Overview of Indian

nocuasgk” Financial System

Ei ns of Financial
Overview of Indian Financial System : Characteristics, Components and Functio
System.
Financial Instruments -
Financial Instruments : Meaning, Characteristics and Classification of Basic
Equity Shares, Preference Shares, Bonds-Debentures, Certificates of Deposit, and Treasury Bills.
- Capital
Financial Markets : Meaning, Characteristics and Classification of Financial Markets
Market, Money Market and Foreign Currency Market.
ions -
Financial Institutions : Meaning, Characteristics and Classification of Financial Institut
Commercial Banks, Investment-Merchant Banks and Stock Exchanges.

Wehavereadstories aboutthe globalfinancialcrisis of 2008 that almost brought banks, stock

markets, regulators, governments, internationalfinancial institutions all on their knees. Banks
started to lose confidenceto provide loans andit threatened to halt the economicactivity.
Crisis in one country impacted the whole world and it required a coordinated responseofall
the governments and central banks to bring back economy on track, while some countries in
Western Europe are still struggling to comeout. It is important to understand whata financial
system is all about and whatare their constituents. Upon successful completion of this chapter,
you will understand following

Learning Objectives

e Financial system, role and functions and components.

© Financial Markets, role and importanceofthe financial markets, categoriesoffinancial markets

ie. money market, capital market, foreign exchange.
¢ FinancialInstitutions, commercial banks, merchantbanks,stock exchanges.
¢ Financial instruments,types offinancial instruments and advantages.
 Finance Management (MU) 12 Overview of Indian Financial

1.1 Introduction to Financial System ee

large
se of any goodsor service to construction of
© Every economic activity starting from purcha
require funds and involves flow of funds
infrastructure projects such as airports, highways
ector, is a system responsible for
Thefinancial system of a country, alsocalled as the financials
transfer and supply of funds in an economy.
such as banks, stock markets, regulators,
© Thefinancial system comprises of many constituents
The fina ncia l sys tem can be def ine d as an ecosystem consisting of
merchant banke! rs etc.
institutions, instruments and markets to facilitate the savings and t rransfer of funds.
financial
of funds, movement of
¢ Financial system provides an ecosystem which enables the availability
from areas of the
funds and repaymentof funds. It facilitates efficient transfer of money
economyhaving surplus to theareas having deficit and provides funds for investment.
© When wedeposit our surplus funds or savings with the bank, the bank pools savings of many
such depositors and lends it onwardsto businesses or other household borrowers. The bank
also gives interest to the depositors for depositing the money and charges interest from the
borrowers for the use of money.

© Acountry with well-developed financial system also invariably has strong and stable economy.
The success offinancial system for the benefit of overall economy can be gauged bystudyof
multiple parameters such as the depth offinancial system,accessibility of the financial system
to the people, efficiency of the system and stability.

© In India traditionally the penetration and reachofthe financial system has beenlimited due to
various factors such as in adequateinfrastructure,illiteracy, lower incomelevels etc. In the
recent past, access to financial system has improved significantly driven by increase in
penetration ofinternet, rollout of Aadhar, adoption of technology by financial institutions,
demonetizationetc.

1.1.1 Features/Characteristics of Financial System

Financial system acts as linkage between savers and borrowers.

© It consists offinancial institutions or intermediaries, financial markets, financial instruments

and involves financial transactions.
It is applicable atfirm level, regional level, national level and international level.

«It encourages savings and investmentin the economy.

 Finance Management (MU! 1-3 Overview ofIndian Financial System

1.1.2 Function and Role of the Financial System

lizing savings for
Financial system of a country provides an efficient mechanism for channe
by performing
creationof assets and plays a critical role in economic developmentof the country
following functions.
ary assets fixed
Liquidity function : Financial system facilitates conversion of monet
and in the process
deposits, shares, debentures etc. into money minimizing bss of value
shares of company,
providesliquidity. For example, stock market offers platform to sell
banks allow easy redemption offixed deposits.
Savings function : Financial system encourages savings in the economy by providing
parks
regulated mechanism for deploymentof surplus funds. For example, when a depositor
funds with banksthey earninterest income,thus encouraging more savings.
investment
Capital formation: Financial system acts as intermediary and provides fundingfor
in new projects, new products, expansion etc. thereby leading to formationofcapital,
whichis essentialfor sustainable economic growth.
mode
Paymentfunction : Thefinancial system offers convenient, reliable and cost effective
of paymentfor goods andservices. Electronic fund transfer, cheque system, credit cardsetc.
are some of the commonly used paymentoptions.
ces
Risk function: Financial system is constantly evolving and has built in checks and balan
for carrying out various financial transactions and helps in improving safety of the
investment. Thefinancial system also provides options to insure risk against life, property,
frauds, burglary etc.
Lowercost of transaction: Financial system enablestransactions at low cost thus encouraging
more transactions and economic growth.

1.2 Components of the Financial System

Financial system thas three major components. These are financial markets
(capital market, money marketetc.), financial instruments (shares, debentures etc.) and financial
institutions (banks, stock exchange etc.). In the following paragraphs these components are
explained in more details.
 System
ian Financiale
Overview ofindianIndom
Finance Management (MU) 14

1.2.1 Financial Markets

+ creation and exchange of financial assets like shares,
Financia! market is the market for ysical
ure s, bon ds, tre asu ry bill s, com mer cia l papers, foreign currency a It 'snovaph
debent “scan
but refe rs to the arr ang eme ntf or dea lin g into financial assets. The mane mere
market led
ing on the types of financial instrument
be classified into 3 major markets depend
hange market. 1 hw
Le, Money market, Capital market and Foreign exc
wit h sho rt ter m deb t secu riti es (in the nature ° roams) aving a
{a) Money market : It dea ls
and unorganiz. omponent
maturity of less than1 year. Money market has organized
em and
estment of excess funds available Or shor
Money market is used by investors for inv rket is
ding requirements. Organize mene
by borrowers for meeting their short-term fun s
nts in the money market includes cornerste
mainly dominated by banks. Other participa
ey market is operated bythe likes of
insurance companies, mutual fundsetc. Unorganized mon
moneylenders.
etc. having a maturity of more
(b) Capital market : It deals with securities such as shares, bonds
secondary market.
than 1 year. This market is further divided into primary market and
shares,
Primary market deals with new financial instruments such as equity shares, preference
bonds etc. Secondary market orstock exchanges provide a platform for dealinginto previously
issued securities such as shares, bonds etc. Participants in these markets are foreign
institutions, mutual funds, insurance companies, corporates, individuals, brokers, merchant
bankers etc.
(c) Foreign exchange market or Forex market It deals with the transaction in currenciesof
different countries. As mostinternational transactions involve exchange of one currency to
another, the foreign exchange market is the largest ‘market globally by transaction value.
Participants into this markets are commercial banks, corporates, brokersetc.

1.2.2 Financial Instruments

Financial instruments are the financial products through which corporates andinstitutions
raise funds. Financial instruments can bebroadly classified into two types; Short term and
Long
term.

(a) Short term or money marketinstruments : These instruments have

a maturity ofless than
1 year such as commercial paper, treasury bills, certificate of deposits
and form part of money
market. Thedetails ofthese instruments are coveredin mone
y marketdiscussion.
(b) Longterm instruments : These instruments have a
maturity of more than 1 year. Examples
of long term instruments are bonds, preference
shares, equity shares and may or maynot have
a fixed maturity such as shares etc.
 (Muy Overview of Indian
1.2.3 Financial Institutions
Financial institutions act as intermediaries between the savers and users of funds. Commercial
‘banks, investment banks, financing companies etc. fall in the category of financialinstitunons
Financial institutions are classified into categories of banking and non-banking institutions.

(a) Banking institutions : it includes public sector banks, private banks. foreign banks, regional
Tural banks, cooperative banks. payment banks, small finance banks etc. and provide banking
services. State Bank of India HDFC Bank, ICICI Bank SVC Cooperative Bank is some ofthe
examples of banking institutions These are regulated by India’s Central hank the Reserve
Bank of India also called 2s RBI
(0) Non-banking institutions : it includes non-banking financial insttutons engaged in
providing services such as housing finance, consumer finance, vehicle financing, stock broking
merchant banking mutual funds, developmentfinancing companies etc Depending on the
activity non-banking institutions are regulated by banking regulator RBI, capital markets
regulator SEBI, imsurance regulator IRDA etc.
1.3 Financial Markets

In the above section, we understood the concept of financial market. Wewill discuss in more
detail in below paragraphs.
1.3.1 Characteristics and Role of the Financial Market
© Facilitating price discovery : Financial market provides accurate and timely information on
‘the price of the financial assets to the buyers and sellers.
© Provide liquidity to financial asset : Financial markets provide highly efficent and liquid
platform for sale and purchase the financial assets ensuring minimum loss in value of asset
‘spon conversion into cash.
© Reducing the cost of transactions : Financial markets facilitate sale and purchase of
securities at low transaction cost.

«Mobilization of savings : Financial markets bring together the savers and businesses together
and in the process provides avenues to invest the savings. It provides a regulated platform for
investment.
Allocation of savings in productive sectors : As markets provide information of returns and
en
performance of various securities, sectors etc. investors can take informed decisions
investment in various sectors/securities. This it provides mechanism for allocation savings
into most productive sectors.
 Finance (MU) Overview of Indian Financial 5)
1.3.2 Difference between Money Market and Capital Market

Sr.No, Money Market Capital Market

1, }This is a market for short term
instruments.
2. |Money market is used to meet short
term requirements ofcorporations,
banks and Government.
IThis is a market for long term instruments.
[Capital market is used for long term funding|
lrequirements.

3. [Bill of exchange, Treasury bills, Equity shares, Preference shares, Debentures,

Commercial papers etc. are some of Government securities etc. are the instruments
lcommon instruments that are dealt in that are dealt in this market.
this market.

4. |Commercial banks are the largest
participants in this market.
5. {Secondary market is not as large as.
Iprimary market dueto short term
nature of instruments.
IMutual funds, Foreign institutional investors,
insurance companies are the major}
[participants in this market.
[Secondary market is much larger than primary|
market.

6. [Transactions are generally done [Transactions are generally done through stock
through telephone ormails. lexchange.

.4_Money Market
Money market is a market for dealing (sale and purchase) in short term securities which have
‘a maturity period ofupto oneyear. This market is used by investors to park their surplus funds
for short term basis. Due to large ticket size of transactions, money market is typically
dominated byinstitutions such as Banks, Insurance companies etc. however individuals a>
also invest funds in the money market through mutual funds.

Money market in India is regulated by the country’s central bank (.c. Reserve Bank of indi?
(RBI) RBI also parucipates in the market from time totime to manage liquidity in the syste®
and raise funds for the Government of India
 Finance Mana} (mt 1 Overview of Indian FinancialS)

.1 Characteristics and Role of the Money Market

Characteristics and Role of the money market is as follows:

» Money market deals in highly liquid short-term debt securities of maturity between 1 day to
one year.
e Money market caters to the working capital and short-term requirements offirms and the
governments, banks and financial institutions.
© The money market fulfils the borrowing and investment requirements ofproviders and users
of short-term funds and balances the demandfor and supply of short-term funds.
«© Money market offers higher degree ofsafety, compared to othermarkets.
than otherfinancial
© Rate of return or interest rate on the investment is comparatively lower
markets dueto shorter maturity.
intervention
© Itserves as a one ofthepreferred markets for the Reserve Bankof India’s (RBI's)
rates.
in the market to manage money flowin the system and short-term interest
«Generally, transactions take place through oral communication (for eg phone or mobile)in the
icationstake place
money market. The exchangeof relevant documents and written commun
subsequently. There is no formal place for the trading (like a stock exchange).
© Participants in the money market are RBI, Commercial Banks, Non-banking financial
banks are the most dominant
companies, Mutual Funds, Corporate bodies etc. Commercial
participants ofthis market.
1.4.2. Money Market Instruments

1. Call market (call money)

«Call Money, Notice Money and Term Money markets are sub-markets of the Indian mone y
e Money 2-
market. Call Money refers to the borrowing orlending of funds for 1 day, Notic y market
14 days and Term Money more than 14 days upto 1 year. Call Money/notice mone
Is also known as Inter-Bank market.
«Lending and borrowing take place on unsecured or non-collateralim,zedwhicbasis. The trades are
- conducted both on telephone as well as on the NDS Call syste h is an electronic
deals between
screen based system set up by the RBI for negotiating money market
entities permitted to operate in the money market.
call/notice money
«The entities permitted to participate both as lender and borrower in the Co-operative
market are Scheduled commercial banks (excluding Regional Rural hanks}.comp anies and
Banks and Primary Dealers (PDs). Select financial institutions, insurance
mutual funds can participate only as lenders
 18 Overview ofI
nance uy
Ho us eo f In di a Ltd. (DFHI) an tes
sc ou nt an d Fi na nc e
primary Dealers (PDs) are Di we re es ta bl is he d in 19 88 an d 1994 respectively to
trading corporation of India (S TC I)
p th e se co nd ar y ma rk et for mo ne y market instruments.
develo
2. Treasury bills sh or t term borrowing for
T-b ill is an in st ru me nt of
© Treasury bill also. kn own as
Government of India. Go ve rn me nt of India to
Centra l ba nk (R BI ) on be ha lf of
© Treasury bills are issued by the d to manage liquid ity in the
din g req uir eme nts 0 th e Go ve rn me nt an
meet short term fun te governments. Treasury bills are
bil ls are no t iss ued by sta
financial system. Treasury easury bills.
s, namely 91 days, 182 day and 364 day tr
issued of mainly 3 maturitie
ued th ro ug h auc tio ns at 2 dis cou nt and repaid at par at the timeof
© Treasury bills are iss rity of 364 days
sury bill having matu
maturity (same as face value). For example, a Trea e
ue of Rs .1 00 wil l be iss ueda t a pri ce lowerthan 100,let's say Rs.96 andatth
and face val
l be pai d to th e inv est or by the Go ve rnment. Thedifference between
maturity Rs.100 wil
Rs.100 and Rs.96 will be the return by the investor.
is no risk of default The
© As the Treasury bills are issued by Government of India, there
25,000.
minimum amountin which they can be traded is Rs

3. Commercial bills
accepted by
© Commercial bill refers to an accepted bill raised by seller on buyer and duly the buyer
the buyer. When goods are sold on credit, the seller draws a bill of exchange on
ller.
for the amountdue. The buyer accepts It and returnsto these
ed amount at
© The accepted bills signify unconditional agreementto Fepay the seller agre
the end ofcredit period.
© Whentradebills are accepted by commercial banks, they are called commercialbills. These
are negotiable instruments and are generallyissuedfor 30 days to 120 days.
© The seller may either retain thebill till maturity or due date or getit discounted from some
banker and get immediate cash. The amount discounted Is repayable on maturityof the
bill.
In case of need for funds, the bank can rediscountthe bill in the money market and get
ready money. In India, the participants of the commercial bill market are banks 3%
financial institutions. Thebill market in India is not well developed.
4, Certificate of deposits
© Certificate of Deposits also known as CDs have a maturity period between 7 days 1 yew
Most common tenor of CDs are 3, 6 and 12 months. CDs are issued in a dematerisi3™
form, ata discountto face value and redeemed at face value.
 Finance 1-9 Overview of indian Financial S
© Itis a negotiable money market instrument, like a promissory note (Promissory denotes a
promise to pay the lendercertain amount atthe endof agreed creditperiod).
All scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area
Banks (LABs) and all India Financial Institutions permitted by RBI are eligible to issue
Certificates of deposits. CDs are mainly subscribed to by banks, mutual funds, provident
and pension funds and insurance companies.
‘© The minimum amountof a CD is Rs. 1 Lac and in multiplesof Rs 1 Lac thereafter.
‘5. Commercial paper
© Commercial paper is another money market instrument in the form of promissory note
and popularly referred to as CP. It is a short-term unsecured money market instrument, of
‘maturity from 7 days to 1 year. These are issued at a discountto face value and redeemed
at par.
Corporates, Primary Dealers (PDs), and all-India financial institutions (Fls) that have been
permitted to raise short-term resources by Reserve Bank ofIndia are eligible to issue CP.It
is a very popular avenue forraising short term funds for corporates. These can be issued in
denominations of Rs.5 lakh or multiples thereof.
All eligible issuers are required to obtain a credit rating forissuance of Commercial Paper
from a credit rating agency as may be specified by the Reserve Bank ofIndia from time to
time.

6. Money market mutual funds (MMMFs)

‘The money-market mutual funds were introduced by RBI in 1992 and since 2000 they are
brought under the regulationof SEBI.
Itis an open-ended mutual fund which invests in short-term debt securities. This provides
an additional short-term investment avenue for corporate and individuals.
7. Repo and the reverse repo market
Repo means “Repurchase Agreement” and refers to selling specified securities under an
agreementto repurchase it at a predetermined date andrate. Underrepo,the seller gets
immediate funds by selling specified securities with an agreementto repurchase the same
ata mutually decided future date andprice.
A repo transactionfor one counterparty becomes a reverse repo transaction forthe other
counter party. At present, securities acceptable under repo transactions Central
Government dated securities (G-Secs), Treasury Bills (T-Bills), State Development Loans
(SDLs) and Corporate Bonds. The entities permitted to undertake repo transactions
include Scheduled Commercial Banks, Co-operative Banks, Primary Dealers, Mutual Funds.
Insurance Companies and corporate entities
 Overview of Indian Financtal Systen,
re
8. Inter-corporate Deposits
An Inter-Corporate Deposit (ICD) is an unsecured borrowing by corporates and Financia
Institutions from other corporate entities registered under the Companies Act 1956oy
unsecured basis. The corporate having surplus funds can lend to anothercorporate in nee;
of funds.
‘© The short term credit rating of the borrowing corporate would determine the rate at which
{t would be able to borrow funds. The tenorof ICD mayrange from1 day to 1 year, but the
most common tenor of borrowing is for 90 days. Primary Dealers are permitted to borrow
in the ICD market. Primary Dealers cannot lendin the ICD market.
9. Discount and Finance House of India (DFHI)
© Itis a primary dealer and deals in treasury bills, commercial bills, CDs, CPs, short term
deposits, call money market and governmentsecurities. It was established in 1988 by RBI
and is now brought under control ofSBI.
© Establishment of DFHI has helped to developan active secondary market in Money Market
Instruments.
1.5 Capital Market

© Capital market is a market where buyers andsellers engagein creation and tradeof financial
securities having a maturity of more than 1 year. Trading of the securities generally take place
onscreen.
© Capital market provides platform fortrading ofdebt as well as equity securities.
* Capital market consists of primary market and secondary market. Primary market deals with
issuance of new securities, whereas secondary market provides platform for dealing of
previously-issued securities.
© Primary market provides new capital while secondary market provides necessary liquidity for
the sale and purchase of previously issued securities. Existing holders of securities can
sel
their holdings in the secondary market, thus freeing up funds for investment in primary
market issues. Thus, a well-functioning secondary market is key to development
of prima‘?
market.
* Major investors in the capital market are insurance companies, foreign
portfolio investor
mutual funds. commercial banks, non-banking financial institutions,
Provident fund, pensio®
funds.
 Overview of Indian Financial System
1.5.1 Functions, Role and Importance of Capital Market in India
1. Mobilization of savings for financing long term investment.
2. Provide liquidity by enabling sale of securities without anyloss of value.
3. Provide long term riskcapital to entrepreneurs.
4. . Allocation of capital to productive sectors of the economy ascapital market transfers savings
to well-functioning companies.
Capital Markets provide funds for projects in backward areas through competitive pricing
mechanism facilitating developmenteconomic developmentof backward areas,
Capital markets make it possible for companies to attract foreign capital by issuance of bonds,
shares etc.

7. Provide insurance against market risk using derivative instruments.

8. Capital market serves as a reliable guide to the performance and financial position of
corporate, and thereby promotes efficiency.
1.5.2 Capital Market Classification
Based on the type of securities that are traded, capital market is divided into Industrial
securities market and Government securities market. However,primary classification capital
market Is still between primary and second markets.

L— Primary Market
\_ Secondary Market
Fig. 15.2
1.5.3 Industrial Securities Market
Industrial securities market is the market for dealing in shares and bonds ofexisting and new
companies. This market is further divided into primary and secondary market which are
discussed belowin detail.
 Puna my 1iz Overview of Indian Financial System,

1.5. Primary Market

© The primary market is a market where issuance of new securities take place and is also calleq
new issue market. It deals with the new securities which were not previously available for
investment. Corporate enterprises and Government can raise long term funds from the
primary market by issuing long term securities. These securities may be in theform of equity
shares, preference shares, debentures, right issues, deposits etc.
Both new and the existing companies can issue new securities in the primary market. In the
primary market, new issues of equity and debt are arranged in the form of Initial Public
Offering (IPO orvia private placementorin the form ofrights issue to existing shareholders.
1.5.4(A) Characteristics and Role of Primary Market
© Itisa market for the fresh issue ofshares, debentures, etc.
© Ithelps companies to raise capital and long-term loans.
© It includes various financial institutions that support the fresh issue ofsecurities.
© Itenables formationofcapital by channelizing thesavings ofthe public.
© It provides risk and non-risk capital to companies that encourages setting up andexpansion of
new business and creationofjobs.
1.5.4(B) Methods of Raising Funds in the Primary Market

1, Public Issues
Under this method company raises funds from general public, by issuing a prospectus
Securities issued by this method are generallylisted on stock exchanges andavailable for sale
and purchase on exchanges. The prospectus contains information about the company such as
the purpose for which funds are being raised, past financial performance of the company.
background,future plans, risks, gréwth prospects of company etc. This information helps the
prospectiveinvestors to take decision regarding investment. Public issues can be offollowing
types
(a) Initial Public Offering (IPO): This is an offering by an unlisted company for the first time
in its life to the general public. It contains either a fresh issue of securities or an offer for
sale ofexisting securities or both.
(b)Follow-on Public Offering (FPO) : This is an offer for sale of securities by an already liste?
companythrough an offer documentto the general public. It can either be a fresh issue
securities oran offerfor sale of existing securities.
 = 113 Overview of Indian Pinancial

2. Offer tor Sele

Under these method securities are not issued directly to the public but are offered for sale
through intermediaries like issuing houses or stock brokers. Under this method, the sale of
securities takes place in two stages. In thefirst stage, the issuing companysells the shares to
the intermediaries such as issue houses and brokers at an agreed price. In the second stage,
the intermediaries resell the securities to the ultimate investors at a market related price. This
price is generally higher and the difference between the purchase price andtheissue price
represents profit for the intermediaries. This method Is not commonin India.
3. Private Placement
Private placementis the allotment of securities by a company to institutional investors and
some selected individuals. It helps to raise capital more quickly than a public issue. This
involves issuance of securities to less than 50 persons without issuing prospectus letter of
offer and without seeking permission forlisting for the securities. The issuers could be public
limit companies or private limited companies. These securities may be listed or unlisted.
4. Rights Issue
‘This is a method of raising offunds through issuance ofnew shares by the companyto existing
shareholders. The shareholders are offered the ‘right’ to buy new shares in proportion to the
number of shares they already possess. The existing shareholders may accept or reject the
right. Shareholders who do not wish to take up the right shares can sell their rights to another
person. If the shareholders neither subscribe the shares nor transfer their rights, then the
companycanoffer the shares to public.
1,.5.4(C) Procedure of Raising Funds by Way of IPO
Under public issue, the new shares/debentures may be offeredeitherdirectly to the public
through a prospectus (offer document) or indirectly through an offer for sale. An IPO could be
structured for 2 reasons. Firstly, the company may be looking for fresh fundsto finance Its
expansion and diversification plan. This will increase the share capital of the company.
Secondly, the company could also structure it in the form ofan Offer for Sale (OFS). Here there
is no addition to shares but the existing shareholders offload part oftheir holdings in the unlisted
companythrough the market and get it listed in the process. Quite often it is a combination of a
fresh issue and an OFS. The main steps involved in public issue are as follows:
1 Appointment of Merchant Bankers/ Investment bankers
‘The company needs to choose merchant banker to manage the IPO. They act as intermediaries
between companyand investors. Merchant banker does the due diligence to prepare the offer
‘document which contains all the details about the company.
 1 Overview of Indian Financial System
(MUD
sing compliance with the legal formalities in the entire issue
Th ey are also responsible for ensu ers are appointed to ensure full
in g of th e | csu e. So me ti me s und erw rit
process and for market
on si bl e fo r su bs cr ip ti on of th e iss ue in case of any
vabscription. Underwriters are resp
shortfall.
2. Registration for IPO and Filing of Draft Prospectus
pan y mak ing a publ ic issu e or a rights issue ofsecurities of value more than Rs 50
© Any com
to file a draf t offe do cu me nt wit h SEB If or its observations. The
lakhs is required statement! t and a draft
nt ban ker and the com pan y pre par e a regi stra tion
mercha
prospectus.
stra tion sta tem ent incl udes the di rep ort ofit s fiscal health and business
The regi feta iled
a the Security and
plans and is submitted to the regulator of capital markets in Indi
letter
Exchange Board of India (SEBI). SEBI issues its observations by way of observation
‘The validity period of SEBI's observation letter is 12 months only f.e. the companyhas to
openits issue within the period of twelve months starting from the date of Issuing the
observation.
© Post submission of registration document, draft prospectus also called as ‘Draft Red
Herring Prospectus’ is submitted to the SEBI. It includes detailed financial records, future
plans and the specification of expected share price range. This prospectus is meant for
prospective investors who would be interested in buying the stock.
3. SEBI Approval
SEBI verifies the facts disclosed by the company. It looks for errors, omissions, and
discrepancies. Only after SEBI approves the application can the company set a date fortheIPO.
‘The company can openits issue within 3 months from the date of SEBI's approval. SEBIs
approvalis also called observationletter.
|4. The Roadshow
© Once the prospectus is ready, underwriters and company officials go on countrywide
‘roadshows’, conduct investor meets and broker meets across India to sell the idea
retail, HNIinvestors, institutional investors. :
‘* Additionally, companies looking at global investors also conduct road shows at ke?
financial centers across the world like New York. Boston, London, Singapore and Hom
Kong, Investors are provided with detailed information regarding company’s future p2™
and growth potential. They get a feel of investor response through these tours.
 Finance Manager (MU) 1

5. Finalization of Price Band & Share Number

After the Roadshows, SEBI approval, the company, with assistance from the Investment
bankers and underwriters decides on the price band of the shares and also decides the
number of shares to be sold. There are two types of issues: Fixed Price IPO and Book Building
IPO,

1, Fixed Price IPO : In a Fixed priceissue - the companydecides the price of the share Issue
and the number of shares beingsold.
Ex,: XYZ Ltd public issue of 10 lakh sharesof face value Rs.10/- each at a price of Rs.65/-
eachto the public
2. Book Building IPO ; In this method, Company uses hook building process to discover the
price of the issue. The company decides a price bandandit gives the investor an option to
choosetheprice at which he/she wishesto bidfor the company shares.
Bx.: XYZ Ltd issue of 10 lakh sharesof face value Rs.10/- each at a price band of Rs.60 to
Rs.70/- is available to the public thereby generating upto Rs.7 Crores, Here the amount
generated through the issue would depend on the highest amount bid by most investors.

