of the site gives examples of financial structures that
are suitable for different trading types and sizes of business.
HP or leasing is a medium- to long-term solution to support the use of an

asset for a certain period of time. An alternative is a bank loan, which
allows firms to purchase an asset and have immediate ownership of it.
! !335
18.11 Hire Purchase Agreement
A hire purchase agreement is in many ways similar to a lease agreement,

in so far as the terms and conditions are concerned. The important clauses
in a hire purchase agreement are:
1. Nature of Agreement: Stating the nature, term and commencement

of the agreement.
2. Delivery of Equipment: The place and time of delivery and the hirer’s
liability to bear delivery charges.
3. Location: The place where the equipment shall be kept during the
period of hire.
4. Inspection: That the hirer has examined the equipment and is satisfied
with it.
5. Repairs: The hirer to obtain at his cost, insurance on the equipment

and to hand over the insurance policies to the owner.
6. Alteration: The hirer not to make any alterations, additions and so on

to the equipment, without prior consent of the owner.
7. Termination: The events or acts of hirer that would constitute a default

eligible to terminate the agreement.
8. Risk: Risk of loss and damages to be borne by the hirer.
9. Registration and fees: The hirer to comply with the relevant laws,
obtain registration and bear all requisite fees.
10.Indemnity clause: The clause as per Contract Act, to indemnify the

lender.
11.Stamp duty: Clause specifying the stamp duty liability to be borne by

the hirer.
12.Schedule: Schedule of equipment forming subject matter of

agreement.
! !336
13.Schedule of hire charges: The agreement is usually accompanied by

a promissory note signed by the hirer for the full amount payable under
the agreement including the interest and finance charges.
18.12 Summary
Hire purchase is a mode of financing the price of the goods to be sold on a

future date. In a hire purchase transaction, the goods are let on hire, the
purchase price is to be paid in instalments and hirer is allowed an option to
purchase the goods by paying all the instalments. Hire purchase is a
method of selling goods. In a hire purchase transaction, the goods are let
out on hire by a finance company (creditor) to the hire purchase customer
(hirer).
The buyer is required to pay an agreed amount in periodical instalments

during a given period. The ownership of the property remains with the
creditor and passes on to hirer on the payment of the last instalment. A
hire purchase agreement is defined in the Hire Purchase Act, 1972 as
peculiar kind of transaction in which the goods are let on hire with an
option to the hirer to purchase them, with the following stipulations:
a. Payments to be made in instalments over a specified period.
b. The possession is delivered to the hirer at the time of entering the

contract.
c. The property in goods passes to the hirer on payment of the last

instalment.
d. Each instalment is treated as hire charges so that if default is made in

payment of any instalment, the seller becomes entitled to take away the
goods, and
e. The hirer/purchaser is free to return the goods without being required to

pay any further instalments falling due after the return.
Small scale companies and entrepreneurs can benefit from Hire Purchase.
Expensive and important assets can be hired and later owned. This ensures
that they can start using the asset from very first day and use the money
earned to later buy the same assets.
! !337
Hire purchase involves a certain procedure, that is to say, modus operandi

to be followed. For this, an agreement called hire purchase agreement is
made in written between the parties involved in the hire purchase
transaction.
The agreement contains the following:
i. The hire purchase price of the goods to which the agreement relates;
ii. The cash price of the goods — the price at which the good is purchased
for cash;
iii. The date of the commencement of the agreement;
iv. The number and time interval of instalments by which the hire purchase
price is to be paid;
v. The name of goods, with its sufficient identity, to which the hire
purchase agreement relates;
vi. The amount to be paid, if any, at the time of signing the agreement;
vii.The signatures of the parties involved in transaction.
If the hire purchase transaction is financed by the manufacturer or dealer,

then two parties, called, hire vendor and hire purchaser, are involved in the
agreement. The hire purchase transaction is financed by some financial
institution, and then there are three parties involved in the transaction.
These are:
a. Hire Vendor,
b. Hire Purchaser, and
c. Financial Institution.
In such case, the vendor, firstly, receives the bills of exchange for hire
purchase price of the goods from the hirer. The vendor, then, discounts the
bills with the financial institution and, thus, gets payment for the goods
sold under hire purchase system. The financial institution collects the
payments of the bills from the hirer, as and when the instalments fall due.
! !338
Three Party Hire Purchase
Hire-purchase transaction benefits all parties involved in it. While it

increases vendor’s sales, it enables the hire purchaser to make use of
costly machinery, equipment, etc., without making full payment on the
date of signing the agreement. After making the payment of the last
instalment, the hire purchaser also acquires the ownership of the goods
purchased under hire-purchase system.
Small scale firms can acquire industrial machinery, office equipment,

vehicles, etc., without making full payment through hire purchase. With the
help of assets acquired through hire purchase they can produce and sell.
From the earnings, payments can easily be made in instalments. Ultimately
the ownership of assets can be acquired.
Hire Purchase is an important source of financing in recent times. It

provides a convenient way to afford and acquire assets that otherwise
might be financially unattainable. Thus, hire purchase also helps a nation’s
economy to grow further. However, before entering an agreement, one
should clearly understand the costs involved and the disclosures provided.
18.13 Questions
1. What is Hire purchase? Define.
2. What are the characteristics of Hire Purchase Financing? Explain.
3. Write short notes on legal frame work of Hire purchase.
4. What are the terms included in Hire purchase agreement? Explain.
5. Explain in brief Advantages and disadvantages of Hire purchase.
! !339

alternatives)
1. Hire Purchase is defined as an agreement in which the _____________

lets them on hire for regular instalments paid by the hirer.
a. Buyer of the assets
b. Owner of the assets
c. Seller of the assets
d. Anyone holding the assets
2. Each rental payment is considered as a _____________ this means

that, if the hirer defaults on any payment, the seller has all the rights to
take back the assets.
a. Possession
b. charge for hiring the asset
c. partial acquisition
d. ultimate purchase
3. The hire purchase agreement is usually accompanied by a

_____________ signed by the hirer for the full amount payable under
the agreement including the interest and finance charges.
a. promissory note
b. bill of exchange
c. hundi
d. document pertaining to assets
4. “Hire purchase (HP) or leasing is a type of asset finance that allows

firms or individuals to possess and control an asset during an agreed
term, while paying rent or instalments covering depreciation of the
asset, and interest to cover capital cost” _____________ True or false
a. True
b. False
! !340
5. If the hire purchase transaction is financed by the manufacturer or

dealer, then _____________ are involved in the agreement. The hire
purchase transaction is financed by some financial institution, and then
there are three parties involved in the transaction. These are:
a. Hire Vendor,
b. Hire Purchaser
c. Financial Institution
d. Hire vendor and hire purchaser
Answers: 1. (b), 2. (b), 3. (a), 4. (a), 5. (d)
! !341
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !342
LEASE FINANCING
Chapter 19
Lease Financing
Objectives
the Concept of Lease finance, Regulations related to leasing, its legal
structure, difference in leasing & hire purchase, other characteristic
features of lease finance.
Structure:
19.1 Introduction
19.2 What is Leasing?
19.3 History and Developments of Leasing
19.4 Types of Lease
19.5 Advantages of Leasing
19.6 Disadvantages of Leasing
19.7 Accounting Problem in Leasing
19.8 Future of Lease Financing in India
19.9 Summary
19.10 Questions
! !343
LEASE FINANCING
19.1 Introduction
Financial Services basically mean all those kinds of services provided in

financial terms where the essential commodity is money. These services
include: leasing, hire purchase, consumer credit, investment banking,
commercial banking, venture capital, insurance, credit rating, bill
discounting, and mutual funds, stock broking, housing finance, vehicle
finance, mortgages and car loans, factoring among other things. Various
entities that provide these services are basically categorized into (a) Non-
Banking Finance Companies, (b) Commercial Banks, and (c) Merchant
Banks. Financial Services in India are too vast and varied too have evolved
at one place and at one time. One of the main entities that offer financial
services in India is Non-Banking Finance Companies. These NBFCs
registered with the Reserve Bank of India mainly perform fund-based
services to the customer. Fund-based services of NBFCs include: leasing,
hire-purchase and other asset-based services, whereas fee-based services
of NBFCs include bill discounting, portfolio management and other advisory
services.
Leasing was prevalent during the ancient Sumerian and Greek civilizations
where leasing of land, agricultural implements, animals, mines, and ships
took place. The practice of leasing came into being sometime in the latter
half of the 19th century where the railroad manufacturers in the U.S.A.
resorted to leasing of rail cars and locomotives. The equipment leasing
industry came into existence since 1973 when the first leasing company,
appropriately named as “First Leasing” This industry however remained
relegated to the background until the early eighties, because the need for
these industries was not strongly felt in industry. The public sector financial
institutions – IDBI, IFCI, ICICI and the State Financial Corporations (SCFs)
provided bulk of the term loans and the commercial banks provided
working capital finance required by the manufacturing sector on relatively
soft terms. Given the easy availability of funds at reasonable cost, there
was obviously no need to look for alternative means of financing.
The credit squeeze announced by the R.B.I. coupled with the strict
implantation of the Tandon & Chore committees’ norms on Maximum
Permissible Bank finance(MPBF) for working capital forced the
manufacturing companies to divert a portion of their long-term funds for
their working capital.
! !344
LEASE FINANCING
19.2 What is Leasing?
Leasing as Financial Service is a contractual agreement where the owner

(lessor) of equipment transfers the right to use the equipment to the user
(lessee) for an agreed period in return of the rental. At the end of the lease
period the asset reverts to the lessor unless there is a provision for the
renewal of the contractor. There is a provision for the transfers of
ownership to the lessee. If there is any such provision for transfer of
ownership, the deal is treated as hire purchase. Therefore, lease could be
generally defined as:
“A contract where a party being the owner (lessor) of an asset (leased

asset) provides the asset for use by the lessee at a consideration (rentals),
either fixed or dependent on any variables, for a certain period (lease
period), either fixed or flexible, with an understanding that at the end
of such period, the asset, subject to embedded option of the lease, will be
either returned to the lessor or disposed-off as per lessor’s instructions.”
19.3 History and developments of leasing
The history of leasing dates back to 200 BC when Sumerians leased goods.
Romans had developed a full body law relating to lease for movable and
immovable property. However, the modern concept of leasing appeared for
the first time in 1877 when the Bell Telephone Company began renting
telephones in the USA. In 1832, Cottrell and Leonard leased academic
caps, grown and hoods. Subsequently, during 1930s the Railway Industry
used leasing service for its rolling stock needs. In the post-war period, the
American Airlines leased their jet engines for most of the new aircrafts.
This development ignited immediate popularity for the lease and generated
growth of leasing industry.
The concept of financial leasing was pioneered in India during 1973. The
First Company was set up by the Chidambaram group in 1973 in Madras.
The company undertook leasing of industrial equipment as its main activity.
The Twentieth Century Leasing Company Limited was established in 1979.
By 1981, four finance companies joined the fray. The performance of First
Leasing Company Limited and the Twentieth Century Leasing Company
Limited motivated others to enter the leasing industry. In 1980s financial
institutions made entry into the leasing business. Industrial Credit and
Investment Corporation was the first all India financial institution to offer
! !345
LEASE FINANCING
leasing in 1983. Entry of commercial banks into leasing was facilitated by

an amendment of Banking Regulations Act, 1949. State Bank of India was
the first commercial bank to set up a leasing subsidiary, SBI capital
market, in October 1986. CanBank Financial Services., BOB Financial
Service Ltd., and PNB Financial Services Limited followed suit. Industrial
Finance Corporation’s Merchant Banking division started financing leasing
companies as well as equipment leasing and financial services.
19.4 Types of lease
Virtually, all financial lease agreements fall into one of the four types of
lease financing. A certain variation in the elements of lease classifies lease
into different types. Such elements are as follows:
• The degree of ownership risk and rewards transferred to the lessee.

• No. of parties involved
• Location of lessor, lessee and the equipment supplier
• The lessor and the lessee
Here, risk means the chance of technological obsolescence and reward

refers to the cash flow generated from the use of equipment and the
residual value of the equipment.
The four major types of Lease agreements are as under:
1. Capital Lease
This is also called ‘financial lease’. A capital lease is a long-term

arrangement which is non-cancellable. The lessee is obligated to pay lease
rent till the expiry of lease period. The period of lease agreement generally
corresponds to the useful life of the asset concern.
! !346
LEASE FINANCING
Finance lease, also known as Full Pay-out Lease, is a type of lease wherein
the lessor transfers substantially all the risks and rewards related to the
asset to the lessee. Generally, the ownership is transferred to the lessee at
the end of the economic life of the asset. Lease term is spread over the
major part of the asset life. Here, a lessor is only a financier. An example of
a finance lease is big industrial equipment.
A long-term lease in which the lessee must record the leased item as an
asset on his/her balance sheet and record the present value of the lease
payments as debt. Additionally, the lessor must record the lease as a sale
on his/her own balance sheet. A capital lease may last for several years
and is not cancellable. It is treated as a sale for tax purposes.
2. Operating Lease
Contrary to capital lease, the period of operating lease is shorter and it is

often cancellable at the option of lessee with prior notice. Hence, operating
lease is also called as an ‘Open end Lease Arrangement.’ The lease term is
shorter than the economic life of the asset. Thus, the lessor does not
recover its investment during the first lease period. Some of the examples
of operating lease are leasing of copying machines, certain computer
hardware, word processors, automobiles, etc.
In operating lease, risk and rewards are not transferred completely to the
lessee. The term of a lease is very small compared to the finance lease.
The lessor depends on many different lessees for recovering his cost.
Ownership along with its risks and rewards lies with the lessor. Here, a
lessor is not only acting as a financier but he also provides additional
services required in the course of using the asset or equipment. An
example of an operating lease is music system leased on rent with the
respective technicians.
There is some criticism too labelled against capital leasing and operating
leasing. Let us take the arguments given by the proponents and opponents
regarding the two types of equipment leasing. It is argued that a firm
knowing about the possible obsolescence of high technology equipment
may not want to purchase any equipment. Instead, it will prefer to go for
operating lease to avoid the possible risk of obsolescence. There is one
difference between an operating lease and capital/financial lease.
! !347
LEASE FINANCING
Operating lease is short-term and cancellable by the lessee. It is also called

as an ‘Open end Lease Agreement’. In case of a financial lease, the risk of
equipment obsolescence is shifted to the lessee rather than on the lessor.
The reason is that it is a long-term and non-cancellable agreement or

contract. Hence, lessee is required to make rental payments even after
obsolescence of equipment. On the other hand, it is said that in operating
lease, the risk of loss shifts from lessee to lessor.
This reasoning is not correct because if the lessor is concerned about the
possible obsolescence, he will certainly compensate for this risk by
charging higher lease rentals. As a matter of fact, it is more or less a ‘war
of wits’ only.
3. Sale and Lease-back
It is a sub-part of finance lease. Under a sale and lease-back arrangement,

a firm sells an asset to another party who in turn leases it back to the firm.
The asset is usually sold at the market value on the day. The firm, thus,
receives the sales price in cash, on the one hand, and economic use of the
asset sold, on the other.
Yes, the firm is obliged to make periodic rental payments to the lessor. Sale
and lease-back arrangement is beneficial for both lessor and lessee. While
the former gets tax benefits due to depreciation, the latter has immediate
cash inflow which improves his liquidity position.
In fact, such arrangement is popular with companies facing short-term

liquidity crisis. However, under this arrangement, the assets are not
physically exchanged but it all happens in records only.
This is nothing but a paper transaction. Sale and lease-back transaction is

suitable for those assets, which are not subjected to depreciation but
appreciation, say for example, land.
4. Leveraged Leasing
A special form of leasing has become very popular in recent years. This is
known as Leveraged Leasing. This is popular in the financing of “big-ticket”
assets such as aircrafts, oil rigs and railway equipment. In contrast to
! !348
LEASE FINANCING
earlier mentioned three types of leasing, three parties are involved in case
of leveraged lease arrangement – Lessee, Lessor and the lender.
Leveraged lease has three parties – lessor, lessee and the financier or
lender. Equity is arranged by the lessor and debt is financed by the lender
or financier. Here, there is a direct connection of the lender with the lessee
and in a case of default by the lessor, the lender is also entitled to receive
money from the lessee. Such transactions are generally routed through a
trustee.
Leveraged leasing can be defined as a lease arrangement in which the

lessor provides an equity portion (say 25%) of the leased asset’s cost and
the third-party lenders provide the balance of the financing. The lessor, the
owner of the asset is entitled to depreciation allowance associated with the
asset.
Leases are classified into different types based on the variation in the
elements of a lease. Very popularly heard leases are financial and
operating leases. Apart from these, there are sale and lease-back and
direct lease, single investor lease and leveraged lease, and domestic and
international lease.
A lease is a very important financing option for an entrepreneur with no or

inadequate money for financing the initial investment required in plant and
machinery. In a lease, the lessor finances the asset or equipment and the
lessee uses it in exchange of fixed lease rentals. In other words, lease
financing is an arrangement where the lessee who requires the equipment
or machinery gets the finance from the lessor for the agreed rental
payments. Such kind of lease is called finance lease. There are many such
arrangements and hence, there are many types of lease. Let us have a
look at the different kinds of lease.
There are some other types of lease also. Such as…
• Sale and Lease-Back and Direct Lease
In the arrangement of sale and lease-back, the lessee sells his asset or
equipment to the lessor (financier) with an advanced agreement of leasing
back to the lessee for a fixed lease rental per period. It is exercised by the
! !349
LEASE FINANCING
entrepreneur when he wants to free his money, invested in the equipment

or asset, to utilize it at whatsoever place for any reason.
On the other hand, a direct lease is a simple lease where the asset is either
owned by the lessor or he acquires it. In the former case, the lessor and
equipment supplier are one and the same person and this case is called
‘bipartite lease’. In a bipartite lease, there are two parties. Whereas, in the
latter case, there are three different parties viz., equipment supplier, lessor,
and lessee and it is called tripartite lease. Here, equipment supplier and
lessor are two different parties.
• Single Investor Lease

In single investor lease, there are two parties – lessor and lessee. The
lessor arranges the money to finance the asset or equipment by way of
equity or debt. The lender is entitled to recover money from the lessor only
and not from the lessee in case of default by a lessor. Lessee is entitled to
pay the lease rentals only to the lessor.
• Domestic and International Lease

When all the parties to the lease agreement reside in the same country, it
is called domestic lease.
• The International lease

It is of two types – Import Lease and Cross-Border Lease. When lessor and
lessee reside in the same country and equipment supplier stays in the
different country, the lease arrangement is called import lease. When the
lessor and lessee are residing in two different countries and no matter
where the equipment supplier stays, the lease is called cross-border lease.
Leasing is becoming a preferred solution to resolve fixed asset

requirements vs. purchasing the asset. While evaluating this investment, it
is essential for the owner of the capital to understand whether leasing
would yield better returns on capital or not. Let us have a look at leasing
advantages and disadvantages:
! !350
LEASE FINANCING
19.5 Advantages of Leasing
1. Balanced Cash Outflow: The biggest advantage of leasing is that cash

outflow or payments related to leasing are spread out over several
years, hence saving the burden of one-time significant cash payment.
This helps a business to maintain a steady cash-flow profile.
2. Quality Assets: While leasing an asset, the ownership of the asset still
lies with the lessor whereas the lessee just pays the rental expense.
Given this agreement, it becomes plausible for a business to invest in
good quality assets which might look unaffordable or expensive
otherwise.
3. Better Usage of Capital: Given that a company chooses to lease over

investing in an asset by purchasing, it releases capital for the business
to fund its other capital needs or to save money for a better capital
investment decision.
4. Tax Benefit: Leasing expense or lease payments are considered as

operating expenses, and hence, of interest, are tax deductible.
5. Off-Balance Sheet Debt: Although lease expenses get the same

treatment as that of interest expense, the lease itself is treated
differently from debt. Leasing is classified as an off-balance sheet debt
and doesn’t appear on a company’s balance sheet.
6. Better Planning: Lease expenses usually remain constant for over the
asset’s life or lease tenor, or grow in line with inflation. This helps in
planning expense or cash outflow when undertaking a budgeting
exercise.
7. Low Capital Expenditure: Leasing is an ideal option for a newly set-up

business given that it means lower initial cost and lower CapEx
requirements.
8. No Risk of Obsolescence: For businesses operating in the sector,

where there is a high risk of technology becoming obsolete, leasing
yields great returns and saves the business from the risk of investing in
a technology that might soon become out-dated. For example, it is ideal
for the technology business.
! !351
LEASE FINANCING
9. Termination Rights: At the end of the leasing period, the lessee holds
the right to buy the property and terminate the leasing contract, this
providing flexibility to business.
19.6 Disadvantages of Leasing
1. Lease Expenses: Lease payments are treated as expenses rather than

as equity payments towards an asset.
2. Limited Financial Benefits: If paying lease payments towards a land,

the business cannot benefit from any appreciation in the value of the
land. The long-term lease agreement also remains a burden on the
business as the agreement is locked and the expenses for several years
are fixed. In a case when the use of asset does not serve the
requirement after some years, lease payments become a burden.
3. Reduced Return for Equity Holders: Given that lease expenses

reduce the net income without any appreciation in value, it means
limited returns or reduced returns for an equity shareholder. In such
case, the objective of wealth maximization for shareholders is not
achieved.
4. Debt: Although lease doesn’t appear on the balance sheet of a

company, investors still consider long-term lease as debt and adjust
their valuation of a business to include leases.
5. Limited Access of Other Loans: Given that investors treat long-term

leases as debt, it might become difficult for a business to tap capital
markets and raise further loans or other forms of debt from the market.
6. Processing and Documentation: Overall, to enter into a lease

agreement is a complex process and requires thorough documentation
and proper examination of an asset being leased.
7. No Ownership: At the end of leasing period the lessee doesn’t end up

becoming the owner of the asset though quite a good sum of
payment is being done over the years towards the asset.
8. Maintenance of the Asset: The lessee remains responsible for the

maintenance and proper operation of the asset being leased.
! !352
LEASE FINANCING
9. Limited Tax Benefit: For a new start-up, the tax expense is likely to
be minimal. In these circumstances, there is no added tax advantage
that can be derived from leasing expenses.
19.7 Accounting Problem in Leasing
The Indian leasing companies are following a variety of lease accounting

practices. Lessees neither show the leased assets on the asset side nor
the future lease rental obligations as liabilities. Therefore, the lease
transaction seems to be an off-balance sheet transaction. Lessors show
the leased assets as owned assets in their balance sheets, even though
they lose the economic possession of assets by making finance lease.
The first flaw is reporting the lease income in the financial statements. It
is evident from the examination of books that the accounting practices of
various leasing companies have been far from uniform and consistent. The
leasing companies are not amortising the value of the leased asset during
the primary lease period (period in which leasing companies recovered
more than 95 per cent of the asset value). Instead of amortising the full
equipment cost, leasing companies are debiting a small part of the leased
asset’s cost by way of straight-line depreciation in the books of accounts.
The depreciation is being shown for more than eight years, even though
there would not be any income through the asset. Hence, in such a case,
the basic accounting concept of matching the cost with revenue is totally
ignored.
The second flaw lies in showing the leased assets in the balance-sheet.
Different leasing companies have adopted a variety of methods and there
is no consistency in the presentation of accounts. It is interesting to note
that the method of providing depreciation is also different from that of the
owned assets. Leasing companies are following written down value
methods of depreciation for owned assets and straight line method for
leased assets.
The recent amendment to the Companies Act, 1956, ensures that all the
companies including leasing companies, should follow accrual system of
accounting. This will cause unnecessary hardship to the leasing companies.
However, there is disagreement in the treatment of depreciation
allowances, possessions of assets under the Income-tax Act, 1961, and the
Indian Companies Act, 1956. There is thus a strong discontentment
! !353
LEASE FINANCING
among leasing companies regarding the accounting treatment in their

financial statements.
19.8 Future of Lease Financing in India
Lease financing in India has come a long way, but the journey is far from
over. No doubt, leasing has grown by leaps and bounds in the eighties but
it is estimated that hardly 1% of the industrial investment in India is
covered by the lease finance, as against 40% in the USA and 30% in UK
and 10% in Japan.
The prospects of leasing in India are good due to growing investment

needs and scarcity of funds with public financial institutions. In view of its
growing popularity, there is no denying the fact that leasing business has
good prospects in India.
At the same time, there are certain difficulties or challenges before the
leasing industry to overcome. At present, the leasing industry is growing in
almost regulatory vacuum. But, the regulation of these companies is
necessary not only to protect the funds of the public and the banks, but
also to place the leasing industry on a sound footing. These are found
urgently wanting.
The present era is known as the “survival of the fittest”. So is leasing

industry also. With the ascent of specialisation as the key to success, it is
high time for leasing industry also to reorient itself to the very needs of the
market and lay its sole emphasis on market responsiveness. This is what is
called professional outlook.
In this context, a case in point is that of “Standard Medical Leasing

Limited” which specialises only in leasing out medical and allied equipment.
Admittedly, such specialisation will go a long way in building up public
confidence leading to toned up company image on a sound footing.
Last. but no means the least, the past success does not guarantee the
future prosperity. Growth and success in leasing business require well-
planned marketing efforts in identifying a suitable and realistic lease
proposal and properly educating the clients on the pros and cons
modalities of a lease agreement. In the final analysis, like in product
marketing, it is here also the total consumer (clientele) satisfaction which
! !354
LEASE FINANCING
should become the core focus of concern and attention for the leasing
industry to grow in future.
19.9 Summary
A finance lease or capital lease is a type of lease in which a finance

company is typically the legal owner of the asset during the duration of the
lease, while the lessee not just has operating control over the asset, but
also has a substantial share of the economic risks and returns from the
change in the valuation of the underlying asset.
More specifically, it is a commercial arrangement where:
• the lessee (customer or borrower) will select an asset (equipment,

vehicle, software);
• the lessor (finance company) will purchase that asset;
• the lessee will have use of that asset during the lease;
• the lessee will pay a series of rentals or instalments for the use of that
asset;
• the lessor will recover a large part or all of the cost of the asset plus earn
interest from the rentals paid by the lessee;
• the lessee has the option to acquire ownership of the asset (e.g. paying
the last rental, or bargain option purchase price);
Finance lease is one in which risk and rewards incidental to the ownership
of the leased asset are transferred to lessee but not the actual ownership.
Thus, in case of finance lease we can say that notional ownership is passed
to the lessee. The amount paid as interest during lease period is shown in
P/l DR side of lessee. It's not cancelable.
The lessor may or may not bear the cost of insurance, repairs,
maintenance etc. Usually, the lessee must bear all cost. The lessor may
transfer ownership of the asset to the lessee by the end of the lease term.
The lessee has an option to purchase the asset at a price which is expected
to be sufficiently lower than the value at the end of the lease period.
! !355
LEASE FINANCING
Presently, leases in India are generally small-ticket leases. The equipment

ordinarily leased are plants and machinery; however, the important
potential markets are heavy plant and machinery, ships, aircrafts,
satellites, data processing equipment, trucks, chemical plants, high-tech
equipment by means of import leasing, leveraged leasing, and vendor
leasing. Leasing has also plenty of scope in the service sectors, such as
developing the transportation and communication industries. Recently, the
Motor Vehicles Act has been amended for incorporating the interest of the
lessor in the registration certificate. This was a long-awaited demand of
the industry, and the government has done well in recognising the
importance of the leasing industry in developing the transport sector. This
will help increase the vehicle leasing for transport and non-transport
industry. The electronic and technological revolution sweeping the office
automation and data processing would create ample scope for leasing.
Leasing is a service industry as it provides funds and also taps the capital
market. It supplements the government’s developmental plan by
supplying equipment to the industry. The Eight plan's projections, coupled
with the flexible government policies towards industry, modernisation and
expansion of capabilities and the emphasis on technological upgradation
augurs well for the prospects of leasing.
Leasing is a growing industry. It is seen that leasing has grown in the latter
80s, and is still growing. It is, however, worth noting that despite good
prospects for leasing, many existing private sector leasing companies do
not find a place in the market; only a few leaders from the private sector,
besides the public sector, remain in the fray. This shows that the leasing
industry needs full support, co-operation, and encouragement of the
government. At the same time, regulatory framework is essential to
control its mushroom growth and irregularities, and to ensure a healthy
growth. It is expected that a substantial number of manufacturers of
many types of equipment may set up their leasing operations either as an
integral part of the parent company or through a subsidiary to sell their
products. If the leasing industry continues to be innovative, it will find a
ready market for the service it must offer.
! !356
LEASE FINANCING
19.10 Questions
(A)Answer the following questions:
1. What is leasing? Define.