“6. Available to Public for Purchase

Onthe dates mentioned in the prospectus, the shares are available to public, Investorscanfill
out the IPO form and specify the price at which they wish to make the purchase and submit the
application.

7. allotment of Shares
¢ Once the subscription period is over, members of the underwriting banks, share issuing
companyetc. will meet and determine the price at which shares are to be allotted to the
prospective investors.
© The price would be directly determined by the demand and the bid price quoted by
investors. Once the price is finalized, shares are allotted to investors based on the bid
amountsand the shares available. In case of oversubscribed issues, shares are not allotted
to alt applicants.
© Investors who have applied through ASBA & to whom shares were allotted would get the
shares credited to their DEMAT accounts & their funds getting debited from their bank
‘ accouat or else for thase investors to whomthe shares were notallotted, funds wauld ger
unblocked in their bank account

» 8. Listing
E
Thelast step Is the listing in the Stock Exchanges. Finally, thereis the actual listing uf the stock
which converts the {PO Into a secondary market play. From that day. ee stock can be
purchased and sold on the secondary inarket.
 W Finance Management (MU) 1-16 Overview ofIndian Financial System

1.5.4(D) Financial Intermediaries involved in the IPO Process

Financial Intermediaries involved in the IPO process are as follows:
1. Merchant Banks : Merchant banksact as issue managers, lead managers or co-managers.
Merchant banksare responsible for compliance and marketingofthe issue.
2, Registrars to the issue : Registrars are intermediaries who undertakeall activities connected
with new issue management suchas allotment of shares. They are appointed by the company
in consultation with the merchantbankers to the issue.
3. Bankers : Some commercial banks act as collecting agents and some act as co-ordinating
bankers. Theyplay an importantrole in transfer, transmissionand safe custodyof funds.
4. Brokers : They act as intermediaries in purchase and sale of securities in the primary and
secondary markets. They have a network of sub brokers spread throughout the length ang
breadth of the country.
5. Underwriters : Generally, investment bankers also act as underwriters. They agree to take a
specified number of shares or debentures offered to the public, if the issue is not Fully
subscribed by the public. Company needs to pay a separate fees called underwriting fees.
Underwriters maybe financial institutions, banks, mutual funds, brokersetc.

1.5.5 Secondary Market/Stock Exchange

¢ Secondary market is a market for sale and purchaseof existing securities. Secondary market
generally means organized stock exchanges as they provide a continuous and regular market
for buying andselling of securities. In some cases, unlisted securities are traded over the
phone. howeverit represents small portion of equity market.
* Stock exchanges in India are regulated under the Securities Contracts (Regulation) Act 1956,
Under the Securities Contracts (Regulation) Act, 1956 a stock exchange is defined as ‘an
association, organization ar body of individuals, whether incorporated or not, established
for
the purpose ofassisting, regulating and controlling business of buying, selling and dealing
in
securities. Securities can be listed and traded on multiple stock exchanges.
© In India, currently there are 6 stock exchange as listed by SEB). There are BSELtd
or Bombay
Stock Exchange, National Stock Exchangeof India Ltd known NSE, Calcutta Stock
Exchange Ltd
India International Exchange (India INX), NSE IFSC Ltd, Metropolitan Stock Exchan
ge of Indis
Ltd, BSE and NSE are the two ofthe largest stock exchanges in India.
BSE is also the oldest
stock exchange in Asia and has the distinction of the largest numbersof listed
companies in the
world. However, NationalStock Exchangeor NSE ts the largest stock exchange in
India in terms
Of the daily turnover and counts as al! major financial institutions
as investors, INX and IFSC
are based in Gandbinagar and only provide derivative services.
 W Finance Management (MU
1.5.5(A) Characteristics of Stock Exchange
1, Stock exchangeprovides a continuous and regular marketfor buying and selling of securities.
2. Stock market allowstradingof onlylisted securities. Each listed security has unique ticker or
code provided by the exchange.
3. Stock markets provides periodic information related to trading of securities such as price,
volumeetc.
4. Tradingin the stock market takes place through the authorisedstock brokers,
5. Interest of the participants are protected through a surveillance mechanism on the trading
activity capable of detecting any abnormal trading activity.
6, Stock exchange are considered as an indicator of the current and future of the economic
activities of the country.

1.5.5(B) Role and Functions of Stock Exchanges

1. Stock exchanges provide liquidity through a continuous and ready market.
2. Stock exchanges ensure mechanism for safe and uninterrupted trading and transfer of
securities.
3. Stock exchange encourage Jong term savings in the economy by providing a liquid, accessible
and Jong term securities market
4. Stock exchanges provide mechanism for new capital formation as for existing holders can
easily sell their securities and can participate in new public issues.
5. Stock exchanges enable allocation of funds from unproductive sectors of the economy to
productive sectors.
6, Entrepreneurs or existing businesses can use stock exchange information as an important
parameterfor deciding investments tn new businesses.
7. Publicly listed companies on stock exchanges have an added advantage of creating larger
brand awareness as multiple investors trade on stock exchanges
8, Listed companies on stock exchanges need to provide periodic updates on their financial and
business performance. This also puts pressure on the management todisclose information and
operate efficientty.

1.5.6 Government Securities Market

. © Government securities also called as ‘Gilt edged’ securiues market. The term ‘gilt edged’ means
the gold edged and refers to the best quality in the context of securities. Since Government
Securities have nil degree of the nsk of default, so these are called gilt-edged securives its a
market where Governmentsecurities are traded. Government issues both long term and short
term securities.
 Lis ¢ ew of Ind)
Finance Ma (ML

tra l Go ve rn me nt are e also‘called G c aretraded in this

ued by Cen
© The long term 1 securities iss
ernmentsecurities called as treasury
ills are traded in the money
market. Short term Gov
market
and State
mark et is a sour ce of long -ter m funds to the Government of India
The G-se c
securities hav ing a fixed d ate of matunty and are
Gove rnments. The Government bonds are
to raise medium and long-term loans in the open market. G-sec are issued by
issued
o Central Government
9 State Governments
cipalities
© Semi Government authorities like City Corporations, muni
© Autonomous bodes such Airports, Port Trusts etc
State Government entities such as Transport corporations, State Electricity Boards
© Public Sector Enterprises
© All India andStatelevel financialinstitutions etc.
© G-sec market in India for all practical purposes represents securities issues by Central
Government. G-Secs are securities issued for a tenor ranging from5 years to 40 years. These
are aimed at financing the shortfails in fiscal balances.
¢ G-Secs carry a coupon rate or interest rate which is paid half-yearly and are redeemed ar
maturity at par value on maturity date. The G-Secs issuances are managed by the RBI. which
issues them onbehalf of the Centre by auction method. The total auctionsize generally ranges
between Rs. 15,006 - Rs 18,000 Cr
* Considering such Jarge issuance size, they are underwritten by Primary Dealers. Commercial
banks, Primary Dealers, Insurance Compamtes, Provident Funds, Mutual Fundsare the primary
investors in the G-sec market. G-Secs have a very liquid and vibrant secondary market.

1.5.7 Long-term Loans Market

In addition to primary and secondary markets, sometimes long term marke
tis also referred as
a part of the capital market. Commercial banks and non-banking finan
cial companies provide long
term loans to corporate and individual customers. Long
term Loans market {5 further classified
into
{a} Term Loan Market
{b) Mortgages Market
(c} Financial Guarantees Market
 W Esnance Management (Mi 1-19

1.5.7(A) Term Loan Market

Term loans are long term loans offered by financial institutions for businesses to meet their
long term requirements and generally having maturity of more than 3 years. Governmentof India
had created industrial financing institutions such as ICICI, IDBI, IFCI to provide long term loans to
corporate customers. The primary objective was to provide loans for setting up and expansion of
newprojects. However, over the years, the role of these institutions have diminished as ICICI and
IDBI has converted into a bank and commercial banks noware the main providers of long term
loans.

1.5.7(B) Mortgage Market

This market consists of the institutions which supply mortgage loan. A mortgage loan is a loan
against the security of immovable property like real estate. The term ‘mortgage refers to the
transfer of interest in a specific immovable property to secure a loan. Many non-banking financing
institutions such as HDFC, LIC Housing Finance, Tata Capital Housing and all major commercial
banks such as SBI, Bankof Baroda, ICICI Bank provide mortgages to individual and non-individual
customers.

1.6 Foreign Exchange Market/Forex Market

Foreign exchange marketdeals with the transaction in currencies ofdifferent countries. The
rate at which one currency is converted into another is called as Exchangerate. Foreign exchange
market provides mechanism for exchanging onecurrency into another.

1.6.1 Organization of Foreign Exchange Market

© The foreign exchange market is also known as forex, FX, or the currency market. It is an over-
the-counter (OTC) global market that determines the exchange rate for currencies around the
world.
¢ Participants are ableto buy,sell, exchange, and speculate on currencies.

| © Participants in the Foreign exchange markets are banks, forex dealers, corporates, central
| banks, investment management firmsetc.

| © Itis the largest and most liquidfinancial market in the world.

|
:
© Foreign exchange markets are screen based and comprises of a global network of financial

:
centres.It has no physical location and operates 24 hours a day.

1.6.2 Terminologies used in Foreign Exchange Market

Currencies are always traded in pairs, so the “value” of one of the currencies in that pair is
relative to the value of the other. For example, USDINR means value of 1 USD in terms of Rupee
which is currently prevailing in the range 73-75.
 Overview of Indian Financial System
Finance agement (MU
a
exchange
ti of the foreign exc market. USDbeing
nship is the main function Usp
ex ch an ge ra te s of ot . r ¢ urrencie
he s are quoted relative° to
Ee e e c yy of
e wo
the orlrl d,
d
i
reserv e cur ren
called cross currency rate.
is
e of on e cu rr en cy int o another not involving USD
Ce ‘on’ versio n rat
of exchange tra des; a) Spot b)
Forward
There are two main types ; t
on ref ers t 10 ex cha nge of cur ren cies with, a standard settlemen
. S| : A spot transacti
or T+2 . The p' ric e of a cur ren cy at the point of exchange for a different
tim
ae eframe of two day s
to as a spot rate.
currency in the FX market is referred
date
andseller agree on an exchangerate for any
Forward : In a Forward transaction, a buyer buyer
. This provides certainty to both the
in the future, and the transaction occurs onthatdate
d regardless of what the marker
andsellerof the foreign currency as the exchangerates are fixe
one day, a few days, months oryears.
rates are then. The duration of the trade can be
and Card Rates depending on the
The types of FX rates offers are called Interbank, Merchant
market.
banks within the Indian
The inter-bank rate entails the foreign exchange trading price between
usually centralized by a
forex market. The foreign exchangeof currencies between banks is
to other banks
commercial bank which conducts the trade and determinesthe inter-bankrates
such as central banks and nationalized banks among others.
merchants
Merchantrates,onthe other hand,consist of the foreign currency prices offered to
of the import and export businesses within the Indian market. These merchants gettheir
merchantrates from any of the numerous commercial banks that deal in the Indian forex
market.
* Card rates are currency prices that are designed for basic and minor forex transactions such as
tourism and hospitality transactions. For example, when a Foreign Tourists walk into any bank
andasks for conversion of USD into Rupees,they will be offered exchange at card rates.

1.7_ Financial Instruments

Financial Instruments or products comprise of short term and long term instruments. Short
term instruments are also called money market instruments. We have been discussed in detail
about money marketinstruments in the money market section 1.4.2 of the financial markets,
hence we haveonlylisted only these instruments in the below paragraphs. Long term or capital
market instruments are discussed in more details in following paragraphs

1.7.1 Money Market Instruments

1. Call money/notice money

2. Treasury bills

3._ Commercial Paper

4 Commercial Bill

5. REPO
6 Certificate of Deposit

7. Money Market Mutual Fund

These instruments have been discussed in detail in the money market section.

1.7.2. Capital Market Instruments

Equity/Hybrid Instrument DebtInstrument Derivatives

9. Equity, Preterence ©.g. Bonds, e.g. Futures, Options,
Shares Debentures Swaps

Fig. 1.7.1
1.7.2(A) Equity Shares
© Equity shares also called ordinary shares of a company and represent proportionate
ownership in the company. Share capital also called as ownership capital of the company,is
divided into a number of equity shares and each share represents ownership in the company.
« Accompanyissues new shares when it requires long term funds. Equity share capital is the
sourceofrisk capital for the company.
« Equity share issuance is the most preferred route for raising long term risk capital for the
companies as this provides access to capital without any fixed commitmentlike interest
paymentetc. Company makes paymentof dividend to the shareholders only after servicing the
interest and tax payments.
Equity share are lowestin tarms of claimsover the assets and earnings of the company.In case
the company suffers heavy losses and ends up bankrupt, the holders of the equity shares are
the last ones to get their money backafter creditors, bondholders, and holders of preference
shareholders.
Shares of listed public companies can be bought and sold the on stock exchanges thus
providingliquidity to the shareholders. °
1,7.2(B) Preference Shares
© Preference shares are also part of the share capital of the company. They carry preferential
right overthe dividend in comparisonto equity shares of the company.
© reference shareholders generally get fixed dividend which is much higher than equity
shareholders.
 122 Overview of Indian Financial Systep,
¢ Mani pent (MU)
y.
or s do n' t’ ge t voting rights in the compan
e paid before equity
Prefer enc e sha reh old
ati on of the co mp an y, pre ’ ference shareholders ar
. In case of liquid to financial and operation
creditors of the
shar eholders, but are lower In priority compare+d
company.
es
7.2(C) Bonds and Debentur
us ed int erc han gea bly on many occasions and represen;
eare
The terms, bond and debentur an 1 year.
the nature loan) of more th
Jong term debt instruments {in
Financia)
t, Autonomous bodies, Municipalities,
These are issued by Corporates, Governmen
funding requirements.
Institutions etc. to meet their long t erm
es issu ed by Gove rnme nt ar e call ed Government Securities or G-sec, while
Debentur
Corporate bonds.
debentures issued by Corporates are called
at regular intervals (monthly,
© Bond/debentures issuers pay interest al so called as coupon
on maturity to the holders of these
semi-annually or annually) and principal amounts
instruments.
highly
° Bonds generally have a fixed maturity period (repayment period). However sometimes
In caseof
rated companies issue bonds without any fixed maturity called as perpetual bonds.
at the fixed
perpetual bonds, company needs to only service interest to the bondholders
interval.
in
They are either secured bya collateral or claims over assets of the company or unsecured
nature.
Bonds/debentures are freely transferable and may or may not be listed on stock exchanges.
Bonds/Debentures also classified as convertible and non-convertible debentures/bonds. A
convertible instrument can be converted into equity aftera fixed maturity.

.7.2(D) Derivatives

A Derivatives instrument derives its value from one or moreits underlying assets such 2s
-quity shares, bonds, foreign currency etc. It represents contract overthe future estimated market
value of an underlying securities. Futures/Forwards, Options and Swaps are the most commos
lerivative contracts
Futures : These are financial contracts in which both parties agree to buy andsell the
underlying asset/security at a pre-agreed price on a specified future date. Future contrac®
trade on stock exchanges. For example, future contract of Reliance Industries shares dated ¢
months from current date indicates the rate price at which a buyer andseller are ready to UY
or sell at a future date. Similarly contracts when entered in case of currencies or commoditi®
they are called as forwards. Both the buying andselling party are bound by the contract
« Option : Options contracts are instruments that give the holder of the instrumentthe right to
buyor sell the underlying asset at a pre-agreed price at a future date. Buyer of the option has
to pay a premium forright to buyorsell the security.Seller of this option also called option
writer receives the premium for agreeing to sell or buy the asset at a pre-agreed price at a
future date. An option to buyis called as Call option, while an option to sell is called Put option.
When the price of underlying security on future date is higher than the pre-agreed price, the
holder of the option can buy the asset at a pre-agreed price andsell at higher price. In case the
price at a future dateis lower, then holder option does notbuythe asset.

1.8 Financial Institutions

Financial institutions provide financial services such as deposit, fund transfer, lending,
investing etc. The term “financial institutions” refers to all kinds of organizations which
intermediate and facilitate financial transactions of both individual and corporate customers.
Financial Institutions are integral to the financial sector of the economy. Strong financial
institutions support economic growth of the country while weakerfinancial institutions lead to
inadequate funding for the economicactivities.

1.8.1 Role and Function of Financial Institutions

1, Mobilize savings : Financial institution provide multiple avenues for investment of surplus
funds for individual and corporate function.
2. Supply of Credit : Financial institutions extend loans to the individual and corporate
borrowers.
3. Transfer of Funds : They provide fund transfer services in very costeffective manner thus
enabling flow of goods and servicesin the economy.
4, Risk Mitigation : Financialinstitutions extendscredit to diversified customer base, helping to
mitigate the largescale risk of default.
5. Flow of Funds: Financial institution dueto their diversified presence ensuresflowofcredit to
all the geographies ofthe country.
6. Financial Inclusion : Financial institutions through their widespread network facilitate
financial inclusion.

1.8.2 Classification of Financial Institutions

(a) Bankinginstitutions
(b) Non-bankingfinancialinstitutions
 Overview of Indian Financial

Non-Banking Financial
Institutions

}— Regulated by ABI-NBFCs

Reguiated by SEBI-Stock
Bank.
|__ Exchange. Merchant
Venture Capital, Stock
Broking Companies
Sector Banks L_ Reguiated by IRDA
[ insurance Companies
Private Sector Banks

t— Foreign Banks
L_ Regional Rural Banks
Fig. 1.8.1

1.8.3 Banking Institutions

ution that doesthe
Accordingto the Banking Regulations Act, a bankinginstitution is an instit
of deposits of money
business of banking, The term banking businessis defined as the accepting
from the public for the purpose of lending or investment and repayable on demand. A banking
institution mobilizes the savings ofthe public through accepting of deposits of moneyandlends
the same to theindividual and corporate customers to meet their short term, medium term and
long term financial requirements and invests the surplus amountin various securities.

Central Banks : Central banks are the financial institutions responsible for monitoring and
regulation of banking institutions in the country. Reserve BankofIndia is India’s central bank was
set up in 1935 by RBI act and is head- quartered in Mumbai. Reserve Bank of India performs
important functions of inflation management by setting up benchmark interest rates and
controlling flow of money in the economy. Lowerinterest rates lead to higher inflow of money
drives up demand of goods andservices andleadsto higherinflation. Higher interest rates lead to
highercostof funds and hence tempers the demand andputs brakeson inflation.

Reserve Bank ofIndia also maintainsstability in the foreign exchange markets. It also acts @&
banker to the Government by issuing the Government securities and buying and selling of
Government securities.
 (mit

1.6.3(A) Commercial inking

s from
Commercial banks are the backbone of the Indian finanetal system They accept deposit
tail and carparate customers and lead the funds to retail and corporate customers for thelr
working capital and long tern funding requirenients, There four major types commercial banks i
india Le (4) Public Sector banks, (b) Private Sector banks, (c) Foreign banks and (d) Kegional
rural banks
1.8.3(B) Functions and Role of Commercial Banks

Primary Functions

1, Accept deposits : Commercial s accept deposits from public. These deposits are in the
form of savings deposits, time de ostts and cu Mt deposi

{a)Saving deposits ; These are the deposits made to the savings accounts that a person uses
to deposit: and withdraw monies without any restrictions, Any person competent to
contract can open a savings account and deposit funds tn the count. Banks pay interest to
depositors for the amounts lying in the savings account. Generally, Individuals use sayings
bank accounts for depositing short termsavings for meeting regul expenses, A savings
account can also be openedin the nameof duly formed club, soctety, provident fund and
trust. Savings accounts generally have a limit on number of transactions and charges are
payable for additional transactions.
(b)Time deposits : These are deposits for a fixed period of time and generally carry higher
rate of interest than saving deposits, Typically banks offer time deposits for 7 days and
moreperiod, Banks generally put restrictions on early withdrawal of deposits by charging
penalty etc.
(c) Current account : Current account ts a type of bank account for those who want to make
large number of transactions on a regular basis. Unlike savings account there is generally
notransaction limit. Deposits made in these accounts i.e. current deposits do not earn any
interest. These are used by professtonal, businesses entities for managing day to day cash
flow.
2, Making loans and advances : Commercial banks provide loans and advances for short term
and long term fund requirements toindividuals and non-individuals for various needs.
3. Transfer of funds : Banks form part of payment and settlement system in the country and
enable transfer of funds from In¢ person to another,

Secondary Functions

1 Overdraft facility : It is an advance given to a customer by keeping the current account to

overdraw up to the given limit.
 Overview of Indian Financt

ge : Bi ll of ex ch an g! e js a commercial bill acknowledging

of exchan re agai nst the goo ds purchased. Bani.
later da te in fu tu
bil | of exchange.
ym en t to the sel He r by discounting the
provide facility of earlypa) tancy ete.
sul
of tax es, fil ing of tax r eturns, bill payment, tax con
tio n
3, Utility services ; Collec exchangeservices to the
rv ic es : Ba nk s pr ov id e foreign currency
4. Foreign exchange se
n currencies.
customers by buying andselling foreig d buying the
an d sel lin g of the sec uri tie s ; It offers services of selling an
5. Purchasing
securities.
kers facility to the c ‘ustomersfor safe keeping ofvaluable
6. Lockerfacilities : Bank provides loc
items, documents etc.

1.8.4 Types of Commercial Banks

banks, and
Commercial banks are classified into public sector banks, private sector banks, foreign
regional fural banks.

1.8.4(A) Public Sector Banks

© Public sector banks are the banks that are majority (more than 50%) owned by Governmentof
India. As of April 2020, India had 12 public sector banks, largest of them is State bankofIndia
also called as SBI. Other large public sector banks are Punjab National Bank, Bank of Baroda,
Canara Bank, BankofIndia, Union BankofIndia, Central Bankof India etc. Public sector banks
dominate shareof public deposits and loans, however it has down rapidly in recent years.
* The public sector banks cameinto existence, when Reserve Bankof India acquired 60% stake
in erstwhile Imperial Bank of India and renamed it as State Bank of India. Further
nationalization took place when in a major decision, Government ofIndia nationalized 14
majorprivate banks in 1969and 6 morein 1980to increase penetration of bankingin India.

1.8.4(B) Private Sector Banks

‘These include banks in which major shareholdingis held by private shareholders. In India at
presentthereare22 private sector banks. HDFC Bank,ICICI Bank, Kotak Bank, Indusind bank,Yes
Bank, Federal Bank are amongthelargest private sector banks in India. IDBI
Bank alsoclassified
as private sector bank; however, Life Insurance Corporation of India (LIC
of India) holds majority
stake in IDB! Bank. LICis at present 100% owned by the Govern
ment of India.
1.8.4(C) Foreign Banks

These are the banks that needto follow regulations in their home
country as well as in the
country of operations. In India, currently there are 46 foreign
banks operating in India through
branches are wholly owned subsidiaries as on May 31, 2020.
 Overview of indian Financial System

es
However. they have limited presence and each bank only operate through few branch
Standard Chartered, Citibank, HSBC are amongthe largest foreign banks operating in India.

1.8.4(D) Regional Rural Banks (RRB)

nt
Regicnal rural banks are scheduled commercial banks operating at regionallevel in differe
society. They
ctates Theyare established to provide credit (loans) to weaker sections of the
central
provide banking to rural and semi-urban areas. The RRBs have 3 shareholders ie.
ively.
eovernment of India, sponsor bank and state government in the ratio of 50:35: 15 respect
ponsor bank can be any commercial banks; however currently only public sector banks are the
sponsor banks. Currently there are about 43 functioning RRBs in India. Examples of RRBs
operating in Maharashtra are Vidharbha Konkan Gramin Bank and Maharashtra Gramin Bank and
are sponsored by Bank of India and Bank of Maharashtra respectively.

1.8.5 Cooperative Banks

* These banks are established on the cooperative basis and owned by its members. They are
registered under Cooperative Societies Act, 1912 and are run by a managing committee,
elected by the members. They were established with the objective of promoting savings and
proving creditin the rural areas.
© Cooperative banks are further divided into urban cooperative banks and state co-operative
and semi-
banks. Urban co-operative bank refer to the cooperative banks located in urban
of
urban areas. The primary customer base of these banks are small businessmen, a group
communities etc. State co-operative banks act as custodian of the cooperating banking the
state. Currently there are about 1482 urban cooperative banks and 58state cooperative banks
in the country.
well as
© Cooperative banks were traditionally under the dual control of cooperativesocieties as
RBI. Cooperative society overlooked incorporation, registration, management, audit,
supersession of board of directors and liquidation, RBI was responsible for regulatory
functions. Cooperative banking sector has beentraditionally plagued with number of frauds.
Recently Government of India brought cooperative banks under the RBI supervision to
improve the functioning of cooperative banks and safeguard the deposits in the cooperative
banks.

1.8.6 Other Banks

* inaddition to the commercial and cooperating banking, RBI has tn recent past granted licenses
to small finance banks and payment banks. Small finance banks play role in serving under
the country.
banked sections ofsociety to improvethe financial inclusion in
 12 Overview of Indian Financial Syston

f the example of small finance

Ujjiwan Small Finance Bank are someo
ea e How ed to acc ept res tri cte d deposits, currently upto Rs. 1 Lakh Der
Fe
ete
ee er ec e like fun d tra nsf er via net banking, mobile banking, debit cards
a ao ,
y han dfu l pay men t ban ks in the country. Paytm Payment bank, Ing
‘hereate currently onl
ment banks.
Post Payment Bank are examples of pay
Banks. Scheduleg
s ied on the basis of Scheduled and Non-Scheduled
. Banks can also beclassif
Act, 1934. Mostof the
banks are covered under the 2"4 Schedule of the Reserve Bank ofIndia
banks India are scheduled commercialbanks.
© Scheduled Banks are covered underthe depositor insurance program of Deposit Insurance and
Credit Guarantee Corporation (DICGC), whichis beneficial for all the account holders holding
savings andfixed / recurring deposit account. Under DICGC, bank deposits of up to Rs lakh
are insured.

1.9 Non-Banking Finance Institutions

© Non-banking institutions do not hold banking license, however, facilitate finance related
services,
RBIdefines non-banking finance company as a companyregistered under the CompaniesAct
1956 engaged in the businéss of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local authority or other
marketable securitiesof a like nature,leasing, hire-purchase, insurance.

NBFCs are regulated by different regulators depending on the type activit

ies carried. These
include a) Non-banking finance companies or NBFCs (e.g. Sunda
ram Finance, Tata Capital)
regulated by RBI b) Insurance Companies (eg. LIC, New
India, HDFC Life) regulated by
insurance regulator IRDA c)entities regulated
by SEBI such as Mutual Funds. (SBI Mutual
Fund,
ICICI Prudential Mutual Fund), Merchant Bank
s(e. -g. Axis Capital, Kotak Mahindra), Venture
Capital Funds, Stock Exchanges
etc, 4) housing finance companies (e.g.
Indiabulls Housing
Fin ance, Magma Home Finance) regul

and also understand briefly about

NBFCs regulated by the RBI.
1.9.1 Merchant Banks

broaderrange of services and more popularly know

n
 ;
1 Overview of Indian Finan
Finance Management (MU) 29

ged inthe business of issue

«Merchant Banker in India is defined as, any person whois enga cribing to the
ng, or subs
management either by making arrangements regarding selling, buyi
securities as manager, consultant,adviser in relation to such an issue management.
range offinancial services
Merchant Banks are the financial institutions which provide a wide
nt, consulting services to
such as issue management, financial advisory, portfolio manageme
large corporate houses or individuals.
-known global
Goldman Sachs, Morgan Stanley, Credit Suisse, CLSA are some of the well
tal Markets,
merchant banks, In India, Axis Capital, Kotak Mahindra Capital Company,SBI Capi
are examples of some ofthe large merchant bankers.

1.9.1(A) Role and Function of Merchant Bank

ffersall the
Merchant Banks provide a rangeof services, although not every merchant bankero
services. Followingis list of importantfunctions/services provided by merchant banks.
ies
1. Issue management : Merchant Bankers advise on the issuanceofdifferent types of securit
such as equity shares, preference shares and debentures. Issue management services involve
functions such as public issue, underwriting, marketing,pricing of issues.
2. Underwriting of public issue : Merchant bankers coordinate and participate in underwriting
of public issues, coordination with other underwriters etc.
3. Loan syndication : The Merchant Banks arrangeloans for the clients for their projects by
forming a consortium of financiers

4. Portfolio management : Merchant Banks help their clients in investing and managing
investment portfolio by investing funds into various asset classes such as equity, debt etc.
depending on the risk appetite of the clients.
5. Broking : Many Merchant Banksact as brokers of stock exchanges. They buy and sell shares
andotherlisted securities on behalfof their clients.
6. Advisory on mergers/acquisitions : Some Merchant Banks provide consultation and
advisory servicesto theclients on strategic decisions such as expansion, mergers, acquisitions,
takeovers, sale of business etc.
7. Valuation : Merchant bankers provide valuation services for various purpose such as
investment in unlisted securities, merger and acquisitions of business or a division of business,
brandetc.
8. Project appraisal : Merchant bankers provide services related to project appraisals from
different angles of investment, technology, location, marketing etc.
9, Leasing services : Some Merchant Banks are engaged in leasing services in which lessor
allows the use of specific assets to the lessee for a certain period for payment of rentals.
 30
Overview of Indian Financial 5 JStem
Finance Management(MU)
n t B a n k e r ii 's Publlicic I
1.9.1(B) Role o
f Mercha ic.
nc e to pr ep ar e th e offer document wh
lige
nc e : Me rc ha nt ba nker does a he due di po ns ib le fo r en su ring complian,,
1, Due dilige mp an y. They are also
res|
ils ab ou t th e co
contains all the deta ess.
al it i es in th e entire issue proc
with the lega l fo rm
for the iss5 ue. Deipending on
po in tu l nd er wr it er s
may ap
Un de rw ri ti ng: So meti mes company r on it s own or In syndic
ation With
2. a merc! ha nt b i an ke
hant banker acts
the size of issue merc e pr oc e’ ss wi th underwriters.
d coordinate the is su
other underwriters an in g ofthe iss' ue. Merchant banker,
bl e fo r ma rk et
ers are resp on si
3. Marketing : Merchant bank et th e pr os pe ct iv e in ve stors and gauge the
ere company official me
arrange roadshows, wh
response ofthe investors. e
a n a g e m e n t o n P ) ri ci ng of the issue dependingon th
s vise the m
4. Pricing : Merchant banker ad
setc.
market conditions, response from investor
nkers
1.9.1(C) Categories of Merchant Ba
ities and Exchange Board of India (SEBI),
Merchant banksin India are regulated by the Si ecur Iii
fied merc hant ban ker s into four cate gori es Category I, Category II, Category
whichhasclassi
and Category IV merchantbankers.
folio
gory I merc hant bank er can act as Issu e Mana gers, Consultants, Advisors, Port
© Cate
banker ca! nnot act as an issue manager but
Managers and Underwriters. Category II merchant
as a co-m anag er. Cat ego ry III mer cha nt bank er cannotact as issuer or provideportfolio
can act
s can only act as advisor or consultant for
managementservices. Category IV merchant banker
hant bankers registered with SEBI.
issue of capital. At present there are more than 200 merc

1.9.2 Stock Exchanges

t sub-section of the capita
Stock exchange has been explained in details in the secondary marke
market section.

Review Question:

Q.1 Explain the meaningof Financial System and characteristics of financial system.

Q.2 Explain the role of financial system.

Q.3 Whatare the components of financial system?

Q.4 What are the financial markets and whatare the types of financial markets?
Q.5 What the characteristics offinancial market and role of the financial market?

Q.6 Distinguish between capital market and money market

 Return and Risk
Module» 2.17
CMe a a
Concepts of Return and Risk : Measurement of Historical Returns and| Expected Returns of »
Single Security and a Two-security Portfolio; Measurement of Historical Risk and Expected Risk of 3
Single Security and a Two-security Portfolio.

We comeacrossthe sentencessuchas ‘highertherisk, higher the reward’or‘norisk, nopai,

‘in our everyday conversations. While intuitively we know the conceptofrisk and return, we w,
learn how to measurethe risk and return in this chapter. We will also learn how to minimizeris,
for a required return or maximize returnsfor an acceptable level of risk.

Learning Objectives
¢ Components of return, measurement ofhistorical and expected return.

© Understanding risk, measurement of risk on historical and expected returns, norma

distribution curve.
« Measurementof historical and expected return of twosecurity portfolio.
e Measurementofhistorical and expected risk of two security portfolio.

2.1 Concepts of Return and Risk

2.1.1 Historical Returns - Return on Asset of a Single Security

Portfolio
When we invest funds in financial assets such as fixed deposits, mutual funds, shares
debentures etc., we earn returns in two forms
1. Income from the asset in the form ofinterest or dividend
2. Change in theprice of asset known as capital gain orloss
So the total return is sum total of interest/dividend inco
me and capital gain or loss.
 inance Manager (MUj} 22 Return and Risk

Returnis generally expressedin percentage terms and calculated as total return dividedby the
beginning investment return earned in the form of dividend income is called dividend yield,
returnin the form of interest income is called interest yield and return from change in price is
called capital gain yield. Thus, total return expressed in percentage terms {s sum of capital gain
yield and interest yield or dividend yield.
Mlustration : Let us consider an example. Let's assume we invested money in the shares of
Reliance Industries Limitedatthe cost of Rs.2000per share one year ago. Todayafter 1 year, price
of Reliance shares appreciates to Rs.3000. During the year, Reliance also paid a dividend of
Rs.100. Calculate the rate of return.
Return £2000 2000) + 100
’ eturn " 2000
1100
= 2000 * 55%
100, 3000 - 2000
Here R
2000* 2000
R = 0.05+0.50
R = 0.55 or 55%
Here, 5% is knownas dividend yield and 50% is knownascapitalgain yield.
In general, the return for a year is can be calculated as below:
DIV, + (P; - Po)

ea(21.1)
where
DIV,- Dividend received during the year
P,- Price at the endof the period
Py - Price at the beginning of period
R- Return for the period.
Illustration 2 negative returns
Let's take one more example. Assume thatyou invest fundsin shares of Suzlon Energy Limited
at a price of Rs.7 per share. Companyis making a loss and hencedoes notdeclare any dividend.
Furtherat the endofthe yearprice of share dropsto Rs.5. Calculate therate of return

The investmentin shares of Suzlon yielded returns of - 28.6% consisting of - 28.6% capital
gain yield and 0% dividendyield.
 Return and Rigy
ement (MU)

w
Finance M.

e Rate of Return
2.1.2 Av erag investments. Many invest
ors hol
arket for Jon) g te rm

ta l m a r k e t @ cons idered as ma e r a g e ra te of return over a histor, May

Capi y ear For suc h in ve st or s av
mm or e t h a n o n e n. The average rate of retu
rn Petey,
ti es fo r an a 1: v e ur
securi
3 pr re ct pi ct ur eof returns th ge rate of return is as foll
ows
period convey od, T he form ul a fo r av e} ra
ag e of re tu ry ns tor each pe ri
to the av er A213)
1s
R= ne x

period.
R, Rate of return for {

INustration
ave rage returns. Table 2);
lo ok th e hi st or ic al sh ar e price data to understand the
Let’s ha ve a
*t Janu ary of each year from 2010 to 2020. For the ease
d on 1
showsthe sh are prices of MRF limite by the company each year.
consid eredthe divi dend declared
of understanding we have n ot
of MRF
Table 2.1.1: Share prices

[Date Closingprice Capitalgain [ % Return

01-01-2009 | 1.631
5,668 4,037 248%
01-01-2010
5,943 275 5%
01-01-2011
0101-2012 |__7.782 1,839 31%
01-01-2013 12,975 5,193 67%
19,228 6253 48%
39,672 20,444 106%
01-01-2016 35,345 -4327_ - 11%
01-01-2017 51,397 16,052 45%

01-01-2018 67,826 16,429 32%

01-01-2019 _61,119 - 6,707 - 10%
01-01-2020 66,597 5.478 0%
_Average 52%
Based on the Table 2.1.1 Average rate of return for MRF Limited in last 10 years will
= 28845431 + 67 + 4B + 106 + (- 11) + 45+ 32+ (- 10) +9
- 10
R 52%
Note : Pee
Please note we have not considered dividends, including which the average rate ofof return wel
ven higher. It's a common practice to calculate average annualreturn while evaluating
fustoncal returns.
 Frnance Management (MU) Return and Risk
2.1.3 Holding Period Return
«In above examples we calculated the annual rate of return. What if we wantto calculate the
cate of return for the period for which we were holding the security. This return is referred to
as the holding period return or HPR Holding period return isexpressed as a percentage andis
the (otal return receivedfromholding an asset or portfolioof assets over a periodoftime
The holding period return ts calculated by multiplying a notional investment amount of 1 with
returns on for each period and then subtracting 1 from thetotal value.

Iitustration
Let's calculate the holding period return for MRF Ltd between 2015 to 2019, based on the
price history ay provided in Table 2.1.1, The annual returns considered for calculation are

2015 - (11%), 2016 ~ (4596), 2017 - (329%), 2018 - (-109), 2019 - (9%)
R © 1x ((1~ 10%) (1 + 45%) (1 + 32%)
(1 - 1096)(1+ 996)) - 1
= (1) (0.90) (1.45) (1.32) (0.90) (1.09) - 1
= 169-1 = 0.69 or 69%
Molding period for 5-year period for MRF Ltd between 2015 to 2029 Is 69%.
If we were to calculate annual compound rate of return for the above period, we need to
calculate the geometric which will be calculated as follows :

Compound annualrate of return = 5 (0.90) (1.45) (1.32) (0.90) (1.09) - 1

= 1.10 - 1.00=0.10 or 10%

2.1.4 Measures of Risk for One Security

Insectton 2.1.2, we calculated the average return of MRF Limited for 10-year period which was
52% p.a. However,therate of return in each period wasnotconstant and varied from between
~ 9% to 248%. This variation in rate of return gives rise to the risk. Measurementofthis
variation or uncertainty is the measure ofrisk associated with the investment. There are two
measures of this variation orrisk
1, Variance and
2. Standard deviation.
* Variance is calculated as the average of sum of square of difference between actual rate of
return and average rate of return. Varianceis expressed as o.
* Standard deviation ts the square rootof the variance andis expressed as o

Variance (0?) = aye Ry? (2.1.3)

W Finance M. nt (MU) 25 Return and Risk

Standard Deviation o =
(214)

where
R,- Rate of return of security in i™ interval ofperiod
R - Average rate ofreturn.
Illustration

Let's calculate variance for MRFLimited. Wewill follow the below steps.

1. Calculate the average rate of return. This is denoted as R. As seen previously for MRF Limiteg
R= 52.
2. Then calculated the difference betweenthe actualrate of return and averagerate of return for
each period.
3. Calculate square of each of this difference and take sum of the squares of eachof this
difference, which is denoted as ))(R - R)?.
4. Lastly divide this sum by n - 1, where nis numberof observation in sample data.
Weare dividing the sum by n - 1 to accountfor loss degree of freedom when we considera
sample data. This is because we are only considering sample from entire population of returns of
the security. Let’s calculate the variance for MRF Limited

Date Annual Returns (%) (R- R) (R-R)?

01-01-2009
01-01-2010 248 196 38416
01-01-2011 5 -47 2209
01-01-2012 31 -21 441
01-01-2013 67 15 225
01-01-2014 48 -4 16
01-01-2015 106 54 2916
01-01-2016 -11 -63 3969
01-01-2017 45 -7 49
01-01-2018 32 -20 400
01-01-2019 10 ~62 3044
01-01-2020 9 -43 1849
TOTAL 54334
AVERAGE RETURN 52
 nance Management (MU) 2-6 Return and Risk

2 gzapeszy’s (5-s2y'+ on-s2y’s (67-52)? + (48-5277 (106-S2y%s (19 say's (45-52)! s (52-52) (10-52)(9-52
. 9

Variance o* = 6037

Standard Deviation = {eos =78

Whatdoes this indicate? MRF shares offered an average annual return of 52, but had a
standard deviation of 78 which is an indicator of fluctuation of actual returns from average
returns. This variation orfluctuations in returns is quite high and indication of high degree of
volatility in returns. However, kindly note that the standard deviation for 10 years may not
adequateto calculate the implied risk and the risk may be lowerif we lookat larger population of
data. Whenever weinvest in shares for short term, we should be prepared for the volatility in the
prices

2.1.5 Expected Returns of Single Security

In the previous examples wecalculated risk and returns based onhistorical information. We

canalso calculate risk and returns based on the expected returns. For this welist rate of returns
expected under possible scenarios and assign probability to each of the possible scenarios.
Expected return is equal to the weighted average of rate of returns under all the possible
outcomes.

Expected Rate of Return expressed as E(R)can becalculated as below

E(R) = Ear ww (2.1.5)

Where

P- Probability of the outcome

R- Rate of Retum

i-i* outcome

n- Total numberof possible outcomes

Illustration

Let's take an example of security XYZ Ltd whose possible returns under various scenarios are
tabulated as below :
 Return andRis,
2-7
Finance Management (MU
Table 2.1.2

Expected Rate of|

Scenario Probability (P,)| Rate of Return
Return (%) (R,)| Return (Pu (Ri)
-10 (0.20)(- 10)
Negative growth 0.20

0.30 10 (0.30)(10)
Stable growth
20 (0.50)(20)
High growth 0.50
11.00
Total 1.00

be calculated as below:
Based ontheTable 2.1.2, expected return will
= 11%
E(R) = (0.20) (- 10) + (0.30) (10) + (0.50) (20)
as below:
Variance ofreturns in the above examplewill be calculated

2.1.6 Expected Risk of Single Security

k
In section 2.1.4 we calculated the risk of investment based on historical returns. Theris
to
measures i.e. variance and standard deviation canalso be calculated by assigning probabilities
expected returns. In the above example, returns from investmentin XYZ Ltd are expected to vary
between -10% to 20% underdifferent scenarios. Risk associated with investmentin XYZ Ltd will
be calculated as below:
Variance (02) (0.20) (- 10-11)? + (0.30) (10 - 11)*+ (0.50)(20 - 11)?
(0.20) (441)+ (0.30) (1) + (0.50) (81)
= 88.1+ 0.30 + 40.5 =128.9
Standard Deviation (6) = 128.9 = 11.35
For large number of probable outcomes, variance canalso be expressed as below:

Variance (07) = P;(Rj- E(R))"* Pz (Rz - E(R))* + P3 (Ra- E(R))*+ ...

+ Pa (Rn- E(R))?

= DP (Er BR)? {2.48}

2.1.7 Use of Standard Deviation and Normal Distribution
Wehave studied the examples where distribution of probability was discrete or returns had
limited number ofoutcomes. However,in practice distribution ofstock returns is more likely to bé
continuous as the stock returns can take values from a very high positive numberto negative
number. Such a continuous distribution of returns is called normal distribution. Norma!
distribution is a symmetrical, continuous, bell shaped curveas shown in Fig. 2.1.1.
 Finance St yt (MU
28 Return and Risk

=
3 -2 4
A
0 1 2 3
Standard deviations
Fig 2.1.1 : Norma! Distribution Curve

Normaldistribution curvehas following properties:

1. Area under the curve is equal to 1 and represents the probability ofall the outcomes.

2. Maximum valueof probability underthe curveis at the expected valueofdistribution.

3, 50 percentofthearea falls within (+/-) 0.67 standard deviation (right and left), 68 percentof
the distributionfalls within (+/-) 1 standard deviation (right andleft) of the expected return;
95 percentfalls within (+/-) 2 standard deviations(right andleft); and over 99 percentfalls
within (+/-) 3 standard deviations (right andleft).

Blustration
Let’s take the case where average expected return or mean return is 15% and standard
deviation is 10%. As per normaldistribution, 68% of all returns will fall within 1 standard
deviation right andleft of the mean return i.e. (+/-) 10% of 15% i.e. between 5% and 25%. This
also means that there is a 68% probability that returnswill fall between 5% to 25%. The normal
probability table (given at the endof the book) can bereferred for determining area under normal
curve for various standard deviations. For example, the probability of returns having 1 standard
deviation higher than expected return i.e. 25% (10% higher than expected return of 15%) will be
represented by the area ontherightof 1 standard deviation i.e. 35%.
Normal distribution can be standardized usingfollowing formula
Ss R-E(R)
< (2.1.7)
Where
Sis the difference between actual return and mean return expressed as multiple of standard
deviation
 on to calculate probability of negative returns4,
ett use the concept of standard deviat
Table 2.1.2, expected return or mean return of Xyy :, .
security XYZ Ltd As mentioned in the
11% and the standard deviation is 11.35

Answer

First, we need to calculate distance S of 0% from the mean return of 11% in terms Of standary
deviation
S= ou =-097
to 0.97 standard deviations o,
Above value indicates that 0% return will fall area equivalent
left of from the mean return. Asdiscussed above, area covered 1 standard deviation is 34%. Hence
area corresponding to 0.97standard deviation 1s 0.97times 34% Le. 32.98%
of Negative
‘Area on the curve ontheleft of 0.97 standard deviation will indicate the probability
returns Le. 17.02% (50 - 32.98).