2. What are the characteristics of lease Financing? Explain.
3. Write short notes on types of lease.
4. What is accounting problem of leasing? Explain.
5. Explain in brief Advantages and disadvantages of lease finance.
(B) Multiple Choice Questions: (Mark X against the most

appropriate alternatives)
1. There are Certain variation in the elements of lease classifies lease into
different types. Such elements are _____________.
a. The degree of ownership risk and rewards transferred to the lessee.
b. No. of parties involved, lessor and the lessee
c. Location of lessor, lessee and the equipment supplier
d. All of the above
2. Please arrange in which the lessor provides an equity portion (say 25%)
of the leased asset’s cost and the third-party lenders provide the
balance of the financing is called as _____________.
a. Capital lease
b. Operating lease
c. Leveraged lease
d. Sale and Lease-back
3. Lease expenses usually remain constant for over the asset’s life or lease
tenor, or grow in line with _____________.
a. Inflation
b. Capital increase
c. Cash Flow
d. Taxation changes
! !357
LEASE FINANCING
4. “Given that lease expenses reduce the net income without any
appreciation in value, it means limited returns or reduced returns for an
equity shareholder. In such case, the objective of wealth maximization
for shareholders is not achieved” _____________True or false.
a. True
b. False
5. The prospects of leasing in India are good due to _____________ with

public financial institutions.
a. growing investment needs
b. scarcity of funds
c. both a and b
d. controlled inflation
Answers: 1. (d), 2. (c), 3. (a), 4. (a), 5. (c)
! !358
LEASE FINANCING
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !359
LONG-TERM FINANCE AND SMALL BUSINESS FINANCE
Chapter 20
Long-Term Finance And Small Business
Finance
Objectives
After studying this lesson, you will be able to identify the various sources of
long-term finance; explain the meaning and importance of capital market;
identify the special financial institutions in India; describe the nature and
role of special financial institutions; explain the concept of mutual funds;
describe the role of leasing companies; identify the foreign sources of long-
term finance; explain the importance of retained earnings as a source of
long-term finance and various ways to raise finance for small loans and
also as start-ups.
Structure:
20.1 Introduction
20.2 Long-Term Financing
20.3 Sources of Long-Term Financing
20.4 Small Business Loans
20.5 Sources of Finance
20.6 Summary
20.7 Questions
! !360
20.1 Introduction
The sources of long-term finance refer to the institutions or agencies from,

or through which finance for a long period can be procured. As stated
earlier, in case of sole proprietary concerns and partnership firms, long-
term funds are generally provided by the owners themselves and by the
retained profits. But, in case of companies whose financial requirement is
rather large, the following are the sources from, or through which long-
term funds are raised.
a. Capital Market
b. Special Financial Institutions
c. Mutual Funds
d. Leasing Companies
e. Foreign Sources
f. Retained Earnings
It is a common method adopted by companies for meeting short-term

financial requirements. Cash credit refers to an arrangement whereby the
commercial bank allows money to be drawn as advances from time to time
within a specified limit. This facility is granted against the security of goods
in stock, or promissory notes bearing a second signature, or other
marketable instruments like Government bonds. Overdraft is a temporary
arrangement with the bank which permits the company to overdraw from
its current deposit account with the bank up to a certain limit. The
overdraft facility is also granted against securities. The rate of interest
charged on cash credit and overdraft is relatively much higher than the
rate of interest on bank deposits.
PART-A
20.2 Long-Term Financing
Funding obtained for a time frame exceeding one year in duration. When a
business borrows from a bank using long-term finance methods, it expects
to pay back the loan over more than a one year period. For example, this
might include making payments on a 20-year mortgage. Another long-term
finance example would be issuing stock.
! !361
As the name suggests, Long-term financing is a form of financing that is

provided for a period of more than a year. Long-term financing services are
provided to those business entities that face a shortage of capital. There
are various long-term sources of finance. It is different from short-term
financing which is normally used to provide money that has to be paid back
within a year. The period may be shorter than one year as well.
Examples of long-term financing include – a 30 year mortgage or a 10-year

Treasury note. Equity is another form of long-term financing, such as when
a company issues stock to raise capital for a new project.
20.2.1 Purpose of Long-Term Finance
• To finance fixed assets.

• To finance the permanent part of working capital.
• Expansion of companies.
• Increasing facilities.
• Construction projects on a big scale.
• Provide capital for funding the operations. This helps in adjusting
the cash flow.
20.2.2 Factors determining Long-term Financial Requirements
• Nature of Business
• Nature of Goods produced
• Technology used
20.2.3 Types of Long-Term Financing
The kind of long-term financing that is provided to a company depends on

its type. For example, the long-term financing that is provided to a solo
proprietorship is different from the one received by a partnership firm.
20.2.4 Uses of Long-Term Financing
Long-term financing is used in separate ways by different types of business

entities. The business entities that are not corporations are only supposed
to use long-term financing for the purpose of debt. However, the
corporations can use long-term financing for both debt
and equity purposes.
! !362
20.3 Sources of Long-Term Financing
There are various sources of finance such as equity, debt, debentures,

retained earnings, term loans, working capital loans, letter of credit, euro
issue, venture funding etc. These sources are useful in different situations.
They are classified based on time period, ownership and control, and their
source of generation.
Sources of finance are the most explored area especially for the
entrepreneurs about to start a new business. It is perhaps the toughest
part of all the efforts. There are various sources of finance classified based
on time period, ownership and control, and source of generation of finance.
Having known that there are many alternatives of finance or capital a

company can choose from, choosing right source and the right mix of
finance is a key challenge for every finance manager. The process of
selecting right source of finance involves in-depth analysis of each and
every source of finance. For analysing and comparing the sources of
finance, it is required to understand all characteristics of the financing
sources. There are many characteristics on the basis of which sources of
finance are classified.
Sources of Finance — Equity Share, Euro Issue, Debentures, Trade Credit,

Preference Shares, Lease Finance based on a time period, sources are
classified into long-term, medium-term, and short-term. Ownership and
control classify sources of finance into owned capital and borrowed capital.
Internal sources and external sources are the two sources of generation of
! !363
capital. All the sources of capital have different characteristics to suit

different types of requirements. Let’s understand them in a little depth.
20.3.1 According to Time period
Sources of financing a business are classified based on the time period for
which the money is required. Time is commonly classified into following
three:
(A) Long-Term Sources of Finance
Long-term financing means capital requirements for a period of more than

5 years to 10, 15, 20 years or maybe more depending on other factors.
Capital expenditures in fixed assets like plant and machinery, land and
building etc. of a business are funded using long-term sources of finance.
Part of working capital which permanently stays with the business is also
financed with long-term sources of finance. Long-term financing sources
can be in the form of any of them:
• Share Capital or Equity Shares

• Preference Capital or Preference Shares
• Retained Earnings or Internal Accruals
• Debenture/Bonds
• Term Loans from Financial Institutes, Government, and Commercial
Banks
• Venture Funding
• Asset Securitization
• International Financing by way of Euro Issue, Foreign Currency Loans,
ADR, GDR etc.
(B) Medium-Term Sources of Finance
Medium-term financing means financing for a period of 3 to 5 years.

Medium-term financing is used generally for two reasons. One, when long-
term capital is not available for the time being and second, when deferred
revenue expenditures like advertisements are made which are to be written
off over a period of 3 to 5 years. Medium-term financing sources can in the
form of one of these:
! !364
• Preference Capital or Preference Shares

• Debenture/Bonds
• Medium-Term Loans from
• Financial Institutes
• Government, and Commercial Banks
• Lease Finance/Hire Purchase Finance
(C) Short-Term Sources of Finance
Short-term financing means financing for a period of less than 1 year. Need
for short-term finance arises to finance the current assets of a business like
an inventory of raw material and finished goods, debtors, minimum cash
and bank balance etc. Short-term financing is also named as working
capital financing. Short-term finances are available in the form of:
• Trade Credit
• Short-Term Loans like Working Capital Loans from Commercial Banks
• Fixed Deposits for a period of 1 year or less
• Advances received from customers
• Creditors
• Payables
• Factoring Services
• Bill Discounting etc.
20.3.2 According to Ownership and Control
Sources of finances are classified based on ownership and control over the
business. These two parameters are an important consideration while
selecting a source of finance for the business. Whenever we bring in
capital, there are two types of costs – one is interest and another is
sharing of ownership and control. Some entrepreneurs may not like to
dilute their ownership rights in the business and others may believe in
sharing the risk.
(A)Owned Capital
Owned capital is also referred to as equity capital. It is sourced from

promoters of the company or from the general public by issuing new equity
shares. Business is started by the promoters by bringing in the required
capital for a start-up. Owner’s capital is sourced from following sources:
! !365
• Equity Capital
• Preference Capital
• Retained Earnings
• Convertible Debentures
• Venture Fund or Private Equity
Further, when the business grows and internal accruals like profits of the
company are not enough to satisfy financing requirements, the promoters
have a choice of selecting ownership capital or non-ownership capital. This
decision is up to the promoters. Still, to discuss, certain advantages of
equity capital are as follows:
• It is a long-term capital which means it stays permanently with the

business.
• There is no burden of paying interest or instalments like borrowed

capital. So, the risk of bankruptcy also reduces. Businesses in infancy
stages prefer equity capital for this reason.
(B) Borrowed Capital
Borrowed capital is the capital arranged from outside sources. These

include the following:
• Financial institutions,
• Commercial banks or
• The public in case of debentures.
In this type of capital, the borrower has a charge on the assets of the
business which means the borrower would be paid by selling the assets in
case of liquidation. Another feature of borrowed capital is regular payment
of fixed interest and repayment of capital. Certain advantages of borrowing
capital are as follows:
• There is no dilution in ownership and control of business.
• The cost of borrowed funds is low since it is a deductible expense for

taxation purpose which ends up saving on taxes for the company.
• It gives the business a leverage benefit.
! !366
20.3.3 According to Source of generation
(A) Internal Sources
Internal source of capital is the capital which is generated internally from

the business. Internal sources are as follows:
• Retained profits
• Reduction or controlling of working capital
• Sale of assets etc.
The internal source has the same characteristics of owned capital. The best
part of the internal sourcing of capital is that the business grows by itself
and does not depend on outside parties. Disadvantages of both equity
capital and debt capital are not present in this form of financing. Neither
ownership is diluted nor fixed obligation/bankruptcy risk arises.
(B) External Sources
An External source of finance is the capital which is generated from outside

the business. Apart from the internal sources finance, all the sources are
external sources of capital.
Deciding the right source of finance is a crucial business decision taken by

top-level finance managers. The wrong source of finance increases the cost
of funds which in turn would have a direct impact on the feasibility of
project under concern. Improper match of the type of capital with business
requirements may go against the smooth functioning of the business. For
instance, if fixed assets, which derive benefits after 2 years, are financed
through short-term finances will create cash flow mismatch after one year
and the manager will again have to look for finances and pay the fee for
raising capital again.
! !367
PART-B:
20.4 Small Business Loans
Acquiring financing to grow your small business can be a challenge, but is

achievable if you plan. Before you get started with loan applications you
must have a solid understanding and justification for why you need a loan
for your business. You cannot walk into the bank and simply ask for more
money because you feel you need it. Take a hard look at your business'
financial situation and be prepared to defend your reasoning on why you
need a loan. A bank will be hesitant to throw good money after bad, so if
your business is losing money hand over fist they probably won't be willing
to lend to you.
(A) Types of Small Business Loans
Business loans are used for specific reasons: buying equipment or renting
space to operate, financing growth of an already proven business, or
providing capital to expand.
• Term Loans
If your business needs a sum of money to buy equipment or real estate up

front, you need a term loan. This is a loan set to terms, meaning there is a
set interest rate, down payment or collateral, monthly payments, and a
term of months or years that consistent payments will be made through.
Businesses in the start-up phase must provide a lot of documentation,

business planning, and personal collateral for a bank to be willing to risk
lending the funds to your new business. Operations in the growth and
expansion stage typically see better results because they have consistent
profits or rising sales to prove they have a good chance of repaying the
loan.
• Lines of Credit
A different type of lending is done through a line of credit. Just like you can
tap the equity in your home to finance a purchase, a bank can lend against
the value of something in your business as collateral to help finance your
operations. Lines of credit are usually more fluid since you may not need to
use the maximum of what you can borrow.
! !368
• Factoring
Accounts receivable factoring is an interesting type of lending where the
factoring company buys your accounts receivable amounts and proceeds to
collect on them in the future under the normal terms. You could sell your
accounts receivable for 97% of their value, and the factoring company
earns the 3% as they are paid by the customers that owe you money.
Factoring is a different way of going about getting access to capital, but it

can be quite costly with your AR being worth anywhere from 95% to 98%
of its value in a month. When you add up the discount the factoring
company gets over a year, the "interest" you are paying is quite high.
(B) Small Business Administration Loans
The Small Business Administration was created to help foster the creation
and growth of small businesses in the United States. The government
provides its bank lending partners a guarantee that the loan will be paid
even if the business fails. This is to help foster some entrepreneurial risk to
get businesses started up in communities across the country.
Sourcing money may be done for a variety of reasons. Traditional areas of

need may be for capital asset acquirement — new machinery or the
construction of a new building or depot. The development of new products
can be enormously costly and here again capital may be required.
Normally, such developments are financed internally, whereas capital for
the acquisition of machinery may come from external sources. In this day
and age of tight liquidity, many organisations have to look for short-term
capital in the way of overdraft or loans in order to provide a cash flow
cushion. Interest rates can vary from organisation to organisation and also
according to purpose.
20.5 Sources of Finance
According to a recent study, over 94% of new businesses fail during first
year of operation. Lack of funding turns to be one of the common reasons.
Money is the bloodline of any business. The long painstaking yet exciting
journey from the idea to revenue generating business needs a fuel named
capital. That’s why, at almost every stage of the business, entrepreneurs
find themselves asking – How do I finance my start-up?
! !369
Now, when would you require funding depends largely on the nature and
type of the business. But once you have realized the need for fund raising,
below are some of the different sources of finance available.
This will help you to raise capital for your business. Some of these funding
options are for Indian business, however, similar alternatives are available
in different countries.
1. Bootstrapping
Self-funding, also known as bootstrapping, is an effective way of start-up

financing, especially when you are just starting your business. First-time
entrepreneurs often have trouble getting funding without first showing
some traction and a plan for potential success. You can invest from your
own savings or can get your family and friends to contribute. This will be
easy to raise due to less formalities/compliances, plus less costs of raising.
In most situations, family and friends are flexible with the interest rate.
Self-funding or bootstrapping should be considered as a first funding option

because of its advantages. When you have your own money, you are tied
to business. On a later stage, investors consider this as a good point. But
this is suitable only if the initial requirement is small. Some businesses
need money right from the day-1 and for such businesses, bootstrapping
may not be a good option. Bootstrapping is also about stretching resources
– both financial and otherwise – as far as they can.
2. Crowdfunding
Crowdfunding is one of the newer ways of funding a start-up that has been
gaining a lot of popularity lately. It’s like taking a loan, pre-order,
contribution or investments from more than one person at the same time.
This is how crowdfunding works – An entrepreneur will put up a detailed

description of his business on a crowdfunding platform. He will mention the
goals of his business, plans for making a profit, how much funding he
needs and for what reasons, etc. and then consumers can read about the
business and give money if they like the idea. Those giving money will
make online pledges with the promise of pre-buying the product or giving a
donation. Anyone can contribute money toward helping a business that
they really believe in.
! !370
The best thing about crowdfunding is that it can also generate interest and
hence helps in marketing the product alongside financing. It is also a boon
if you are not suing if there will be any demand for the product you are
working on. This process can cut out professional investors and brokers by
putting funding in the hands of common people. It also might attract
venture-capital investment down the line if a company has a particularly
successful campaign.
Also, keep in mind that crowdfunding is a competitive place to earn

funding, so unless your business is absolutely rock solid and can gain the
attention of the average consumers through just a description and some
images online, you may not find crowdfunding to work for you in the end.
Some of the popular crowdfunding sites in India are Indiegogo, Wishberry,

Ketto, Fundlined and Catapooolt.
In US, Kickstarter, Rocket Hub, Dream funded, One vest and GoFundMe are
popular crowdfunding platforms.
3. Angel Investment
Angel investors are individuals with surplus cash and a keen interest to
invest in upcoming start-ups. They also work in groups of networks to
collectively screen the proposals before investing. They can also offer
mentoring or advice alongside capital.
Angel investors have helped to start up many prominent companies,

including Google, Yahoo and Alibaba. This alternative form of investing
generally occurs in a company’s early stages of growth, with investors
expecting a up to 30% equity. They prefer to take more risks in investment
for higher returns. Angel Investment as a funding option has its
shortcomings too. Angel investors invest lesser amounts than venture
capitalists.
Some of the popular Angel Investors in India are – Indian Angel Network,
Mumbai Angels, Hyderabad Angels.
There are also individual Angel Investors in India, some of these active
angel investors have invested in many successful start-ups.
! !371
4. Venture Capital
This is where you make the big bets. Venture capitals are professionally
managed funds who invest in companies that have huge potential. They
usually invest in a business against equity and exit when there is an IPO or
an acquisition. VCs provide expertise, mentorship and act as a litmus test
of where the organisation is going, evaluating the business from the
sustainability and scalability point of view.
A venture capital investment may be appropriate for small businesses that

are beyond the start-up phase and already generating revenues. Fast-
growth companies like Flipkart, Uber, etc. with an exit strategy already in
place can gain up to tens of millions of dollars that can be used to invest,
network and grow their company quickly.
However, there are a few downsides to Venture Capitalists as a funding

option. VCs have a short leash when it comes to company loyalty and often
look to recover their investment within a three- to five-year time window.
If you have a product that is taking longer than that to get to market, then
venture-capital investors may not be very interested in you.
They typically look for larger opportunities that are a little bit more stable,
companies having a strong team of people and a good traction. You also
have to be flexible with your business and sometimes give up a little bit
more control, so if you’re not interested in too much mentorship or
compromise, this might not be your best option.
Some of the well-known Venture Capitalists in India are – Nexus Venture

Partners, Helion Ventures, Kalaari Capital, Accel Partners, Blume Ventures,
Canaan, Sequoia Capital and Bessemer Ventures.
5. Business Incubators and Accelerators
Early stage businesses can consider Incubator and Accelerator programs as

a funding option. Found in almost every major city, these programs assist
hundreds of start-up businesses every year. Though used interchangeably,
there are a few fundamental differences between the two terms.
Incubators are like a parent to a child, who nurtures the business providing
shelter, tools and training and network to a business. Accelerators do more
! !372
or less the same thing, but an incubator helps/assists/nurtures a business

to walk, while accelerator helps to run/take a giant leap.
These programs normally run for 4-8 months and require time commitment
from the business owners. You will also be able to make good connections
with mentors, investors and other fellow start-ups using this platform.
In the US, companies like Dropbox and Airbnb started with an accelerator –
Y Combinator. Here is a list of top 10 incubators & accelerators in the US.
In India, popular names are Amity Innovation Incubator, AngelPrime, CIIE,
IAN Business Incubator, Villgro, Start-up Village and TLabs.
6. By Winning Contests
An increase in the number of contests has tremendously helped to

maximize the opportunities for fund raising. It encourages entrepreneurs
with business ideas to set up their own businesses. In such competitions,
you either must build a product or prepare a business plan. Winning these
competitions can also get you some media coverage.
You need to make your project stand out in order to improve your success
in these contests. You can either present your idea in person or pitch it
through a business plan. It should be comprehensive enough to convince
anyone that your idea is worth investing in.
Some of the popular start-up contests in India are NASSCOM’s 10000 start-
ups, Microsoft BizSparks, Conquest, NextBigIdea Contest, and Lets Ignite.
Check out the latest start-up programs & contests in your area. Here is a
calendar of various Business Plan competitions.
7. Through Bank Loans
Normally, bank is the first place that entrepreneurs go when thinking about
funding. The bank provides two kinds of financing for businesses. One is
working capital loan, and other is funding. Working Capital loan is the loan
required to run one complete cycle of revenue generating operations, and
the limit is usually decided by hypothecating stocks and debtors. Funding
from bank would involve the usual process of sharing the business plan
and the valuation details, along with the project report, based on which the
loan is sanctioned.
! !373
Almost every bank in India offers SME finance through various programs.
For instance, leading Indian banks – Bank of Baroda, HDFC, ICICI and
Axis. Banks have more than 7-8 different options to offer collateral free
business loans. You can check out the respective bank sites for more
details.
In the US, sites like Kabbage can help you get working capital loan online
in minutes. Unlike traditional lenders, Kabbage approves small business
loans by looking at real-life data, not just a credit score.
8. From Microfinance Providers or NBFCs
What do you do when you can’t qualify for a bank loan? There is still an
option. Microfinance is basically access of financial services to those who
would not have access to conventional banking services. It is increasingly
becoming popular for those whose requirements are limited and credit
ratings not favoured by bank.
Similarly, NBFCs or Non-Banking Financial Corporations are corporations

that provide Banking services without meeting legal requirement/definition
of a bank.
9. Govt. Programs
The Government of India has launched 10,000 Crore Start-up Fund in

Union budget 2014-15 to improve start-up ecosystem in India. In order to
boost innovative product companies, Government has launched ‘Bank of
Ideas and Innovations’ program.
Government-backed ‘Pradhan Mantri Micro Units Development and