2.1.8 Two Security Portfolio

Wehave seen how to measure risk and returnsfora single security.In practice, investors don’,
invest all fundsin a single security butin multiple securities with primary objective of diversifying
their investment. We have heard of an old idiom ‘Don’t putall your eggs in one basket’, which
effectively mean don’t put all investmentin one bucket. Weall intuitively know thatdiversification
reducesthe risk. Let’s see it mathematically.

2.1,8(A) Returns in Two Security Portfolio - Historical

Whenweinvest funds in a portfolio consisting of two securities, rate of return is calculated
based on proportionofeach security in total investment andrate of return for each security. Such
rate of return is called rate of return onthe portfolio and expressed as R,

Ry = w,R,+ wR,
Where,
w,- Weightageofsecurity in the portfolio
R, - Rate of return forsecurity 1

w2- Weightage ofsecurity 2 in the portfolio

R, - Rate ofreturn for security 2

 1 Return and Risk
Oro at (MU zie

vested funds in a portfolio consisting of two securities A and B in the proportion

Let's say we IN 24% while shares of
30% respectively. Shares of company A provided a return of
bof 30% and of return for the portfolio.
ovided 8% returns. Calculate the rate
company 6 Pr

oe R, = (0.30) (24) + (0.70) (8)

= 7.2+5.6=128%

Portfolio
(B) Expected Return of Two Security
2.1. 8
ightage average
rl y, w e ca n ca lc ulate expected return of portfolio by adding the we
simila .
e p o r t f o l i o i n d i f ferent scenarios 018)
s
return of t h w ) E ( R e )
E( R,) = wE(R,) + (1-

ty A in the portfolio
- Weightage of securi
in the portfolio
j-w- Weightage of security
rity A
- Expected return of secu
- Expected return of security B
)- Expected return ofportfolio
urn of Portfolio for any noof securiti es.
the abo ve for mul a for Exp ect ed Ret
Wecan extend

justration
n
ntin security A and 70% of the amount‘i
Weare planning to invest 30% of the amou
returns of security A and security B under
ity B. Table 2.1.3 provides expected rate of
. . Let’s calculate the expected rate of return
ofthe portfolio.
t scenarios
Table 2.1.3

te of Return| Portfolio Expected Rate of

| Seenarfo Probability] Rate of Return Ra curity B Return |Return ofPortfolio
(Pd of Security A of Se
(30%) (70%) (PdR,)
:
4 (0.30) (3) +
| 7 3 (0.70) (4)
10 4.0 0.80
Negative 0.20 -10
|_growth 17.0 5.10
0.30 10 20
| Stable

4 8.80 4.40
| High 0.50 20
|_growth 10.30
Total 1.00
 Vv Finance Management (MU) 2-11 = Return
ae. and Ris,
tfolio
2.1.9 Measuring Portfolio Risk for Two Security Por
returns of individua,
While the return of the portfolio is equal to the sum of weighted average
the risk calcul ation ofport folio is little different, although measures ofrisk ie. standarg
securit y, t of
variance of portfolio depends on the co-movemen
deviation and variance is same. This because
additi on to the varian ce of indivi dual securi ties. The co-movement or relationship
the securities in e.
nth e retu rns of the secu riti es is exp ressed by the term called as covarianc
betwee
a stat isti cal mea sur e of the deg ree to which the variables move togethe,,
Covariance is
when one
tive cova rian ce mea ns retu rns of the secu rities movein similar direction meaning
Posi
security has positive returns other will also
havepositive returns and vice versa. Negative value of
es move in opposite directions. Nil cova
riance meang
cova rian ce mea ns retu rns of two secu riti
security with other.
there is no relationship between returns of one
Variance ofthe portfolio is expressed as 0”, (2.1.9)
Variance (02,) = w2, 07, + W2p 079 +2Wa Wy (COVan)
where
Wa We represent weightageof security A and B in portfolio respectively
0, Og represent standard deviation ofsecurity A and respectively
Covag represent covariance ofsecurity A and B.

Illustration
security A and 70% in
Let's calculate variance of a portfolio consisting 30% investmentin
ded below:
security B. A table showing probability and returns under different outcomesis provi
‘Scenario [Probability] Ry] Re [Ra-E(R,)} Re- o% 7s |Covariance|
E(Ra)
1 2/3 4 5 |mMer|wer| ME)
Negative growth; 0.2 - 10} 10 -21 0 88.1 0 0

Stablegrowth 0.3 10| 20} -1 1o 03 30 -3

High growth os 20] 4 9 -6 405 18 -27
11| 10 128.9] 48 -30
o, Pp (0.30)? (128.9) + (0.70)? (48) + 2 (0.30) (0.70) (- 30)
(0.09) (128.9) + (0.49)(48) + 2 (0.21) (- 30)
”

11.60 + 23.52 - 12.60

22.52
Standard deviation of portfolio a,is V2252= 4.74.

The relationship between Covariance of two securities can be expressed in terms of standard
deviation of security A and asfollows:
 to
Th e co rr el ation coefficient is used
The term Cory, is called as correlation coe ffi cie nt:
s
be tw ee n - 1 (0 1. Po si tive correlation indicate
es
measure between two vartables. Itt akes valu ile ne gative value indicates
negative
iti vel y cor rel ate d, wh
that movement of A and B are pos tes that the covariance of
wee n mov eme nt of A and B. This express jon indica
correlation bet
rd devial tion of A and B and
the correlation
B is mul tip lic ati on of sta nda
portfolio consisting A and
coefficient
Cov,
Cotas = (a4)(a8)
The varianceofportfolio can now be expressed as
at, = wy ott wie oe +2 (wala) (04)(6a)( Coras)ww (2.1.10)
l
also be usedt o calcu lat te var ian ceo f the portfolio based on historica
The above formula can .e. 075 will be
{.e. o®,and variance ofsecurity i
‘returns. In thatcase the variance ofsecurity A
‘calculated based onhistorical returns.
d variance and standard devi ation depends
Kindly notethat therisk of the portfolio measure
rities ani \d 2) Proportion of investmen
t in
upon three factors 1) Correlation of the two secu
ch security 3) standard deviation of each security.

2.1.10 Diversification and Reduction of Risk

ive correlation and
Securities having a correlation coefficient + 1 means there is perfect posit
tion.
combiningthese securities may notresult in meaningfulreduction in standard devia
A correlation coefficient - 1 means a perfectly negative correlation and combining these
securities mayoffer highest reduction in risk.
In general, combining securities with negative correlation will have highest impact in
reduction ofrisk, while combining securities with positive correlation will be lower andwill be
impacted more bythe standard deviation ofeach security.

illustration
In the above example wecalculated expected returns and risk ofsecurity A, . security B an and

Particulars Security A Security B Portfolio

Expected Return 11.00 10.00 10.30
Standard Deviation 11.35 6.93 4.74
 213

a r e d to 11 .3 5 for security 4 ,
4. 95 is much lower comp ceg nd
deviation of po rt fo li o at
in , 2 t w o se cu ri ti es, risk has redu
that by comb
table suggests at di versification ofinves tmen,
ca ll y pr ov es th
This mathematt
compromising
rs in the ca ptt al markets.
can reduce sk of recu
ce portfolio
Minimum varian an d no w wi sh to create a portfoj,,
vest me nt
assul me we have fi
nalized 2 securities for in ty,
Let's
m. Po rt fo li o va ri an ce will change dependingon e
o variance will be mi nimu
such that the portfoli tw o ot he r fa ct or s Le . standard deviation and
as
stment in two secu rities
proportion of the inv re o having minimum variance {s called as
minimyy,
e se cu ri ti es . Po rt fo li
correlation are fixed fo th
r

variance portfolio.
fo li o, we ig ht age of sec uri ty A can be calculated using below
In a minimum variance po rt

formula
iy
al |
> Formula: Wa =x e
(e+ 0% — 2COVA8)
—_(48 -(-
(128.9 + 48 - (- 30))
2
= 78
256.9
= 0.30

Hence, the portfolio consisting of 30% of investment t in security

A and 70
yaa Mein cariee
the minimum variance portfolio.

2.1.11 Solved Examples

Bee i ee ni eee ea capocied we conus came ta
ne ann Suewo ywcapa seer Sous rot anna Captalexpected ec 2
. " in market, share price of Mahatma Capital expected reach
at the end of the year, Calculate following returns for Mr. Prasad. . ° =
2. Capital gain yield
1 Capital gain amount

3. Dividend amount 4. Dividend yield

5.
oom: Total return amount 6. Total retum in Percentage ge retums. .

Capital gain per share = Market Valueof investment (expected)1) - Valueof original investm

= 275-250 ” ™
= 25
 OY fina Management (MU) 214 Return and Risk

Capital gain in amount = (25) (100) « 250

0
Capital gain yield = (2e
75 - 250
T = 10%
Dividend Income = (Dividend per share)
(No of shares)
= (5) (100)
= 500
Dividend yield = (35)
= 2%
Total return = Capital gain amount+ Dividend amou
nt
= 2500+500
= 3000
Total return amount
Total return in percentage Orieinat investment
Capitalgain yield + Dividend yield
| 10% + 2%
= 12%
Ex. 2.1.2 :Calculate Expected Returnsand Risk for Security A.

Outcome Probability Rate of Return (R)

Good 30% 15

Normal 50% 10

Bad 20% 5

Soin. :

loutcome|Probability|Rate ofReturn (R)|PiRi|R~E(R)| (R-E(R))* |p(E-E(R))

Good 30% 15 45 45 20.25 6.075

Normal 50% 10 5 -05 0.25 0.125

Bad 20% 5 1 -55 30.25 6.05

100% 10.5) 50.75 12.25

Expected Return 10.5

Variance 12.25
Standard Deviation! 3.5
 rate of Return (R)| PR /R-E(R)| (R-E(R))? PCE ey,
m% |7s| 145 | 210.25 8300
i550 ] -05 0.25 01
-10 -2.0} - 20.5 420.25 84.05

10.5 630.75 147.25

Expected Return 103
Variance 147.25
Standard
Deviation 12.13

ty A and 50%,
Ex. 2.1.4 :Caiculate expected return and risk for Portfolio consisting of 50% of Securi
Security B.
Outcome Probability (p) (Ra) (Ra)
Good 30% 15 25
Normal 50% 10 10
Bad 20% 5 |-10
Soin.:

e|
(Outcome|Probal bility (p) (Rd/Ra) Portfolio}
(R)
E(R,)
pR,
P(E-£
RE (R,) (R-{- E(Ry)) 2 my?
Good 30% 15 25 20 6.0 9.5 90.25 27.08
Normal 50% 1o|10/ 10 5.0 -0.5 0.25 0.13
Bad 20% S |-10] -25 -05 -13.0 169 33.8
100% 10.5 259.5 61
Expected 108
Return |
Variance 61 |
Standard 78 |
Lt Deviation |__|
 16 Return and Risk
Finance Management (MU

standard deviation of possible retums

ex 215 An asset has an expected return of 25% ond the
125% What is the probability of the retum of asset will be zero or negative?
Son.
s - SEqR)
o-25
12.5
= -2
Negative returns are2 standard deviations onthe left side from the mean.
Innormal distribution area underthe curve upto +/- 2 standard deviation from meanIs 95%.
right side and
Remaining area ts 5% and is divided between high positive returns on the
negative returns on the left

Probability = sh. 2.5%

@.1 What is retum? Explain the components of returns.

@.2 Define holding period return and show how it is calculated.

@.3 Explain the concept of risk. How it is calculated?

@.4 Whatis normal distribution? How it can be used for calculating probability of stock retums?
@.5 What is coefficient of correlation? What is the relatioriship between covariance and coefficient of
correlation?
@.6 Explain how diversification reduces risk.
 Time Value of Money
dceteaa
y Due: Preser
f Time Value of Money : Future Value of 2 Lump Sum. Ordinary Annuity, and Annuit
| Vatue of @ Lump Sum, Ordinary Annuity, and Annuity Due Continuous Compounding arg
Continuous Discounting,

our childhood. in this

‘Time is Money’ is one of the most commonly heard proverbs since
andlearn various
chapter we will understand the value of time in the context of investment
concepts as mentioned.

Learning Objectives

© Concept of Time Value, Future Value, Rate of Return, Compounding.

© Future Value of a Lump Sum, Ordinary Annuity, and Annuity.

© Present Value of a Lump Sum, Ordinary Annuity, and Annuity Due.

Continuous Compounding and ContinuousDiscounting.

3.1 Concept of Time Value of Money

© If we are given a chance to choose between receiving Rs.10000 today Vs Rs.10000 a year later,”
most of us will choose to receive today. There may be multiple reasonsfor this choice such 3 |
need for consumption i.e. meeting expenses at present or avoiding uncertainty ofreceiving
money at the end of one yearorto avoid loss of investment opportunity.

© The requirement for consumption may be subjective to each individual and uncertainty a
investment will depend on the type of investment. However, the loss of investmest |
opportunity will apply to all the situations. '
'
!
 Finance Management (Mu) 3-2 Time Value of Money.

This is because we can always invest the money and expect to earn a positive return over this
nvestment. Simplest example of investmentis creating a fixed deposit in a bank for 1 year.
Hence, most of the rationale human beings will choose Rs.10000 today over receiving the same
amount a year later
This preference for receiving money now compared to receiving same amountof money at
some later period is called the Time Preference for Money or Time Value of Money.

3.1.1 Future Value

When we chooseto receive money in future over present, we will naturally expect higher
amount than what we would wereceive today. Future Value refers to this higher amountthat we
expect to receive in future. Future Valueis the amountto whicha currentor a present asset would
grow overtime. Investors can evaluate future value expected from different investment avenues
and take informed decisions. This Future Value is importantfor investors andit allows them to
take decisionson their investment.

Illustration
Let us continue with our exampleof Rs.10000 and assumethat we decide to invest the amount
ina 1-year bank deposit earninganinterestrate of 7% p.a. In 1 year,at the rate of 7%,we will earn
interest amount of Rs.700 and wewill have Rs.10700 at the end of year 1. Let us represent the
future value at the endofyear 1 as FV;. In terms of mathematical formula FV ofRs. 10,000 after 1
year at 7% p.a. can be calculated as below:
FV, = 10,000 + 10,000 x 7% = 10000 x (1 + 7%) = 10, 700.

3.1.2 Simple Interest and Concept of Compounding

In the above example by investing Rs.10,000 for 1 year, we earnedan interestof Rs.700 which
is simple interest. Whatif we choosereinvest interest along with principal at the end of 1 year?
‘Wewill earn the interest over the principal of Rs.10,000 and on Rs.700 interest. Interest earned
‘onthe principal is called as simple interest, while the interest income earned on the principal and
interest amountis called as the compoundinterest. This process of earninginterest on principal
and interest is called as compounding.

Ailustration
Whatif we reinvest Rs.10,700 for one moreyear, the amountreceivable after year 2 will be as
lows:
FV, = 10,700 x (1+ 7%) = 10,000 x (1 + 7%)? = 11449
Total interest earned in 2 yearswill be 1449 (the difference between 11,4¢9 and 10,000)
 Time Valueof
Finance Management (MU 33 M

3.1.3 Rate of Return

as an interest Providing
earned Rs.700is equivalent to a
¢ In the above example byin investing ig Rs.10,0! 00 for 1 year
ay,
s that receiving Rs. 10,000 tod
us a return of 7%. This also mean
our moneyin fixed depos' it.
Rs.10,700 a year later provided weinvest
we wil
unt more than Rs.10700at the end of1 year,
© So if we are offered an amount of any amo
What if there js an
prefer to receive money after 1 year, provided there is no uncertainty.
? Will we expect similar return as 7%? We will
element of risk in receiving moneyafter 1 year
nty orrisk. This rate of return expected
expect a higher return to compensate for this uncertai
rate of return. The
from the investment will depend on therisk andis called as required
required rate of return by an investoris the rate of return offered by investing in asset having
equivalentrisk and is sameas opportunity cost ofcapital, which.

© Whatif we had invested this amountRs.10,000 in share market. Wewill expect a higherreturn
of may be 15% per annum onthis investment. This expectation of higher return is due to
higherrisk involved in share market investment. This 8% difference betweenreturns of 15%
and 7% is called the risk premium. Risk premium refers to the extra return demanded by
investors overrisk free rate of return for the additionalrisk taken for investing in riskier
assets.

© Whatif we are asked to choose between receiving Rs.10,000 today and Rs. 12,000 to
be
received in 2 years, assuming opportunity costof capital of say 7% p.a. As seen
above, 10,000
invested at 7% will becomeRs. 11,449 and less than Rs. 12,000.In this scenario
we will choose
to receive Rs. 12,000 after 2 years than Rs. 10,000 today.

Thusif we know required rate of return we cash

choose between different cash flows at
different periods. Let's take one more example.

Tilustration t

To compare Rs.50 Lakh toda

y and Rs.70 Lakh after 2 yea
rs, let's
years using required rate of
15% pa.
 nance Management (MU) 34 ‘Time Value of Mon

FV, 50(1 + 15%)?

8
50(1.15)’= 50(1.323) = 66.125

4
As propertyoffers higher appreciation, Mr. Shah should take favorable decision to invest in

commercial property.

3.1.4 One-time Investing/Lump Sum Investing

*,
vals of time. When
Investors have an option of investing moneyin one go or at different inter
ng or onetime investing. Future value
the fundsareinvested in one go, it is called lumpsuminvesti

of lumpsum investment can be calculated as below:

‘The Future Value FVn can be expressed as

FV, Px (1+i)" e311),

where
n = No.ofperiods

Rate of return per period

”

FV, = Future Valueat the end ofperiod n

P Principal amountororiginal investment amount

The factor (1 + i)” is called as Future Value Interest Factor (PVIF) or CompoundValue Interest
Factor (CVIF). It represents Future Valueof Rs.1 invested for a period of n at therate ofi

So if we substitute (1 + i)” with CVIF, the Future Value formula can be expressed as

FV, = PXCVIFpy (3.1.2)

where

CVIF,,, is the compound value interest factor for period of n at an interest of i and it represents

ue future value of Rs.1 invested for a period of n years at the rate of i% per period.

CVIF or CompoundValue Factor makes it easy for calculation of Future Values involving large
umber of years without using computer orscientific calculator. CVIF table provides values for
ferent combinations of interest rate and noof years.
 35
Time Value of
Finance M: t (MU

Titustration
a?
re va lu eof Rs. 50 00 in ve st ed for 7 years at the rate of 5% p.
What will be the Futu

Answer
rmula |
tu re val uea t th e en d of 7 ye ars can be calculated by using fo
Fu
|
FV, = Px(1+i)"
|
FV, = 5000x(1+5%)’
FV, = 5000 x CVIF75%
e Future Value in this example
We can refer to the CVIF or PVIFtable below to calculat
FV, = 5000 x 1.407 = 7028
Table 3.1.1 : CVIF/FVIF Table

ds, FVIF(, ») |
Puture value interest factor of Rs.1 per period at 1%for n perio
Period] 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% |
1} 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.109)
2 1.020 1.040 1.061 1.082 1.103] 1.124 1145 1.166 1.188 1.210 |
3 |1030 1.061 1.093 1.125 1.158] 1191 1.225 1.260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1.262 1311 1360 1.412 146
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 14691539 1611)
6 1.062 1126 1194 1.265 1340/1419 1501 1587 1.677 1.772)
7 |10072 1149 1.230 1.316 1.407| 1504 1606 1.714 1828 1.949 |
a 1.083 1.172 1.267 1.369 1.477] 1594 1.718 1851 1.993 2.144 |
9 1.094 1.195 1305 1.423 1.551 1.689 1.838 1.999 2.172 2.358 ||
10 [1105 1.219 1344 1480 1.629] 1.791 1.967 2159 2.367 2594 |
11 1.116 1.243 1.384 1.539 1.710 1.898 2105 2.332 2.580 2.053 |
12 [1.127 1268 1426 1.601 1.796 2.012 2252 2518 2813 3.138
13, 1.138 1.294 1469 1.665 1.886 2.133 2410 2.720 3.066 3452 |
14 [1.149 1319 1513 1.732 1.980 2.261 2579 2.937 3.342 3.797 |
15] 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177,
16 1.173 1373 1.605 1.873 2.183] 2540 2,952 3.426 3.970
17 1,184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054 |
18 1.196 1428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142
20 1.220 1.486 1806 2.191 2.653 3.207 3.870 4661 5.604
 Finance Management (MU)

7.0
6.0
5.0
340
@$3.0
s
“20

Fig. 3.1.1 : FVIF/CVIF Chart at different interest rates

3.1.5 Future Value of Annuity (Ordinary Annuity)

Annuity as the name indicates refers to fixed amountpaid or received at annual frequency.
More particularly it refers to stream ofconstant cash flows due every year. Whenthe fixed amount

of cash flows is received or paid at the end ofthe year or a periodit is called Ordinary Annuity.

In case cash flows are received or paid at the beginning ofthe yearora period it is called Annuity
Due.

Illustration

In the above example, we invested Rs.5000 for 7 years in lump sum orin one go. Suppose
insteadif investing 5000 in Lump sum, wedecide to deposit Rs.1000 at the endof each year for 5
years we have created an annuity. Alternatively, when wetake car loan or housingloan, we repay
the loan in constant monthlyinstallments, we have created an annuity.

To calculate future value of Rs. 1000 annuity we will need to calculate the future value for each
investment of Rs. 1000. Thefirst investment of 1000 madeatthe endofyear1, will earn invest for

4 years, while the last investment of 1000 made at the end of 5 years will not earn any interest.
This is expressed as below:
 Fig. 3.1.2
FVAs = 1000 x (1 + 5%)*+ 1000 x (1 + 5%)*+ 1000 x (14 5%)?
+ 1000 x (1 + 5%)'+ 1000 x (1 + 5%)?
= (1000)x (1.216) + (1000) x (1.158) + (1000)x (1.103),
+ (1000)x (1.05) + 1000
= 1216 + 1158 + 1103 + 1050 + 1000 = 5527
The Future Value FV,, at the end of n yearfor the annuity valueofRs. A, at the rate of 1%
can be calculated as below:
FVA, = Ax(1+i)"'+Ax(14i)"?+ 4 Ax (141)?

FVA, = Ax Gspet (a)

"
The term Gauren is called as Compound Value Interest Factor
for Annuity (CVIFA) or fam
ValueInterest Factor for Annuity (PVIFA).
|
‘Thus a Future Value of Annuity can be expressed as
below:
FV, = Ax CVIFA,, on (3M
Where
A- Annuity cash flow
CVIFA,;- Compound ValueInterest Factor fo
r Annuit y of Rs.1 for n periods at theinterest
Per period.
Table 3.1.2 shows the table of Fut
ure value of annui ty of Rs.1 for diff
rates. erent period and
 @ Finance
7 inagement ( (MLu)
Manag: 7
3-8 Time Value of Money
Table 3.1.2: Future/Compound Value Interest
Factor Table of Annuity (FVIFA/CVIFA)

Future value Interest factorof an ordinary annuity of Rs.1 per period at 1% for n periods,
CVIFA/FVIFA(,
jJ———
period| 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000} 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050] 2.060 2.070 2.080 2.090 2.100
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4506 4.573 4.641
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105
6 6.152 6.308 6468 6633 6.802 6.975 7.153 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8923 9.200 9.487
8 8.286 8.583 8892 9.214 9.549 9.897 10.260 10.637 11.028 11.436
9 9.369 9.755 10.159 10.583 11.027]11.491 11.978 12.488 13.021 13.579
10.462 10.950 11.464 12.006 12.578} 13.181 13.816 14.487 15.193 15.937

11 11.567 12.169 12.808 13.486 14.207] 14.972 15.784 16.645 17.560 18531
12 |12.683 13.412 14.192 15.026 15.917} 16.870 17.888 18.977 20.141 21.384
13. [13.809 14.680 15.618 16.627 17.713) 18.882 20.141 21.495 22.953 24.523
14 |14.947 15.974 17.086 18.292 19.599/21.015 22.550 24.215 26.019 27.975
15 |16.097 17.293 18.599 20.024 21.579| 23.276 25.129 27.152 29.361 31.772
16 17.258 18.639 20.157 21.825 23.657] 25.673 27.888 30.324 33.003 35.950
17 |18.430 20.012 21.762 23.698 25.840) 28.213 30.840 33.750 36.974 40.545
18 19.615 21.412 23.414 25.645 28.132/ 30.906 33.999 37.450 41.301 45.599
19 20.811 22.841 25.117 27.671 30.539] 33.760 37.379 41.446 46.018 51.159
20 [22.019 24.297 26.870 29.778 33.066| 36.786 40.995 45.762 51.160 57.275

Illustration

Mr. Mukherjee decides to invest an amountofRs.1,00,000 each yearfor a period of next 20

years to create a corpusfor future. He expects to earn a return of 10% eachyear onthe invested
mount. Calculate the Lumpsum amountthat Mr. Mukherjee will receiveat the end of20 years.
 Time Value of Mon, ey
W Finance Management (MU 3-9

lated using amnuiy

years can be calculated
“"
of annuity of Rs.1,00,000at the end of2 0
Future value
formula
FVAz0 Ax CVIFA20,10%

100,000x57.275

$7,27,500.
7.28 Lakh. This also shows
mea ns a tot al in ve st me nt of Rs .2 0 Lakh have becomeof Rs.5
This
the power of compounding.
the importance of early investment and

3.1.6 Sinking Fund

® Sinking Fundrefers to a fund created using a constant amounts deposited at regular interyaj,
to accumulate a future fund amount after a certain period. Sinking fund concept is used
manyplaces such as creationofrepair fund for a housing society, redemption ofdebentureby
companies etc.

© Let's say a companyhas issued debentures amounting to Rs.100 Cr to a bank, maturingafter,

period of 5 years. Company needs to create a sinking fund to meet the redemption of this
debenture after 5 years. Company expects to earn annual return of 7% p.a from the amounts
kept aside. How much amountshould a companysetasideat the end of each year.
¢ In this example Future Value of Annuity or FVA is 100 Cr and annuity needsto becalculated
Wecancalculate the annuity by using the formula for Future Valueof Annuity.

FV, = AXCVIF,,
As we
CVIF,;
100
A= 3751
A = 17.38Cr
1
In the above example the term ovr, 5 called as Sinking Fund Factor.
 Time Value of

317 annuity Due

. in the above example of anna 2 constant sum was deposited at the end of each period

whet ¢ « faxed mem set aside at the start of each period instead of end of the period.

«Ths annuity created by Gepositing a constant sum at the start of each period is called as
agmsits Dae. Anmsity Due ts a series of fixed payments made at the beginning of each period
for specfied sumber of periods
. Wresever we buy any item om loan generally the bank will start recovering instalments from
the begianing of the loan For example, if we buy a mobile phone in the EMI scheme of 12
a
smooths, bank will start to recover instalment from the beginning of the month instead of
month. This is called Annuity Due
«Let's say we invest Rs 1000 at the beginning of year in each of the next 5 years. In this case the
gmoum invested in the last will also earn a return as it remains invested for 1 year. Hence the

caicatation of Future Value will become

FV, = Ax(i+i®eAx(1+it t++ Ax(1+i)
FV, = Ax CVIFA,, (1+) (3.1.5)

3.1.8 Present Value of Money

« in previous sections, we understood how to calculate future value of cash flows and compare
cash flows received at different periods of time. What if we were to calculate the present value
of future cash flows to arrive at the decision? Presentvalue is the value of cashflow available
taday, which is equivalent to the future value and is denoted as PV. Present value or PV is also
called the discounted value as it is calculated by discounting the future cash flows. Process of
discounting is reverse of compounding.

© The rate which is used to discount the future cash flows for calculating the present value is
called the discount rate. When presentvalue is invested at the discountrate it will match with
fuvare value.

Tiustration

Suppose you were to choose between receiving Rs. 10,000 today or Rs. 12,000, 2 years down
he line, using present value concept Assume your discountrate is 7% pa.
 Time Value of Mong
3-11
Finance Management, (uu,

Answer
.10,000.
th e pr es en tv al ue of Rs, 12 ,000 and compare it with Rs
Wewill calculate
i count the future ' at the disco unt rate hig
valulue
have to dis
Tocalculate the present value, we
is 7% p.a. in this case.

Formula for FutureValue is

FV, = P(1+7%)?

12,000 = P(1+7%)?
* 10,481
12,000 _
P = 12000 <a oF 11449

ch is 481 higher than Rs.10,000.

Thepresent value of Rs.12,000is Rs.10,481, whi
of period n at required rate of i% pa
Similarly, we can calculate Present Value of FV at the end
above example, we can calculate py by
Present value is represented as PV. Using the
discounting Future Valueattherate of i.

PV = (3.15,
G+"
-
1
Pu = Yee aye
1
PV = FVn* CVIF,,
value interest factor and
The inverse of compound valueinterest factor is called as present

denoted as PVIF. It represents presentvalue of Rs.1.

PV = FV, x PVIFay B17)
Where

PV - Present Value

FV,, - Future Value at the end ofyearn

i - Rate at which future cash flows are discounted is called as discountrate

PVIFn,i - Present Value Interest Factorfor a period n and interestrate of | per period

Wecancalculate the present values of Rs.1 for different combinations of discountrate

 Finance Management(MU) Time Value of Mone:

Table 3.1.3 : Present Value Interest Factor Table

——
| Present value Interestfactor of Rs.1 per+ period atl% for!aperiods, PVIFins ]

| Pertod 1% 2% 3% 4% 5% 6% ™% B% 9% 10%

1 0.990 «60.980 (0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909

2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826

3 0971 0942 0.915 0.889 0.864 0840 0816 0.794 0.772 0.751
4 0961 0.924 0888 0.855 0.823 0.792 0.763 0.735 0.708 0.683

5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621

6 0.942 0.888 =60.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564

7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513

8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467

Q 0.914 0.837 0.766 0.703 0.645 0.592 0544 0.500 0.460 0.424

10 0.905 0.820 0.744 0676 0.614 0.558 0508 0.463 0.422 0.386

ML 0896 0804 0.722 0.650 0.585 0.527 0475 0429 0.388 0.350

12 0.887 0.788 0.701 0625 0.557 0497 0444 0397 0.356 0.319

13 0879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290

14 0.870 0.758 0.661 0577 0.505 0442 0.388 0,340 0.299 0.263

15 0.861 0.743 0.642 0555 0.481 0417 0.362 0.315 0.275 0.239

16 0853 0.728 0.623 0534 0.458 0.394 0.339 0.292 0.252 0.218

7 0.844 0.714 0.605 0.513 0.436 0.371 0317 0.270 0.231 0.198

18 0836 0.700 0.587 0494 0.416 0.350 0.296 0.250 0.212 0.180

19 0.828 0.686 0570 0475 0.396 0.331 0.277 0.232 0.194 0.164

20 0.820 0673 0554 0456 0377 0312 0.258 0215 0.178 0.149

Present Value Chart

The graph shows the presentvalueof Rs.1 at different discounting rates overdifferent periods.
As seen from the graph the present value decreases as the time period increases and
discounting rate increases.”
Thegreater the interest rate, steeperis the declinein presentvatue.
 Time Value of M, on
W Finance Management (MU)

6 7 8 9 10

Fig. 3.13
3.1.9 Present Value of Annuity (Ordinary Annuity)
m offixed cash flows
Wehave seen in previous sections that in case of ordinary Annuity strea
annuity each ofcash flow will be
occur at the end ofthe period. To calculate Present Value of
A and n periods
discounted separately. The present value of annuity PVA for annuity amount of
can be calculated as below:
A A_, ,A_
PVAn = ep? aege +d
A 1 1
PVAn = (+i) eae +#1)
1 1
PVA, = ax(j Tae)
PVA, = AXxPVIFAy, (3.1.8)
where
PVIFA,, is present value factor of annuity of Rs.1 for n period for an interest rate ofi per

period.

PVAIs presentvalue of annuity and PVAn for a period n.

 Finance Management (MU) 3-14 TimeValue of Money
Table 3.1.4 : Present value interest factor Table of an
(ordinary) annuity PVIFA
Present value interest fector of an (ordinary) annuity of Rs.1 per period at 1% for n periods,
PVIFA inp
Period| 1% 2% 3% 4% «5% 6% 7% 8% 9% 10% |
1 |0990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 |
2 1.970 1.942 1913 1886 1.859 1.833 1808 1.783 1.759 1.736
3 2941 2884 2829 2.775 2.723 2673 2624 2577 2531 2487
4 3.902 3.808 3.717 3.630 3.546 3.465 3387 3.312 3.240 3.170
5 4.853 4.713 4.580 4452 4329 4.212 4100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4623 4.486 4355
7 6.728 6472 6230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5535 5.335
9 8566 8162 7.786 7.435 7.108 6.802 6515 6.247 5.995 5.759
10_ 9.471 8.983 8530 8.111 7.722 7.360 7.024 6.710 6418 6.145
11 |10.368 9.787 9.253 8.760 8.306 7.887 7.499 7,139 6805 6.495
12 {11.255 10.575 9,954 9.385 8.863 8384 7.943 7.536 7.161 6.814
13 |12.134 11.348 10.635 9.986 9.394 8853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8244 7.786 7.367
15 ]13.865 12.849 11.938 11.118 10.380] 9.712 9.108 8559 8.061 7.606

Illustration
An investment in a new business is expected to provide guaranteed return ofRs.10,000 each
yearatrate of 10% p.a. for next 5 years. Calculate the investment amount.

Answer
In above example, the investmentis expected to provide an annuity of Rs.10,000.
Presentvalueof S-year annuity as represented by PVA can becalculated as below:

pva, = AGA A, A A
PVAs = Ax PVFAs, 10%
PVAs 10000 PVFAs, 10%
PVAs 10000 x 3.791 = 37,910
The amountthatneed to be invested is Rs.37,910.
Using the above formula, we can also calculate the annuity for a given value of investment,
Period of investment.
 Finance Management (my 3-15 of

IMustration
XYZ Ltd plans to invest an amount of Rs.1 Lakh in setting up a plant that is expecteg Ben,
Me
fixed returns every year at an annualrate of 10%. Calculate the value of cash flows expecteg wos
generated every year.

Answer
Here we are provided with the present value of annuity i.e. Rs.1,00,000 and we Need»,
calculate the value of annuity.

PVA, = Ax PVFAs,10%
Nowas seen in the earlier example, we know thatthe value of presentvalue factor of annuity
for 5 years at 10% is 3.791. Hence

100000 = Ax3.791
_ 10000 = 26,378
A= 3791
Similarly, for given value of annuity, investment and period of investment, we can calculate the
implied rate of return.

Illustration
Let's calculate the implied rate of interest of an investment plan, which
provides annuity 9
Rs.26,378onan investmentof Rs.1,00,000for a period of 5 years.
100,000 = 26,378 x PVFAs,
100,000
PVPAs = “Sp4ng = 3.791
When we refer to Present Value Annuity Table for a period 5 years and valueo
f3.791, we pe
an interest rate of 10% p.a.

3.1.10 Present Value of Annuity Due

In case of annuity due, cash flows happen at the beginning of the year.
Presentvalue of the
annuity due amountingto A will be calculated as below:
A * Geet
PVA, = fen A
tA
PVA, = Grae wt 1)

The above expression can be written as below:

PVA, = AOLe
; 1
t age
1
? tte):
@_ Finance Management (MU) 3-16 Time Value of Money

This effectively means multiplying the present value of ordinary annuity with a factor of (1 + i).
Hence present value of annuity due can be expressed as below:
PVA, = Ax PVFA,,(1+i) (3.1.9)

3.1.11 Multi Period Compounding /Compounding for more than

once a Year

Inall our previous examples,the cash flows are compoundedannuallyie. interestis paid once
a year. However, in practice we mayreceive interest more frequently than once a year, say
semi-annually or quarterly. For example, corporate bonds may provide interest semi-annually
or banks maygive quarterly interest paymenton savings deposits. In such cases, the investor
is earning interest twice or four timesa year.If this amountis re-invested, total interest earned
will be higher than annualinterestrate.
« The interestrate is usually mentioned on annual basis irrespective of the paymentfrequency
as a commonpractice and is known as nominal interest. The actualinterest rate for the year
maybe different depending on the frequency of compounding and is called effective interest
rate (EIR).
e Let's calculate effective interest rate (EIR) on Rs.100 deposit which provides pay out, semi-
annually atan interestat the rate of 10% p.a.

Amount after 6 months = 100x2*3°%- 195,

Amountavailable after 1 year = 105 x joj. 105 x 1.05 = 110.25

Interest income in 1 -year will 110.25 - 100 = 10.25, which isalsothe effective interestrate.
« Effective interest rate can also be calculated by compounding 100 for 2 semi-annualperiods at
rate of 5% as shown below:
@ + 40%) 1
EIR 3
EIR = (1.05)*-1
EIR 10.25%
Similarly, in case quarterly paymentthe interest would be compounded 4 times in a year. EIR
of i% nominal interest rate will be
iy
EIR = (1-4) -1
© Based on above understanding we cancalculate the future for a given a periodoftime for a
multi period compounding.Let's calculate the Future value of P invested for n years that pays
interest m times yearat the rate of 1% p.a.
 Finance M: ment (MU. 3-17

FVn = P (i “B14

Where
1 -rate of return per annum
m- number of compounding per year
n- numberof years
same COMPOUNGlay
© The presentvalue canbe calculated by discountingthe future value by the
factor
FV,

ma” 1+ .

3.1.12 Continuous Compounding

In the above examples, we have seen compounding happen at discrete intervalse.g. an,
semi-annual, quarterly etc. Theoretically interest can be compounded at infinite intervals

mee Ko
continuously. As seen in the above example

As m the frequency of compounding in a year approaches infinity (00) we Bet continuoys

compounding and the term (a +b)approaches (e)™ where e is approximately 2.7197,

Therefore the future value of investment P where interest is compounded continuously at
the
interest rate of i is
FV, = P(e)" (3.1.11)
Example Let's calculate future value of Rs.100 deposit at the
end of 3 years with continuow
compounding at8 percent will be
FV3 = 100(e)°83)
= 100(2.71828)°* = 127.12
How does this compare with the annual comp
ounding?
FV; = 100 (1 + 8%)? = 100 (1.08)? = 125.97
3.1.13 Present Value Using
Continuous Discounting
 Finance Management (MU) 3-18 Time Value of Money

The ‘Rule of 72” and Double the money

Aquick way to calculate interest or time required to double your money is the use of the “Rule|
of 72.” This rule states that if the number of years, n, for which an investmentwill be held is|
divided into the value 72, wewill get the approximateinterestrate, | required for the investment
to double in value.
For example, if we wantto calculate the time required to double money if weinvest in fixed
deposit thatyields an interest rate of 8% p.a.
72
No. ofyears = “g =I years

Alternatively,if want to double our money in 6 years, what should be the interestrate.

Rateof interest = Bw

Please note Rule of 72 does notgive the exact answer, but provides an easy wayto calculate
approximate value.

Using Excel for Time Value of Money

Excel provides easy tools for calculation of terms used in Time Value of money problems. We
need to know following terms used while using excel formulaefor time value of money problems
FV - Future value
NPER - Numberofperiods (e.g. for 4 years with quarterly compounding NPERwill be 16)
RATE Interest rate per period (e.g. 10% p.a. with quarterly compoundingRATE will be 2.5%).
PMT- Periodic payment, used only for annuities.
PV - Presentvalue
Functions maybe entered directly or a function wizard may be used for input. If the functions
are entered directly, the required inputs andstructureare below.
Future Value = FV(rate, nper, pmt, pv, type); type refers to the timing of payment Le.0 for
beginning of the period and 1 at the endofthe period
Present Value = PV(rate, nper, pmtfv, type)
NPER =NPER(rate, pmt, pv,fv, type)
RATE =RATE(nper, pmt, pv,fv, type, guess); here guess means estimated valueofinteres:
expressed in decimal e.g. 0.1 for 10%.
ANNUITY (PMT) = PMT(rate,nper,pv,fv,type)
Excel uses a sign convention that indicates whether an amountis a cash inflow or cash outflow
For example, for calculation of present when we inputpositive future value, it will provid:
negative presentvalue, indicating the valueofupfrontinvestment.
For example, Present Value of Rs.1000 ordinary annuity at the rate of 10% for next 20 year
becalculated as = PV(rate, nper, pmt. fv, type) = PV (10%, 513
 Time Value of Mo,
Th

(MU
Wr Finance Management
S o l v e d E x a m p les (Refer t _
3.1.1 4
Tables)
Present Value
5 years atrate of interes o
100 invested for 4 period of of 10% p.a
re value of (1) Fi
Ex. 3.1.1 :Calculate the futu nually at the end of each year at interest rato
0 invested an
10% p.a. (2) Ris.10
Soin.: 000
Jumpsum investment of Rs.1
(a) Future value of 10%)°
FV = 1000(1+ 11) = 1611
(1000) (1.6
= 1000 (CVIFs om) =
ity
i investment of Rs.100 ie. FV of annu
(b) Future value of annual 5

pa = aitiowl=2
(1+0.1 0)°- 4 2 100 (CVIFAs,:0%) = (100) (6.105)
= 100°—910
= 610.50
if interes:
:Cal cula te the pres ent val ue of Rs. 1,0 00 receivable at the end of 5 years,
Ex. 3.1.2 (required rate g‘
usly. Opportunity of capital
cost of
naa.
n ree
(a) annu ally uequarterly (c) continuo
en(b)

Soin. :

Present Value PV ==

Where
car
+ mn

FV,- Future valueatthe end of yearn

i -rate of return per annum

mi - number of compounding per year
n- numberofyears

(a) Present Value for annual compounding PV = —1000_

{1+10%)°
_ 1000 920.73
Teri =
(b)PVformula for Quarterly Compounding PV = —122 0__
(1-208 )"

1000 1000
e 10
= o
(1+ 2.5%)" 1.639
= 610.27
 3-20 Teme Value of More:
ince Management (MU

FV
{c) PY formula for Continuous compounding PV = oy
1000
PV for future value of Rs. 1000 =1000/e°* = 16497 606.42

ex. 3.1.3: Mr. Patil plans to invest an amount ofRis 25,00,000 to purchase an annuity that will provide
him with a steady income over the next 10 years. He has heard that an insurance plan provides
guaranteed 8 percent compound interest on an annual basis. If he were to invest his funds, what the
‘amount that he would be able to withdraw annually such that he would have a zero balance after his last
withdrawal 10 years from now?
Soin. :
In this example, present value of the investment is provided and the investor wants to
purchase 10-year annuity offering him annualinterestrateof 8.
25,00,000 = (A) (PVIFAio9%)
25,00,000 = (A)(6.710)
25,00,000
A= 6.710 = 3,72.578

Ex. 3.1.4:You have inherited a debenture investment having residual maturity period of 6 years and
pays an amount Rs. 3,000 atthe end of each year. Prevailing market price of debenture is Rs. 13,869.
What is the implicit rate of return?
Soln.:
PVA (A)(PVIFA,, )
13,869 3,000 (PVIFAg,)
PVIFAs, = 13869
“3090
PVIFAg ; 4.623
After referringto the table Present Value of annuity, value 4.623 corresponds to interest rate of
8% pa.

Q.1 Explain various motive for time preference for money.

Q.2 Explain why the interestin multi period compounding is higher than annual compounding?

Q.3 What is an annuity? Whyis present value of annuity due is higher than ordinary annuity?
 Financial Management
nll
Overview of Corporate Finance : Objectives of Corporate Finance; Functions of Corporate
Finance-Investment Decision, Financing Decision, and Dividend Decision. Financial Ratio
Overview of Financial Statements-Balance Sheet, Profit and Loss Account, and Cash Flow Staterneng
Purpose of Financial Ratio Analysis; Liquidity Ratios; Efficiency or Activity Ratios; Profitability Ratog
Capital Structure Ratios; Stock Market Ratios; Limitations of Ratio Analysis.

Very oftena difference between success and failure of a business can be attributed to efficiency
the financial management. A company having a highly successful product can slowly BO iney
oblivionif it fails manage its finances properly. On the other hand, a companylosing market ca
survive and make a comeback ifit has strong finances. This chapterintroduces the reader to work
to the corporate finance.

Learning Objectives
¢ Financial Management, Functionsof Financial Management
© Objectives of Firm and Corporate Finance
e Financial Statements - Balance Sheet, Profit & Loss, Cash Flow
¢ Financial Ratios - Liquidity Ratios; Efficiency or Activity Ratios; Profitability Ratios; Capitd
Structure Ratios; Stock Market Ratio
¢ Limitations ofRatio Analysis

4.1 Introduction to Financial Management

© Assuccessful business is built on thepillars of three critical functions ie. production,

andfinance.
* Production and marketing functions work towards creation and delivery of products
services desired by the customers, while the finance function ensures uninterrupted
support for these functions.
 Finance Management (MU) Financial Management

of everyactivity of
«Finance ts like life blood of company and needed for efficient functioning
business from initial investmentto selling goods and services on credit to customers.

The finance function in the businessis also called Corporate Finance and the managementof
this function is knownas Financial Management
« Traditionally financial management was only tasked with raising funds; however, it has
evolved over a period to coverfunctionsof investment managementand profit distribution.
According to Guthman andDougal, financial management means, “the activity concerned with
the planning, raising, controlling and administering of funds used in the business.”

4.1.1 Financial ManagementDecisions

Finance management covers three main responsibilities of the business Le. arranging finance,
investment offunds into assets and distributionofprofits. These functions involve three decisions
mentioned as below
1. Investment Decisions
2. Financing Decisions
3. Dividend Decision
In addition to the above functions, Financeis also responsible for managingliquidity position
for the company to ensure uninterrupted funding for day to day operations.

4.1.1(A) InvestmentDecisions
© Onan ongoing basis, finance manager needsto take decisions on creation or acquisition of long
term and short-term assets. These decisions include selection of projects/assets for
investment, periodof investments, period for investment etc.
© The decisions of investmentin long term assets involve large sums of money and are expected
to provide returns over a longer period. These decisions are also called capital budgeting
decisions.
« Every long-term investment decision will involve an elementofrisk. Risk and returns from
investments are interrelated and the financial manager need to strike an optimal balance
keepingoverall objectiveofthe firm in mind.
© This balanceofrisk and reward is called as the risk reward trade-off.
© A finance manager needs to evaluate multiple investment options before finalizing the
optimum investmentfor the company.
© Capacity expansion, purchase of equipments, land and building, mergers and acquisitions are
examples of capital budgeting decisions. Divestmentorsaleofassets also fall in the domain of
capital budgeting decision.
 Financial Ma;
43
W_Finance Managernent (MU).
men t decisi
d e c i s i ons that at will will maximize e th the value of
e inv est
° Fi nance mal nageris expected to tak
company,
e investment in cul
rrent assets such as stock, debtor
est men t de ci si on s inv olv
¢ Short term inv decisions.
fixed deposits etc. _ and and are called working capi rtlhe level afstock to be maina
fota tained, credi

create policies
© Afinance managerneeds to f Shorttery
d to buy ers , pu rc ha se of ra w mate! rial on cash orcredit, investmento
to be grante
tetc.
to mutual funds, fixed deposi d requi
impact on profitability an
r i ng g
cap ita l dec isi ons are taken kee ping in mind
© w
Wo rk in
ing uncertainty in business in the backdropofs
th e bus ine ss. Du e to gr ow l
ofliquidity for higher leye a
log ical changes, a large business prefers
economic cycles and rapid techno
liquidity.
s
4.1.1(B) Financing Decision
investment requirements of the fim
© Finance manager needs to raise funds to meet the
inationof both. The ma,
Funding can be raised by taking on debt(loan funds) or equity or comb
between equity and debtis called as the capital structure.
will remain same and may
© Use of more debt will mean that the number of shareholders
increaseprofit available for shareholders. However,it also leads to higherrisk as debt involve
fixed expenses towards interest and repaymentofdebt irrespective of the performanceof th
firm.
¢ Use of equity provides flexibility; howeverit comes at higher cost as the shareholders demant
higher return compared to debtholders.
¢ Finance managerneeds to maintain optimum capital structure that helps to maximize value ¢
thefirm for acceptablelevel of risk. A finance managerwill look at multiple factors befor
choosing a funding such as rate ofinterest, availability of external funding, risk profile of |
Project, estimated timeframe of returns from the project etc.