Refinance Agency Limited (MUDRA) starts with an initial corpus of Rs.
20,000 crore to extend benefits to around 10 lakhs SMEs. You are
supposed to submit your business plan and once approved, the loan gets
sanctioned. You get a MUDRA Card, which is like a credit card, which you
can use to purchase raw materials, other expenses etc. Shishu, Kishore
and Tarun are three categories of loans available under the promising
scheme.
! !374
Also, different states have come up with different programs like Kerala
State Self Entrepreneur Development Mission (KSSEDM), Maharashtra
Centre for Entrepreneurship Development, Rajasthan Start-up Fest, etc. to
encourage small businesses. SIDBI – Small Industries Development Bank
of India also offers business loans to MSME sector.
If you comply with the eligibility criteria, Government grants as a funding

option could be one of the best. You just need to make yourself aware of
the various Government initiatives.
10.Some other Quick Ways
There are a few more ways to raise funds for your business. However,
these might not work for everyone.
Product Pre-sale: Selling your products before they launch is an often-

overlooked and highly effective way to raise the money needed for
financing your business. Remember how Apple & Samsung start pre-orders
of their products well ahead of the official launch? It’s a great way to
improve cash flow and prepare yourself for the consumer demand.
Selling Assets: This might sound like a tough step to take but it can help
you meet your short-term fund requirements. Once you overcome the
crisis, you can again buy back the assets.
Credit Cards: Business credit cards are among the most readily available
ways to finance a start-up and can be a quick way to get instant money. If
you are a new business and don’t have a ton of expenses, you can use a
credit card and keep paying the minimum payment. However, keep in mind
that the interest rates and costs on the cards can build very quickly, and
carrying that debt can be detrimental to a business owner’s credit.
To summarise, if you want to grow really fast, you probably need outside
sources of capital. If you bootstrap and remain without external funding for
too long, you may be unable to take advantage of market opportunities.
While the plethora of lending options may make it easier than ever to get
started, responsible business owners should ask themselves how much
financial assistance they really need. Now the big question is – How do you
prepare your business for fund raising? It’s better to start from the
! !375
beginning with good corporate governance as it might get hard to go back

later and try to exert fiscal discipline. To address these concerns, invest in
a good accounting software and keep your finances in order.
20.6 Summary
There are several sources which a business enterprise company can use for
raising the required amount of capital. What sources and methods the
company will use depends largely on the period for which finance is
required. Based on the period for which finance is required, it may be
broadly classified under two broad heads as given below:
Fixed or Long-term Finance
Working or Short-term Capital
Sources of Fixed or Long-term Capital:
The sources of obtaining fixed or long-term capital are as follows:
Issue of shares is the most important, popular and easy source of

obtaining fixed or long-term capital. The share is a company’s owned
capital which is split into a large number of small equal parts, each such
part being called a share. Those who purchase these shares are called
‘shareholders’. They are the owners of the company. It is a permanent
capital and provides a base to the capital structure of a company. It is
because the money raised in the form of shares remains in the Company
up to the date of winding up. According to the provisions of companies Act,
1956, a company can issue only the following two types of shares.
a. Preference Shares
b. Equity Shares.
Issue of debentures is another important source of obtaining fixed or long-

term capital by a joint stock company. A debenture is an acknowledgment
of a debt by a company usually issued under a common seal. Debentures
are the uniform parts of a loan raised by the company. According to
Thomas Evelyn, “A debenture is a document under the company’s seal
which provides for the payment of a principal sum and interest thereon at
regular intervals, which is usually secured by a fixed or floating charge on
! !376
the company’s property or undertaking and which acknowledges loan to

the company.” A debenture-holder is a creditor of the company. A fixed rate
of interest is paid on debentures. The interest on debentures is a charge on
the profit and loss account of the company. Debenture holders are not the
owners of the company.
Accumulated large profits are also considered to be good source of

financing long-term capital requirements. It is the best and cheapest
source of finance. It creates no charge on future profits. Retained profits
may be represented by various uncommitted reserves and surpluses or
specific reserves created out of profits.
The main sources of obtaining short-term capital are as follows:
Commercial banks are the most important and easy source of providing
short-term capital to business enterprises. They constitute the major
portion of working capital loans. They are given on the security of tangible
and readily marketable securities. They provide a wide variety of loans
tailored to meet the specific requirements of the business enterprise. The
chief forms in which commercial banks provide short-term finance to
business enterprises are;
a. Loans
b. Cash Credit
c. Overdraft
d. Discounting of Bills
Another source of short-term finance is to invite public deposits for a

specified period at a fixed rate of interest. Usually the companies inviting
public deposits pay a higher rate of interest than the commercial banks for
the similar period. Companies accept public deposits for a maximum period
of three years which may be renewed on the consent of both the parties.
This method is usually employed by the companies established mostly in
southern part of India, such as, Mumbai, Chennai, Calcutta etc.
Indigenous Bankers: Indigenous bankers are private money lenders and

other country bankers who provide short-term finance and charge high
rates of interest. Nowadays with the development of commercial banks and
other financial institutions they have lost their earlier monopoly. These
! !377
days, the business houses take the shelter of indigenous banks only in case
of urgency.
Depreciation funds created out of profits of the company provide a good

service of short-term capital, provided they are not invested in or
represented by an asset.
Present-day business is built on credit. Trade credit refers to the credit

extended by the supplier (seller) to the buyer. Under this arrangement,
credit is not granted in cash. The goods are sold on credit. The usual
duration of trade credit varies from 15 days to 90 days. It is granted to
those customers who have sound financial standing, goodwill and
reputation.
There has never been a better time to start your own business. Here's a
ready reckoner on where and how to find the money for your
entrepreneurial dream
The signs are everywhere. Students, women, yuppies, the unemployed,

those facing a mid-life crisis, and a whole lot of other categories have
succumbed to the e-bug. Frankly, the environment has never been more
conducive. Of course, the risks associated with start-ups remain, with more
than 50% of all start-ups failing within the first five years. It's just that
landing funds to fuel your venture is easier than ever before.
Venture Intelligence, a research firm focused on venture capital and private

equity deals in India, says there are 43 angel networks, 111 venture
capital investors and 37 incubators in the country. We have come a long
way from the days when bootstrapping—falling back on savings, fixed
assets, and money from friends and family—was the only option.
Nonetheless, this is still the most preferred starting point for most
businesses.
The trouble with bootstrapping is that it usually means scrimping on

capital, which, in turn, curtails the start-up's flexibility and ability to grow.
There is also a very real risk of fledgling entrepreneurs overleveraging
themselves.
! !378
A less risky way to raise seed capital is to pool resources with a group of
people who have shared interests and work together to escalate a business
idea to at least a prototype. However, if you are sure of the scalability of
your venture and are not obsessive about retaining independent control,
private funding could be the best option.
20.7 Questions
(A) Answer the following questions:
1. What is long-term Finance? Explain.

2. Explain Medium-term source of finance.
3. Write short Note on: Sources of small business finance
4. Angel investment in start-up business — Describe.
5. How you will get business loan from Business Incubators &
Accelerators?

1. Long-term financing is a form of financing that is provided for a period

of _____________
a. More than a year
b. More than 2 years
c. More than 3 years
d. More than 5 years
2. F a c t o r s d e t e r m i n i n g L o n g - t e r m F i n a n c i a l R e q u i r e m e n t s
includes_____________
a. Nature of Business
b. Nature of Goods produced
c. Technology used
d. All of the above
! !379
3. Certain advantages of borrowing capital is _____________

a. There is no dilution in ownership and control of business.
b. The cost of borrowed funds is low since it is a deductible expense for
taxation purpose which ends up saving on taxes for the company and
it gives the business a leverage benefit
c. Both a & b
d. Cheaper rate of interest
4. A venture capital investment may be appropriate for small businesses

that are _____________ the start-up phase and already generating
revenues.
a. Beyond
b. Before
c. During
d. All of the above
5. T h e b e s t t h i n g a b o u t c r o w d f u n d i n g i s t h a t i t c a n a l s o
generate_____________ and hence helps in marketing the product
alongside financing.
(a) Capital
(b) Limited liabilities
(c) Interest
(d) Relationship
Answers: 1. (a), 2. (d), 3. (c), 4. (a), 5. (c)
! !380
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture Part 2 
! !381
VENTURE CAPITAL
Chapter 21
Venture Capital
Objectives
After studying this chapter, you should be able to understand about

venture capital, its features and methods of venture capital financing,
venture capital in India and funding process of venture capital.
Structure:
21.1 Introduction
21.2 What is Venture Capital?
21.3 Features of Venture Capital Investments
21.4 Methods of Venture Capital Financing
21.5 Categories of Venture Capital Funds in India
21.6 Venture Capital Guidelines
21.7 Venture Capital: India Scenario
21.8 Venture Capital Funding Process
21.9 Advantages and Disadvantages of Venture Capital
21.10 Fees and Interest in Venture Capital Funding
21.11 Venture Capital Taxation Laws
21.12 Summary
21.13 Questions
! !382
VENTURE CAPITAL
21.1 Introduction
'Venture Capital' is an important source of finance for those small and

medium-sized firms, which have very few avenues for raising funds.
Although such a business firm may possess a huge potential for earning
large profits in the future and establish itself into a larger enterprise. But
the common investors are generally unwilling to invest their funds in them
due to risk involved in these types of investments. To provide financial
support to such entrepreneurial talent and business skills, the concept of
venture capital emerged. In a way, venture capital is a commitment of
capital, or shareholdings, for the formation and setting up of small scale
enterprises at the early stages of their life cycle.
Venture capitalists comprise of professionals of various fields. They provide

funds (known as Venture Capital Fund) to these firms after scrutinizing the
projects. Their main aim is to earn huge returns on their investments, but
their concepts are totally different from the traditional moneylenders. They
know very well that if they suffer losses in some project, the others will
compensate the same due to high returns. They take active participation in
the management of the company as well as provide the expertise and
qualities of a good banker, technologist, planner and managers. Thus, the
venture capitalist and the entrepreneur literally act as partners.
21.2 What is venture capital?
It is a private or institutional investment made into early-stage/start-up

companies (new ventures). As defined, ventures involve risk (having
uncertain outcome) in the expectation of a sizeable gain. Venture Capital is
money invested in businesses that are small; or exist only as an initiative,
but have huge potential to grow. The people who invest this money are
called venture capitalists (VCs). The venture capital investment is made
when a venture capitalist buys shares of such a company and becomes a
financial partner in the business.
Venture Capital investment is also referred to risk capital or patient risk

capital, as it includes the risk of losing the money if the venture doesn't
succeed and takes medium- to long-term period for the investments to
fructify.
! !383
VENTURE CAPITAL
Venture Capital typically comes from institutional investors and high net
worth individuals and is pooled together by dedicated investment firms.
It is the money provided by an outside investor to finance a new, growing,

or troubled business. The venture capitalist provides the funding knowing
that there’s a significant risk associated with the company’s future profits
and cash flow. Capital is invested in exchange for an equity stake in the
business rather than given as a loan.
Venture Capital is the most suitable option for funding a costly capital
source for companies and most for businesses having large up-front capital
requirements which have no other cheap alternatives. Software and other
intellectual property are generally the most common cases whose value is
unproven. That is why; Venture capital funding is most widespread in the
fast-growing technology and biotechnology fields.
! !384
VENTURE CAPITAL
21.3 Features of Venture Capital investments
• High Risk
• Lack of Liquidity
• Long-term horizon
• Equity participation and capital gains
• Venture capital investments are made in innovative projects
• Suppliers of venture capital participate in the management of the
company
21.4 Methods of Venture capital financing
• Equity
• participating debentures
• conditional loan
The venture capital recognises different stages of financing as under:
• Early stage financing – This is the first stage financing when the firm is
undertaking production and needs additional funds for selling its
products. It involves seed/initial finance for supporting a concept or idea
of an entrepreneur. The capital is provided for product development, R&D
and initial marketing.
• Expansion financing – This is the second stage financing for working

capital and expansion of a business. It involves development financing so
as to facilitate the public issue.
• Acquisition/buyout financing – This later stage involves:
❖ Acquisition financing in order to acquire another firm for further growth
❖ Management buyout financing so as to enable the operating groups/

investors for acquiring an existing product line or business and
❖ Turnaround financing in order to revitalise and revive the sick

enterprises.
! !385
VENTURE CAPITAL
21.5 Categories of Venture Capital Funds in India
In India, the venture capital funds (VCFs) can be categorised into the
following groups:
Those promoted by the Central Government controlled

development finance institutions, for example:
• ICICI Venture Funds Ltd.

• IFCI Venture Capital Funds Limited (IVCF)
• SIDBI Venture Capital Limited (SVCL)
Those promoted by State Government controlled development

finance institutions, for example:
• Gujarat Venture Finance Limited (GVFL)

• Kerala Venture Capital Fund Pvt. Ltd.
• Punjab Infotech Venture Fund
• Hyderabad Information Technology Venture Enterprises Limited (HITVEL)
Those promoted by public banks, for example:
• Canbank Venture Capital Fund

• SBI Capital Markets Limited
Those promoted by private sector companies, for example:
• IL&FS Trust Company Limited

• Infinity Venture India Fund
Those established as an overseas venture capital fund, for

example:
• Walden International Investment Group

• SEAF India Investment & Growth Fund
• BTS India Private Equity Fund Limited
! !386
VENTURE CAPITAL
21.6 Venture capital Guidelines
All these venture capital funds are governed by the Securities and
Exchange Board of India (SEBI). The SEBI is the nodal agency for
registration and regulation of both domestic and overseas venture capital
funds. Accordingly, it has made the following regulations, namely,
Securities and Exchange Board of India (Venture Capital Funds)
Regulations 1996 and Securities and Exchange Board of India (Foreign
Venture Capital Investors) Regulations 2000. These regulations provide
broad guidelines and procedures for establishment of venture capital funds
both within India and outside it; their management structure and setup; as
well as size and investment criteria of the funds.
Recently, the SEBI (Securities and Exchange Board of India) has defined
Angel Investor as a person who proposes to invest in an Angel Fund and
who has net tangible assets of at least two crore rupees, in individual
capacity, excluding value of his principal residence, and who:
• has early stage investment experience, or

• has experience as a serial entrepreneur, or
• is a senior management professional with at least ten years of
experience.
‘Early stage investment experience’ means prior experience of investing in

a start-up or emerging or early-stage ventures. ‘Serial entrepreneur’
means a person who has promoted or co- promoted more than one start-
up venture.
The definition of investors, who can invest in certain types of higher risk
investments including seed money, hedge funds, private placements and
angel investor networks, is different in each country. The term generally
includes wealthy individuals known as accredited investors.
Venture Capitalists are long-term investors who take a very active role in
their portfolio companies. They invest with a horizon of 5-8 years, on an
average. The initial investment is just the beginning of a productive
relationship between the venture capitalist and entrepreneur. Venture
capitalists bring value by providing capital and management expertise.
Venture capitalists often are invaluable in building strong management
teams, managing rapid growth and facilitating strategic partnerships.
! !387
VENTURE CAPITAL
21.7 Venture capital: India scenario
The nature of Venture Capital is such that it offers an opportunity for

wealth creation – by investing in entrepreneurs driven by high growth
aspirations. The Indian scenario offers:
• An attractive high-growth opportunity.
• Strong entrepreneurial spirit taking root in Young India.
• Unique business ideas offered by Indian start-ups that fulfil the unmet
needs of the target segment.
• Vibrant environment for sharing gains with co-founder, equity

participation and strategic exits for appropriate returns.
• Significant value creation by first generation entrepreneurs in recent

years energizing early stage opportunities.
• Limited availability of early stage funding in India.
21.8 Venture capital Funding Process
! !388
VENTURE CAPITAL
Process of Venture capital funding
The venture capital funding procedure gets complete in six stages of

financing corresponding to the periods of a company's development.
• Seed money: Low level financing for proving and fructifying a new idea
• Start-up: New firms needing funds for expenses related with marketing
and product development
• First-Round: Manufacturing and early sales funding
• Second-Round: Operational capital given for early stage companies

which are selling products, but not returning a profit
• Third-Round: Also, known as Mezzanine financing, this is the money for

expanding a newly beneficial company
• Fourth-Round: Also, called bridge financing, 4th round is proposed for

financing the "going public" process
The step by step process is as under:
Step 1: Idea generation and submission of the Business Plan
The initial step in approaching a Venture Capital is to submit a business

plan. The plan should include the below points:
• There should be an executive summary of the business proposal

• Description of the opportunity and the market potential and size
• Review on the existing and expected competitive scenario
• Detailed financial projections
• Details of the management of the company
There is detailed analysis done of the submitted plan, by the Venture

Capital to decide whether to take up the project or not.
! !389
VENTURE CAPITAL
Step 2: Introductory Meeting
Once the preliminary study is done by the VC and they find the project as
per their preferences, there is a one-to-one meeting that is called for
discussing the project in detail. After the meeting the VC finally decides
whether or not to move forward to the due diligence stage of the process.
Step 3: Due Diligence
The due diligence phase varies depending upon the nature of the business
proposal. This process involves solving of queries related to customer
references, product and business strategy evaluations, management
interviews, and other such exchanges of information during this time
period.
Step 4: Term Sheets and Funding
If the due diligence phase is satisfactory, the VC offers a term sheet, which
is a non-binding document explaining the basic terms and conditions of the
investment agreement. The term sheet is generally negotiable and must be
agreed upon by all parties, after which on completion of legal documents
and legal due diligence, funds are made available.
21.9 Advantages and disadvantages of Venture Capital
Advantages of Venture Capital
• They bring wealth and expertise to the company
• Large sum of equity finance can be provided
• The business does not stand the obligation to repay the money
• In addition to capital, it provides valuable information, resources,

technical assistance to make a business successful
! !390
VENTURE CAPITAL
Disadvantages of Venture Capital
• As the investors become part owners, the autonomy and control of the
founder is lost
• It is a lengthy and complex process
• It is an uncertain form of financing
• Benefit from such financing can be realized in long run only
Exit route
There are various exit options for Venture Capital to cash out their
investment:
• IPO
• Promoter buyback
• Mergers and Acquisitions
• Sale to another strategic investor
21.10 Fees and interest in Venture Capital funding
Management fees
Annual payment is made by the investors (in the VCF) to the Fund
manager for carrying out the operations. In a typical Fund, the general
partners receive an annual management fee up to 2% of the committed
capital.
Carried interest
This is a share of the profits of the Fund (typically 20%), which is paid to
the VCF’s management company as a performance incentive. The
remaining 80% of the profits are paid to the investors. Strong limited
partners, in top-tier venture firms, have commanded a carried interest of
25% to 30% of the profits, in the recent past.
! !391
VENTURE CAPITAL
21.11 Venture capital Taxation Laws
In the year, December 2013, Indian Tax laws allow a pass-through benefit,
to venture capital so that income will be taxed in the hand of the investor
only and not taxed at the VCF level. However, it is advisable to consult a
tax expert because every exit has its own nuances. The main tax
implications for the beneficiaries of the fund are –
Exit gains on sale/buyback of securities
The gains arising from the sale of shares held in the Portfolio Companies
may be treated either as “capital gains” or as “business income” for Indian
tax purposes. In case of “capital gains” –
1. The short-term capital gains are taxed at the marginal rate of tax that is
full tax rate applicable to the investor e.g. an individual resident in India
is taxed at 30.90%.
2. Long-term capital gains: There will be no tax on Residents/Non-

Residents in case shares are listed in India and the sale is subject to
Securities Transaction Tax (STT) or in the case of sale of unlisted equity
shares under an offer for sale to the public included in an initial public
offer and the sale is subject to STT.
For unlisted shares –
For Residents in India after considering indexation
3. if beneficiary is a Domestic Company, it is 21.63%.
4. if beneficiary is any other assessee, it is 20.60%
For Residents in India without indexation benefit or sale not

subjected to STT (i.e. off-market transactions)
5. if beneficiary is a Domestic Company, it is 10.82%.
6. if beneficiary is other assessee, it is 10.30%.
For Non-Residents:
! !392
VENTURE CAPITAL
7. if beneficiary is a Foreign Company, it is 10.51%.
8. if beneficiary is any other assessee, it is 10.30%.
21.12 Summary
Considering the high risk involved in the venture capital investments

complimenting the high returns expected, one should do a thorough study
of the project being considered, weighing the risk return ratio expected.
One needs to do the homework both on the Venture Capital being targeted
and on the business requirements.
Venture Capital is a term used for the money, or capital, provided to early-
stage, high-potential, high-risk start-ups. The Venture Capital Fund (VCF)
gets an equity stake in the start-up, in lieu of the funds it provides. These
start-ups usually own a novel technology or choose to operate in high
technology industries, such as biotechnology, IT, mobile, internet and
software.
Venture Capital investment, mostly, takes place after the seed or angel
funding. It is considered growth funding because it generates a return,
when the start-up goes for an IPO, trade sale, strategic investment etc.
The general partners and other investment professionals of the venture

capital firm are often called “venture capitalists” or “VCs”. Broadly
speaking, VCs either have an operational or a finance background, though
there is no hard and fast rule.
The types of financing options roughly correspond to the stage of a start-

up’s development and amount of risk capital required.
• Seed funding: Small funding given to prove a new idea, often provided
by angel investors, incubators or accelerators. Crowd funding is also
emerging as an option for seed funding.
• Start-up funding: Early-stage ventures need funding for expenses

associated with marketing and product development. It is normally
provided by early stage venture funds, like YourNest, or angel funds.
! !393
VENTURE CAPITAL
• Early Stage (Series A): At this stage, some of the risks associated with
a start-up have been negated or refuted, the market has validated the
concept and its value proposition to some extent. Normally known as
Series A funding, it continues to be an early stage funding but for
growth. YourNest normally participates in such subsequent round of
funding, also.
• Growth Stage funds: These Venture Funds provide growth capital to

established businesses that are now ready to scale-up, on the backing of
significant brand building, or ramping the manufacturing or production
capabilities.
• Bridge Round: Working capital for early stage companies that are
selling their products or services however, are not showing cash profits,
yet. These funds are intended to finance the process to “go public” or a
“private equity” round.
An Angel Investor is an individual who believes in entrepreneurship, can

create value for the economy and has allocated part of his investible
surplus for supporting start-ups or investing in a Venture Capital Fund.
Venture Capitalists invest in private enterprises and get return on

investment as and when they dispose-off their shareholding to another
investor. “Exit” is a crucial moment for any VC. Typically, an “Exit” could be
achieved when the portfolio company goes public (IPO) or merged or
purchased by another company.
A VCF's lifespan is 8-12 years. It normally has an investment holding

period of 4-6 years in each portfolio company. When the shareholding in
the portfolio company is disposed-off the VCF realizes cash against the
original investment. The “sales proceeds” are distributed among all, in
proportion of their contribution to the fund. An individual investor does not
have a say in the liquidation of the investments in the portfolio company.
He or she gets a return only on “Exit” by the VCF along with all other
investors.
Private placement (or non-public offering) is a funding round through sale

of shares, which are not sold through a public offering, but through a
private offering, mostly to a small number of chosen investors. The PPM is
a legal document stating the objectives, risks and terms of investment of
! !394
VENTURE CAPITAL
the private placement. This includes financial statements, management

biographies, detailed description of the business, etc. An offer
memorandum provides buyers with information on the offering and
protects the sellers from the liability associated with selling unlisted
securities. The contents of the document are governed by the securities
regulator i.e. the SEBI in India.
Venture Capital is a subset of Private Equity. Therefore, all Venture Capital

is Private Equity, but not all Private Equity is Venture Capital. Both PE firms
and VCs invest in companies and make money by exiting – selling their
investments. The key difference is that PE firms buy mature companies
whereas VCs invest, mostly, in early-stage companies.
The risk associated with early stage investments is expected to be high due
to a variety of reasons. The portfolio company may be less than 3 years
old, promoted by first generation entrepreneurs, offering a service or
product for the first time in a market. In some cases, they may have
revenue, but may not have achieved break-even. Most VCF exercise risk
mitigation through –
• Time & Portfolio Diversification – Investment is spread over 3-5

years so that all investments are not made at the peak of an
economic cycle. Moreover, 10-15 start-ups are nurtured so that the risk
is balanced across the portfolio.
• Milestone-based disbursements – Investment tranches are linked to

realistic milestones so that capital is optimally utilized.
• Effective deal structuring & investor protection – This is ensured

with measures such as founder vesting, founder lock-in, pre-emptive
right, liquidation preference, information rights, right of first refusal,
valuation protection, tag along, drag along, special rights to exit etc.
! !395
VENTURE CAPITAL
21.13 Questions
1. Define the Venture capital and explain.

2. Explain the Categories of Venture Capital Funds in India.
3. Describe the Venture Capital Funding Process.
4. Explain Advantages and disadvantages of Venture Capital.
5. Write short notes on: “Venture capital Taxation Laws”.

1. The SEBI (Securities and Exchange Board of India) has defined

_____________ as a person who proposes to invest in a Fund and who
has net tangible assets of at least two crore rupees, in individual
capacity, excluding value of his principal residence.
a. Promoter investor
b. Associate investor
c. Angel Investor
d. Foreign investor
2. If the due diligence phase is satisfactory, the VC offers a

_____________, which is a non-binding document explaining the basic
terms and conditions of the investment agreement.
a. Introductory
b. Due diligence
c. Term sheet
d. Agreement
3. Main Disadvantage of Venture Capital includes _____________.

a. As the investors become part owners, the autonomy and control of
the founder is lost
b. It is a lengthy and complex process
c. It is an uncertain form of financing
d. All of the above
! !396
VENTURE CAPITAL
4. What are the exit options for Venture Capital to cash out their
investment?
a. IPO/Promoter buyback
b. Mergers and Acquisitions
c. Sale to another strategic investor
d. All of the above
5. “In case of Long-term capital gains there will be no tax on Residents/

Non-Residents in case shares are listed in India and the sale is subject
to Securities Transaction Tax (STT) or in the case of sale of unlisted
equity shares under an offer for sale to the public included in an initial
public offer and the sale is subject to STT”_____________ True or False
a. True
b. False
Answers: 1. (c), 2. (c), 3. (d), 4. (d), 5. (a)
! !397
VENTURE CAPITAL
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture
! !398
FOREIGN VENTURE CAPITAL INVESTMENT IN INDIA
Chapter 22
Foreign Venture Capital Investment In
India
Objectives
After studying this chapter, you should be able to understand about Foreign
venture capital, conditions for its registration in India, obligations and RBI
guidelines issued recently. Taxation guidelines and exit strategy for venture
capital fund.
Structure:
22.1 Introduction
22.2 What is Foreign Venture capital?
22.3 Registration of Foreign Venture Capital: Conditions
22.4 Indian Venture Capital Undertaking (IVCU)
22.5 Venture Capital Fund (VCF)
22.6 Investment Conditions for Foreign Venture Capital Fund
22.7 General Obligations and Responsibilities of Foreign Venture Capital
Fund
22.8 RBI Guidelines on Foreign Venture Capital
22.9 Taxation on FVCI
22.10 Exit Strategy
22.11 Summary
22.12 Questions
! !399
22.1 Introduction
"There is a tide in the affairs of men, which taken at the flood, leads on to
fortune. And we must take the current when it serves, or lose our
ventures." — William Shakespeare
In today’s global scenario of trade and communication, the tide of offshore

investments is at a hike. There is an immense increase in the investments
made by different countries to foreign countries to increase efficient trade
and commerce relationship and to enhance the economy of one’s own
country. Looking at the status of investments in India by foreign investors,
there has been quite an increase in the venture capital investments
resulting in favourable amendments in the rules governing these
investments to enhance effective trade relationships between India and
foreign countries.
The investments by a foreign investor in Indian Venture Capital

Undertakings (VCU) and Venture Capital Funds (VCF) are governed by
Foreign Exchange Management regulations and Securities Exchange Board
of India regulations. The foreign country investing in the Venture Capital in
India is called as the Foreign Venture Capital Investor (FVCI).
22.2 What is foreign Venture capital?
The term FVCI has been defined under the SEBI (Foreign Venture Capital
Investor) Regulations 2000 to mean:
“an investor incorporated or established outside India, which proposes to

make investments in venture capital fund(s) or venture capital
undertakings in India and is registered under the FVCI Regulations”
Therefore, it is mandatory for a foreign investor that it should have got

itself registered with the SEBI before it proceeds to make investment in
Venture Capital Company of India. According to the definition given in
Foreign Exchange Management (Transfer or Issue of Security by a person
Resident outside India) Regulations, 2000, FVCI means an investor
incorporated and established outside India and which proposes to invest
money in Venture Capital Funds or Venture Capital Undertaking in India
and is registered with the SEBI.
! !400
Thus, clearly from the above definitions, there are three requirements to
be satisfied by a foreign investor before it can make investments in venture
capital companies in India:
1. It should have been incorporated and established in any country outside

India;
2. It should be willing to make investment in VCFs or VCUs in India in

accordance with the SEBI regulations; and
3. It should have got itself registered with the SEBI as a FVCI.
Such a FVCI can be in the form of a company including a body corporate or

a trust.
22.3 Registration of foreign venture capital: Conditions
Before a Foreign Investor can obtain certificate of recognition as FVCI from

the SEBI, it has to satisfy certain eligibility criteria. Some of these criteria
which are to be considered by the SEBI are the applicant’s track record,
professional competence, fairness and integrity of applicant, financial
soundness of applicant, prior experience, whether applicant is fit and
proper person in accordance with the SEBI (Criteria for Fit and Proper
Person) Regulations, 2004, etc. Further, it has to be seen that whether the
applicant has got necessary approvals from the RBI for making
investments in India or not.
Once the SEBI is assured that applicant satisfies all conditions under
Regulation 4, it can proceed to grant registration to the applicant as FVCI
allowing him to make investment in Indian VCUs and VCFs in accordance
with applicable rules and regulations. This depends upon the discretion of
the SEBI which can impose suitable terms and conditions upon the
applicant before it is recognised as FVCI.
After an investor has been recognized and registered as FVCI by the SEBI,
it has to seek further approval of the RBI under FEMA Regulations before
making investment in India. Such an FVCI can apply to the RBI for general
permission through the SEBI to invest in IVCU or VCF or in a scheme
floated by such VCF.
! !401
The definitions of VCFs and VCU are given both in FEMA (Transfer or Issue
of Security by a person Resident Outside India) Regulations, 2000 and the
SEBI (Foreign Venture Capital Investor) Regulations 2000. The definitions
are almost similar in nature except the fact that the SEBI Regulation uses
the term VCU whereas FEMA regulations use the term IVCU. Joint reading
of both these regulations explains the terms VCFs and VCU in following
manner:
22.4 Indian Venture Capital Undertaking (IVCU)
IVCU means a company incorporated in India whose shares are not listed
on a recognized stock exchange in India and which is not engaged in an
activity specified under the negative list specified by the SEBI. IVCU is
generally a newborn private company which is yet to establish itself and is
in need of funds and experienced advice and support.
22.5 Venture Capital Fund (VCF)
It is a fund established in the form of a trust or a company including a

body corporate and registered with the SEBI under the SEBI (Venture
Capital Fund) Regulations 1996 and which has a dedicated pool of capital
raised in the manner specified in regulations and which invests in VCU in
accordance with the said regulations. A VCF is also allowed to make
investments in VCU subject to provisions in the SEBI(Venture Capital Fund)
Regulations.
Therefore, an FVCI that has got registered with the SEBI as such and has
been permitted by the RBI to make investments in India can make
investment in either IVCU or VCF or both. FVCI that has been permitted by
the RBI to make investment in IVCU or VCF can make investment by
purchasing equity or equity-linked instruments or debt instruments or
debentures of an IVCU or of a VCF. Equity-linked instruments mean and
include instruments that are later convertible into equity shares or share
warrants, preference shares or debentures convertible into equity. These
investments can be through Initial Public Offer or Private Placement or in
units of schemes/funds set up by VCF. But an FVCI registered with the
SEBI and permitted by the RBI can make investment only in those IVCU
and VCF that are also registered with the SEBI under respective SEBI
regulations.
! !402
22.6 Investment conditions for foreign Venture capital fund
An FVCI registered with the SEBI is permitted to make investments in

following manner:
1. An FVCI can invest all of its funds in a domestic VCF — a registered

FVCI is allowed to invest 100% of its funds in a VCF registered under
the SEBI(Venture Capital Fund) Regulations.
2. It has to invest at least 66.67% of its investible funds in unlisted equity

shares or equity-linked instruments of Venture Capital Undertakings.
3. It can invest only 33.33% of its funds (and not more), by—
• Subscribing to initial public offer of adventure capital undertaking whose

shares are proposed to be listed;
• Investing in debt or debt instrument of the VCU provided it has already

invested by way of equity in such a VCU;
• Preferential allotment of equity shares of a listed company subject to the

lock-in period of one year;
• Investment by subscription or purchase in the equity shares or equity-

linked securities of a financially weak listed company or industrial listed
company;
• Investment by way of subscription or purchase in Special Purpose

Vehicles created for the purpose of facilitating or promoting investment in
accordance with these regulations.
An FVCI have a fixed life cycle. Every FVCI making investments in IVCU or
VCF has to mandatorily disclose life cycle of its fund before making any
investments. It has to further disclose all its investment strategies to the
SEBI before it makes any investment in India.
! !403
22.7 General obligations and responsibilities of foreign

venture capital fund
The following are the general obligations and responsibilities of the Foreign
Venture Capital Investor:
• Every foreign venture capital investor shall maintain for a period of eight
years books of account, records and documents which shall give a true
and fair picture of the state of affairs of the Foreign Venture Capital
Investor;
• He shall intimate to the Board, in writing, the place where the books,
records and documents are being maintained;
• The Board may at any time call for any information with respect to any
matter relating to its activity;
• Where any information is called for the same shall be furnished within
the time specified by the Board;
• Foreign Venture Capital Investor or a global custodian acting on behalf of

the foreign venture capital investor shall enter into an agreement with
the domestic custodian to act as a custodian of securities for foreign
venture capital investor;
• He shall ensure that domestic custodian takes steps for—
a. Monitoring of investment of foreign venture capital investors in India;

b. Furnishing of periodic reports to the Board;
c. Furnishing such information as may be called for by the Board.
• He shall appoint a branch of a bank approved by the RBI as a designated

bank for opening of foreign currency denominated accounts or specified
non-resident rupee account.
! !404
22.8 RBI guidelines on Foreign Venture capital
In order to further liberalise and rationalise the investment regime for

FVCIs and to give a fillip to foreign investment in the start-ups, the extant
regulatory provisions have been reviewed by the RBI and in consultation
with the Government of India amendments have been carried out in
Schedule 6 of Foreign Exchange Management (Transfer or Issue of security
by a person resident outside India) Regulations, 2000, through Foreign
Exchange Management (Transfer or Issue of Security by a Person Resident
outside India) (Third Amendment) Regulations, 2016.
As per this Amendment, any FVCI which has obtained registration under
the Securities and Exchange Board of India (FVCI) Regulations, 2000, will
not require any approval from the Reserve Bank of India and can invest in:
(a)Equity or equity linked instrument or debt instrument issued by an

Indian company whose shares are not listed on a recognised stock
exchange at the time of issue of the said securities/instruments and
engaged in any of the following sectors:
1. Biotechnology
2. IT related to hardware and software development
3. Nanotechnology
4. Seed research and development
5. Research and development of new chemical entities in pharmaceutical
sector
6. Dairy industry
7. Poultry industry
8. Production of bio-fuels
9. Hotel-cum-convention centres with seating capacity of more than three
thousand
10.Infrastructure sector (This will include activities included within the
scope of the definition of infrastructure under the External Commercial
Borrowing guidelines/policies notified under the extant FEMA
Regulations as amended from time to time).
(b) Equity or equity-linked instrument or debt instrument issued by an

Indian ‘start-up’ irrespective of the sector in which the start-up is engaged.
A start-up will mean an entity (private limited company or a registered
partnership firm or a limited liability partnership) incorporated or registered
! !405
in India not prior to five years, with an annual turnover not exceeding INR
25 Crore in any preceding financial year, working towards innovation,
development, deployment or commercialization of new products, processes
or services driven by technology or intellectual property and satisfying
certain conditions given in the Regulations.
(c) Units of a Venture Capital Fund (VCF) or of a Category I Alternative

Investment Fund (Cat-I AIF) (registered under the SEBI (AIF) Regulations,
2012) or units of a Scheme or of a fund set up by a VCF or by a Cat-I AIF.
It is clarified by the RBI that downstream investments by a Venture Capital

Fund (VCF) or a Cat-I AIF, which has received investment from FVCI, shall
have to comply with the provisions for downstream investment as laid
down in Schedule 11 of the Principal Regulations.
Other salient features of the revised regulatory framework are as

under:
1. An FVCI may open a foreign currency account and/or a rupee account

with a designated branch of an Authorised Dealer for the purpose of
making transactions only and exclusively under this Schedule.
2. The consideration for all investment by an FVCI shall be paid out of

inward remittance from abroad through normal banking channels or out
of sale/maturity proceeds of or income generated from investment
already made.
3. There will be no restriction on transfer of any security/instrument held

by the FVCI to any person resident in or outside India.
An entity receiving investment directly from a registered Foreign Venture

Capital Investor (FVCI) will be required to report the investment, mutatis
mutandis, in form FCGPR. The necessary changes in the E-biz portal are
being made and separate instructions will be issued in due course. Till such
time, reporting requirements, as hitherto, shall continue.
! !406
22.9 Taxation on FVCI
Under Section 90(2) of the Income-tax Act, a non-resident assessee based

in a country with which India has a Double Taxation Avoidance Agreement
(DTAA), may opt to be taxed either under the IT Act or the DTAA,
whichever is more beneficial.
Under Section 10(23FB) of the IT Act, any income of a registered FVCI is

exempt from income tax. The FVCI can carry on business in India through
a permanent establishment in India, and yet its entire income would be
tax-free. On the other hand, if the FVCI opts to be taxed under the DTAA
and it has a permanent establishment in India, its Indian income will not
be tax-free.
The tax exemption under section 10(23FB) has to be read with section
115U of the IT Act, which confers a pass-through status on the SEBI-
registered venture funds. Investors in such funds would be liable to tax in
respect of the income received by them from the FVCI in the same manner
as it would have been, had the investors invested directly in the venture
capital undertaking. In other words, income earned by an FVCI by way of
dividend, interest or capital gains, upon distribution, would continue to
retain the same character in the hands of its investors.
This brings us to a question as to what is the nature of the income derived

by an FVCI from its Indian investments. While dividend declared by an
Indian company is tax-free in the hands of any recipient, including an FVCI,
the gains an FVCI would make upon exit from an Indian investment, was
so far regarded as capital gains. However, the Authority for Advance Ruling
has held that profits made by a private equity fund or venture capital fund
should be taxed as business profits and not as capital gains.
Are non-resident investors in an FVCI, therefore, liable to pay Indian

income tax on what they receive from the FVCI as business profits, even
though the FVCI itself does not have to pay any tax? Although Section 115
U begins with the words ‘Notwithstanding anything contained in any other
provisions of this Act’, and it would override the normal provisions relating
to taxability of individual items of income, it cannot override Section 90(2)
relating to DTAA provisions. India is a signatory to the Vienna Convention
on the Law of Treaties and, therefore, tax treaties have a special status as
compared to domestic tax legislation and would prevail unless there is an
! !407
express specific domestic provision to override the treaty. In the present

case, it does not appear to be the intention of the legislature that Section
115 U should override Section 90(2).
Accordingly, a non-resident investor in an FVCI, who receives dividend

from the FVCI, is entitled to characterize the same as dividend under the
DTAA, by opting to be taxed under the DTAA and not the IT Act. Due to its
very recent enactment, obviously, there is no precedent or case law and,
therefore, it is not improbable that the Indian tax authorities may contend
that the investor is not entitled to the DTAA benefit in view of Section 115
U and is liable to pay tax on business profits in India. Tax planning
structures could be worked out to protect against such an eventuality,
however remote it may be.
22.10 Exit strategy
Exit strategy is the method by which a venture capitalist or business owner

intends to get out of an investment that he or she has made in the past. In
other words, the exit strategy is a way of "cashing out" an investment.
Examples include an initial public offering (IPO) or being bought out by a
larger player in the industry. It is also referred to as a "harvest strategy" or
"liquidity event”
A special exemption has been carved out for FVCIs in as much that an FVCI
may acquire or sell its Indian shares/convertible debentures/units or any
other investment at a price that is mutually acceptable to both the parties.
Thus, there are no entry or exit pricing restrictions applicable to an FVCI.
This could be a very significant benefit for FVCIs, especially in the case of a
strategic sale or buy-back arrangement with the promoters at the time of
exit from unlisted companies.
! !408
22.11 Summary
The venture capital fund is a high risk and reward activity. The investments
are made by high net worth individuals and institutions to reap high
returns. The investor in venture capital funds does not involve himself in
day-to-day management of the fund and the activities of the funds are
managed by professionals. The investors therefore like to keep their
liability limited to the contribution committed by them to the fund and are
not willing to take on any other liability. The venture capital funds are set
up for a limited life and on maturity the returns are distributed amongst
the investors. The structure of venture capital funds should therefore
protect the interest of investors and the liquidation process should be
simple. There are some recommendations, which I strongly feel, are
considerable for making the investment provisions much better to develop
this sector of trade
• Investments by VCFs in VCUs should not be subject to any sectoral

restrictions except those to be specified as a negative list by the SEBI in
consultation with the Government which may include areas like real
estate, finance companies and activities prohibited by Law.
• There is no need for any ceiling of investment in the equity of a company.

It is understood that the investment ceiling of 40% of paid-up capital of
VCU under the Income Tax Act has already been removed. As a
prudential norm, the investment in one VCU should not exceed 25% of
the corpus of VCF.
• The investment criteria need to be amended to provide for investment

criteria whereby VCFs invest primarily in unlisted equity and partly in
listed equity, structured instruments or debts also. The investment in
listed equity shall be through IPO or preferential offer and not through
the secondary market route. The VCF shall invest at least 70% of the
investible funds in unlisted equity of VCU and 30% of investible funds
may be used for investment through IPO, preferential offer, debt, etc.
The investible funds would be net of expenditure incurred for
administration and management of the funds.
! !409
The downstream investments by a Venture Capital Fund (VCF) or a Cat-I

AIF, which has received investment from FVCI, shall have to comply with
the provisions for downstream investment as laid down in Schedule 11 of
the Principal Regulations.
An entity receiving investment directly from a registered Foreign Venture

Capital Investor (FVCI) will be required to report the investment, mutatis
mutandis, in form FCGPR. The necessary changes in the E-biz portal are
being made and separate instructions will be issued in due course. Till such
time, reporting requirements, as hitherto, shall continue.
Under Section 90(2) of the Income-tax Act, a non-resident assessee based

in a country with which India has a Double Taxation Avoidance Agreement
(DTAA), may opt to be taxed either under the IT Act or the DTAA,
whichever is more beneficial.
Under Section 10(23FB) of the IT Act, any income of a registered FVCI is

exempt from income tax. The FVCI can carry on business in India through
a permanent establishment in India, and yet its entire income would be
tax-free. On the other hand, if the FVCI opts to be taxed under the DTAA
and it has a permanent establishment in India, its Indian income will not
be tax-free.
Exit strategy is the method by which a venture capitalist or business owner

intends to get out of an investment that he or she has made in the past. In
other words, the exit strategy is a way of "cashing out" an investment.
Examples include an initial public offering (IPO) or being bought out by a
larger player in the industry. It is also referred to as a "harvest strategy" or
"liquidity event”.
! !410
22.12 Questions
1. What is Foreign Venture capital and describe the characteristic features

of Foreign venture capital.
2. Explain the registration process of foreign venture capital Fund.
3. Write short Notes on: General obligations and conditions for foreign
venture capital.
4. Explain the investment opportunities that foreign venture capital has as

per the revised RBI guidelines.
5. What are the taxation regulations for foreign venture capital?

1. It is mandatory for a foreign investor that it should have got itself

registered with _____________ before it proceeds to make investment
in Venture Capital Company of India.
a. SEBI
b. RBI
c. Registrar of companies
d. All of the above
2. FVCI can be in form of a company including _____________

a. a body corporate
b. a trust
c. a or b
d. partnership firm
! !411
3. The requirement that is required to be satisfied by a foreign investor

before it can make investments in venture capital companies in India
includes _____________
a. It should have been incorporated and established in any country
outside India;
b. It should be willing to make investment in VCFs or VCUs in India in
accordance with the SEBI regulations; and
c. It should have got itself registered with the SEBI as an FVCI.
d. All of the above
4. Every foreign venture capital investor shall maintain for a period of

_____________ years books of account, records and documents which
shall give a true and fair picture of the state of affairs of the Foreign
Venture Capital Investor.
a. 3
b. 5
c. 8
d. 10
5. As per the revised RBI guidelines an entity receiving investment directly

from a registered Foreign Venture Capital Investor (FVCI) will be
required to report the investment, mutatis mutandis, in form
_____________
a. IT return
b. FCGPR
c. FCTRS
d. All of the above
Answers: 1. (a), 2. (c), 3. (d), 4. (c), 5. (b)
! !412
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !413
CORPORATE GOVERNANCE
Chapter 23
Corporate Governance
Objectives

Corporate governance, why it is required to implement in companies,
governing rules, practices followed, governing rule for Board of directors
and shareholders. Finally, you will understand why Corporate governance is
required in India and benefit accrued out of good corporate governance.
Structure:
23.1 Introduction
23.2 Definition
23.3 The Objectives of Corporate Governance
23.4 Concept of Corporate Governance
23.5 Need for Corporate Governance
23.6 Principles of Corporate Governance
23.7 SEBI Code of Corporate Governance
23.8 Best Corporate Governance Practice
23.9 Principles of Good Corporate Governance
23.10 Five Golden Rules of corporate Governance
23.11New Provisions for Directors and Shareholders in Listing
Agreement
23.12 Additional Provisions
23.13 Why is Corporate Governance in India Important?
23.14 Benefits of Corporate Governance
23.15Summary
23.16 Questions
! !414
23.1 Introduction
The Corporate governance is the system by which companies are directed

and controlled. Boards of directors are responsible for the governance of
their companies. The shareholders’ role in governance is to appoint the
directors and the auditors and to satisfy themselves that an appropriate
governance structure is in place.
The responsibilities of the board include setting the company’s strategic

aims, providing the leadership to put them into effect, supervising the
management of the business and reporting to shareholders on their
stewardship.
Corporate governance is therefore about what the board of a company

does and how it sets the values of the company, and it is to be
distinguished from the day-to-day operational management of the
company by full-time executives.
In the UK for listed companies’ corporate governance it is part of the legal

system as the UK Corporate Governance Code applies to accounting
periods beginning on or after 29 June 2010 and, as a result of the new
Listing Regime introduced in April 2010, applies to all companies with a
Premium Listing of equity shares regardless of whether they are
incorporated in the UK or elsewhere.
But good governance can have wider impacts to the non-listed sector
because it is fundamentally about improving transparency and
accountability within existing systems. One of the interesting developments
in the last few years has been the way in which the ‘corporate’ governance
label has been used to describe governance and accountability issues
beyond the corporate sector.
23.2 Definition
What is corporate governance? It is a process set up for the firms based on

certain systems and principles by which a company is governed. The
guidelines provided ensure that the company is directed and controlled in a
way so as to achieve the goals and objectives to add value to the company
and also benefit the stakeholders in the long term.
! !415
The high profile corporate governance failure scams like the stock market
scam, the UTI scam, Ketan Parikh scam, Satyam scam, which were
severely criticized by the shareholders, called for a need to make corporate
governance in India transparent as it greatly affects the development of
the country.
To understand the scope of the legal framework and study the

amendments, proxy advisory firms analyse the role of directors and how
they are impacted by changes in the amendments. Proxy firms offer
analytical data for the shareholders and corporate advisory services to
companies.
Corporate governance refers to the accountability of the Board of Directors

to all stakeholders of the corporation i.e. shareholders, employees,
suppliers, customers and the society in general; towards giving the
corporation a fair, efficient and transparent administration.
Following are cited a few popular definitions of corporate

governance:
1. “Corporate governance means that company manages its business in a

manner that is accountable and responsible to the shareholders. In a
wider interpretation, corporate governance includes company’s
accountability to shareholders and other stakeholders such as
employees, suppliers, customers and local community.” – Cather Wood.
2. “Corporate governance is the system by which companies are directed

and controlled.” – The Cadbury Committee (U.K.)
23.3 The Objectives of Corporate Governance
Transparency in corporate governance is essential for the growth,

profitability and stability of any business. The need for good corporate
governance has intensified due to growing competition amongst businesses
in all economic sectors at the national, as well as international level.
The Indian Companies Act of 2013 introduced some progressive and

transparent processes which benefit stakeholders, directors as well as the
management of companies. Investment advisory services and proxy firms
provide concise information to the shareholders about these newly
! !416
introduced processes and regulations, which aim to improve the corporate

governance in India.
Corporate advisory services are offered by advisory firms to efficiently

manage the activities of companies to ensure stability and growth of the
business, maintain the reputation and reliability for customers and clients.
The top management that consists of the board of directors is responsible
for governance. They must have effective control over affairs of the
company in the interest of the company and minority shareholders.
Corporate governance ensures strict and efficient application of
management practices along with legal compliance in the continually
changing business scenario in India.
23.4 Concept of corporate governance
i. Corporate governance is more than company administration. It refers to

a fair, efficient and transparent functioning of the corporate
management system.
ii. Corporate governance refers to a code of conduct the Board of Directors

must abide by while running the corporate enterprise.
iii. Corporate governance refers to a set of systems, procedures and

practices which ensure that the company is managed in the best
interest of all corporate stakeholders.
! !417
23.5 Need for Corporate Governance:
The need for corporate governance is highlighted by the following factors:
1. Wide Spread of Shareholders
Today a company has a very large number of shareholders spread all over
the nation and even the world; and a majority of shareholders being
unorganised and having an indifferent attitude towards corporate affairs.
The idea of shareholders’ democracy remains confined only to the law and
the Articles of Association; which requires a practical implementation
through a code of conduct of corporate governance.
2. Changing Ownership Structure
The pattern of corporate ownership has changed considerably, in the

present-day-times; with institutional investors (foreign as well Indian) and
mutual funds becoming largest shareholders in large corporate private
sector. These investors have become the greatest challenge to corporate
managements, forcing the latter to abide by some established code of
corporate governance to build up its image in society.
3. Corporate Scams or Scandals
Corporate scams (or frauds) in the recent years of the past have shaken
public confidence in corporate management. The event of Harshad Mehta
scandal, which is perhaps, one biggest scandal, is in the heart and mind of
all, connected with corporate shareholding or otherwise being educated
and socially conscious.
The need for corporate governance is, then, imperative for reviving
investors’ confidence in the corporate sector towards the economic
development of society.
4. Greater Expectations of Society from the Corporate Sector
Society of today holds greater expectations from the corporate sector in

terms of reasonable price, better quality, pollution control, best utilisation
of resources etc. To meet social expectations, there is a need for a code of
! !418
corporate governance, for the best management of company in economic

and social terms.
5. Hostile Take-Overs
Hostile take-overs of corporations witnessed in several countries, put a

question mark on the efficiency of managements of take-over companies.
This factors also point out to the need for corporate governance, in the
form of an efficient code of conduct for corporate managements.
6. Huge Increase in Top Management Compensation
It has been observed in both developing and developed economies that

there has been a great increase in the monetary payments (compensation)
packages of top level corporate executives. There is no justification for
exorbitant payments to top ranking managers, out of corporate funds,
which are a property of shareholders and society.
This factor necessitates corporate governance to contain the ill-practices of

top managements of companies.
7. Globalisation
Desire of more and more Indian companies to get listed on international

stock exchanges also focuses on a need for corporate governance. In fact,
corporate governance has become a buzzword in the corporate sector.
There is no doubt that international capital market recognises only
companies well-managed according to standard codes of corporate
governance.
! !419
23.6 Principles of Corporate Governance:
The fundamental or key principles of corporate governance are described

below:
1. Transparency
Transparency means the quality of something which enables one to

understand the truth easily. In the context of corporate governance, it
implies an accurate, adequate and timely disclosure of relevant information
about the operating results etc. of the corporate enterprise to the
stakeholders.
In fact, transparency is the foundation of corporate governance; which

helps to develop a high level of public confidence in the corporate sector.
For ensuring transparency in corporate administration, a company should
publish relevant information about corporate affairs in leading newspapers,
e.g., on a quarterly or half-yearly or annual basis.
2. Accountability
Accountability is a liability to explain the results of one’s decisions taken in

the interest of others. In the context of corporate governance,
accountability implies the responsibility of the Chairman, the Board of
Directors and the Chief Executive for the use of company’s resources (over
which they have authority) in the best interest of the company and its
stakeholders.
3. Independence
Good corporate governance requires independence on the part of the top

management of the corporation i.e. the Board of Directors must be strong
non-partisan body so that it can take all corporate decisions based on
business prudence. Without the top management of the company being
independent, good corporate governance is a mere dream.
! !420
23.7 SEBI Code of Corporate Governance
To promote good corporate governance, the SEBI (Securities and Exchange