4.1.1(C) Dividend Decisions

||
¢ Third important decision for a finance manager is distribution of
profits, known as divide! |
decision. This decision involves decision on how much Profit to be
retained in the busin ess ¥5
avis distribution to shareholders.
* Depending on growth opportunities availabl
e for the company, cash balance of the compa
and requirementoffunds, finance manager
will take decision on retention ofthe prof
its.
* Shareholders of the company having
good o} Pportunities for growth, will prefer to retai n hight |
share ofprofits in the company, which it can reinvest the profits in the
higher returns.
business to gene™|
 Finance Management(MU ‘

+ Dividends are generally taxed at higher rate in most of the countries, hence companies choose
to buy back shares to reward shareholders instead
ofdeclaring large d ividends.
4.1.2 Objective of Corporate Finance

«Effectiveness of financial management decisions can be gauged from its successto achieve the
objective.
Itmay seem that maximization ofprofit and dividendsare natural object
ives of the corporate
finance. Every businessis set up to make money or earn profit from sale ofits products and
services. Hence, one mayargue that Profit maximization is the most obvious object
ive of the
company.
« Profit maximization can be defined as the management of financial resources
aimed at
increasing the profit ofthefirm. Profit maximization can be achieved through rangeof
actions
such asraising the prices of product and/or Producing more for samecost by cost
reduction or
more efficient production If a firm goes on to increase prices to take advantages
of high
demand, market will attract more sellers and once demand supplyare in equilibrium, price
will stabilize.
* These actions will provide short term profits for the company. Company can also achieve
higher profits in short term by avoiding investments and saving on interestcosts. However,it
may impact future prospect of the company. On the contrary what if it makes large
investments that has providesreturns after a very long period?
The goal of profit maximization mainly suffers from following shortcomings:
1, Short term or long-term profit : Profit maximization objective does not specify short- or
long-term profit maximization, hence is ambiguous in guiding actions ofthe firm.
2. Time of Value of money : Profit maximization objective fails to consider the time value of
money.
3. Risk management: Profit maximization objective does not considerthe risk and uncertainty
in the business.
© Maximization of profit was considered main objective of the firm till the concept of
shareholders wealth maximization came into being overcome the shortcomings ofprofit
maximization.
Vv Finance Management MU) 4-5 ames Financial
ncial Manage

tive of corporate fina

Finance managers are the agents of the shareholders and the objec
function is to maximize shareholders wealth. Shareholders are the ae m thefirm here,
maximization of owners’ Weal,
the maximization of shareholders wealth is synonymous with

4.1.2(A) Shareholders’ Wealth Maximization

t whi
maximization of returns on their investmen
© Shareholders of the firm are interested in
zed.
is maximized when the valueof the firm is maximi
(NPV) ofall the cash flows ofthefirm.
© Valueof the firm is sumof net presentvalue
ent, time value Pi
© NPV considers actual cash flows overcoming flaws of accounting treatm
riate ray ’
money, uncertainty or risk profile offuture cashflows by considering an approp
discounting.
All those projects with positive net present value (NPV) are considered for investmentFinan,
manager will prioritize projects thatoffer the best returns for the acceptablelevel ofrisk
© Objective of shareholders wealth maximization provides a framework for taking decision e
investment, financing orprofit distributions as finance will choose decisions that Maximize
the NPV ofthe firm.
© Mostof thelarge companies are publicly listed andtheir shares are traded on stock exchange,
Hence,for listed companies, shareholders’ wealth maximization also means maximization
marketpriceofits shares.

4.1.3 Agency Problems

In large companies, generally the ownership and managementof the companyisdivorce.
Shareholders own the companyand professional managers are responsible for running t
business and take decisionsfor the company. _
* Relationship between shareholders and the mangers is that of Agency in which managers x:
as agents for shareholders with objective of maximizing shareholders’ wealth.
The separation of ownership from management may giverise to situationswhere manage
met |
may actinits own best interests rather than those ofthe shareholders.
Managers may prioritize to maximize their wealth in the form salaries and perks,
ut
decisions that may subordinate shareholders’ interests in favorof other
stakeholders or 9 |
altogether avoid every risky Project to safeguard
their position in the company, leading to ks
ofpotential opportunities for the company.
* This conflict between the interests of shareholders
and managers is called as theAge®
Problem. The agency problem leads to agency costs, which includes the cost incurred #
monitoring and controlling actions of managers
|
and possibility of less than optimu
Price of the company. m st#*
 Hnance Management (MU 46 Fin Management
¢ Many companies give stock options to the managers to ensure that the interests of
shareholders and managers are aligned. However, still there maybe situations of conflict in the
interest of managers and shareholders
* Shareholders appoint directors on the Board of the company, The company’s board has a
primary responsibility to keep an oversight on the managers’ actions, performance,
remuneration etc. and guide the management. Scrutiny of outside analysts or corporate
governance advisory firms also help reducing the risk of conflict of interest between
shareholders and managers.
4.1.4 Organization of Finance Function
© Finance function (s very critical functionfor the organization;inefficient financial management
can also lead to failure of the companies; Hence, the finance function directly reports to the
managing director or head of the company.
The executive heading the financefunction in an organization {s known as Chief Finance Officer
(CFO)or sometimes directorof finance.
© In large companies,-CFO will delegate the responsibilities to the Finance Controller and
Treasurer. Following chart explains the functions and responsibilities of these officers.

Chief Executive
Ofticar (CEO)

, Preparation of Budget and Forecast Glanking Relationship

; Taxation Investor Relations
f ‘Accounting Risk Management
; Mergers and Acquisitions
 e a n d fi na nc ia l position of the
ncial performan c
e r e c o r d s of fi na
are th
Financial statements
i n a sp ec if ic pe riod
io n fo r al l th e de ci sion makers
compan y l | informat
ts are the main
source of financia re gulators, ta
Financtal statemen s, S! ha re ho ld er s, creditors,
vestor
us ed by th e management, in
and are
departmentsetc. ac co un t an d Ca sh Flow statement
ss
en ts in cl ud e Ba la nc e Sheet, Profit & Lo
Financial statem
year.
andare prepared each st ar ts fr om April 01 to March 31.
di n In di a
Financial year is also called as fiscal year an ies
at em en t fo r th is pe riod. In India, compan
st
ed to prepare financial
Companies are requir statements every quar
l
ter.
anges are req| uired tofile financia
listed on main stock exch

}— Turnover Cash Flow from

t— Assets
g g Activities
| Operatintin
’ Gross Profit
abilities |__ Cash Flow trom
}— Operating Profit Investing Activities
Cash Flow from
\— Profit After Tax ~~ Financing Activities

4.2.1 Balance Sheet

of
s and owners’ equity at a point
Balance sheet is a summary statem: entof assets, liabilitie

r value owned andcontrolled by the individual or an entity

t is a resource with economic
Asseee
that
. les o! of assets are plant and machine! ry, , cash.
expected to provide future benefits. Examples

Liability is edat financial obli igation owed by the indiv

ee ii dual or r anentity to external parties such a5
indivi

Balance sheet provides a picture ofthe financial position at that pointof time for example
a statement ofassets andliabilities 0 in chat
balance sheet as on March 31, 2020 will provide least
 it (MU) +8 Financial M:
Balance sheet of the companyprovides following important information
1. How much assets are owned by the company?
1. How is company financingthe assets?
4. How isthe company’s liquidity position?
‘4, Whatis the owners’ equity in the company?
Let's take an example ofbalance sheet and understand importantitems of thebalance sheet.
Particulars (Amount in Rs Lakh) 31-Mar-20 31-Mar-19
Equity and Liabilities
Shareholders’ Funds
Share Capital 6,000 6,000
Reserves and Surplus 5875 2,500
Total Shareholders’ Funds 11,875 8,500
Non-CurrentLiabilities
Long Term Borrowings 2,000 2,000
Long Term Provisions 1,250 1,250
Total Non Currentliabilities 3,250 3,250
CurrentLiabilities
Short Term Borrowings 3,200 3,000
Trade Payables 2,700 2,500
Short Term Provisions 1,500 1,250
Total Current Liabilities 7,400 6,750
TOTAL 22,525 18,500
Assets
Non-Current Assets
Fixed Assets
Tangible Assets 11,000 10,000
Intangible Assets - -
Total Fixed Assets 11,000 10,000
Non-Current Investments - -
Current Assets
Inventories 3,000 2,250
Trade Receivables 3.950 3,000
Cash and cash equivalents 4375 3,000
OtherCurrentAssets 250 250
Total Current Assets 11575 | 8,500
TOTAL 22,575_| 18,500
 rinanciat
¥
Assets t as se ts . Cu rr ent assets ary
cu rr en t as se ts and non-curren TT ER E it A855
cay
hed betw ee n , NO M- CU
assets“athwatccaannbbee converted into cash wit thin a period of 1 year Canney
“
converted into ca sh easily.
Current assets include
su ch as fix ed dep osits, treasu! ry bills etc
.
© Cash and cash equ iva len ts
d debt
© Marketable securities such as listed equity an
securities.
she d goods etc.
+ Inventory which include raw material,fini
s wh ic h inc lud e rec eiv abl es du e to sal e on credit to customers,
© Debtor
© Other current assets such as tax claims etc.
Non-current assets include
ix ed ass ets whi ch inc lud e pla nt an d mac hin ery , bui ldi ng, lan d, furniture, IT assets etc. Foui
«F valueof fixed assetsis
ass ets hav e fin ite use ful life an d un de rg o we ar an d tea r. He nc e, the
r. This expene
amortized overthe period of useful life of asset by allocating expense each yea
is called as depreciation.
‘© Investments thatcannot be easily liquidated in 1 year or notintended to be liquidated within
year such as investments in other companies, securities etc.
© Intangible assetssuch patents, brand, goodwill. These typically arise in case ofacquisitions
Liabilities
Liabilities are categorized into current, non-currentliabilities and shareholders’ funds. Curret
abilities include the obligations that are due and payable within 1 year. Non-currentliabilities
include obligations are payable after 1 year.
Current Ilabilities include
© Trade payables arising due to purchases on credit.
© Short term borrowings such as cashcredit, overdraft, loans repayable in one year etc.
© Other current liabilities such as provisions fortaxes, dividends etc.
Non-current liabilities include
«Long term borrowing repayable after 1 year.
Tax abilities payable overlong term also called as deferred tax labitties
Shareholders’ Funds is owners’ capital and reserves and
company’s operations. su plus accumulated over a perio?!
«Profit & Loss account ts a statement of company’s financial performance for a given period
.
Profit & Lass account is also called as P & L account and provides a summary of the sales,
expenses and profits/loss in each period of time
«The period for which P & L statement is prepared ts called as accounting
period. Accounting
period is generally a period of 1 year and in India spans between April 01 to March 31.
« Listed companies are required to report P & L account every quarter and file the same with
stock exchanges.
« P&Laccountis prepared using ‘matching concept’. Matching conceptrefers to the principle of
accounting expenses against the revenues earned during that period.
« For example, expenses incurred for purchase of stocks to be sold next year will not be
accounted this year butwill be accounted in next year’s P & L statement
Let's take an exampleofP & L statement of ABC Pvt Ltd.
Particulars (Amount in Rs.Lakh) 2020 2019
Net Revenue 34,000 29,000
Otherincome 2,000 1,800
Total Revenues 36,000 30,800
Operating Cost
Cost of Materials Consumed 24,500 21,000

Employee Benefit Expense 3,000 2,500

Other Expenses 2,500 2,000
Depreciation and Amortization Expense S00 450
Profit Before Interest and Tax 5,500 4,850
Finance Costs : 1,000 850
Profit Before Tax 4,500 4,000
Income Tax 1125 1,000
Profit After Tax 3,375 3,000
Main categories of P & L statement ofa company include :
nues.
* Revenues from sale ofgoodsservices also referred to as operating reve
 ait
ale of equipments etc. also called as

= income received from interest, rent aividends.

operating revenues. of goods sold.
«Expenses incurred on consumption of naterials ascowt
inistration etc.

as operating expenses.
© Interest expense on the borrowings.
© Profit before tax.
© Tax expenses.
© Profit after tax.
Profit has following main categories
ss Prof it (GP ) : This is the diff eren ce bet wee n sales and cost of goodssold. Cost of
Gro
od. Material consumed
sold is the material consumed for the goods sold during the peri
unsold goods becomes part of inventory reported in the balance sheet.
© Profit before depreciation, interest and taxes (PBDIT) : This refers to the
equivalent to revenues minus all operating expenses after excluding de
Depreciation is excluded as it is only an allocationoffixed asset cost.
‘© Operating profit (PBIT/EBIT) : This refers to profit/earnings before interest and tax
the difference between revenues andall operating expenses.
. aoe 1 This refers to difference between operating profit and int
=jenses ani excluding osshow-operating incomes. PBT means thedifference between I

© Profit after tax (PAT) : This refers to the difference between PBT and taxes.
4.2.3 Cash Flow Statement
Cash flow statement is a statement of change in cash i between
balance sheet dates. It summarizes the sources
and uses ofeach Teeth categor
sponties
e Le.
activities, investing activities and financing acti
vities. Sum of the three categories is the
cash position of the company. Analysis of cash flow
Importance insights about the quality of the s “Stement of the company
company’s earnings,
 Financial M

2020 2019
Cash Flows from Operating Activities
Net Profit before tax 3.375 3,000
Adjustment for
Depreciation 500 450
Interest expenses 1,000 850
non-operatingincome - -
Operating profit before working capital changes 4875 4,300
changes in working capital = 1,500 - 1,300
Net cash flow from operating activities 3,378 3,000

Cash Flows from Investing Activities

Purchase ofFixed Assets -1,000 500
Sale ofFixed Assets - -
Non-operating income = -
Net Cash Flow InvestingActivities -1,000| 500

Cash Flows from FinancingActivities

Interest Paid -1,000 -850
Dividend Paid - -
Repaymentfrom Long Term Borrowing, - =
Net cash flow from Financing Activities ~1,000 - 850
Net increase/decrease In cash and cash equivalents 1,375 2,650

Cash flow from operating activities

This refers to the sources and uses of cash from operations of the business. In simple words it
‘S the difference between cash received during the period from sales and the cash payment made
‘wards operating expenses.
 CIAL May
413
Mu)
adjys
rofit after tax as starting point and
Operating cash flow is calcul aren t assets and current liabillties.
oe 1
noo-operating incomes and expenses, change?
Cash flow from investing activities s investments. This inclyey
es of ©
ca sh fr om co mp an y’
Thisrefers to the sources and us building,
nd, eq ui pm en ts , purchase and sey
as
purchase and sale of fixed assets such
investments, interest and dividend income ete
Cash flow from financing activities

This refers to thesources

and uses ofcash to banks, financial institutions, investors etc Ty,
paymen
Includes repayment of loans, payment of interest.
additional borrowings etc.
4.3 Financial Ratio Analysis
© Financial statements of a firm are analysed by the internal and external stakeholders ie
management, investors, bankers, suppliers and customers for taking important decisions. For
example, suppliers use them to decide whether to give more credit or reduce the credit tothe
company.
‘¢ Investors may use it to decide on holding on to shares,sell or purchase the shares. Bankers wil
like to decide whether to extend new loans or cap the exposure to the company. Customers
like to see if companyis capable of investing required resource to fulfill a large project
Management will like to analyse the financial statements to benchmark against competit
and identify areas of improvement.
Financial Ratio analysis is the studyof ratios of the financial parameters of the company. It
used to understandfinancials of the company on many parameters as mentioned below
Liquidity
-eNo

Efficiency
Profitability
Capital Structure
5. Valuation orstock market ratios
4.3.1 Liquidity Ratios
° As the name cusses liquidity ratios are use
Uquidlty ratios helps d to ‘studyliquidity position of the
to understand the company’s ability to
obligations that are payable within 1 year, meet current liabiit®
= "
OG fone MU) 14 Financial ment
Lack of adequate liquidity may lead to company defaulting on its payment obligations.
financial and trade creditors can becomejittery, stop extending fresh credit or may start
demanding early repayments of existing credit. If liquidity doesn’t improvein time, it can
result in loss ofbusiness and can also lead to bankruptcy situations in the worst case.
«Excess liquidity may not have such negative impact butcan have less than optimum returns.
‘The most commonliquidity ratios are currentratio and quick ratio.
4.3.1(A) Current Ratio

« Current ratio Is the ratio of currentassets to the current liabilities of the company and
represents company’s ability to repay currentliabilities using current assets. Current liabilities
are the financial obligations that are repayable within one year.
Frm:Curns =A
« Current assets include those assets that can be converted into cash within one year without
adversely impacting valueof the assets and include stock of raw materials, finished goods,
work in progress, debtors, cash and marketable securities.
‘Current ratio ofless than 1 is considered unsatisfactory and Indicate that currentassets don't
fully cover current liabilities. Current ratio between1 to 2 is considered satisfactory, while
more than 2 indicate company’s funds maybe locked in unproductive assets. In additionto the
ratio, it is important to understand the composition of current assets as it will affect the
company’s ability to liquidate them andconvert to cash.

* Forexample, non-moving stocks or debtors appearing in current assets maybe very difficult to
convert to cash.

4.3.1(B) Quick Ratio

Quick ratio also called as acid test ratio is the ratio ofliquid assets to the current liabilities
and used to measure company’s ability to service current liabilities using liquid assets. While
of
Calculating quick ratio Inventortes are subtracted from current assets as early clearance
‘oventory may lead to loss of value.
aa = Quick ratio (acid test ratio)) =As se
‘Current a ts
Liabilities
—_—
4-15
W_rinance Ma
Inustration
d . ____ —T3- ar-2 0 31-Mar-19 ——_s, tena

Lt rT
a R
Equity and Liabilities
Shareholders’ Funds 6,000 6,000
5,875 2,500
Share Capital 71675 3.500
Reserves and Surplus
Total Shareholders’ Funds
2,000 2,000
Seeores 1,250
Long Term Provisions 1,250
3,250 3,250
Total Non Current liabilities
Current Liabilities 3,000
Short Term Borrowings 3,200
2,700 2,500
‘Trade Payables 1,250
Short Term Provisions 1,500
Total CurrentLiabilities 7,400 6,750
TOTAL 22,525 18,500
Assets
Non-Current Assets
Fixed Assets
Tangible Assets 11,000 10,000
. .
Intangible Assets

Total Fixed Assets 11,- 000 10,= 000

Non-CurrentInvestments |
~ -
Current Assets
Inventories .
3.000 2,250
Trade Receivables |
3,950
Cash and cash equivalents
4375
Other Current Assets
Total Current Assets 20 |
TOTAL 11575 |
22,575
O_fane -¢ Management (MU) 416 Financial Management
Current ratio = Assets
Current Liabilities
= 11575
* "7.400 = 156.
Quick ratio = SUETERE Assets - Inventory
Current Liabilities
= 1575S
B - 3,000
= 16
4.3.2 Efficiency or Activity Ratios
Company invests funds in creation of fixed and current assets in the normal cour
se of business.
Eficiency or activity ratios are used to study how efficiently a company is using
its assets.
4.3.2(A) Inventory Turnover

Inventory turnoverratio indicates number times companyturns overthe inventory each year
and provides information on how quickly companyis able to sell its inventory. For example,
inventory turnoverratio of 9 indicates that the company is able to sell its inventory nine times a
year.
t -
> Formula: Inventory tumover rato =Reeds
‘The averageinventory is the average of opening and closing inventory.
We can calculate inventory holding period of Inventory daysby dividing no of days of the year
by inventory turnover ratio. For example, if a firm has an inventory turnoverratio of9, inventory
days will be as 40.5 days.
365,
[> Formula : inventory days = invent ory
inventory.
= 365 Cost of goods sold
Forthe external stakeholders. such as analysts cost of goods may not be available. In such
Cases, they canuse sales in place of cost of goods sold to calculateinventory turnoverratio.
Sales
Formuta : inventory tumover ratio = Average inventory

Sometimes in place of average inventory they useclosing inventory in the denominator.

Sales
Inventoryturnover ratio = jpyentory
 ntory turnover Fatio is of cost
e nd inventory are mentioned on the cog, mate
handily note that the most approprat
to average inventory a8 both the ory
What isthe appropriate value of wae industry of operations and inventory turnover
Inventory turnover 1300 depends *ies in past and other firms in the indy Further
ol company needs to be compared inventory {s calculated as average monthly Mogg
frmhaving high seasonality. avera8e |
inventory to even out the effect of seasonally
Inustration
Gost of goods sold
Inventory turnover ratio * Average inventory

(cost) _ _ . 9.33
: 24,500 9,

3 6 365 5 . 3 3658
12 days
Inventory days = Fayentory trunover ratio” 9.33 39
Where cost ofsalesis not available sales can be used in place of cost ofsales.
4.3.2(B) Debtors Turnover
«Debtors represent the amount receivables by firm from its customers. A firm sells its goods:
cash or credit. Debtors turnover ratio provides a measure of numberoftimes debtors ¢
turnover each year and is used to calculate efficiency of the collection of receivables. It
calculated as follows:

> Formula : Dabiors tumover rato =prea

where

‘Average debtors i the average ofopening and closing debtors.