Board of India) constituted a committee on corporate governance under
the chairmanship of Kumar Mangalam Birla. On the basis of the
recommendations of this committee, the SEBI issued certain guidelines on
corporate governance; which are required to be incorporated in the listing
agreement between the company and the stock exchange.
An overview of the SEBI guidelines on corporate governance is given

below, under appropriate heads:
1. Board of Directors
a. The Board of Directors of the company shall have an optimum

combination of executive and non-executive directors.
b. The number of independent directors would depend on whether the

chairman is executive or non-executive.
c. In case of non-executive chairman, at least one third of the Board

should comprise of independent directors; and in case of executive
chairman, at least half of the Board should comprise of independent
directors.
The expression ‘independent directors’ means directors, who apart from

receiving director’s remuneration, do not have any other material
pecuniary relationship with the company.
2. Audit Committee
(A) The company shall form an independent audit committee whose

constitution would be as follows:
i. It shall have minimum three members, all being non-executive

directors, with the majority of them being independent, and at least one
director having financial and accounting knowledge.
ii. The Chairman of the committee will be an independent director.
! !421
iii. The Chairman shall be present at the Annual General Meeting to answer
shareholders’ queries.
(B) The audit committee shall have powers which should include the
following:
a. To investigate any activity within its terms of reference

b. To seek information from any employee
c. To obtain outside legal or other professional advice
d. To secure attendance of outsiders with relevant expertise, if considered
necessary.
(C) The role of audit committee should include the following:
a. Overseeing of the company’s financial reporting process and the

disclosure of its financial information to ensure that the financial
statement is correct, sufficient and credible.
b. Recommending the appointment and removal of external auditor.
c. Reviewing the adequacy of internal audit function
d. Discussing with external auditors, before the audit commences, the

nature and scope of audit; as well as to have post-audit discussion to
ascertain any area of concern.
e. Reviewing the company’s financial and risk management policies.
3. Remuneration of Directors
The following disclosures on the remuneration of directors shall be made in

the section on the corporate governance of the Annual Report:
i. All elements of remuneration package of all the directors i.e. salary,

benefits, bonus, stock options, pension etc.
ii. Details of fixed component and performance-linked incentives, along

with performance criteria.
! !422
4. Board Procedure
a. Board meetings shall be held at least four times a year, with a

maximum gap of 4 months between any two meetings.
b. A director shall not be a member of more than 10 committees or act

as chairman of more than five committees, across all companies, in
which he is a director.
5. Management
A Management Discussion and Analysis Report should form part of the

annual report to the shareholders; containing discussion on the following
matters (within the limits set by the company’s competitive position).
a. Opportunities and threats

b. Segment-wise or product-wise performance
c. Risks and concerns
d. Discussion on financial performance with respect to operational
performance
e. Material development in human resource/industrial relations front.
6. Shareholders
Some points in this regard are:
In case of appointment of a new director or reappointment of a director,

shareholders must be provided with the following information:
• A brief resume (summary) of the director
• Nature of his expertise
• Number of companies in which he holds the directorship and membership

of committees of the Board.
A Board Committee under the chairmanship of non-executive director shall

be formed to specifically look into the redressing of shareholders’ and
investors’ complaints like transfer of shares, non-receipt of Balance Sheet
! !423
or declared dividends etc. This committee shall be designated as

‘Shareholders’/Investors’ Grievance Committee’.
7. Report on Corporate Governance
There shall be a separate section on corporate governance in the Annual

Report of the company, with a detailed report on corporate governance.
8. Compliance
The company shall obtain a certificate from the auditors of the company
regarding the compliance of conditions of corporate governance. This
certificate shall be annexed with the Directors’ Report sent to shareholders
and also sent to the stock exchange.
23.8 Best Corporate Governance Practice
In this chapter, we discuss Five Golden Rules of best corporate governance

practice — key concepts in embracing good corporate governance and best
practices in business. Embracing these principles will mean the company’s
culture and therefore public image will shine out as an example of an open,
well and fairly run organisation.
The public image of a corporation will quite accurately reflect the culture of
that body. It follows, then, that good corporate governance must be in the
bones and bloodstream of the organisation since this in turn will be
reflected in the culture. To carry the analogy further, in the same way that
healthy blood and bones are reflected in the naturally healthy look of a
person, so an organisation whose internal functions are healthy will
naturally look so from an external perspective.
! !424
23.9 Principles of good corporate governance
All the “goodies”, to a great degree, abided by these rules. All the
“baddies” ignored them. The principles underlying these rules are:
1. ethical approach – culture, society, organisational paradigm
2. balanced objectives – congruence of goals of all interested parties
3. each party plays his part – roles of key players: owners/directors/

staff
4. decision-making process in place – reflecting the first three

principles and giving due weight to all stakeholders
5. equal concern for all stakeholders – albeit some have greater weight
than others
6. accountability and transparency – to all stakeholders
Hence, the social responsibility of business begins and ends with increasing
profit, we contend that running the business successfully is not simply
about market domination and shareholder value.
And best corporate governance practice is not simply about a battle

between distant, disloyal institutional shareholders and greedy directors
but about the ethos of the organisation and fulfilling its clearly agreed
goals.
These goals may be set by the entrepreneur who starts the business, but
they are accepted by all parties as being high-minded and in everyone’s
interests. This is notwithstanding the fact that some parties have bigger
stakes and some benefit more than others. And, of course, different parties
want different things from the company. There must be, therefore, a
process of identifying the different needs and, as much as possible,
harmonising them. This is the starting point for the smooth running of the
business. As soon as dissonance in the common goal creeps in the danger
of the standard of corporate governance deteriorating rises steadily.
! !425
Clearly, external regulation can only play a limited part in ensuring that
such a deep-seated and beneficial culture as that described above exists.
Equally clearly, however, the task of ensuring this desirable state and
adhering to best corporate governance practice belongs to the various
stakeholders, who can and should, through their proper participation, bring
this about.
23.10 Five Golden Rules of corporate governance
As we have iterated, this section of the website lays out and explains our
view of best corporate governance practice and the holistic approach by
which we believe an organisation can ensure that a state of good corporate
governance exists, or is brought into being if its existence is uncertain. It
takes the view that there is an over-riding moral dimension to running a
business and that the standard of governance will depend on the moral
complexion of the operation. Hence the approach developed is based on
the belief that:
• the business morality or ethic must permeate (Penetration) the entire

operation from top to bottom and embrace all stakeholders, a best
corporate governance practice becames integral part of good
management practice also permeating the entire operation, and not an
esoteric (difficult) specialism addressed by lawyers, auditors and
sociologists
• The principles of this approach are therefore framed in relation to the

conventional way of looking at how a business should be properly run.
1. Ethics: a clearly ethical basis to the business
2. Align Business Goals: appropriate goals, arrived at through the

creation of a suitable stakeholder decision-making model
3. Strategic management: an effective strategy process which

incorporates stakeholder value
4. Organisation: an organisation suitably structured to effect good

corporate governance
! !426
5. Reporting: reporting systems structured to provide transparency and

accountability
This approach recognises that the interests of different stakeholders carry

different weight, but it does not, by any means, suggest that those with a
major interest matter and the rest don’t. On the contrary, best corporate
governance practice dictates that all stakeholders should be treated with
equal concern and respect.
For obvious reasons, although the methodology we will propose involves

taking major stakeholders into greater account when formulating strategy,
it is designed to generate all round support because of the fact that every
stakeholder, no matter how small, is given the opportunity to express a
view, through the continuous monitoring of stakeholder perceptions. It is
key to the approach that organisations truly respect minority interests. Like
the spirit of the US constitution, the approach can be said to embrace
liberty, equality and community, but like the US economy, it aspires to
produce the most powerful and effective result in the world.
Best corporate governance practice = best management practice
The regulatory approach to the subject would regard governance as

something on its own, to do with ensuring a balance between the various
interested parties in a company’s affairs, or more particularly a way of
making sure that the chairman or chief executive is under control,
producing transparency in reporting or curbing over-generous
remuneration packages. This indeed is what the Cadbury recommendations
and the subsequent reports and code are all about. However, as we
express in the rest of this website, we regard this as much too limited a
view of governance, and hence of best corporate governance practice.
The essence of success in business is:

• having a clear and achievable goal
• having a feasible strategy to achieve it
• creating an organisation appropriate to deliver
• having in place a reporting system to guide progress.
There are very many websites and publications advising on how to do this,
and of course, this is what is described as good management. Best
corporate governance practice is about achieving the stakeholders’ goal,
! !427
and delivering success in an ethical way. Hence it follows that it must entail
a holistic application of good management.
To demonstrate the totality, and the need for a holistic approach, we

present below an illustration showing the pressures on a large
organisation.
Pressures on a Company
It is important that a wide perspective is taken when considering corporate

governance because one cannot emphasise too strongly our belief that
good management practices will deliver good corporate governance.
Compliance with checklists of regulations and codes, in the setting of bad
management or a lack of commitment to good management,
will NOT deliver good corporate governance. The longer term consequences
! !428
of this externally-applied regulatory approach will be a progressive

introduction of more and more rules which are held in less and less regard,
and which produce less and less effect.
The result benefits neither business nor its customers, and has only served
to spawn a growing industry of specialist advisers in corporate governance
and lobby groups. It has also failed to prevent more and bigger corporate
failures. So while most of the provisions of the various Codes of Conduct
could certainly be considered best corporate governance practice — or at
least good corporate governance, if they are imposed externally and not
truly bought into by every part of the company and its stakeholders, and
monitored effectively, there will always be those who try — and succeed —
in hiding from or bending the rules.
The big advantage of the shareholder model over the stakeholder model in
management terms is the simple goal it presents: maximise shareholder
value. No such simple target attaches to the stakeholder approach, and yet
without a clear goal, management faces an impossible task in trying to do
its job properly – what exactly is its job?
The governance, the goals and the strategy of a business must be

compatible, and there must be congruence between the expectations of the
various interested parties. Clearly, in defining best corporate governance
practice, this means that:
• there is a common view as to the ethic by which the business is

conducted
• the views of all interested parties are taken into account when deciding
the goal
• an appropriate weighting is given to those views to arrive at a conclusion

as to how to achieve the greatest good
• a strategy is formulated to attain the chosen goal which takes account of

the likely behaviour of the various interest groups
• an implementation programme is drawn up which makes the necessary

organisational arrangements to fulfil the strategy and to protect the
interests of the various stakeholders
! !429
• the implementation programme includes reporting systems which ensure

transparency and regular feedback on matters which affect various
stakeholders
23.11 New Provisions for Directors and Shareholders in

Listing Agreement
Corporate governance was guided by Clause 49 of the Listing Agreement

before introduction of the Companies Act of 2013. As per the new
provision, the SEBI has also approved certain amendments in the Listing
Agreement so as to improve the transparency in transactions of listed
companies and giving a bigger say to minority stakeholders in influencing
the decisions of management. These amendments have become effective
from 1st October 2014.
• One or more women directors are recommended for certain classes of

companies
• Every company in India must have a resident directory
• The maximum permissible directors cannot exceed 15 in a public limited

company. If more directors have to be appointed, it can be done only
with approval of the shareholders after passing a Special Resolution
• The Independent Directors are a newly introduced concept under the Act.
A code of conduct is prescribed and so are other functions and duties
• The Independent directors must attend at least one meeting a year
• Every company must appoint an individual or firm as an auditor. The

responsibility of the Audit committee has increased
• Filing and disclosures with the Registrar of Companies has increased
• Top management recognizes the rights of the shareholders and ensures

strong co-operation between the company and the stakeholders
• Every company has to make accurate disclosure of financial situations,

performance, material matter, ownership and governance
! !430
23.12 Additional Provisions
Related Party Transactions – A Related Party Transaction (RPT) is the

transfer of resources or facilities between a company and another specific
party. The company devises policies which must be disclosed on the
website and in the annual report. All these transactions must be approved
by the shareholders by passing a Special Resolution as the Companies Act
of 2013. Promoters of the company cannot vote on a resolution for a
related party transaction.
Changes in Clause 35B – The e-voting facility has to be provided to the

shareholder for any resolution is a legal binding for the company.
Corporate Social Responsibility – The company has the responsibility to

promote social development in order to return something that is beneficial
for the society.
Whistle Blower Policy – This is a mandatory provision by the SEBI which is

a vigil mechanism to report the wrong or unethical conduct of any director
of the company.
23.13 Why is Corporate Governance in India Important?
A company that has good corporate governance has a much higher level of
confidence amongst the shareholders associated with that company. Active
and independent directors contribute towards a positive outlook of the
company in the financial market, positively influencing share prices.
Corporate Governance is one of the important criteria for foreign
institutional investors to decide on which company to invest in.
The corporate practices in India emphasize the functions of audit and

finances that have legal, moral and ethical implications for the business
and its impact on the shareholders. The Indian Companies Act of 2013
introduced innovative measures to appropriately balance legislative and
regulatory reforms for the growth of the enterprise and to increase foreign
investment, keeping in mind international practices. The rules and
regulations are measures that increase the involvement of the
shareholders in decision-making and introduce transparency in corporate
governance, which ultimately safeguards the interest of the society and
shareholders.
! !431
Corporate governance safeguards not only the management but the

interests of the stakeholders as well and fosters the economic progress of
India in the roaring economies of the world.
23.14 Benefits of Corporate Governance
Following are some of the major benefits of corporate governance:
1. Good corporate governance ensures corporate success and economic

growth.
2. Strong corporate governance maintains investors’ confidence, as a

result of which, company can raise capital efficiently and effectively.
3. It lowers the capital cost.
4. There is a positive impact on the share price.
5. It provides proper inducement to the owners as well as managers to

achieve objectives that are in interests of the shareholders and the
organization.
6. Good corporate governance also minimizes wastages, corruption, risks

and mismanagement.
7. It helps in brand formation and development.
8. It ensures organization managed in a manner that fits the best interests

of all.
! !432
23.15 Summary
Corporate Governance refers to the way a corporation is governed. It is the

technique by which companies are directed and managed. It means
carrying the business as per the stakeholders’ desires. It is actually
conducted by the board of Directors and the concerned committees for the
company’s stakeholders’ benefit. It is all about balancing individual and
societal goals, as well as, economic and social goals.
Corporate Governance is the interaction between various participants

(shareholders, board of directors, and company’s management) in shaping
corporation’s performance and the way it is proceeding towards. The
relationship between the owners and the managers in an organization must
be healthy and there should be no conflict between the two. The owners
must see that individual’s actual performance is according to the standard
performance. These dimensions of corporate governance should not be
overlooked.
Corporate Governance deals with the manner the providers of finance

guarantee themselves of getting a fair return on their investment.
Corporate Governance clearly distinguishes between the owners and the
managers. The managers are the deciding authority. In modern
corporations, the functions/tasks of owners and managers should be clearly
defined, rather, harmonizing.
Corporate Governance deals with determining ways to take effective

strategic decisions. It gives ultimate authority and complete responsibility
to the Board of Directors. In today’s market- oriented economy, the need
for corporate governance arises. Also, efficiency as well as globalization are
significant factors urging corporate governance. Corporate Governance is
essential to develop added value to the stakeholders.
Corporate Governance ensures transparency which ensures strong and

balanced economic development. This also ensures that the interests of all
shareholders (majority as well as minority shareholders) are safeguarded.
It ensures that all shareholders fully exercise their rights and that the
organization fully recognizes their rights.
! !433
Corporate Governance has a broad scope. It includes both social and

institutional aspects. Corporate Governance encourages a trustworthy,
moral, as well as ethical environment.
23.16 Questions
1. What is corporate Governance? Define.

2. Write short Note on Objective of corporate Governance.
3. What is the need for Corporate Governance? Explain.
4. Write short notes on: Principles of Corporate Governance.
5. Explain: SEBI Code of Corporate Governance.

1. Transparency in corporate governance is essential for _____________

of any business
a. Growth
b. Profitability
c. Stability
d. All of the above
2. Who provides concise information to the shareholders about these newly

introduced processes and regulations, which aim to improve the
corporate governance in India?
a. Investment advisory services and proxy firms
b. Board of Directors
c. Company Secretary
d. Registrar of Companies
3. The directors, who apart from receiving director’s remuneration, do not

have any other material pecuniary relationship with the company is
called as _____________
a. Whole time Director
b. Independent Director
c. Representative of Regulator
d. Representative of Government
! !434
4. What disclosures on the remuneration of directors shall be made in the

section on the corporate governance of the Annual Report?
a. All elements of remuneration package of all the directors i.e. salary,
benefits, bonus, stock options, pension etc.
b. Details of fixed component and performance linked incentives, along
with performance criteria.
c. Both a and b
d. Any one of a or b
5. “Corporate governance safeguards not only the management but the

interests of the stakeholders as well and fosters the economic progress
of India in the roaring economies of the world.” _____________True or
False
a. True
b. False
Answers: 1. (d), 2. (a), 3. (b), 4. (c), 5. (a)
! !435
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !436
CORPORATE RESTRUCTURING
Chapter 24
Corporate Restructuring
Objectives

Corporate restructuring, why Restructuring happens, what are the
methods/types of restructuring, Companies Act 2013 relating to
regulations for corporate restructuring etc.
Structure:
24.1 Introduction
24.2 Corporate Restructuring — Historical Background
24.3 Need and Scope of Corporate Restructuring
24.4 Planning, Formulation and Execution of Various Restructuring

Strategies
24.5 Types of Corporate Restructuring Strategies
24.6 Emerging Trends in Corporate Restructuring
24.7 Expanding Role of Professionals in Corporate Restructuring Process
24.8 Restructuring & Companies Act, 2013
24.9 Summary
24.10 Questions
! !437
24.1 Introduction
Corporate restructuring is defined as the process involved in changing the

organization of a business. Corporate restructuring can involve making
dramatic changes to a business by cutting out or merging departments. It
implies rearranging the business for increased efficiency and profitability.
In other words, it is a comprehensive process by which a company can
consolidate its business operations and strengthen its position for achieving
corporate objectives-synergies and continuing as competitive and
successful entity.
Corporate restructuring is the process of significantly changing a

company's business model, management team or financial structure to
address challenges and increase shareholder value. Restructuring may
involve major layoffs or bankruptcy, though restructuring is usually
designed to minimize the impact on employees, if possible. Restructuring
may involve the company's sale or a merger with another company.
Companies use restructuring as a business strategy to ensure their long-
term viability. Shareholders or creditors might force a restructuring if they
observe the company's current business strategies as insufficient to
prevent a loss on their investments. The nature of these threats can vary,
but common catalysts for restructuring involve a loss of market share, the
reduction of profit margins or declines in the power of their corporate
brand. Other motivators of restructuring include the inability to retain
talented professionals and major changes to the marketplace that directly
impact the corporation's business model.
24.2 Corporate Restructuring – Historical Background
In earlier years, India was a highly-regulated economy. Though

Government participation was overwhelming, the economy was controlled
in a centralized way by Government participation and intervention. In other
words, economy was closed as economic forces such as demand and
supply were not allowed to have a full-fledged liberty to rule the market.
There was no scope of realignments and everything was controlled. In such
a scenario, the scope and mode of Corporate Restructuring were very
limited due to restrictive government policies and rigid regulatory
framework.
! !438
These restrictions remained in vogue, practically, for over two decades.

These, however, proved incompatible with the economic system in keeping
pace with the global economic developments if the objective of faster
economic growth were to be achieved. The Government had to review its
entire policy framework and under the economic liberalization measures
removed the above restrictions by omitting the relevant sections and
provisions.
The real opening up of the economy started with the Industrial Policy, 1991
whereby 'continuity with change' was emphasized and main thrust was on
relaxations in industrial licensing, foreign investments, transfer of foreign
technology etc. With the economic liberalization, globalization and opening
up of economies, the Indian corporate sector started restructuring to meet
the opportunities and challenges of competition.
The economic and liberalization reforms, have transformed the business

scenario all over the world. The most significant development has been the
integration of national economy with 'market-oriented globalized economy'.
The multilateral trade agenda and the World Trade Organization (WTO)
have been facilitating easy and free flow of technology, capital and
expertise across the globe. A restructuring wave is sweeping the corporate
sector the world over, taking within its fold both big and small entities,
comprising old economy businesses, conglomerates and new economy
companies and even the infrastructure and service sector. From banking to
oil exploration and telecommunication to power generation, petrochemicals
to aviation, companies are coming together as never before. Not only these
new industries like e-commerce and biotechnology have been exploding,
but old industries are also being transformed.
With the increasing competition and the economy, heading towards

Globalisation, the corporate restructuring activities are expected to occur at
a much larger scale than at any time in the past. Corporate Restructuring
plays a major role in enabling enterprises to achieve economies of scale,
global competitiveness, right size, and a host of other benefits including
reduction of cost of operations and administration.
! !439
!
24.3 Need and scope of Corporate Restructuring
Corporate Restructuring is concerned with arranging the business activities

of the corporate as a whole so as to achieve certain predetermined
objectives at corporate level. Such objectives include the following:
• orderly redirection of the firm's activities;
• deploying surplus cash from one business to finance profitable growth in

another;
• exploiting inter-dependence among present or prospective businesses

within the corporate portfolio;
• risk reduction; and
• development of core competencies.
When we say corporate level, it may mean a single company engaged in

single activity or an enterprise engaged in multi activities. It could also
mean a group having many companies engaged in related or unrelated
activities. When such enterprises consider an exercise for restructuring
their activities they have to take a wholesome view of the entire activities
so as to introduce a scheme of restructuring at all levels. However, such a
scheme could be introduced and implemented in a phased manner.
Corporate Restructuring also aims at improving the competitive position of
an individual business and maximizing its contribution to corporate
objectives. It also aims at exploiting the strategic assets accumulated by a
! !440
business i.e. natural monopolies, goodwill, exclusivity through licensing

etc. to enhance the competitive advantages. Thus, restructuring would help
bringing an edge over competitors.
Competition drives technological development. Competition from within a

country is different from cross-country competition. Innovations and
inventions do not take place merely because human beings would like to be
creative or simply because human beings tend to get bored with existing
facilities. Innovations and inventions do happen out of necessity to meet
the challenges of competition. Cost cutting and value addition are two
mantras that get highlighted in a highly competitive world. Monies flow into
the stream of production in order to be able to face competition and deliver
the best possible goods at the convenience and affordability of the
consumers. Global Competition drives people to think big and it makes
them fit to face global challenges. In other words, global competition drives
enterprises and entrepreneurs to become fit globally. Thus, competitive
forces play an important role. In order to become a competitive force,
Corporate Restructuring exercise could be taken up. Also, to drive
competitive forces, Corporate Restructuring exercise could be taken up.
The scope of Corporate Restructuring encompasses enhancing economy