 @rrosncs Ma ment v (MU) $18 Financial Management
«if the collection period much higher compared to 30, let's say 45 days, then company’s
colection efficiency is low. It also means company’s customers are not very credit worthy and
gre needed to be watched carefully
mustration
Sales
pebtors turnover ratio = pepo = ———34.000__ 34,000
(is 30001) ="y475 = 978
360 65
Debtor daY5 = Debtors turnoverratio ‘9.78 = 37:32 days
4.3.2(C) Ageing Schedule
This refers to the analysis of debtors based on numberof days for which they are outstanding,
Inthis, outstanding debtors are categorized as per the ageing of receivables i. number of days
since when they are outstanding. Ageing analysis provides a pictureof slow-moving debtors.
ageing (no ofdays) Outstanding Amount (Rs.) Percentage ofTotal Debtors
| 0-30 50,00,000 50.0%
| 31-60 22,50,000 225%
| 61-90 22,50,000 225%
| More than 90 days 5,00,000 5.0%
| Total 100,00,000 100.0%
4.3.2(D) Asset Turnover Ratio

It the measure used to calculate theefficiency of total assets of the company.It is the ratio of
sales to total assets. Higher the ratio betteris theefficiency of the assets.

io St
b amie: see noe no rag

on
Sometimes, analysts use Sales/Total Assets to calculate asset turnover ratio
> Formuta
: Fixed assets turnover ratio = —_ _Seles_
Zrerage Fixed Asses
on
Sometimes, analysts use Sales/Fixed Assets to calculate fixed asset turnover ratio
 ___340 000 _—_ —_) oe =1.66
Asset turnover ratio = ( ST S « 18500

Profitability Ratio
typesof profit me‘asures such a,
In the proffitit and loss statement, we have seen different
r . ope rat ing pro fit , PB T etc . Whi le the se pro fit me as ur es Pro vide absolute vay
rofifit, ab
iciency of company’s operat
profitfits,s, they don't provide us the information about the eff
the efficiency.
Profitability ratios help in measurementof

4.3.3(A) Gross Profit Margin

It s the ratio of gross profitto the sales of the company and is expressed in percentage tem
Itis the amount ofgross profit earned by the companyfor each Rs.100 sales.
Sales - Costo f goods sold
Gross Profit Margin = Soles
Gross Profit
Sales

4.3.3(B) Operating Profit Margin

It is the ratio ofoperating profit to the sales of the company.It is the amountofoperating pr
earned by the companyfor each Rs.100 sales.
Operating Profit Margin = Operating
se
= Operat
Sales
ing

{tisthe ratio of profit before interest depr

eciation and tax to the sales of the comp
amount of operating profit earned by the any. It
company for each Rs.100 sales.
Operating Profit M; ~ PBDIT
sero Margin Soles
= expe nses
Sales
 | che ratio of profit after taxto the sales of the companyand is expressed In percentage
shows the information us the amount of gross profit earned by the company for each
00 sales
Net Profit Margin = afer

tiastration
| particulars (Amount in Rs, Lakh) 2020
[Net Revenue | 34,000
Other income 2,000
| Total Revenues (A) 36,000
i Operating Cost
Cost of goodssold (B) 24,500
Gross profit (C) = (A-B) 11,500
Gross profit margin (C)/(A) 31.94%
Employee Benefit Expense(D) 3,000
OtherExpenses (E) 2,500
PRDIT/EBITDA(G) = C-D-E 6,000
EBITDA margin(G)/(A) 16.67%
Depreciation and Amortization Expense (F) 500
EBIT (H)= (C-D-E-F) 5,500
EBIT Margin (H)/(A) 15.28%
Finance Costs (1) 1,000
Profit Before Tax (J) 4,500
Income Tax L125,

Profit AfterTax (K) 3,378

Net profit margin (K)/(A) 9.38%

434 Capital structure Ratios

wasel structure of a companyis the composition oftotal capital of the companybetweendeo:
r “qulty, Debt to equity ratio and total debt ratios are commonly used <apita! tr
"vides us the information how is company financing the assets.
 rmancaal M;

angee
tDebt -equity Ratio
4.3.4(A)
Total debty
* Total equit

io
4.3.4(B) Total Debt Rat Total Debt
Total debt al Deb t ‘+Total Equity
= Fotal Capital ~ Tot
ra ti o me an s th at t he companyi s financing its
Low debt to equ ity rat io or low er deb t en ts to eq ui ty sh ar ebogg:
to make an y fi xe d pa ym
using own sources. As companydoes not have levels of assets and operating,
It ts less risky source of funding. Hence, companies with lowto finance their assets using
competitive or uncertain business environment will choose
than debt. Companies having large asset base and having predictable cas h flows will choose highs
level of debt financing, Utility companies, power generation comp anies, raw material etc usedy
g, Debt is call ed leve rage and com pan ies havi ng high er debt are tered
as main source offundin
leveraged companies.
4.3.5 Return Ratios
investments. Anas
Return ratio are used to calculate the efficiency of the company’ess and company’s havieg
compare the return ratios ofdifferent companies to compare efficienci
higher return ratios generally command higher market value.
4.3.5(A) Return on Equity (ROE)
It is the ratio of profit after taxto the average equity and is expressed in percentage terms t
shows how much return companyis earning on the shareholders equity.
Profit after tax
Return onequity (ROE) = Average equity ‘OR

Sometimes, Return onequity = Srarcholdesssoul

3.5(B) Return on Investment (ROI)

It is the ratio of earnings before interest and taxes and average of total assets. It shows
much return company can generate on total assets.
Return on Investment (RON) = f et
Average total asse ts
where, EBIT is earnings before interest and tax
OR

Sometimes, Return on Investment (ROI) TH

 (au)
¥ Finance, 422
eancial
saustration
pebt to Equity Ratio
pefer to Balance sheet of ABC Ltd for 2020,
Total Debt = Short term debt +
Long term debt
= 2,000 + 3,200= 5,200
Total Equity = 11,875,
Debt to equity ratio = 3 oss,
4.3.6 Stock Market Ratios (Valuati
on Ratios)
Stock market ratios are used to calculate the val
uation of the company’s shares using certain
benchmark financial parameter. Analysts, investors use these ratios to
companies in the industry or with the historical valuation compare with other
of the company.
4.3.6(A) Price to Earnings Ratio (P/E
Ratio)
This is the ratio of market price ofshare to the earnings per
share of the company.Earnings
per share is the net profit of the company divided by total numberofshares.
Pp Share price
E Earnings per share
4.3.6(B) Price to Book Ratio (P/B Ratio) .
This Is the ratio of market price of share to the book value per share ofthe company. Book
value per share is shareholders’ equity of the company divided by the total number ofshares.
P Share price
Bratio = Book value per share
4.3.6(C) Price to Sales (P/S Ratio)
* This is the ratio of market price of share to the sales per share of the company.Book value per
share is total sales of the companydivided by the total number of shares.
Pp Share price
grado = Sales per share
el cheaper
* Lower the value of these ratios means that the share price i trading comparnv
"i s may
Compared to the denominator value, which may signify that the share price attractive
toby,
 l an al ys ts fo re ca st the finangai
ed financia x
4 calculate th e ra ti os us in g CU T
rates oe© nerally 23 98 an
tating vabuation

}
share price (P)
| sales per share (5) 10 0 150

o t s b a r e s ) |
(roa also (E) 25 40
| Earnings per share
(Net Profit/No. of shares)
125 200
Book value per share (B)
)
(Shareholders’ equity/No. of shares
10 875
P/E
2 1.75
PB
25 233
P/S
4.3.7 Use of Ratio Analysis
ers etc. It helps in following
Ratio analysis is very useful tool for investors, management, lend
manners.
L Trent aalyss : Financial ratio analysis helps to compare current performanceofcompat}
oan errs helps in study of different trends. For example, a company selingS
, Compare gross profit margins of these product with each other and a
with their|historical performance and feform opinion
withee opin! on tre nd: Ils on demand,
emai ¢ -ompetit®

t: Performance of one compan}

oerhmar
2. Benc i com;ipetitioncomp
anteswith
conpking arin g the pany can be benc hmar i ked wit
in industry by ver, it ts important to cons?
companies of similar size for more useful com, ratios. Howe
Parison.
3, Areas of improvement :: Study offinan
improvement. lal ratios can help management wentfy 27% ¢
{
|
oS Pheancial Management
| 4.3.8 Limitations of Ratio Analysis
patio analysis ts used an tant tool for analysis a company’s performance However. it
should not be osed as the only source for anatysis, as it has limitations and that need to
before judging company's performance based on the ratio analysis. Important
bm tations of rao analysis are as below
4. Historical information : Ratio analysis is based on historical financial information. For major
stakeholders such as Investors, lenders etc future performance of the company ts more
relevant performance. Company's future financial results may not be in line with the past
performance
2, External Factors : Company's financial performance depend on the external environment
such as competition, regulatory changes, global recession etc. Ratio analysis does not consider
the impact of these factors.
3. Operational changes : Ratio analysis does not factor impact of internal changes ofthe
company. For example, new product launch, appointment of newmanagementetc.
4, Changes in accounting policy : Companies can change accounting policy and procedures. In
such cases, reported financial numbers for that period may not be comparable with financial
results of the past. Hence, comparison offinancial ratios for two periods will become different.
Further, accounting policies of two companies may be different, making the comparison
between the two difficult. Analysts are expected to adjust the reported numbers while
calculating the ratios and comparing the ratios.
$. Manipulation offinancial statements : Financial statements of companies are required to be
audited by the chartered accountants, However, chartered accountants rely on the financial
information provided to them by the management. In fact, preparationof financial statements
many times involve interpretation of accounting standards and an element of judgment
Management can interpret such policies as per their convenience. For example,in some cases,
large numberof debtors may be not being recoverable and need to be accounted as loss, but
management may certify that these amounts are recoverable In such cases, financial
statements andthe ratio analysis may not provide true and fair picture of the company’s
Performance.
6 Seasonality : Large number of businesses are dependentof seasonal changes in demand and
be substantially
supply. In such cases performance of company in accounting period can
different from performance in other accounting period. Analysts need to consider the effect of
Seasonality while using ratio analysis.
 go od s sol d at 00,000 and aap
aw 85,00.000, c08t of
45. 00! (000 . Calculate the gross Prot may,
assets of Fis

les - Cost of sold)

00.-40,00.000) 227.2%
(ss,90,955,00,
Sales 55,00,000 2
11 times
Inventory turnover = Tpeantory ~ 5.00:
les 55,00,000
0 ~ +7?
Assetturnover * Fayah assets ~ 40,00,00
es of s.5 5,0 0,0 00, tot al sha reh old ers ’ equity of Fis.20,00,000 ant
Ex. 4.3.2 :A company has total sal
000 shares outstanding and market price per shaw
profit after tax of Fs.5,00,000. ‘The company has 50,
ings ratio, price to book ratio.
is Rs.75. Calculate retum on equity, price to ear
Soin. :
Return on equity =
Net m ed
profit

5,00,000
20,00,000 25%
Earni ling per share = <— ——Netprofit_ng_
No. of shares outstandi
5,00,000
50,000 = 10
Frodo = -iacepershare—
15
10775
Book value pershare = Net worth or Shareholders’
No. of shares outstanding
= 20,00,000
= “50,000 = 40-
P
Fratio = —Pricepershare * 40
75, = 1.87
5 Book value per share
 a ay ‘ Financ ment
eros
33 .Fotoerng 9 0 ertractIESof he balancedesheet Sumitomo Electr: and Samara Electc Calculate
6.07 anon tor Bon COMPAN ANd Conclu which has better net profit margins, return on equity.
oeark 1280. MVATHOLY UTOVET TAO
np

Current assets.
1, Currentratio = Current liabilities
40,00,000
Sumitomo Electric current ratio = 359900 = 133
Samara Electric currentratio =. D860? « 1.09
2. Inventory turnover ratio
Sumitomoinventory turnover ratio = aes +50
Samara inventory turnover ratio = 100800 = 387
3 Net profit margin -“StBESAt
Sumitomo Electric net profit margin = Fesfgg = 10%
Samara Electric net profit margin = <22ye9g0" 11%
§ Return equity = ——N etp profitit__
Net rof
on Shareholders equity
Sumitomo Electric ROE = 7épH.900 7 10%
750,000
|
9,90,000
Samara Electric ROE = 799,009,000 ° 990%
 Financial Ma,
427
et

at vnt ami ne ran brc ona teo oso fee

jmiz
ran
atio n
ce
obje
m
ctiv e
a
being better than Profit maxima
Wy is sharoldos' wealth
a2
objective?
a3
Wate the agency problem and wy does & aise?
ae What are the mitigants to resolve agency problems?
as How does ratio analysis help in financial analysis?
as What are the ratios to measure liquidity of the fir?
t are the activ ity ratio s: how doe s curr ent asse ts tun ove r rati o, fixe d asse t tumover ry
a7 Wha
indicate?
as ‘What are the limitations of ratio analysis?
 Capital Budgeting

capital Budgeting : Meaning and Importance of Capital Budgeting: Inputs for Capital Budgeting
Decisions: Investment Appraisal Criterion-Accounting Rate of Return, Payback Period, Discounted
payback Period, Net Present Value (NPV), Profitability Index, Intemal Rate of Return (IRR), and
Modified Internal Rate of Return (MIRR).

s
Long term investmentdecisions are probably the mostcritical of the corporate finance decision
as they have the potential to shape thefutureof the business. Investment in new technology at the
right time or a wrong acquisition can make or break a company’s fortunes. In this chapter we
understand how to evaluate the long- term capital decisions.

Learning Objectives
+ Capital Budgeting - Meaning, Importance, type of projects
InvestmentDecision criteria - capital budgeting appraisal techniques °

5.1 Capital Budgeting Decisions

¢ The investment decision involves decision to invest funds in creation of long term andshort-
term assets (current assets). Among the twotypeof assets decisions on investmentin long
term assets are more critical as they typically involve large sums of money and provide returns
over a longer period. Examples of long-term investments are purchase of equipment, land,
building, acquisition, joint venture, divestment etc. The long-term investment decisions are
called as capital budgeting decisions. The investment decision in short term assetsis called as
workingcapital decisions.
«The primary objective of anyfirm is to maximize shareholders’ wealth. Hence,finance manager
needs to assess multiple proposalsbefore finalizing projects for investment. Capital budgeting
is the process of capital allocation andrefers to the decisions on the investmentin long term
assets and projects of the company.
 Capital Bug
Finance Management (MU, 5-2

¢ Capital budgeting process involves

ts,
1. Identification of investment projec

2. . Evaluation of investment proposal

3. Selection of investment proposals
tation
4 |. Preparation of capital budget and implemen
5, . Performancereview of the inv
estment projects.
tn
uts suc h as req uir eme nt of inv estment, estimated cash flows
© Capital budgeting uses inp
jected financials, expected rate
of return etc. to evaluate Vato
period of cash flows, pro
investment proposals.

5.1.1 Importance of Capital Budgeting

ure and has following characteristics Whig
Capital budgeting differs from current expendit
make them mostimportant investment decisions for a company.
stment amounts.
1 Capital budgeting decisionsinvolve outlay of large inve
2. It helps to control costs of the projects by optimizing expenses.
eof the company
3, Capital budgeting decisions havelong term impact on the performanc
4. Capital budgeting decisions are generally irreversible in nature.
5. Capital budgeting decision involve an element of uncertainty or risk.
6. Capital budgeting decisions are critical for shareholder wealth maximization.
7. It involves review ofthe performance of projects and feedback.

5.1.2 Types of Investment Projects

Investment projects can beclassified into following 3 types based on their dependenceon eat
other.
Independent Projects
These projects are not related to each other and decision of selection of the projects can &
done independentofanother.A firm if deems fit can chooseorreject all the independent projec
based onthe investment appraisal.
Mutually exclusive projects

These are mutually exclusive projects, which means that when a company chooses oneprojec!
otherprojects automatically get rejected. Examples of mutually exclusive projects are selection
semi-automatic or fully automatic manufacturing set up,in house manufacturing or outsourcing
 ement (MU) .5-3
wo roans Mans Capital Budgetiny

complementary projects
- mes two projects
; under evaluation are complementaryto each other, meaning selection
atone project requires selection of another project

ing Techniques
5.2Investment Appraisal - Capital Budget
investment proposals are carefully appraised before finalization using capital budgeting
techniques. Most commonly used capital budgeting techniques are as mentioned below.
Accounting Rate of Return (ARR)
1
payback Period (PB)
wn

Net Present Walue Method (NPV)

RR)
internal Rate of Return (I
-

5 Modified Internal Rate of Return (MIRR)

6 Profitability Index (PB)
(ARR), cash flows and not
Inall the above methodologies, except for Accounting Rate of Return
nt the
the accounting profits/losses are considered as basis to calculate returns and investme in

projects.
5.2.1 Accounting Rate of Return (ARR)
res profitability
Accounting Rate of Return (ARR)is also called as Average rate ofreturn measu
Accounting rate of return is the ratio of
of the investment using financial accounting information.
e investment. The average
average annual profit after tax for the projected period to the averag
and valueat the end of thelife
investmentis calculated by taking an average of initial investment
maybe fulfy depreciated, or it may
of the project. At the endof project life, the value of investment
some salvage value.
R __Average netprofit
~ Average investment
for thelifesof the project
Total netprofitNo.
Average net profit = of year

Salvage value)
Average Investment= $ (initial Investment+
ntworking capital is also added.
Some times in the calculation of average investme
Acceptance Rule ided
ARR higher than minimum hurdle rate dec
* In this method, all projects having an
managementare accepted.
ghestS 2¢cePred
© Incase of mutually exclusive projects, hi O
‘wllr Techiiemtetet
 a! Bia
54

nd Y are provided in the Table 5.2.1 Calovigy

Illustration 5
Following details of the ewe profects . warn Te 5.2: 1
“thavi
having the highest accot unting rate oftable
project
a

00. = 5,000
3500 + 4500 + 5500 + 65
Average Net profit for ¥ = 4

soon $000, = 27,500

Average investmentfor Xe

£40000+ $000) 2 22,500.

+
Average investmentfor Y=

a$500.
ARRfor X= 35-600 ae 20%

000
ARR for ¥ = BON» 2286

Project Y has higher IRR compared to project X

Merits and Demerits

Merits

1. {tas very simple method as it accounting statements are readily available.

2. ARRincorporates accounting profitability that is used by analysts.

Demerits
1 tt ignores the cash flows and only rely onthe accounting profit: s
 ce Management (MU 5

irdoes not consider time value of money,

2L
3 1 doesn't provide the value added to the shareholders.
4, Itdoes not takeinto accountthe risk profiles of different projects,
5.2.2 Payback Period
payback period is the amount of time taken by the firm to recover the inves
tment in the
project. It is generally expressed in numberof years. In other words,it is the time taken by the
firm to achieve breakeven.
Methodology for using paybackperiod as mentioned below
1, Calculate the cash inflows and outflowsfor each period
2, Calculate cumulative cash flow at the end of each period
3, Calculate the pointoftime in year at which the cumulative cash flows equalzero.

Iiustration
A firm decides to invest Rs.5 Crin setting up of garment manufacturingplant. It is expected to
take 1 year to set up the plant and start the production. Cash flows after the start of production
are as mentioned in the below table. Whatis the payback period?
CFy =- 500 Lakh ; CF, = 100 Lakh,CF, = 175 Lakh, CF; = 225 Lakh, CF,= 225 Lakh,

Cumulative cash flows at the endof each year.

Table 5.2.2
Year Cash Flow Cumulative Cash Flow
o | -s00 | - 500
1 | 100 | - 400
2 175 | 225
3 225 | 0
From the Table 5.2.2, we understand that cumulative cash flows becomezero at the end of
year 3. Hence, payback period is 3 years.
Acceptance Rule for Payback Period
* Managementcan decide on maximum payback period for accepting any investment projects.
All projects having paybackperiod less than the threshold paybackperiod are accepted.
* Incase of mutually exclusive projects, projects with lowest payback period is chosen.
 Capita 1B
-6 Sp
ement (MU 5
W Finance
°
Merits and Demerits of using PaYDSN
Merits it projects.
technique to 10 select investmen! rtainty associated with projects wit
1. Itis very simple thus avoid unce! Ii
returns,
2. If focuses on near term
payback period. t h l o w e r p a y backperiod.
obtain fut ndi ng f or projects wi
3. Itmay be easier to

Demerits
af te r the payback period.
1, . It ignores ca sh fl ow s
of money.
2. It ignores thetime val ue
projects.
3, It ignores therisk element in the Vv: ra lu e maximization, as pr
ojects having
with the shareholder lay
4. It is not consistent cash fl lows over longer pe
riod.
despite higher
payback period are rejected
yback Period
5.2.3 Discounted Pa
si mp le ca sh fl ow s ar e substituted by discom,
period method,
In the discounted payback hod all the cash flows involving
in
value of money. In this met
cash flows to account for time whi chis typically the Opportunity,
approp! ria te dis cou ntra te ,
project are discounted using an trisk.
or rat e of ret urn exp ect ed fr om a project having equivalen
of capital

Iiustration
%.
the ab ov e exa mpl e, let ’s as su me the firm has required rate of return of 10
In
Table 5.2.3

| ounted Cash Flow, Cumulative discounted

Year Cash Flow Disc
? _ Cash Flow ax
-500 -500
0 - 500 |
91 — 409
1 100
145 264 | |
2 175
1649 =95 1|
||
3_
4
j__222255 15
; rom ime Table 5.2.3, we understand that cumulative cash flows become zero bem
year and 4. The payback period for the project falls betwee: end of
cumulative cash flows equal -95 Lakh. aren Senda Atul
95
No.of years required for recovery of Rs.95 Lakh = J54 = 0.62

Discounted payback period = 3+ 0.62 = 3.62 years.

 it (MU 5-7
Capital Bu

posits 204 Demerits of using Discounted Payback Period

qffocuses on Mi ear term retui ims, th thus avoid uncertain

1 payback period. ty associated with projects with longer

2 Disco!unted payback period takes into consid

eration time value of money,
pemerits
Ltt ignores cash flows after the payback period.
2 Itinvolves estimation of additionalvariable i.e. discounting rate.
4. It is not consistent with the shareholder value maximization, as projects having
longer
payback period are rejected despite highercashflows over longerperiod.
5.2.4 Net Present Value Method (NPV)
Net present value or NPV is the sum ofpresentvalueofall current and future cash flows. In
this method, NPV for each investmentproject is calculated. Projects having positive NPV are
“expected to enhance shareholders value and can be selected for investment. If the firm must
choose between mutually exclusiveprojects,then the project having a maximum NPV is selected.

steps to calculate NPV

1. Calculate the opportunity cost of capital depending ontheriskof the project.
2. Calculate net cash flows in each period. All cash outflows carry negative sign, while cash
inflows have positive sign.
3. Calculate present value by discountingthe cash flows.
4. Calculate sum of presentvaluesofcashflows.

Formula :NPV = — Fy + Se oe
>
cy” (rip
> Formula: NPV = — CFo + CF; (PVIF;,) + CF:{PVIF,,) + CFa(PVIFa,) + ... + CF, (PVIF,)
Where,
CF - Net Indicates cash flowsin each period
i- Discounting rate
n- No ofyears
PVIF - Present valueinterest factor
Mustration
In the above example involving Rs.5 Cr investment Jet’s calculate the NPV ofproject.
 Finance Management (MU)
a
175_ 225225 5y
NPV = -500+9. 49 * (1.10)? * (1.10) (10% Foy
= -5004+91 +145 + 169 + 154 +93
= 152
‘The NPVof the aboveproject is Rs.152 Lakh and can be considered for investment.
Acceptance Rule

1. Projects having positive NPV are accepted forinvestment.

2. Incase of mutually exclusiveprojects, the project with highest NPV is chosen.

Merits and Demerits of using NPV method

Merits
1 . NPV method provides the absolute value addedto thefirm by choosingan investmentprojec.
2. NPV method considers time value of money and riskof investment.
3. NPV method considers the cash flows over the completelife of the project.
4. NPV method provides unambiguous methodology forselection of projects.

Demerits
1 NPVcalculation can vary substantially depending on the assumption ofdiscountrate.

2. NPV method considers same discount rate for cash flows in near and longerfuture of the
project, which may have differentlevels of risk.

NPV method is not very useful for selecting among projects having materially different
investment requirement.

5.2.5 Internal Rate of Return (IRR)

Internalrateof return is the rate of return received by the company by investing in the projec.
It ts the discountrate for which NPV of the project becomes zero. Internal rate ofreturn is als?
termed as IRR. For decision making purpose, IRR of the Project is calculated and compared with
the required rate of return. All projects having an IRR morethan the required rate
of return art |
considered for investment. If a firm has to choose between mutually
exclusive projects, projec
having the highest IRR is selected.

Steps to calculate IRR

) 1. Calculate the initiate investment outflow.
2. Calculate net cash flows in each period. Cash outflows Carry negativesign, while
cash inflow’
have positive sign
3. Calculate the discounted cash flows using IRR
as discountingas rate.
 parce Managernens (MU)
ai Budgetiny
CP
——S CR, CP,
CARRY!" ChsiRRY ** TPiRRps
se, CF,
‘ (1+1RR)? (1+IRR}*
—oeee "CF Ca
f Coe & —te
|, Formula: CFo= © aay |
—_ |
tnustration
In the above example involving Rs.5 Cr investment
500 = a10
o0e, 1175
S 2222
5 52225
2550
(1+1RR) (+IRR}? * (sIRR) * (+R)! * IR
R)
Solving above example using excel formula provides us the value of IRR
as 20 3%.
acceptance Rule

« Management will decide a cut-off or hurdle rate for acceptance of projects. All project
s having
IRR greater than the hurdle rate are accepted.
« Incase of mutually exclusive projects, investmentproject having highestIRR is chosen.
Merits and Demerits of using IRR method
Merits
1. Investors can compare IRR with the required rate of return and take decision on the selection
of projects.
}, 2, IRR measure can be used to compareprojects having different investment requirements.
Demerits
1. Selection of projects based on IRR method does not consider the overall value added to the
firm.
}, 2. IRRassumes thatall future cash flowsare reinvested at the IRR.
3, IRR can be used only when there is requirement ofinitial investment involving cash outflow at
initial period. For the projects involving multiple net cash outflows, the IRR formula can
: provide more than one value.In such cases, use of IRR becomes confusing.

5.2.6 NPV Profile

¢ NPV method and IRR method generally provides sameresults while selecting conventional
projects havinginitial outflows followed by net positive cash flows in subsequent periods. In
the aboveproject involving Rs.500 Lakh investment, NPV waspositive and the IRR of 20.3%
was higher than discounting rate of 10%. Both the methods concluded acceptance of the
Project.
NPV is inversely related to the required rate of return. For a given set of cash flows, NPVis
maximum whenthe required rate of return or discountingrateis zero, as it will be simply sum
_totalofall Positive and negative cash flows.
 10
Finance Management (MU)
n reducing and will become 2et5 .
ses , NP V wil l go 0 wh
of return incre:
ting rates higher than IRR NPV will become
i a
As the required rate
l to IRR For dis c
oun
required rateis equa
oy
ES
30
25
20
15

16 2

Discounter rate (%)

file
Fig. 5.2.1: Example of an NPV pro
rn (MIRR)
5.2.7 Modified Internal Rate of Retu
on of internal rate of retum »
Modified Internal Rate o! f Return (MIRR) is the modificati
ogy.
‘overcometwo shortcomings ofthe IRR methodol

(a) One shortcoming of the IRR methodology is the assumption that the positive cash flows ay
thepositive ag
invested at the rate of IRR which may notbe practical. MIRR assumesthat
flows are reinvested at reinvestmentrate, which is taken at the company’s costof capizi
Presentvalueof cash flows is calculatedusing financing.
(b) IRR formula provides multiple values of IRR in projects involving investmentoutflows in mo:
thanperiod
'
n
> Formula: MIRR = [ENCE — 1

FVCF- Future valueof positive cash flows.