(cost reduction) and improving efficiency (profitability). When a company
wants to grow, or survive in a competitive environment, it needs to
restructure itself and focus on its competitive advantage. The survival and
growth of companies in this environment depends on their ability to pool all
their resources and put them to optimum use. A larger company, resulting
from merger of smaller ones, can achieve economies of scale. If the size is
bigger, it enjoys a higher corporate status. The status allows it to leverage
the same to its own advantage by being able to raise larger funds at lower
costs. Reducing the cost of capital translates into profits. Availability of
funds allows the enterprise to grow in all levels and thereby become more
and more competitive.
Corporate Restructuring aims at different things at different times for

different companies and the single common objective in every restructuring
exercise is to eliminate the disadvantages and combine the advantages.
The various needs for undertaking a Corporate Restructuring exercise are
as follows:
! !441
i. to focus on core strengths, operational synergy and efficient allocation

of managerial capabilities and infrastructure.
ii. consolidation and economies of scale by expansion and diversion to

exploit extended domestic and global markets.
iii. revival and rehabilitation of a sick unit by adjusting losses of the sick
unit with profits of a healthy company.
iv. acquiring constant supply of raw materials and access to scientific

research and technological developments.
v. capital restructuring by appropriate mix of loan and equity funds to

reduce the cost of servicing and improve return on capital employed.
vi. Improve corporate performance to bring it at par with competitors by

adopting the radical changes brought out by information technology.
24.4 Planning, formulation and execution of various

restructuring strategies
Corporate restructuring strategies depend on the nature of business, type

of diversification required and results in profit maximization through
pooling of resources in effective manner, utilization of idle resources,
effective management of competition etc.
Planning the type of restructuring requires detailed business study,

expected business demand, available resources, utilized/idle portion of
resources, competitor analysis, environmental impact etc. The bottom line
is that the right restructuring strategy provides optimum synergy for the
organizations involved in the restructuring process.
It involves examination of various aspects before and after the

restructuring process.
Important aspects to be considered while planning or implementing

corporate restructuring strategies:
The restructuring process requires various aspects to be considered before,

during and after the restructuring. They are
! !442
• Valuation & Funding

• Legal and procedural issues
• Taxation and Stamp duty aspects
• Accounting aspects
• Competition aspects etc.
• Human and Cultural synergies
Based on the analysis of various aspects, a right type of strategy is chosen.
24.5 Types of Corporate Restructuring Strategies
Various types of corporate restructuring strategies include:

1. Merger
2. Demerger
3. Reverse Mergers
4. Disinvestment
5. Takeovers
6. Joint venture
7. Strategic alliance
8. Slump Sale
9. Franchising
10.Strategic alliance etc.
Let us understand these strategies in brief:
1. Merger
Merger is the combination of two or more companies which can be merged

together either by way of amalgamation or absorption. The combining of
two or more companies is generally by offering the stockholders of one
company securities in the acquiring company in exchange for the surrender
of their stock.
Mergers may be
i. Horizontal Merger: It is a merger of two or more companies that

compete in the same industry. It is a merger with a direct competitor
and hence expands as the firm's operations in the same industry.
Horizontal mergers are designed to achieve economies of scale and
result in reducing the number of competitors in the industry.
! !443
ii. Vertical Merger: It is a merger which takes place upon the

combination of two companies which are operating in the same industry
but at different stages of production or distribution system. If a
company takes over its supplier/producers of raw material, then it may
result in backward integration of its activities. On the other hand,
Forward integration may result if a company decides to take over the
retailer or Customer Company. Vertical merger provides a way for total
integration to those firms which are striving for owning of all phases of
the production schedule together with the marketing network
iii. Co-generic Merger: It is the type of merger, where two companies are
in the same or related industries but do not offer the same products,
but related products and may share similar distribution channels,
providing synergies for the merger. The potential benefit from these
mergers is high because these transactions offer opportunities to
diversify around a common case of strategic resources.
iv. Conglomerate Merger: These mergers involve firms engaged in

unrelated type of activities i.e. the business of two companies are not
related to each other horizontally or vertically. In a pure conglomerate,
there are no important common factors between the companies in
production, marketing, research and development and technology.
Conglomerate mergers are mergers of different kinds of businesses
under one flagship company. The purpose of merger remains utilization
of financial resources, enlarged debt capacity and also synergy of
managerial functions. It does not have a direct impact on acquisition of
monopoly power and is thus favoured throughout the world as a means
of diversification.
2. Demerger
It is a form of corporate restructuring in which the entity's business

operations are segregated into one or more components. A demerger is
often done to help each of the segments operate more smoothly, as they
can focus on a more specific task after demerger.
! !444
3. Reverse Merger
Reverse merger is the opportunity for the unlisted companies to become

public listed company, without opting for Initial Public offer (IPO). In this
process the private company acquires the majority shares of public
company, with its own name.
4. Disinvestment
Disinvestment means the action of an organization or government selling

or liquidating an asset or subsidiary. It is also known as "divestiture".
5. Takeover/Acquisition
Takeover means an acquirer takes over the control of the target company.
It is also known as acquisition. Normally, this type of acquisition is
undertaken to achieve market supremacy. It may be friendly or hostile
takeover.
• Friendly takeover: In this type, one company takes over the

management of the target company with the permission of the board.
• Hostile takeover: In this type, one company takes over the

management of the target company without its knowledge and against
the wish of their management.
6. Joint Venture (JV)
A joint venture is an entity formed by two or more companies to undertake

financial activity together. The parties agree to contribute equity to form a
new entity and share the revenues, expenses, and control of the company.
It may be Project-based joint venture or Functional-based joint venture.
• Project-based Joint venture: The joint venture entered into by the

companies in order to achieve a specific task is known as project-based
JV.
• Functional-based Joint venture: The joint venture entered into by the

companies in order to achieve mutual benefit is known as functional-
based JV.
! !445
7. Strategic Alliance
Any agreement between two or more parties to collaborate with each other,
in order to achieve certain objectives while continuing to remain
independent organizations is called strategic alliance.
8. Franchising
Franchising may be defined as an arrangement where one party

(franchiser) grants another party (franchisee) the right to use trade name
as well as certain business systems and process, to produce and market
goods or services according to certain specifications. The franchisee usually
pays a one-time franchisee fee plus a percentage of sales revenue as
royalty and gains.
9. Slump sale
Slump sale means the transfer of one or more undertakings as a result of

the sale of lump sum consideration without values being assigned to the
individual assets and liabilities in such sales. If a company sells or disposes
of the whole or substantially the whole of its undertaking for a
predetermined lump sum consideration, then it results in a slump sale.
24.6 Emerging Trends in Corporate Restructuring
In order to present a composite view of effective practices that have

emerged from inbound investors’ experience conducting M&A in India.
KPMG in India and merger market in the year 2012, shortlisted a number
of successful deals based on their size and prominence in the Indian
marketplace. They conducted interviews with key M&A Heads or equivalent
from International companies involved in these transactions over the
course of 2012. The report represents a summary of these conversations
and the learnings that have emerged from these transactions.
Almost all participants acknowledged that India was an important part of

their overall global expansion strategy, and by and large, participants have
been pleased with the success of their respective deals despite the fact
that some are still in the process of completing integration.
! !446
The key insights that emerged are as follows:
• Acquirers come to India for its domestic market and the

innovation capabilities of its companies
The primary attraction for acquirers when investing in India is the potential
of its domestic market and the opportunity to use India as a springboard to
access some of the regional South Asian, Middle East and even African
markets. Participants also cited capabilities for innovation that Indian
companies have built over the last two decades, especially to serve low
cost value conscious consumers in the emerging markets as a key reason
behind doing deals in India.
• Investable targets are hard (but not impossible) to find
Given India’s size, its federal regulatory structure and socio-political

diversity, most businesses take a regional approach to market growth in
the country, and as a result, few truly national players exist. Having said
that, many of the regional markets these businesses serve have the
potential of being as large as or even larger than national markets in other
countries.
Coverage and availability of information on domestic companies in India is

still patchy, making secondary market scans difficult. And while auction
processes are prevalent, many deals are done based on local relationships
and a deep understanding of the regional operations of potential targets. In
fact, for many of the successful acquisitions and partnerships highlighted in
this report, acquirers were in India building relationships well before their
transactions materialized either by forming an Indian subsidiary or by
maintaining trading relationships.
Even once a potential deal is on the table it can take time for a seller to
furnish historical financials and realistic forecasts that link back to past
performance. Most acquirers tended to take an independent view of a
target’s growth prospects while factoring in the right level of investment
support post-deal.
! !447
• It takes time and effort to get to know the family
Managing the relationship with the promoter (seller) can be of paramount

importance for a successful deal. Promoters are also typically involved in
direct management of the business, and selling would mean losing regular
income, personal status and an important family asset. Furthermore,
promoter-led businesses often have more than one decision-maker and
depending on family history, internal politics often become part of the M&A
process. For International Companies looking to acquire in India, it means
spending considerable months to get to know and understand the
promoters and the family well, before starting a transaction conversation.
• The process can seem long and complicated (because it often is)
The deal process in India can initially seem long even when there is no
competitive bidding process. Finding issues with compliance, tax or
historical financial performance is common during diligence and these may
seem like deal breakers at first.
To manage these challenges, acquirers preferred to implement transaction

structures that allow buyers to leave liabilities behind with the sellers
where possible, while ensuring sufficient engagement from promoters to
ensure a smooth transition post-deal. Participants also highlighted the need
to build a business forecast bottom up, seeking independent verification of
future contract commitments and an assessment of the dependence on
promoter relationships for continuity of business.
Where it is possible, buyers should request involvement of professional

advisors on the sell side and ask for a well-managed process including
electronic data rooms, verified financial information, explanation of
discrepancies with published results, etc., at the start of the process.
• The hard work begins once the deal is done
Most participants had a small base in India prior to the acquisition and
hence integration of local domestic operations with the target was not
really a big challenge. Key focus during the integration revolved around
navigating cultural differences, managing employee expectations from an
international acquirer and alignment of management styles. Their approach
was cautious, with over half the respondents spending between 1-3 years
! !448
to complete the integration activities. In almost all the cases, integration

was a distinct project led by teams based locally and with significant senior
management involvement.
Reflecting on the overall success of the transaction, most respondents felt

that they were by and large happy with the overall outcome of the deal and
with the quality of management that they had acquired as a result of the
transaction.
24.7 Expanding role of professionals in corporate

restructuring process
The restructuring process does not only involve strategic decision-making

based on the market study, competitor analysis, forecasting of synergies
on various respects, mutual benefits, expected social impact etc., but also
the technical and legal aspects such as valuation of organizations involved
in restructuring process, swap ratio of shares, if any, legal and procedural
aspects with regulators such as Registrar of Companies, High Court etc.,
optimum tax benefits after merger, human and cultural integration, stamp
duty cost involved etc.
It involves a team of professionals including business experts, Company

Secretaries, Chartered Accountants, HR professionals, etc., who have a role
to play in various stages of restructuring process. The Company
Secretaries being the vital link between the management and stakeholders
are involved in the restructuring process throughout as co-coordinator, in
addition to their responsibility for legal and regulatory compliances.
The restructuring deals are increasing day by day to be in line with

business dynamics and international demands. It necessitates the
expanded role of professionals in terms of maximum quality in optimum
time.
! !449
24.8 Restructuring & Companies Act, 2013
The Companies Act, 2013 has brought many enabling provisions with
regard to mergers, compromises or arrangements, especially with respect
to cross-border mergers, time-bound and single window clearances,
enhanced disclosures, disclosures to various regulators, simplified
procedure for smaller companies etc. It may be noted that Sections
230-240 of the Companies Act, 2013 and the rules made thereunder are
yet to be notified.
Salient Features of Companies Act, 2013 relating to Corporate

Restructuring (Sections 230-240)
• National Company Law Tribunal to assume jurisdiction of High Court.

• Section 230(2) – Application for compromise or arrangement to be
accompanied by an affidavit, disclosing
1. All material facts relating to the company.
2. Reduction of capital, if any, included in the compromise or arrangement;
3. Any scheme of corporate debt restructuring consented to by not less

than 75% of the secured creditors in value along with creditors’
responsibility statement, report of the auditor as to the funds
requirement after CDR and the conformity to liquidity test etc.
• Proviso to Section 230(3) – Notice relating to compromise or

arrangement and other documents to be placed on the website of the
company.
• Section 230(5) – Notice of meeting for approval of the scheme of

compromise or arrangement be sent to various regulators including:
1. The Central Government;

2. Income-tax Authorities;
3. Reserve Bank of India (`RBI’);
4. Securities Exchange Board of India (`SEBI’);
5. The Registrar;
6. Respective Stock Exchange;
7. The Competition Commission of India, if necessary, and
! !450
8. Other Sectoral regulators which could likely be affected by the scheme.

Representation, if any, by the above authorities will have to be made
within a period of 30 days from receipt of notice.
• Proviso to Section 230(4) – Persons holding not less than 10% of the
shareholdings or persons having outstanding debt amounting to not less
than 5% of the total outstanding debt as per the latest audited financial
statement, entitled to object the scheme of compromise or arrangement.
• Proviso to Section 230(7) – No sanction for Compromise or

arrangement if accounting treatment is not AS-compliant.
• Section 234 – Cross-border Merger permitted. The 1956 act permits

merger of foreign company with Indian company and not vice versa.
• Section 233 (10) – Abolishing the practice of companies holding their

own shares through a trust (Treasury Stock) in case of merger of holding
and subsidiary companies. Ultimately, the shares are to be cancelled.
• Section 233 – Fast track mergers introduced. – The new Act enables
fast track merger without the approval of NCLT, between:
1. Two or more small companies. Small company is defined under the Act.
2. Holding and wholly owned subsidiary company
3. Other class of companies as may be prescribed
• Section 230(6) – Approval of scheme by postal ballot thereby involving

wider participation;
• Section 230(11) – Any compromise or arrangement may also include

takeover offer made in the prescribed manner. In case of listed
companies, takeover offer shall be as per the regulations framed by the
SEBI.
! !451
24.9 Summary
Corporate restructuring becomes a buzzword during economic downturns.

A company going through tough financial scenario needs to understand the
process of corporate restructuring thoroughly. Although restructuring is a
generic word for any changes in the company, this word is generally
associated with financial troubles.
Corporate restructuring is a corporate action taken to significantly modify

the structure or the operations of the company. This usually happens when
a company is facing significant problems and is in financial jeopardy. Often,
the restructuring is referred to the ways to reduce the size of the company
and make it small. Corporate restructuring is essential to eliminate all the
financial troubles and improve the performance of the company.
The troubled company’s management hires legal and financial experts to

assist and advise in the negotiations and the transaction deals. The
company can go as far as appointing a new CEO specifically for making the
controversial and difficult decisions to save or restructure the company.
Generally, the company may look at debt financing, operations reduction
and sale of the company’s portions to interested investors.
Corporate restructuring is implemented under the following

scenarios:
• Change in the Strategy: The management of the troubled company

attempts to improve the company’s performance by eliminating certain
subsidiaries or divisions which do not align with the core focus of the
company. The division may not seem to fit strategically with the long-
term vision of the company. Thus, the company decides to focus on its
core strategy and sell such assets to the buyers that can use them more
effectively.
• Lack of Profits: The division may not be profitable enough to cover the
firm’s cost of capital and cause economic losses to the firm. The poor
performance of the division may be the result of the management
making a wrong decision to start the division or the decline in the
profitability of the division due to the increasing costs or changing
customer needs.
! !452
• Reverse Synergy: This concept is in contrast to the M&A principles of

synergy, where a combined unit is worth more than the individual parts
together. According to reverse synergy, the individual parts may be worth
more than the combined unit. This is a common reasoning for divesting
the assets. The company may decide that more value can be unlocked
from a division by divesting it off to a third party rather than owning it.
• Cash Flow Requirement: A sale of the division can help in creating a

considerable cash inflow for the company. If the company is facing some
difficulty in obtaining finance, selling an asset is a quick approach to
raising money and reducing debt.
There are various ways in which a company can reduce its size. The
following are the methods by which a company separates a division from
its operations:
• Divestitures: Under divestitures, a company sells, liquidates or spins off

a subsidiary or a division. Generally, a direct sale of the divisions of the
company to an outside buyer is the norm in divestitures. The selling
company gets compensated in cash and the control of the division is
transferred to the new buyer.
• Equity Carve-outs: Under equity carve-outs, a new and independent

company is created by diluting the equity interest in the division and
selling it to outside shareholders. The new subsidiary’s shares are issued
in a general public offering and the new subsidiary becomes a different
legal entity with its operations and management separated from the
original company.
• Spin-offs: Under spin-offs, the company creates an independent

company distinct from the original company as is done in equity carve-
outs. The major difference is that there is no public offering of shares,
instead, the shares are distributed among the company’s existing
shareholders proportionately. This translates into the same shareholder
base as the original company, with the operations and management
totally separate. Since the stocks of the new subsidiary are distributed to
its own shareholders, the company is not compensated by cash in this
transaction.
! !453
• Split-offs: Under split-offs, the shareholders receive new stocks of the

subsidiary of the company in trade for their existing stocks in the
company. The reasoning here is that the shareholders are letting go of
their ownership in the company to receive the stocks of the new
subsidiary.
• Liquidation: Under liquidation, a company is broken apart and the

assets or the divisions are sold piece by piece. Generally, liquidations are
linked to bankruptcies.
Thus, Corporate restructuring allows the company to continue to operate in

some way. The management of the company tries all the possible
measures to keep the entity going on. Even when the worst happens and
the company is forced to pieces because of the financial troubles, the hope
remains that the divested pieces can function good enough for a buyer to
acquire the diminished company and take it back to profitability.
24.10 Questions
(A)Answer the following questions:
1. What is corporate restructuring? Define and explain.
2. Why corporate restructuring is required? Describe.
3. Explain the importance of Planning, formulation and execution of

various restructuring strategies.
4. Write short notes on: Mergers and types of mergers
5. Write short notes on: Salient Features of Companies Act, 2013 relating
to Corporate Restructuring.
! !454

1. Corporate Restructuring is concerned with arranging the business

activities of the corporate to achieve certain predetermined objectives at
corporate level. Such objectives include _____________
a. orderly redirection of the firm's activities;
b. deploying surplus cash from one business to finance profitable growth
in another;
c. exploiting inter-dependence among present or prospective businesses
within the corporate portfolio; risk reduction; and development of
core competencies.
d. All of the above
2. Corporate restructuring strategies depend on the _____________

through pooling of resources in effective manner, utilization of idle
resources, effective management of competition.
a. nature of business
b. type of diversification required and results in profit maximization
c. both a & b
d. Only profit motive
3. The merger which takes place upon the combination of two companies
which are operating in the same industry but at different stages of
production or distribution system is called as _____________
a. Horizontal Merger
b. Vertical Merger
c. Conglomerate Merger
d. Co-generic Merger
4. Reverse merger is the opportunity for the _____________ to become

public listed company, without opting for Initial Public offer (IPO).In this
process the private company acquires the majority shares of public
company, with its own name.
a. Unlisted companies
b. Listed company
c. New Company
d. Sister concern
! !455
5. When the company creates an independent company distinct from the

original company is called as _____________
a. equity carve-outs
b. Spin off
c. Split off
d. Liquidation
Answers: 1. (d), 2. (c), 3. (b), 4. (a), 5. (b)
! !456
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !457
BUSINESS VALUATION AND TECHNIQUES
Chapter 25
Business Valuation And Techniques
Objectives
After studying this chapter, you should be able to understand why business
valuation is required, stages of business valuation, methods of valuation,
techniques used in valuation etc. and various other options for acquisitions
and take over.
Structure:
25.1 Introduction
25.2 Requirement of Valuation
25.3 Motive of Valuation in Acquisition
25.4 Factors Influencing Valuation
25.5 General Principles of Business Valuation
25.6 Preliminary Steps in Valuation
25.7 Methods of Valuation (Valuation Techniques)
25.8 Other Aspects as to the Methods of Valuation
25.9 Fair Value of Shares
25.10 Free Cash-flows (FCF)
25.11 Valuation Standards
25.12 Summary
25.13 Questions
! !458
25.1 Introduction
Valuation is an exercise to assess the worth of an enterprise or a property.

In a merger or amalgamation or demerger or acquisition, valuation is
certainly needed. It is essential to fix the value of the shares to be
exchanged in a merger or the consideration payable for an acquisition.
There are a number of situations in which a business or a share or any
other property may be required to be valued. Valuation is essential for (i)
strategic partnerships, (ii) mergers or acquisitions of shares of a company
and/or acquisition of a business. (iii) Valuation is also necessary for
introducing employee stock option plans (ESOPs) and joint ventures. From
the perspective of a valuer, a business owner, or an interested party, a
valuation provides a useful base to establish a price for the property or the
business or to help determine ways and means of enhancing the value of
his firm or enterprise.
The main objective in carrying out a valuation is to conclude a transaction

in a reasonable manner without any room for any doubt or controversy
about the value obtained by any party to the transaction. Acquisition of
Business or Investment in the Equity of an enterprise could be understood
by the following two illustrations in this regard.
A Party that enters into a transaction with another for acquiring a business
would like to acquire a business as a going concern for the purpose of
continuing to carry the same business, it might compute the valuation of
the target company on a going concern basis. On the other hand, if the
intention of the acquirer is to acquire any property such as land, rights, or
brands, the valuation would be closely connected to the market price for
such property or linked to the possible future revenue generation likely to
arise from such acquisition. In every such transaction, therefore the
predominant objective in carrying out a valuation is to put parties to a
transaction in a comfortable position so that no one feels aggrieved.
! !459
25.2 Requirement of Valuation
The following are some of the usual circumstances when valuation of

shares or enterprise becomes essential:
1. When issuing shares to public either through an initial public offer or by

offer for sale of shares of promoters or for further issue of shares to
public.
2. When promoters want to invite strategic investors or for pricing a first

issue or a further issue, whether a preferential allotment or rights issue.
3. In making investment in a joint venture by subscription or acquisition of

shares or other securities convertible into shares.
4. For making an ‘open offer for acquisition of shares’.
5. When company intends to introduce a ‘buyback’ or ‘delisting of shares’.
6. If the scheme of merger or demerger involves issue of shares. In

Schemes involving Mergers/Demergers, share valuation is resorted to in
order to determine the consideration for the purpose of issue of shares
or any other consideration to shareholders of transferor or demerged
companies.
7. On Directions of Company Law Board or any other Tribunal or Authority

or Arbitration Tribunals directs.
8. For determining fair price for effecting sale or transfer of shares as per
Articles of Association of the Company.
9. As required by the agreements between two parties.
10.For purposes of arriving at Value of Shares for purposes of assessments

under the Wealth Tax Act.
11.To determine purchase price of a ‘block of shares’, which may or may

not give the holder thereof a controlling interest in the company.
! !460
12.To value the interest of dissenting shareholders under a scheme of

Amalgamation merger or reconstruction.
13.Conversion of Debt Instruments into Shares.
14.Advancing a loan against the security of shares of the company by the

Bank/Financial Institution.
15.As required by provisions of law such the Companies Act, 1956 or

Foreign Exchange Management Act, 1999 or Income Tax Act, 1961 or
the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations,
2011 [the Takeover Code] or the SEBI (Employee Stock Option Scheme
and Employee Stock Purchase Scheme) Guidelines, 1999 or the SEBI
(Buyback of Securities) Regulations, 1998 or Delisting Guidelines.
25.3 Motive of Valuation in Acquisition:
An important aspect in the merger/amalgamation/takeover activity is the

valuation. The method of valuation of business, however, depends to a
grant extent on the acquisition motives. The acquisition activity is usually
guided by strategic behavioural motives. The reasons could be:
a. either purely financial (taxation, asset-stripping, financial restructuring

involving an attempt to augment the resources base and portfolio-
investment) or
b. business-related (expansion or diversification).
c. behavioural reasons have more to do with the personal ambitions or

objectives (desire to grow big) of the top management.
The expansion and diversification objectives are achievable either by

building capacities on one’s own or by buying the existing capacities. (Do a
“make (build) or buy decision” of capital nature.)
The decision criteria in such a situation would be the present value of the
differential cash flows. These differential cash flows would, therefore, be
the limit on the premium which the acquirer would be willing to pay. On the
other hand, if the acquisition is motivated by financial considerations
(specifically taxation and asset-stripping), the expected financial gains
! !461
would form the limit on the premium, over and above the price of physical
assets in the company. The cash flow from operations may not be the main
consideration in such situations. Similarly, a merger with financial
restructuring as its objective will have to be valued mainly in terms of
financial gains. It would, however, not be easy to determine the level of
financial gains because the financial gains would be a function of the use of
which these resources are put.
The acquisitions are not really the market driven transactions; a set of
non-financial considerations will also affect the price. The price could be
affected by the motives of other bidders. The value of a target gets
affected not only by the motive of the acquirer, but also by the target
company’s own objectives.
25.4 Factors influencing Valuation
Many factors have to be assessed to determine fair valuation for an

industry, a sector, or a company. The key to valuation is finding a common
ground between all of the companies for the purpose of a fair evaluation.
Determining the value of a business is a complicated and intricate process.