PVCF - Present value of negative cash flows.

n- No. of periods.
 ment (MU)
os ce Ma
1)
pital Budge
and pemerits of using MIRR method

wert

}' addresses the shortcomingsof IRR, by distinguishing betweenIRR andreinvestmentrate.

se uses rate of financing for discounting the negative cash
flow: 's which reflects the actual cost
{ 2 ‘ funds and may vary for different companies dependi
ng on modeof financing. For example,
i vempan using debtfunding for project will useinterest rat
e as financing rate
f ® comparing MIRR and cut-off or hur
dle rate managementcan take decisi
ons on Project
selection.

| pig more complicated method and difficult to unde

rstand for persons without financial
‘ ackground.
+ Like IRR it also doesn’t provide the value addedto the shareholders,
5.2.8 Profitability Index (PI)
profitability Index (Pl!) is the ratio of present value of future cash flows
and initial cost of the
ject profitability index of more than 1 indicates that companyis making money from the
La after considering time value money and the project viable. All projects havin
g PI of more
than 1 can bE selected. In case of mutually exclusive projects, projects having maximum PI are
selected.
PV
PI = CFo

pr = eh | Ch
(1+i)?” (asi)? (asi? ee
CF,
— n
A
> Formula : Pt So-it
CFo
Eample
In the above example involving Rs. 5 Cr investment, Profitability Index will be calculated as
below:
100 _175_ _225_ _225_ _150
P= 710° G10)? * (1.10) * (1.10)(1.10)
500
_= $52
500
1.30
 Capita
ital l Budge,
12
BH Finance Management (MU)
ects where PI <1
ance Rule
the pro jec ts wh er e PI > Lo r Pl= ! and reject the prj
© pt the
AcAccceept Pl is accepted.
the highest
projects, one wi ith
© Incase of mutually exclusive
of using MIRR method
Merits and Demerits

Merits
ney.
1. Pl considers timevalue of mo “sahalers’ vate
ated wi th the projects.
2. Pl considers risk assoct
tive and add to sharebo
Pr oj ec ts wi th PI >1 al so mean that NPVis posi
3. nts,
al ua ti onof pr oj ec ts re qu ir ing intermittent cash investme
4. Pi method can be used for ev

Demerit
added to the shareholders.
1. Itdoesn’t provide the value

5.2.9 Capital Rationing

a firm has access to unlimitey
A firm keeps on evaluating multiple projects all the time. If
shareholders value will p.
capital, all the investment proposals that are expected to enhance
d capital for investment, furthe-
selected. However, in practice a firm will have only limite
management. In suc
unchecked capital investment may pose problem of efficient monitoring and
l investment cap
cases, projects that are providing highest return over investment within overal
are chosen. The profitability index is a proxy for the return over investment and canbeused t»
decide on projects in case of capital rationing.

Tiustration

Let's take an example, where managementonly has capital budget of Rs. 10,00,000 and it has
evaluated multiple projects with different investment requirements, based on IRR, NPV and
profitability index (PI) as below
ee
| Project
Investment IRR (%)
' T
A {600000 | 16 | 240,000 | 1.40
K—+— -
eeu its
B | 8.00,000
Cc | 400000
18 | 2,00,000 | 1.25
| «18 | 180,000 1.45 |

2 j2e0emn [21
|p
E
|| 20000
2.0 4 0
| 2,00,000
|{21
17
|
|re
1,20,000 ||
100,000 | 1.50 |
170)
1.70 }

Management can make multiple com

binations based on each criterion for
to Rs. 10,00,060 as below
projects amoun0™’
 ancae Manageement (MU) .“4
Capital Budgeting

[TOTAL |__| 1,000,000

ProjectPI Inveaun
170 200,000

200,000

A 1401 600,000
|__| 1.000,000460,000 |
Project | PI ~
Investment
240,000 | 600,000
: 400,000
TOTAL | 420,000 1,000,000

profitability index provides combination of projects that maximize returns for given
investment and management will choose projects D, E and A.
inting the future cash ao
Factor (PVIF) for disc
INote : Use Present Value Interest
CVFIFVIF) for
Compound Value Interest Factor also called Future interest Factor (CVIFI )
calculating future cash flows.

dit
5.2.10 Project Monitoring and Au
5.2.10(A) Solved Example
fx 5.2.1 : Management is evaluating options of buying a new welding machine. A new
machine of Schumak Machines company hastotal investment requirementof Rs. 2,50,000 and
has net cash flow of Rs. 250,000 for 9 years. An alternative to Schumak is another machine of
Honto Intemational costing Rs. 15,00,000 and has cash flows of Rs. 250,000 for 11 years.
The required rate of return is 12 percent. Calculate the IRR, NPV and PI of both projects.
Soin. :

(A) Schumak Machines

‘ NPV of Schumak - 12,560,000 + 250,000 x PVAFsoi2
"

~12,50,000 + 250,000 x 5.328

= ~ 12,50,000 + 13,32,000 = 82,000

 5-14
MU:
Finance Management
nt at which NPV ts nil
k ts equivalent discou
IRR of Schuma
0 + 25 00 00 x PVAF sien = 0
- 12,50,00
250.00
PVAFoien = 1

PVAF enn = 5

e, PVAFsa1+ = 4.946
Referring to PVAF tabl
5.132
and PVAFso14 =
g to
Hence, IRR correspondin
E = 14% - 0.29 % = 13714
5 = 1 4 % - E S
13,32,000 _ 1.06
* Plfor Schumak = jpyestment ~ 12,50,000
(B) Honito International
0,000 x PVAF11.012
NPV of Honito = -15,00,000 + 25
-15,00,000 + 250,000 x 5.938 |
- 15,00,000 + 14,84,500
|
- 14,500
NPV is nil
© IRR of Honito is equivalent discount at which
-15,00,00 + 250000 x PVAFitinr = 0
15,00,00
PVAFiLie = “250,000
PVAFi::9n = 6
Referring to PVAF table,
PVAFi1012 = 5.938
and PVAFiion = 6.207
Hence, IRR corresponding
ding to S = 12% - (6207
S$ - 5.938
- 5.938) = 12% - 0.23% = 11.77%
Honita == £4:84:500
+ Plforfor Honito 15,00,00 = 0.98

From the comparison of

hence IRR less that afenptanaesn leesth understand that Honito’s NPV is seP"
is than 1. Hence, Honito is rejected.
 eon the importance of capital budgeting decisions.
{ :
FT pagan te aference between intemalrate of return and Accounting rae of reu mn.
of
xian merits and demerits of payback
'YDack period methodology for capital budoet:
ru nett? the shortcomings of IRR methodology?

st differen t capital
Pp budgeting
: and explain wh 'y NPV methodology is the most appropriate
of ‘tal budgeting technique.

goa
 : Working
Capit a l M a n a g e m e n t
Sl
MBs Capital Management :
Concepts of Me an in
’s Work
g Wor
in g
kin
Ca pi
g Capital; Importance
ta l Ne ed s;
of Working
Estimation of Working
ctors Affecting an Entity
Capital Management, Fa ment of Receivables; and
Managemen,
s; Manage
nagement of Inventorie
Capital Requirements; Ma
ties.
of Cash and Marketable Securi

cashare the
ny tim es the phr ase sIi ike ‘Ca sh is king’ meaning those who have
We have heard ma s signify 1,
Udh ar’ me an in g we don ’ts el I] on credit. These phrase
kings or ‘Aaj Nagad Kal wil
d sty le of ma na gi ng wo rk in g capi ital management of firms. We
importance ofcurrent asset an
rking capital management.
study the various components of wo
Learning Objectives
important of working capital management
© Working Capital - concept, meaning,
factors affecting working capital
© Operating cycle, types of working capital,
© Managementofinventory
© Managementof receivables
© Management of cash and marketable securities.

6.1 Introduction to Working Capital Management

© in the normal course of business, a firm need to hold a stock of goods to fulfil sae
requirements in timely manner; provide credit period to customers and maintain cash balance
to meetpayments.
© This requirementto hold investmentin current assets leads to large portion of a firm's ass
locked in current assets. Hence, it’s important to study the management of working capi
There are two major concepts of working capital.
1. Gross working capital
2. Net working capital.
 ment (MU) 62

nce! pt off Gross Working

Working Capital Man ment
Capiital ang N
et Working ca
os ng capital re fers to the total of CU
pI ita! 4
rTentassets invol ving
inventory (also known as

ndtude orki
qhe requirement of wi oneoP dependson the operatingcycle of the company. Hence, to
apaersanid working capi ‘tter, we need to first understand the concept
of operating cycle
gi2 Operating Cycle

operating cvele refers to time Period elapsed betweenthe time of purchaseof raw materia
ls to
. tion of cash from selling the goodsorservices bythefirm.

cycle consists of manyactivities such as purchase of raw materials, conversion of

=, material into WIP or work in progress, conversion to WIP to finished goods, sale of
fished goods and collection ofcash from customers, post-sale.
| | pe time period from purchase of raw materialto sale of goods is the inventory conver
sion
vod for the company.
F
Ly The time period from sale of goodsto collection ofcashis the debtor conversion period. The
¢ inventory conversion period of the companyisalso called inventory days and the
age collection period as debtordays, as calculated infinancial ratio analysis.

Purchase of inventory Sale of inventory

[ Inventory woo Account receivable penod —»

7 —
Acoourts payabie__| Cash cycle
period (Net operating cycie)

Cash paid for inventory Cashreceived trom sale

\
° Operating cycie 4

Fig. 6.1.1
Operating Cycle = Inventory Conversion Period + Debtor Conversion Period

inventory conversion period consists of raw material conversion period

OR

Operating Cycle = Inventory Days + Debtor Days

 Working Capital
63
v Puparic nt (MU),
360 360
0
36ss old * __Credit Sales
operating Cycle © ZostofegoInodventory Average Debtors
Averag
en,
in praction, many fi purchase raw materials on cred
rms: it and get time for Paym
. Hence, t cash blocked in current assets will not be blocpe keq for %
referred to credit pertod he in g cy cl e refe rs to theti me riog te,
sh cycl e or ne t op er at
entire operating cycle Ca th e re al is ation of cash from Sale,
hase of ra w ma ’ ter ial s to
payment of cash for purc
in g following formula:
© The cash cycte Is calculated us
on Pe riod + Debtor Conversion Pe!
riod
e = In ve nt or y Co nv er si
Cash Cycl
~ Creditors Deferral Period.
- Account Receivabl les Days.
Cash Cycle = Inventory Days + Debtor Days
nagement
6.1.3 Importance of Working Capital Ma
trading firms
Current assets form a significant portion ofthe total assets of a firm. In case of
working capital contribution is very high and may contributeto even 80-90% to total assets :
Current assets such as short term investments provide lower returns comparedto fixed asser,
in curren,
tnventories and debtors don’t provide any direct returns. Hence large investment
assets can result in sub-standard return on investment.
ma,
Excessive accumulation ofinventory can result in problem of non-moving inventory and
lose value in future. Large accountreceivables may pose problemsofcollection and in some
cases result in loss due to non-collection.
Qn the other hand, low level of currentassets canlead to delay in fulfilment of orders and may
Jead to temporary loss of business. This may also result poor utilization offixed assets.
@ Inadequate current assets can lead to inefficiencies in day to day operations andcan lead tp
higher cost and affect profitability and competitiveness of the company.
© Shortage of liquid current assets can lead to delay in repayment to operational and financial
creditors and loss of reputation. Continued shortage of current assets can exacerbate these
problems and may even also lead to bankruptcy if companycannot arrange financing in time to
meet obligations.

. Eicient working capital management is required to maintain balance between retum ob

investment and optimum liquidity for smooth operations of the company. Working capi
management requires day to day monitoring of current assets to ensure smooth business

operations and occupies large portion of finance manager's mindshare.

 wnt (MU 4
Working Capital M
ermanent and Va
614 mr rlable Working Capital
A eompany need: Is to main
inttain adequate level of current assets
for smooth running of of ththe
ness However, the amount of current assets is not consta
i
on the seasonal [actors, Curr ee aee
gopendin® ‘ent assets of the company have two com Shane
ecmanent or fixed working capital and Variable (temporary or fluctuating) work
ringtea
capi t “
tor fixed working capital refers to the minimum amount of current asset ts,
equtred by the company. Permanent working capital is akin to fixed
asset investment, as i
wil romail fixed for long term. Further as in case offixed assets company need .
permanent working capital gradually with growth in sales. my °
or fluctuating working capital refers to the additional current assets required
gue to seasonal requirements. For example, a companyneeds to stockpile large finished goods
to meet demand in peak season and will have current assets. The temporary working capital
amount keeps fluctuating depending on the seasonal requirement. In the peak season,
temporary working capital will be high while in slack seasonit will be non-existent.
Temporary working capital

Time
Fig. 6.1.2

Needs
6.1.5 Factors Affecting Working Capital
tinfluence on the workingcapital
« Nature of Business : Nature of business has most significan
ed to carry inventory ofvariety of
requirementof the company. Trading orretail companiesne
companies hold majority of assets
products and has substantial investmentin inventory. Such
construction companies need to carry
in the form of inventory i.e. current assets. Similarly,
especially in government sector, in turn
inventory and also have to deal with high receivables
other hand, utilities such as telecom
deal with high working capital requirement. On the
in fixed assets and low requirement of
companies, electricity have very large investment
working capital.
Factors : Seasonality plays a very important role in det ermining currentassets that
» Seasonal inventory
firm will need to maintain large
company need to maintain. During the peak period,
demand and duringthe slack season inventory will be lower. For a manufacturing
to meet high
be feasible to increase production substantially at a short notice due to
company it may not business
Hence to avoid loss of
constraints of capacity, impact on quality and price.
companies choose to maintain level production throughout the year _
manufacturing _ _—
Se
 6-5 Working Capital Mana, en
W Finance Management (MU
respond to the demandsituatigy, ang
© Cyclicality : Companies operating in cyclical industries
ing hig
st curr ent asse ts acco rdin gly. In the cyclical upturn, when one is waness
adju i,
ntain high current assets to capital ize on the opportun
demand, companies will like to mai asse,, bs
ies will like to wor k wit h minimum investment in Current
In downturn, compan
overhead andfinancing costs.
the com pan yi s lar gel y dri ven byt he credit policy adopteq by
© Credit Policy : Debtor days of dit to their customers, While
need not extend cre
the company.Large established com panies : blish,
ingt o pen etr ate into mar ket t extend credit as a tool to esta
mi ay chooseto
com pan ies look
y influenced by the prevalent industry
themselves. Credit policies of the companies are largel
the customers, howeve;
practices. For example, retail shops need not extend credit to
it to achieve thesales targets.
wholesalers and distributors may have to extend cred
ess used by company impacts the
© Manufacturing Cycle/Technology : Manufacturing proc
less automation may
manufacturing cycle and in turn requirementof currentassets. Useof
help companyto save on fixed asset investments, but will require large inventories due to
plays an
longer manufacturingcycle. Further, flexibility of manufacturing technology also
capacity for
importantrole. Companies having flexible manufacturing operationscan use their
manufacturing different products during slack period. Companies with _inflexibie
manufacturing technique may choose to maintain steady level of production to avoid
underutilization despite lower demandand can add to inventory levels.
© Availability of Credit : Firms that are able to procure input materials on credit from suppliers
can reduce their net working capital requirement and cash cycle by utilizing such credit
Liberal credit terms from suppliers can even allow some firms to operate with negative
working capital. For example, some large retailers can easily a credit period of 60-90 daysfrom
their suppliers, maintain inventory of 30 days orless and sell in cash to retail customers and
thusoperating with negative working capital.
© Operating Efficiency : Firms running operations in efficient manner can reduce the
requirementofcurrent assets. Operatingefficiency has manyfacets. The factors such as easy
availability of input materials, accurate sales forecasting and planning, utilization of resources
etc. can substantially reduce need to carry inventory atall levels and reduce working capital
requirements. Inefficient operations will require higher investment in currentassets.
Scale of operations : Requirementof working capital generally reduces with increasedscale
of operations, as company has more flexibility. Sub-optimal operations require
a firm to
maintain higher of current assets. Smaller firms also find it easier
to obtain working capital
financing compared to long term loans.
Fluctuation in input prices : Investment in current assets are highe
r when the firm
exposed to fluctuation in input Prices. In such cases, cost of raw
material prices fluctuating
howeverfirm has only limited flexibility to pass on price increases to end customers. In su
cases, firm may need to invest large amountin current ass ets to take advan
tage of tavorablt
input prices.
(
Working ¢,
e
in Workin r
g Capital Manag em t
pital Manageme:
ent
on

capital manage! ment involves decision on n fofo}llowin

ot level of ‘si ‘Owing g ttw
woo a: ar"eeaas:
current assets an
d
, ont .
: a!cing mix between short term and long term fi nancing
i. om working capital - Trade off

‘! . obligations and los of

Me and loss of sales
pence, in determining appropriatelevel of current assets, " a trade. - offbe ween profittability vs
pquidity must be considered.
foitustrate this trade-off let's consider3 alternative workingcapital policies, prescr
ib ing use
ofdifferent levels of current assets for achieving same output. The relationship between out
gad current assets is as depicted in the below chart. : m
‘The requirement of current asset increases with increase in output however the relationship
perween current assets and output is not linear. Current assets increase at slower paceat
hugher level of output. This is due to improved operating efficiency at higher level of output

Policy A has the highest investment in current assets for a given output. As current assets are
aso proxy for the liquidity, policy A can be considered as the most conservative Policy C has

the lowerlevel of currentassets, meaning lowestliquidity and can be considered as the most
aggressive, while policy B is average. How do the policies compare in term of profitability
calculated using return on investment (ROI)?
Net Profit
Rol Total assets
Net Profit
Current assets + Non-current assets
t assets, the policy C
« ifcompany can maintain level of sales while reducing the level of curren
ROI or profitability. while
having lowest level of current assets will have the highest
assets, will have lowest profitability
conservative policy A having highest level of current
faces higher risks | delay in payment
However, with increase in profitability company also
dissatisfied cust duet
obligations due to lower cash,lost sales due to lower stock and
‘ower credit period etc.
inv ersely
Thus we can conclude that profitability and liquidity are
related to each other and
‘
ated with higher nsk
crease profitability or return is associ
 Working Capita} Mang
Re
Finance Ma’
ment (MU)
s tr ad e- of f betw: profitability ang
© Hene «, management need to
carefully ma na ge thi
ts.
in the opt t i m u m le vel of curr ent asse
. ciding 0!
risk and return, while de
’

Conservative policy
Lewel of current weno

Fixed asset level

Output

Fig, 6.1.3 : Chart

Mix of short term and long term financing

Generally, interest rates on short term funding are lower than long funding. Further, shox
term debtcan be repaid back duringthe times of lower requirement. Hencehighertheproportic,
ofshort term debt, lowerthe interest cost and highertheprofitability.

6.1.7 Estimation of Working Capital Requirement

Operating cycle of a companyprovides most appropriate methodology to calculate the work
capital requirement. However, in practice other methods are also be used. Three importax
methodologies to estimate working capital requirements are asfollows :
1, Current assets holding period : This method is derived from operating cycle conceptax
involvescalculation of working capital based on holding period ofindividual
current assets
2. Ratio of sales : In this method currentassets
as a Percentageofsales is estimated based ©
assumptions and past experience and accordingly currentasset
s are calculated.This is
commonly used method in practice as it
assumesthe requirement of higher wor
king ap
with increase in sales and is easier to use.
3. Ratio of fixed investment :
 ital estimation,

__|| 2020
2020
| Matertal Cost |
| Raw Materials Consumed | 36,000
| Manufacturing Cost |
| Labour | 12,000
| Power and Fuel
| 10,000 |
Factory Overheads 7,500 |
Other Expenses
| 1,500 |
Depreciation
5,000
AnnualSales 108,000
Fixed Assets Investment 75,000
Finance Costs 1,000
Profit Before Tax 4,500
Total Fixed Assets 25,000
Profit After Tax 3,375,
Assumptionsforcalculating working capital under each metho
disas follows:
Method 1: Inventory : 1 month supply raw materials and
15 days supply offinished goods.
F Debtors : 1 month, Operating Cash: 1 month of total cost
.
Method 2: 20% of annualsales.
" Method 3: 40% of fixed asset investment.
| Method 1 Calculation :

Raw materials inventory = 36,000 _ Rs. 3,000 Lakh

Finished Goods Inventory = cost

36,000 +0
1 12,000 ,
+ 10,0000+ 7,5000
+ 1,5000
+ 5,000
24
72,000
24
Rs. 3,000 Lakh
 ment (MU 6-9 Working Capital Mang

Annual Sales _ 108,00: 000

Debtors = “y7 = 12 Rs. 9. Lakh

Total Cost 72,000 = 3,000 Lakh

Cash balance = ““"y7 = “T7 Rs.3i

Total Current Assets = Raw material inventory + Finished goodsinventory + Debtors

+ Cash balance
= 3000 + 3000 + 9000 + 3000
= Rs. 18,000 Lakh

Note : hy cases where semi-finished goods or WIP inventory also need to be calculated, agg dire}
labor, power and fuel expenses and maintenanceif provided to raw material consumptic,, fel
estimating cost of semi-finished goods. ||
—_
Method 2:
30
CurrentAssets at 30% annualsales = 108,000 x joo

= Rs. 32,400 Lakh

Method 3 :
40
CurrentAssets at 40% oftotal fixed asset investment = 75,000 < 700

= Rs. 30,000 Lakh

In the previous sections, we discussed the importance of working and proces
s for estimation
current assets. Now let’s understand the techniques to managecurrent
assets i.e, management of
inventories, management ofreceivables, management of cash and
marketable securities.

6.2 Managementof Inventories

Inventory forms probably the largest portion

of current assets of manufacturing and trading
companies. Trading companies need to hold finished
Boods inventory for timely fulfillment
customer requirements and loss of customers.
Manufacturing companies also need to hold 12
materials and Wor k in Progress (WIP) inventory in addition to
finished goods. While mw
materials inventory is required to
ensure smooth production, WIP inve
production cycle. ntory arises due

The main objectives of holding

inventory can be Categorized as
below
1. Transaction motive ; Transaction
motive is the main objective of holding
inventory *
involves holding inventory to
ensure smooth pro duction an
Inventory is held depends on man
d supplies for sales acti
yfactors such as th. € producti
on capacity. demand et
 O sirance Ms ment (MU) to
king Capital Management
motive : According
2. Precautionary ing to this motive, businesseshold inventory to guard against
ynforeseen al ind unpre
predi ’ s leading to disruption in production
d| ctable event or supply of
materials.
tive motive : U: nder this
is motive, businesses hold inventory or reduce to take
advantage the. price price movement.
ver For example, retailers may stock up certain goods in
anticipation 0) price increases, while manufacturers may stock up raw materials if the prices
navefallen.
4 other motives : These include motives such as availing discounts associated with bulk
purchases, reduce ordering costetc.

"6.2.1. Inventory ManagementTechniques

© There are many motives and advantagesof holding inventory viz. flexibility in production, take
price advantagethat comes with bulk purchase, smooth fulfilment of customer demandetc.

« The disadvantagesofholding excessinventory are costof storage,cost of funds onthecapital

blocked in inventory, dangers of obsolescenceetc.

ce As long as the benefits of holding inventory outweigh thecostof inventory, managementwill

prefer to hold inventory.
+ Let’s study the principles of inventory control that help in taking important decisions in
inventory managementsuch as how much to order? when to order? what to control? What is
safety stock?
6.2.1(A) Economic Order Quantity (ECQ) (How muchto Order?)
© One of the important considerations in inventory managementis to determine how much
inventory should be ordered.
© Incase of raw materials, it is the quantity of raw materials to be ordered in each order or in
to manufacture in a
case of production of finished goods it’s the decision on how much
two major type of
production run. Whenever a firm buysandstores