Valuing a business requires determination of its future earnings potential,
the risks inherent in those future earnings. Strictly speaking, a company’s
fair market value is the price at which the business would change hands
between a willing buyer and a willing seller when neither are under any
compulsion to buy or sell, and both parties have knowledge of relevant
facts.
! !462
Now let us understand “How do buyers and sellers arrive at this value?”
Arriving at the transaction price requires that a value be placed on the

company for sale. The process of arriving at this value should include a
detailed, comprehensive analysis which takes into account a range of
factors including the past, present, and most importantly, the future
earnings and prospects of the company, an analysis of its mix of physical
and intangible assets, and the general economic and industry conditions.
The other salient factors include:
1. The stock exchange price of the shares of the two companies before the
commencement of negotiations or the announcement of the bid.
2. Dividends paid on the shares.
3. Relative growth prospects of the two companies.
4. In case of equity shares, the relative gearing of the shares of the two
companies.
‘gearing’ means ratio of the amount of Issued preference share capital

and debenture stock to the amount of issued ordinary share capital.)
5. Net assets of the two companies.
6. Voting strength in the merged (amalgamated) enterprise of the

shareholders of the two companies.
7. History of the prices of shares of the two companies.
Also the following key principles should be kept in mind:
1. There is no method of valuation which is absolutely correct. Hence a

combination of all or some may be adopted.
2. If possible, the seller should evaluate his company before contacting

potential buyers. In fact, it would be wiser for companies to evaluate
their business on regular basis to keep themselves aware of its standing
in the corresponding industry.
! !463
3. Go for a third-party valuation if desirable to avoid overvaluation of the

company which is a common tendency on the seller’s part.
4. Merger and amalgamation deals can take several months to complete

during which time valuations can fluctuate substantially. Hence
provisions must be made to protect against such swings.
25.5 General Principles of Business valuation
1. Value is determined at a specific point in time.
2. Value is prospective. It is equivalent to the present value, or economic

worth, of all future benefits anticipated to accrue from ownership.
3. The market determines the required rate of return.
4. Value is influenced by liquidity.
5. The higher the underlying net tangible asset value base, the higher the
going concern value.
25.6 Preliminary Steps in Valuation
A business/corporate valuation involves analytical and logical application/

analysis of historical/future tangible and intangible attributes of business.
The preliminary study to valuation involves the following aspects:
1. Analysis of Business History

2. Profit trends
3. Goodwill/Brand name in the market
4. Identifying economic factors directly affecting business
5. Study of Exchange risk involved
6. Study of Employee morale
7. Study of market capitalization aspects
8. Identification of hidden liabilities through analysis of material contracts.
! !464
25.7 Methods of Valuation (Valuation Techniques)
The most popular methods of valuation amongst other include
1. Asset-based valuation
2. Earnings-based valuation
3. Market-based valuation
Let us understand Each Method in brief:
25.7.1 Valuation-based on Assets
This valuation-method is based on the simple assumption that adding the

value of all the assets of the company and subtracting the liabilities,
leaving a net asset valuation, can best determine the value of a business.
However, for the purposes of the amalgamation the amount of the
consideration for the acquisition of a business may be arrived at either by
valuing its individual assets and goodwill or by valuing the business by
reference to its earning capacity.
If this method is employed, the fixed assets of all the amalgamating

companies should preferably be valued by the same professional valuer on
a going concern basis. The term ‘going concern’ means that a business is
being operated at not less than normal or reasonable profit and valuer will
assume that the business is earning reasonable profits when appraising the
assets. If it is found when all the assets of the business, both fixed and
current, have been valued that the profits represent more than a fair
commercial return upon the capital employed in the business as shown by
such valuation the capitalised value of the excess (or super profits) will be
the value of the goodwill, which must be added to the values of the other
assets in arriving at the consideration to be paid for the business.
This method can be summarized as: The procedure of arriving at the value
of a share employed in the equity method is simply to estimate what the
assets less liabilities are worth, that is, the net assets lying for a probable
loss or possible profit on book value, the balance being available for
shareholders included in the liabilities may be debentures, debenture
interest, expenses outstanding and possible preference dividends if the
articles of association stipulate for payment of shares in winding up.
! !465
However, although a balance sheet usually gives an accurate indication of

short-term assets and liabilities. This is not the case of long-term ones as
they may be hidden by techniques such as “off balance sheet financing”.
Moreover, a balance sheet is a historical record of previous expenditure and
existing liabilities. As a valuation is a forward looking exercise, acquisition
purchase prices generally do not bear any relation to published balance
sheet. Nevertheless, a company’s net book value is still taken into account
as net book values have a tendency to become minimum prices and the
greater the proportion of purchase price is represented by tangible assets,
the less risky its acquisition is perceived to be.
Valuation of a listed and quoted company has to be done on a different

footing as compared to an unlisted company. The real value of the assets
may or may not reflect the market price of the shares; however, in unlisted
companies, only the information relating to the profitability of the company
as reflected in the accounts is available and there is no indication of the
market price. Using existing public companies as a benchmark to value
similar private companies is a viable valuation methodology.
The comparable public company method involves selecting a group of

publicly traded companies that, on average, are representative of the
company that is to be valued. Each comparable company’s financial or
operating data (like revenues, EBITDA or book value) is compared to each
company’s total market capitalization to obtain a valuation multiple. An
average of these multiples is then applied to derive the company’s value.
An asset-based valuation can be further separated into four approaches:
1. Book value
The tangible book value of a company is obtained from the balance sheet
by taking the adjusted historical cost of the company’s assets and
subtracting the liabilities; intangible assets (like goodwill) are excluded in
the calculation.
Statutes like the Gift Tax Act, Wealth Tax Act, etc., have in fact adopted
book value method for valuation of unquoted equity shares for companies
other than an investment company. Book value of assets does help the
valuer in determining the useful employment of such assets and their state
of efficiency. In turn, this leads the valuer to the determination of
rehabilitation requirements with reference to current replacement values.
! !466
In all cases of valuation on assets basis, except book value basis, it is

important to arrive at current replacement and realization value. It is more
so in case of assets like patents, trademarks, know-how, etc. which may
possess value substantially more or less than those shown in the books.
Using book value does not provide a true indication of a company’s value,
nor does it take into account the cash flow that can be generated by the
company’s assets.
2. Replacement cost
Replacement cost reflects the expenditures required to replicate the
operations of the company. Estimating replacement cost is essentially a
make or buy decision.
3. Appraised value
The difference between the appraised value of assets, and the appraised
value of liabilities is the net appraised value of the firm. This approach is
most commonly used in a liquidation analysis because it reflects the
divestiture of the underlying assets rather than the ongoing operations of
the firm.
4. Excess earnings
In order to obtain a value of the business using the excess earnings
method, a premium is added to the appraised value of net assets. This
premium is calculated by comparing the earnings of a business before a
sale and the earnings after the sale, with the difference referred to as
excess earnings.
In this approach, it is assumed that the business is run more efficiently

after a sale; the total amount of excess earnings is capitalized (e.g., the
difference in earnings is divided by some expected rate of return) and this
result is then added to the appraised value of net assets to derive the value
of the business.
25.7.2 Valuation-based on earnings
The normal purpose of the contemplated purchase is to provide for the

buyer the annuity for his outlay. He will expect yearly income, return great
or small, stable or fluctuating but nevertheless some return which is
commensurate with the price paid therefore. Valuation based on earnings
based on the rate of return on capital employed is a more modern method
! !467
being adopted. From the last earnings declared by a company, items such
as tax, preference dividend, if any, are deducted and net earnings are
taken.
An alternate to this method is the use of the price-earning (P/E) ratio

instead of the rate of return. The P/E ratio of a listed company can be
calculated by dividing the current price of the share by earnings per share
(EPS).
Therefore, the reciprocal of P/E ratio is called earnings - price ratio or

earning yield.
Thus, PE = P
Eps
Where P is the current price of the shares
The share price can thus be determined as
P = EPS x P/E ratio
25.7.3 Market-based approach to valuation
Market-based methods help the strategic buyer estimate the subject

business value by comparison to similar businesses. Where the company is
listed market price method helps in evaluating on the price on the
secondary market. Average of quoted price is considered as indicative of
the value perception of the company by investors operating under free
market conditions. To avoid chances of speculative pressures, it is
suggested to adopt the average quotations of sufficiently longer period.
The valuer will have to consider the effect of issue of bonus shares or
rights shares during the period chosen for average.
i. Market Price Method is not relevant in the following cases:
• Valuation of a division of a company
• Where the shares are not listed or are thinly traded
! !468
• In the case of a merger, where the shares of one of the companies under
consideration are +not listed on any stock exchange
• In case of companies, where there is an intention to liquidate it and to

realise the assets and distribute the net proceeds.
ii. In case of significant and unusual fluctuations in market price the

market price may not be indicative of the true value of the share. At
times, the valuer may also want to ignore this value, if according to the
valuer, the market price is not a fair reflection of the company’s
underlying assets or profitability status. The Market Price Method may
also be used as a backup for supporting the value arrived at by using
the other methods.
iii. It is important to note that Regulatory bodies have often considered

market value as one of the very important basis — Preferential
allotment, Buyback, Open offer price calculation under the Takeover
Code.
iv. In earlier days, due to non-availability of data, while calculating the

value under the market price method, high and low of monthly share
prices were considered. Now with the support of technology, detailed
data is available for stock prices. It is now a usual practice to consider
weighted average.
v. If the period for which prices are considered also has impact on account
of Bonus shares, Rights Issue, etc., the valuer needs to adjust the
market prices for such corporate events.
25.7.4 Market Comparable
This method is generally applied in case of unlisted entities. This method

estimates value by relating the same to underlying elements of similar
companies for past years. It is based on market multiples of ‘comparable
companies’. For example
• Earnings/Revenue Multiples (Valuation of Pharmaceutical Brands)
• Book Value Multiples (Valuation of Financial Institution or Banks)
! !469
• Industry-Specific Multiples (Valuation of cement companies based on

Production capacities)
• Multiples from Recent M&A Transactions.
Though this method is easy to understand and quick to compute, it may

not capture the intrinsic value and may give a distorted picture in case of
short-term volatility in the markets. There may often be difficulty in
identifying the comparable companies.
25.8 Other aspects as to the methods of valuation
25.8.1 Valuation based on super profits
This approach is based on the concept of the company as a going concern.

The value of the net tangible assets is taken into consideration and it is
assumed that the business, if sold, will in addition to the net asset value,
fetch a premium. The super profits are calculated as the difference
between maintainable future profits and the return on net assets. In
examining the recent profit and loss accounts of the target, the acquirer
must carefully consider the accounting policies underlying those accounts.
Particular attention must be paid to areas such as deferred tax provision,
treatment of extraordinary items, interest capitalisation, depreciation and
amortisation, pension fund contribution and foreign currency translation
policies. Where necessary, adjustments for the target’s reported profits
must be made, so as to bring those policies in line with the acquirer’s
policies. For example, the acquirer may write off all R&D expenditure,
whereas the target might have capitalised the development expenditure,
thus overstating the reported profits.
25.8.2 Discounted cash flow ( DCF) valuation method
Discounted cash flow valuation is based upon expected future cash flows
and discount rates. This approach is easiest to use for assets and firms
whose cash flows are currently positive and can be estimated with some
reliability for future periods.
Discounted cash flow valuation, relates the value of an asset to the present
value of expected future cash flows on that asset. In this approach, the
cash flows are discounted at a risk-adjusted discount rate to arrive at an
! !470
estimate of value. The discount rate will be a function of the riskiness of

the estimated cash flows, with lower rates for safe projects and higher rate
for riskier assets.
This approach has its foundation in the ‘present value’ concept, where the
value of any asset is the present value of the expected future cash flows on
it. Essentially, DCF looks at an acquisition as a pure financial investment.
The buyer will estimate future cash flows and discount these into present
values. Why is future cash flow discounted? The reason is that a rupee in
future is at the risk of being worth less than a rupee now.
There are some business-based real risks like acquired company losing a
contract, or new competitor entering the market or an adverse regulation
passed by government, which necessitate discounting of cash flows.
The discounted cash flow (DCF) model is applied in the following steps:
1. Estimate the future cash flows of the target based on the assumption for
its post-acquisition management by the bidder over the forecast
horizon.
2. Estimate the terminal value of the target at forecast horizon.
3. Estimate the cost of capital appropriate for the target.
4. Discount the estimated cash flows to give a value of the target.
5. Add other cash inflows from sources such as asset disposals or business
divestments.
6. Subtract debt and other expenses, such as tax on gains from disposals
and divestments, and acquisition costs, to give a value for the equity of
the target.
7. Compare the estimated equity value for the target with its pre-
acquisition stand-alone value to determine the added value from the
acquisition.
8. Decide how much of this added value should be given away to target
shareholders as control premium.
! !471
25.8.3 Valuation by team of experts
Valuation is an important aspect in merger and acquisition and it should be

done by a team of experts taking into consideration the basic objectives of
acquisition. Team should comprise of financial experts, accounting
specialists, technical and legal experts who should look into aspects of
valuation from different angles. Accounting expert has to foresee the
impact of the events of merger on profit and loss account and balance
sheet through projection for next 5 years and economic forecast. Using the
accounting data, he must calculate performance ratios, financial capacity
analysis, budget accounting and management accounting and read the
impact on stock values, etc. besides installing accounting and depreciation
policy, treatment of tangible and intangible assets, doubtful debts, loans,
interests, maturities, etc.
Technician has its own role in valuation to look into the life and
obsolescence of depreciated assets and replacements and adjustments in
technical process, etc. and form independent opinion on workability of
plant and machinery and other assets.
Legal expert’s advice is also needed on matters of compliance of legal

formalities in implementing acquisition, tax aspects, review of corporate
laws as applicable, legal procedure in acquisition strategy, laws affecting
transfer of stocks and assets, regulatory laws, labour laws preparing drafts
of documents to be executed or entered into between different parties, etc.
Nevertheless, the experts must take following into consideration for

determining exchange ratio.
• Market Price of Shares

If the offeree and offeror are both listed companies, the stock exchange
prices of the shares of both the companies should be taken into
consideration which existed before commencement of negotiations or
announcement of the takeover bid to avoid distortions in the market price
which are likely to be created by interested parties in pushing up the price
of the shares of the offeror to get better deal and vice versa.
• Dividend Pay-out Ratio (DPR)

The dividend paid in immediate past by the two companies is important as
the shareholders want continuity of dividend income. In case offeree
! !472
company was not paying dividend or its DPR was lower than the offeror’s,
then its shareholders would opt for share exchange for the growth
company by sacrificing the current dividend income for prospects of future
growth in income and capital appreciation.
• Price Earnings Ratio (PER)

Price earnings ratios of both the offeror and offeree companies be
compared to judge relative growth prospects. Company with lower PER
shows a record of low growth in earnings per share which depresses
market price of shares in comparison to high growth potential company.
Future growth rate of combined company should also be calculated.
• Debt Equity Ratio

Company with low gearing offers positive factor to investors for security
and stability rather than growth potential with a geared company having
capacity to expand equity base.
• Net Assets Value (NAV)

Net assets value of the two companies be compared as the company with
lower NAV has greater chances of being pushed into liquidation.
Having taken all the above factors into consideration, the final exchange
ratio may depend upon factors representing strength and weakness of the
firm in the light of merger objectives including the Liquidity, strategic
assets, management capabilities, tax loss carry overs, reproduction costs,
investment values, market values (combined companies’ shares) book
values, etc.
25.9 Fair value of shares
Valuation can be done on the basis of fair value also. However, resort to
valuation by fair value is appropriate when market value of a company is
independent of its profitability.
The fair value of shares is arrived at after consideration of different modes

of valuation and diverse factors. There is no mathematically accurate
formula of valuation. An element of guesswork or arbitrariness is involved
in valuation. The following four factors have to be kept in mind in the
valuation of shares. These are:
! !473
1. Capital cover,
2. Yield,
3. Earning capacity, and
4. Marketability.
For arriving at the fair value of share, three well-known methods are
applied:
1. the manageable profit basis method (the earnings per share method).
2. the net worth method or the break-up value method, and
3. the market value method.
The fair value of a share is the average of the value of shares obtained by
the net assets method and the one obtained by the yield method. This is,
in fact not a valuation, but a compromise formula for bringing the parties
to an agreement.
The average of book value and yield-based value incorporates the

advantages of both the methods and minimizes the demerits of both the
methods. Hence, such average is called the fair value of share or
sometimes also called the dual method of share valuation.
The fair value of shares can be calculated by using the formula:
Value by net assets method + value by yield method

Fair Value of the shares = !
2
Valuation of equity shares must take note of special features, if any, in the
company or in the particular transaction. These are briefly stated below:
(a) Importance of the size of the block of shares
Valuation of the identical shares of a company may vary quite significantly

at the same point of time on a consideration of the size of the block of
shares under negotiation.
The holder of 75% of the voting power in a company can always alter the
provisions of the articles of association; a holder of voting power exceeding
50% and less than 75% can substantially influence the operations of the
company even to alter the articles of association or comfortably pass a
! !474
special resolution. A controlling interest therefore, carries a separate

substantial value.
(b) Restricted transferability
Along with principal consideration of yield and safety of capital, another

important factor is easy exchangeability or liquidity. Holders of shares of
unquoted public companies or of private companies do not enjoy easy
marketability; therefore, such shares, however good, are discounted for
lack of liquidity at rates, which may be determined on the basis of
circumstances of each case.
The discount may be either in the form of a reduction in the value

otherwise determined or an increase in the normal rate of return.
(c) Dividends and valuation

Generally, companies paying dividends at steady rates enjoy greater
popularity and the prices of their shares are high while shares of
companies with unstable dividends do not enjoy confidence of the investing
public as to returns they expect to get and, consequently, they suffer in
valuation.
(d) Bonus and rights issue

Share values have been noticed to go up when bonus or rights issues are
announced, since they indicate an immediate prospect of gain to the holder
although in the ultimate analysis, it is doubtful whether really these can
alter the valuation.
(e) Statutory valuation

Valuation of shares may be necessary under the provisions of various
enactments like the Wealth tax Act, Companies Act, Income-tax Act, etc.
e.g. valuation is necessary under the Companies Act in the case of an
amalgamation and under the Income-tax Act for the purposes of capital
gains.
Some of the other enactments have laid down rules for valuation of shares.
The rules generally imply acceptance of open market price i.e. stock
exchange price for quoted shares and asset-based valuation for unquoted
equity shares and average of yield and asset methods i.e. fair value, in
valuing shares of investment companies.
! !475
25.10 Free cash-flows (FCF)
FCF is a financial tool mainly used in valuation of a business. It will be

close to the profits after tax without taking into account depreciation.
Depreciation is neither a source of money nor an application of the funds
available at the disposal of a company. FCF of a company is determined by
the after tax operating cash flow minus interest paid/payable duly taking
into account the savings arising out of tax paid/payable on interest and
after providing for certain fixed commitments such as preference shares
dividends, redemption commitments and investments in plant and
machinery required to maintain cash flows. Please refer to Annexure 3 for
a case study involving the acquisition of a firm as a going concern where
valuation has been done on the basis of estimated free cash flows.
25.11 Valuation Standards
Valuation Standards aim to provide uniformity in valuation of various

tangible and intangible classes of assets that provide consistent delivery of
standards.
The International Valuation Standards Council
The International Valuation Standards Council is the established

international standard setter for valuation. Through the International
Valuation Standards Board, the IVSC develops and maintains standards on
how to undertake and report valuations, especially those that will be relied
upon by investors and other third party stakeholders. The IVSC also
supports the need to develop a framework of guidance on best practice for
valuations of the various classes of assets and liabilities and for the
consistent delivery of the standards by properly trained professionals
around the globe.
The IVSC has published International Valuation Standards (IVS) since

1985.
Membership of IVSC is open to organisations of users, providers,

professional institutes, educators, and regulators of valuation services.
IVSC members appoint the IVSC Board of Trustees.
! !476
In a nutshell, valuations of businesses, business ownership interests,

securities, tangible or intangible assets may be performed for a wide
variety of purposes including the following:
• Valuation for financial transactions such as acquisitions, mergers,

leveraged buyouts, initial public offerings, employee stock ownership
plans and other share-based plans, partner and shareholder buy-ins or
buyouts, and stock redemptions.
• Valuation for Dispute Resolution and/or litigation/pending litigation

relating to matters such as marital dissolution, bankruptcy, contractual
disputes, owner disputes, dissenting shareholder and minority ownership
oppression cases, employment disputes and intellectual property
disputes.
• Valuation for Compliance-oriented engagements, for example:
a. Financial reporting and
b. Tax matters such as corporate reorganizations; income tax, Property

tax, and Wealth tax compliance; purchase price allocations; and
charitable contributions.
• Other purposes like valuation for planning, Internal use by the owners
etc.
The same business may have different values if different standard of value
is used and different approaches are adopted. The rising demand for
valuation services has given new avenues for the finance professionals.
Going forward more and more professionals would be engaged in
performing valuation services.
! !477
25.12 Summary
In the business valuation while there are several methodologies and

techniques used within the industry, they can typically be categorized into
three core approaches: Asset-based, Income-based, Market Comparison-
based. While conducting business valuations, a blended model is used
based upon the appraiser's judgment, assets in question, past and future
cash flow capacities, as well as the depth and breadth of available financial,
operational, and industry-relevant data. All applicable methods used are
then reviewed.
The asset, or cost, approach considers the value of a business to be

equivalent to the sum of its parts; or the replacement costs for this
business. This is an objective view of a business. It can be effective in
quantifying the fair market value of an entity's tangible assets, as it adjusts
for the replacement costs of existing, potentially deteriorating, assets.
The income approach identifies the fair market value of a business by

measuring the current value of projected future cash flows generated by
the business in question. It is derived by multiplying the cash flow of the
company times an appropriate discount rate. In contrast, the asset-based
approaches, which are very objective, the income-based approaches
require the valuator to make subjective decisions about discount rates or
capitalization. Many considerations and variables are measured to account
for the specific contribution of primary value drivers in a business that
result in influencing cash flow: revenue drivers, expense drivers, capital
investment, etc. This method, which comes in several approaches, is
useful as it identifies fundamental factors driving the value of a business.
The Market Comparison approach to a business valuation is based upon

current conditions amongst active business buyers, recent buy-sell
transactions, and other comparable business entities. Financial attributes
of these comparable companies and the prices at which they have
transferred can server as strong indicators of fair market value of the
subject company.
No one valuation method is perfect for every situation, but by knowing the
characteristics of the company, you can select a valuation method that best
suits the situation. In addition, investors are not limited to just using one
! !478
method. Often, investors will perform several valuations to create a range

of possible values or average all of the valuations into one.
The valuation methods discussed represent some of the most commonly

used by business valuation professionals to generate an opinion of value.
Although considerable time and effort is involved in preparing formal
business valuations, unfortunately the results may or may not reflect the
“real world” value of a specific company if it were formally offered for sale.
Consulting a professional investment banker can best help you assess the
true value of your company. These professionals will assess your
company’s strengths and weaknesses and employ some of the commonly
used valuations methods used by business valuators. They will also
leverage their insight into the current marketplace to help determine
financing availability and assess many other factors to determine your
company’s potential value in the market place.
! !479
25.13 Questions
1. Why the business valuation is required? Explain.

2. What is the Motive of Valuation in Acquisition? Describe.
3. Explain the Methods of Valuation.
4. Write short notes on: Discounted cash flow (DCF) valuation method
5. Explain: Valuation Standard

1. The acquisition activity is usually guided by strategic behavioural

motives. The reason could be _____________
a. either purely financial (taxation, asset-stripping, financial
restructuring involving an attempt to augment the resources base
and portfolio-investment)
b. business related (expansion or diversification).
c. behavioural reasons have more to do with the personnel ambitions or
objectives (desire to grow big) of the top management
d. any one of the above
2. Valuing a business requires the determination of its future earnings

potential, particularly the _____________ n those future earnings
a. Risks inherent
b. Profit
c. Market competition
d. Value trend
3. The most popular methods of valuation amongst other includes

a. Asset-based valuation
b. Earnings-based valuation
c. Market-based valuation
4. Whether set of non-financial considerations will affect the price?

_____________Yes or No
a. No
b. Yes
! !480
5. Va l u a t i o n f o r C o m p l i a n c e - o r i e n t e d e n g a g e m e n t s i t c a n b e
_____________
a. Financial reporting
b. Tax matters such as corporate reorganizations; income tax, Property
tax, and Wealth tax compliance; purchase price allocations; and
charitable contributions
c. Both a and b
d. Any one of a or b
Answers: 1. (d), 2. (a), 3. (d), 4. (b), 5. (c)
! !481
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture 
! !482
FINANCIAL MANAGEMENT IN PUBLIC ENTERPRISES
Chapter 26
Financial Management In Public Enterprises
Objectives
After studying this chapter, you will learn about Financial Management in
Public Sector Undertakings, Introduction to Public Sector Undertakings,
Capital Expenditure Decisions in Public Sector Undertakings, Budgeting,
Pricing, Guidelines, Profitability and Efficiency, Role of Financial Advisor,
Public Enterprise Policy etc. and some of the problems of financial
management in public undertakings.
Structure:
26.1 Introduction
26.2 Definition of Public Enterprises
26.3 Introduction to Public Sector Undertakings
26.4 Capital Expenditure Decisions in Public Sector Undertakings
26.5 Budgeting by Public Sector Undertakings
26.6 Pricing by Public Sector Undertakings
26.7 Guidelines for Public Sector Undertakings
26.8 Profitability and Efficiency of Public Sector Undertakings
26.9 Role of Financial Advisor in Public Sector Undertakings
26.10 Public Enterprise Policy in Public Sector Undertakings
26.11 Problems of Financial Management in Public Understandings
26.12 Summary
26.13 Questions
! !483
26.1 Introduction
The Government intervention in the economic system for social and

economic reasons is now clearly accepted by everyone and has come to
stay. Governments all over the world, particularly in developing countries,
have gone far beyond the indicative planning to price, wage, and numerous
other controls and to state entrepreneurship.
Radical transformation from a purely agrarian economy to one of the

important industrialized nations of the world, and demolishing of a
regimented structured society to one based on social justice, would not
have been possible without the emphasis which has been laid on the
growth and development of Public Enterprises.
Even in developed countries, when other avenues fail, the State alone
comes to the rescue. Most railway systems in the world have an extensive
history of government initiative and subsidy. For supersonic travel or
communication by way of earth satellites, state initiative is accepted
without hesitation. Similarly, for the development of atomic energy there
was no alternative to government action. These were big leaps from many
developed counties, where the market could not be relied upon. For a
developing country, a steel mill, a heavy engineering industry, a machine
tool plant or production of basic chemicals or intermediates are its big
leaps, which require a comparable initiative by the state.
It is important to remember that much of the losses and shortcomings of

Public Enterprises are really overheads of national economic development
which get reflected in the books of many Public Enterprises. It is worth
considering whether the cost of “national gestation” be treated differently
instead of being debited to Public Enterprises. In countries where private
enterprise heralded industrial development, these costs were borne:
• Through bankruptcies of some enterprises
• By virtual enjoyment of monopoly power over a span of time sufficient to

compensate high initial costs and losses
• Subsidies offered by the government (as in railways); and
• Through multinational operations with all its consequences
! !484
26.2 Definition of Public Enterprises
Public Enterprise is an organisation which is owned by public authorities, to

the extent of 50 per cent or more, is under the top management control of
the owning public authority, is engaged in activities of a business character
(involving the basic idea of investment and returns), and it markets its
output in the shape of goods and services for a price.
The Five-Year Plan and other official documents also use the term “Public
Sector” in the wider sense to cover all governmental activities, including
public, industrial and commercial enterprises.
Another term used for Public Enterprise is “Public Undertakings”. Strictly

speaking, any activity of the government – business or otherwise –- is its
undertaking, but the term perhaps has limited use for industrial and
commercial activities. It is used regarding the parliamentary committee on
“Public Undertakings”. But the very same enterprises as covered by the
parliamentary committee are dealt with by the “Bureau of Public
Enterprises” in the Ministry of Industry.
Public Enterprises are also referred to as “Government Controlled

Enterprises”, “State Economic Enterprise”, and “National Companies”. In
U.K., Public Enterprise is known as “nationalized industry” because most of
the Public Enterprises there were the result of nationalization of existing
industries. In many Latin American and African countries, Public
Enterprises are known as “parastatal” or “parastatal sector” that is, the
group of institutions, organisms and enterprises that, empowered by the
State, cooperate in its aims without being part of the public administration.
26.3 Introduction to Public Sector Undertakings:
Before independence participation of public sector undertakings in

economic development of the country was almost nil. The Railways, Posts
and Telegraphs, Aircraft, Port Trusts, Ordinance factories were the only
undertakings under government control. It was only after the Industrial
Policy of 1956 that public-sector undertakings got a fillip. The socialistic
pattern of development adopted by the government also encouraged the
settings up of public undertakings.
! !485
Public sector undertakings play a dominant role at present. These

undertakings include departmental enterprises, financial institutions and
non-departmental enterprises or government companies.
There has been appreciable growth in investment in Public Sector

Enterprises (PSEs) over the years. In 1951, there were only 5 public sector
enterprises with an investment of Rs. 29 crore which has increased to Rs.
2,74,114 crore in 242 enterprises as on March 31, 2001. As per the Public
Enterprise Survey 2001-02, there were 230 working PSEs with a total
investment of Rs. 3,24,532 crore.
There were 230 working PSEs with a total investment of Rs. 3,24,632
crore. The contribution of PSEs during 2000-01 in country’s total
production of lignite was 100%, in coal about 97%, in petroleum about
81% and in non-ferrous metals viz., primary lead and zinc about 80%. The
internal resources generated by PSEs during 2000-01 were Rs. 37,802
crore.
The PSEs have also been making substantial contribution to augment the
resources of Central Government through payment of dividend, interest,
corporate taxes, excise duties etc., thereby helping in mobilisation of funds
to meet financing needs for planned development of the country. During
2000-01, contribution to the Central Exchequer by the PSEs through these
resources amounted to Rs. 60,978 crore.
26.4 Capital Expenditure Decisions in Public Sector

Undertakings
The Government of India decided way back in 1961 that financing pattern
would have a debt-equity ratio of 1:1. Every new project will have half the
investment in equity capital and the other half in debts. A decision about
capital expenditure involves a number of organisations.
The following organisations are involved in taking up of new schemes,

deciding about expansions, modifications, diversifications, etc. 
! !486
• Board of Directors of the Undertaking

• Administrative Ministry
• Public Investment Board (PIB)
• Planning Commission
• Finance Ministry
• Bureau of Public Enterprises (BPE), and
• Director General of Technical Development (DGTD).
Every capital expenditure proposal is first discussed at Board of Directors’

level of concerned enterprise. The Board can decide only up to a certain
amount. The proposals requiring more investments are recommended by
the board to the concerned Administrative Ministry.
After a proper study at Ministry the proposal is either sent to Public

Investment Board or Project Appraisal Division (PAD) depending upon the
cost involved. PAD evaluates proposals requiring Rs. 1 crore or more
whereas PIB deals with proposals of Rs. 5 crore or more. At this level,
various aspects of the proposal such as technical, financial, economic,
managerial, profitability etc. are evaluated.
After scrutiny at ministry level, the proposal goes to the Investment

Planning Committee of the Planning Commission. The Advisor (Industries)
also examines the proposal and then it is recommended to be included in
5-year plan.
The Finance Ministry has to raise funds for various schemes. The Civil
Expenditures Division and Bureau of Public Enterprises in the Department
of Expenditure under the Ministry of Finance are engaged in scrutinizing
the proposals of public enterprises. Unless the clearance is given by the
Department of Expenditure, the Administrative Ministry cannot incur any
expenditure.
The Director General of Technical Development offers technical advice to

the Administrative Ministries. In case of foreign collaborations, Foreign
Exchange Board is approached. The approval of Parliament is also required
for major investment decisions.
! !487
26.5 Budgeting by Public Sector Undertakings
Proper budgeting system is followed by public sector undertakings. They

prepare budgets like Revenue Budget, Capital Expenditure Budget, Cash
Budget etc. The Revenue Budget is a projected profit and loss account for
the current year and the next year. It is based on production estimates,
sales forecasting, cost of production budget, capacity availability budget,
expenditure estimates etc.
Capital Expenditure Budget is prepared to forecast future capital

expenditure decisions. The expansion, diversification plans etc. are
followed for the future period. Cash Budget is based on the estimates of
generating and utilising cash. Cash budget takes into account the expenses
and incomes shown in revenue budget.
Most of the undertakings prepare budgets for their own use. But
undertakings like Railways, LIC, ONGC, etc. submit their budget estimates
to Parliament every year. The budgets of the concerns are first approved by
the Board of Directors and then sent to the Administrative Ministry, Bureau
of Public Enterprises and Planning Commission.
There is no budgetary control system followed in public undertakings. A

proper budgetary control system ensures the implementing of budgets.
Any deviation from the budget is promptly reported to top management. To
ensure efficiency, there should be a systematic budgetary control system in
public enterprises.
26.6 Pricing by Public Sector Undertakings
The fixing of price for the products manufactured by public sector

enterprises has always remained a problem area. These units are not
earning adequate profits and have not created surplus for expansion etc.
There has always been a controversy about the fixing of prices. Should
these enterprises earn profits like units in private sector? Should their price
structure adhere to utility concept?
In public sector enterprises, there has been administered pricing i.e. price
fixed by the administration and not by the market forces of demand and
supply. The price fixation should have some objective and principles. If the
prices are not fixed rationally, then these can cause either profit or loss.
! !488
If prices are higher, then increased profits will conceal the inefficiency of
the unit. On the other hand, if prices are low then there may be losses and
efficient units will be penalized. Low prices will not allow the units to create
surpluses which are must for further financing of expansion and
diversification.
There are two approaches in price fixation i.e. public utility approach and
rate of return approach. Public utility approach emphasises ‘no profit no
loss’ view. Since public sector units are engaged in basic industries and
their products are an important input for other industries, so their prices
should be kept low.
There is a feeling that public sector units should follow the pattern of
private sector in fixing prices. However, there may be some discrimination
consideration in favour of some consumers or sections of society.
26.7 Guidelines for Public Sector Undertakings
Following guidelines for fixing of prices by public sector enterprises are

taken into consideration.
1. Public enterprises in the industrial and manufacturing areas should aim

at earning surplus so that they are able to generate funds for capital
development.
2. The notional price and income policy of the private sector should be
kept in mind while fixing prices.
3. In case of public utility services the objective is to create more output

rather than a rate of return on investment.
4. PEs should ensure their full capacity utilization.
! !489
26.8 Profitability and Efficiency of Public Sector

Undertakings
Profitability and efficiency are related to each other. The normal yardstick
of efficiency is profitability. If a concern is earning profits, then we call it
profitable and on the other hand, if there are no profits then it will be
called inefficient. This yardstick cannot be applied in case of public
enterprises.
The main aim of public enterprises is to serve a social cause and

profitability comes next. Moreover, these enterprises are providing a basic
infrastructure for the development of industry. So, the efficiency of public
enterprises should be judged in this context.
Profit is the surplus over cost. In private sector the main aim is to
maximize profits. The public enterprises in India should also earn profits
because they get certain benefits as compared to the units in developed
countries. The labour cost, which is an important element of cost, is very
low in India because of abundant supply.
The government provides concessional funds to these undertakings which

should also reduce their cost. Even in marketing the products of these units
are given preference by government departments. There is an urgent need
for the generation of sufficient funds not only for their expansion and
diversification but also to spare funds for plan expenditure of the
government.
Now let us also understand the reasons for Low Profitability:
In spite of many favorable factors, most of the public-sector units are

incurring losses. There was a loss of Rs. 203 crore (after tax) in 1980-81
while these units showed a profit of Rs. 2,368 crore in 1990-91.
! !490
The main reasons for bad performance of Central Public Sector

Undertakings units are:
• Initial heavy costs at the time of plan and implementation stage.
• Longer gestation period of public sector units.
• Large unutilized capacity. The installed capacities are large but actual
utilized capacity is very low and overhead expenses are very high.
• Heavy social costs. These units spend heavy amounts in constructing

townships, providing educational and medical facilities to the employees.
• Low priced products. The prices of the products of these enterprises are
deliberately kept low because many of these products become inputs for
other industrial units.
• High expense ratio. There is no control over the expenses of these units.
There are heavy bureaucratic managements and overstaffing in other
areas.
• The losses are also due to inefficiency of managements.
The top positions in these units are manned by civil servants. There is a
lack of professional people in these organisations. The civil servants are
often transferred so there is lack of accountability. The efficiency of
management is a major reason for low profitability in these units.
Some steps should be taken to improve the performance of public sector
units. There is a need to professionalize management. There is a need to
control operating and non-operating costs. Efforts should be made to
improve capacity utilization in these units. The enterprises should he run
on commercial and competitive lines. All such efforts can certainly improve
the performance of public sector units.
! !491
26.9 Role of Financial Advisor in Public Sector

Undertakings:
The financial advisor has a place of significance in public sector units. The
financial advisor was appointed by the Ministry of Finance as its nominee in
the unit. His concurrence in all financial matters was necessary. These
persons generally belonged to all-India accounting services and were
nominated in the same way as the chief executive, the Board of Directors
having no say in his appointment and tenure.
The role of financial advisor has been a matter of controversy. He

considered himself as an outsider. On the recommendation of a study team
the power to appoint a financial advisor now rests with the Board of
Directors. He works as an advisor to the chief executive. He advises on all
financial matters of the enterprise. He heads the Department of Finance
and Accounts. He is normally assigned the following functions:
• Financial concurrence.
• Payment of bills and accounting thereof.
• Sales and commercial activities.
• Cost accounting, cost control and management accounting
• Budgeting and budgetary control.
• Tax planning.
• Trustee for Provident Fund, Gratuity Fund etc.
• Internal Checking and Internal Audit.
The type of functions performed by the financial advisor is very important.

The success or failure of the organisation is linked to the performance of
these functions. Proper care should be taken while appointing a financial
advisor.
! !492
26.10 Public Enterprise Policy in Public Sector

Undertakings
There is a consensus that the Government should not be operating

commercial enterprises. The reasons for this include scarcity of public
resources, inefficient and loss-making operations of existing public sector
enterprises. Accordingly, as part of the liberalization process, government
has started reforms in public sector enterprises.
The main elements of Government’s Policy towards Public Sector
Undertakings (PSUs) are:
1. Bring down Government equity in all non-strategic PSUs to 26 per cent

or lower, if necessary;
2. Restructure and revive potentially viable PSUs;
3. Close down PSUs which cannot be revived; and
4. Fully protect the interest of workers.
The current direction of privatization policy is summarized in a suo motu

statement laid in both the Houses of Parliament on December 9, 2002.
Government has announced its policy that the main objective of
disinvestments is to put national resources and assets to optimal use and
in particular to unleash the productive potential inherent in our public-
sector enterprises. The policy disinvestment specifically aimed at:
1. Modernization and upgradation of Public-Sector Enterprises.
2. Creation of new assets.
3. Generation of employment,
4. Retiring of public debt.
5. To ensure that disinvestment does not result in alienation of national

assets, which through the process of disinvestment, remain where they
are. It will also ensure that disinvestment does not result in private
monopolies.
! !493
6. Setting up a Disinvestment Proceeds Fund.
7. Formulating the guidelines for the disinvestment of natural assets

companies.
8. Preparing a paper on the feasibility and modalities of setting up Assets

Management Company to hold, manage and dispose the residual
holding of the government in the companies in which government equity
has been disinvested to a strategic partner.
9. Government is taking the following specific decisions:
• To disinvest through sale of shares to the public in Bharat Petroleum

Corporation Limited (BPC).
• To disinvest in Hindustan Petroleum Corporation Limited (HPCL) through

strategic scale.
• To allot, in both cases of BPCL and HPCL, a specific percentage of shares

to the employees of the two companies at a concessional price.
26.11 Problems of financial management in public

understandings
Some of the problems of financial management in public understandings

are as follows:
1. Lack of proper planning
Public sector undertakings spend too heavily on construction as well as

designing. It is primarily because there is a lack of proper planning. This
lack of proper planning results in heavy drainage of funds and thus there is
serious financial problem in the wake.
2. Unfavourable input-output ratio
Public sector undertakings are heavily over-capitalized with the result that
there is unfavorable input-output ratio. Inadequate planning, inordinate
delays in construction etc., are the causes for over-capitalization.
! !494
3. Cost of capital
At present in public sector undertakings cost of capital does not include

cost of raising capital of different types and this cost is not reckoned at
market price. This results in underestimating the cost of the capital.
Consequently, it leads to non-realistic fixing of prices and the
underestimating of market trends. Even it becomes difficult to estimate the
extent of profits and losses as well.
4. Problem of pricing
Another problem of a public-sector undertaking is that of fixing the prices

of the goods produced. As we know that unless pricing policy is sound even
good concerns can run into losses. The public-sector undertakings in India
are facing serious financial problems as they are not following uniform
pricing policy.
5. Problem of surpluses
In the financial field, another problem is that of declaring surpluses. From

surplus, we mean the resources available as surplus, after deducting
working expenses, normal replacements, interest payments and dividends.
But again, in the public-sector undertakings it has not been found possible
to device a policy of declaring surpluses. No clear-cut principles in this
regard have been laid down by the Government for the guidance of public
sector undertakings.
6. Problem of raising loans
All public-sector undertakings are run with the finance of the Government.
Now this has in turn raised many problems. Sometimes Government may
feel it difficult to finance public sector undertakings. In such cases, if these
undertakings depend on capital market, they are bound to disturb financial
structure of the market.
7. Problem of budgeting
Still another problem is that of budgeting. It is seen that most of the

public-sector undertakings have no serious budgeting system. The budgets
! !495
are of course prepared, but these are primarily with a view to obtaining
funds from the Government.
The budget estimates are kept very high providing for a margin for cuts
and when cuts are not made to the extent to which these have been
incorporated the estimated budgets the whole exercise becomes
unrealistic.
That is why usually there is a wide difference between estimated budgets

and actual expenditure. Not only this, but there is another problem namely
that in a public undertaking in India expenditure is not linked with the
performance and targets achieved.
8. Problem of delegation of authority
It is seen that usually there is no delegation of authority in a public sector

undertaking with the result that prior concurrence of the competent
authority is to be obtained for incurring some expenditure. This results in
overloading a person with work and in the wake, he can commit many
mistakes as well.
9. Internal audit
Accounts of every public-sector undertaking are regularly audited. The

main purpose of such an audit is that main financial irregularities are
brought to light so that these are not committed again and again. But in
the field of finances, internal auditors create many problems.
Instead of smoothening everything, they try to create complications and

bundles and in many cases internal audit proves more difficult a nut to
crack than the external or outside audit which is done by statutory
authorities.
10.Role and responsibilities of financial advisor
Whether it is public or private sector undertaking it is most desirable that

the finances should be properly checked and controlled. In public sector
undertaking such an officer is said to be responsible for creating many
problems.
! !496
He does not consider himself part of the whole management system. He

feels that his sole responsibility is to observe financial rules without caring
for the difficulties which their observance will create. He does not feel
himself part of whole system but thinks himself outside the system, which
is bound to result in many serious problems and complications.
11.Problem of inventory holdings
In all public-sector undertakings inventory holding is very high; it has been

estimated that on the whole in public sector undertaking inventory holding
is far higher than even the working capital. In some undertakings inventory
is more than 2 years’ production with the result that cores of rupees are
held up for the sake of nothing. Such an inventory obviously influences
adversely capital output ratio.
12.Problem of calling Reports
One more problem which public sector undertakings quite often face is that
of submitting reports to the administrative ministry. Each ministry calls for
too many reports, both from the financial as well as administrative
management. Attention of financial management is diverted to these
statements. This becomes irritating because administrative machinery does
not use the reports for which these are called.
13.Problem of performance
Whether a financial management is working successfully or not that should

be linked with its performance. Similarly, financial management should also
be judged by the economies which it has affected without prejudicing
efficiency or hostilities of the workers. But again, financial management is
faced with many problems, it is of course criticized everywhere, but so far
there are no means and methods on which performance can be tested.
14.Disinvestment policy of the Government
As a part of privatization, the Govt. has been following the policy of

disinvestment, where public sector undertakings are slowly becoming
private. In fact, a ministry is there to look after disinvestments in public
sector. If this trend continues, except a few, many public-sector
! !497
undertakings may become private, in the days to come and new problems
may creep in such organizations.
26.12 Summary
In fact, the public sector is set for a major change. It is poised for a major
facelift. “The public sector will become selective in the coverage of
activities and its investment will be focused on strategic high-tech and
essential infrastructure.” The Government has also clarified that the public
sector has to mend for itself and stop relying on Government’s budgetary
support.
Privatization has come as the greatest tool in the hands of the Government
for bringing efficiency in the Public-Sector Undertakings. It is the process of
reforming PSEs and aims at reducing involvement of the state or the public
sector in the nation's economic activities by dividing the industries between
public sector and private sector in favour of the latter. The policy of
Greenfield Privatization has made considerable progress since the
introduction of the new economic policy (NEP) in 1991. The process of re-
divide has been mainly through:
• De-licensing
• Reduction in budget allocation
• External aid/grant
• Anomaly in duty structure
• Decision-making systems
Earlier, Financial Management was limited to accounting of various financial

transactions in the Public-Sector Undertakings. Of late, Public Sector
Undertakings have understood that efficiency in Financial management is
of utmost importance, if the PSUs are to survive in the competitive
environment. The competition is also from within i.e. scarce resources of
the Government and from the outside world i.e. competition with private
sector.
A lot has been done; still lot needs to be done to bring efficiency in the
functioning of Public Sector Undertakings.
The public-sector enterprises in the Indian economy are to play an

important role that needs no emphasis. They account for over 22% of the
! !498
country’s GDP, around 6% of the total employment in the organized sector,

and over 20% of direct and indirect tax collections (2011–2012). Several
PSEs also serve critical functions of furthering the socio-economic
objectives of the government and ensuring stability in prices of key
products and commodities.
The public sector in India has always played a dominant role in shaping the
path of the country’s economic development. Visionary leaders of
independent India drew up a roadmap for the development of public sector
as an instrument for self-reliant economic growth. The public sector has
provided the much-required thrust and has been instrumental in setting up
a strong and diversified industrial base in the country. Keeping pace with
the global changes over a period, the PSEs in India also have adopted the
policies like disinvestment, self-obligation/MoU, restructuring, etc.
26.13 Questions
1. Define the public undertaking and explain its definition.
2. In the process of public expenditure, list out the organisations which are
involved in taking up of new schemes, deciding about expansions,
modifications, diversifications, etc.
3. Explain the steps in Budgeting by Public Sector Undertakings.
4. Describe the Role of Financial Advisor in Public Sector Undertakings
5. Write short note on: Guidelines for fixing of prices by public sector
enterprises are taken in to consideration.
! !499

1. Every capital expenditure proposal is first discussed at _____________

level of concerned enterprise.
a. Board of Directors
b. Department
c. Ministry
d. Financial advisor
2. For fixing of prices by public sector, enterprises are taken in to

consideration _____________
a. Public enterprises in the industrial and manufacturing areas should
aim at earning surplus so that they are able to generate funds for
capital development.
b. The notional price and income policy of the private sector should be
kept in mind while fixing prices
c. In case of public utility services the objective is to create more output
rather than a rate of return on investment and PEs should ensure-
their full capacity utilization.
d. All of the above
3. The normal yardstick of _____________ is considered for measuring

the performance of public enterprise.
a. efficiency
b. profitability
c. both a and b
d. any one of a or b
4. In public sector enterprises, there has been administered pricing i.e.

price fixed by the administration and not by the _____________
a. Market forces of demand and supply
b. Cost of manufacturing
c. Considering over all expenditure
d. As advised by marketing dept.
! !500
5. The main elements of Governments Policy towards Public Sector

Undertakings (PSUs) is to _____________
a. Bring down Government equity in all non-strategic PSUs to 26 per
cent or lower, if necessary;
b. Restrictive and revive potentially viable PSUs;
c. Close PSUs which cannot be revived; and Fully protect the interest of
workers
d. All above.
Answers: 1. (a), 2. (d), 3.(c), 4. (a) 5. (d)
! !501
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
Video Lecture
! !502

Financial Management II 605 v1

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Management II 605 v1

Uploaded by

Copyright:

Available Formats

Financial Management - II

Sub Code 605

Program Design and Advisory Team

Prof. B.N. Chatterjee Mr. Manish Pitke

Prof. Kanu Doshi Prof. B.N. Chatterjee

Prof. Dr. V.H. Iyer Mr. Smitesh Bhosale

Prof. B.N. Chatterjee Prof. Vineel Bhurke

Prof. Venkat lyer Dr. Pravin Kumar Agrawal

Prof. Dr. Pradeep Pendse Mrs. Margaret Vas

Prof. Sandeep Kelkar Mr. Anuj Pandey

Prof. Dr. Swapna Pradhan Course Editor

Prof. Bijoy B. Bhattacharyya Prof. B.N. Chatterjee

Mr. P.M. Bendre Course Coordinators

Mr. Ajay Prabhu Ms. Kirti Sampat

Mr. A.S. Pillai Mr. Kishor Tamhankar

COPYRIGHT © by Prin. L.N. Welingkar Institute of Management Development & Research.

NOT FOR SALE. FOR PRIVATE CIRCULATION ONLY.

1st Edition, july 2017

ABOUT THE AUTHOR

Abasaheb Chavan is a Professional Banker currently working with one of

Mr. Chavan is experienced in the establishing and centralization of Banks’

Mr. Chavan was an Executive Committee Member of International Chamber

Mr. Chavan holds a Master’s degree in Science (M.Sc.) and is a Certified

Chapter No. Chapter Name Page No.

1 Financial Management Decisions: Overview 7-17

12 Financial Management in Debentures, Bonds and 224-243

13 Financial Management in Derivatives 244-259

22 Foreign Venture Capital Investment in India 399-413

• Definition and Objectives of Financial Decision-making

1.1 Definition and Objectives

1.1 Definition and objectives

Financial Decisions is comprehensive financial planning and wealth

The general objective of Finance Management team in any organisation is

1. Investment Decision: There are 2 types of investment decisions:

a. Capital Investment Decision

4. Liquidity/Assets Management Decision

• Where to invest the scarce resources of business?

These are some of the questions that a finance manager is expected to

Let us take an overview of major areas where critical Financial decisions

1.3 Investment Decision

Investment decision or capital budgeting involves the decision of allocation

Two important aspects of the investment decision are:

a. the evaluation of the prospective profitability of new investments, and

b. the measurement of a cut-off rate against that of the prospective return

Future benefits of investments are difficult to measure and cannot be

However, there are problems in computing the opportunity cost of capital in

A decision-maker should be aware of capital in practice from the available

1.4 Financing Decision

Financing decision is the second important function to be performed by the

When the shareholders’ return is maximized with minimum risk, the

Once the finance manager is able to determine the best combination of

1.5 Dividend Decision

The finance manager should also consider the questions of dividend

1.6 Liquidity Decision

This is the function of Asset Management. Current asset management that

Investment in current assets affects the firm’s profitability, Liquidity and

In order to ensure that neither insufficient nor unnecessary funds are

1.7 Other Decisions

The function of finance management is to review and control decisions to

In view of this, finance manager is expected to call upon the expertise of

However, in the management of income, finance manager has to act on his

Financial management is looked on as cutting across functional even

One role of financial management is to raise funds from external entities,

A. Answer the following Questions: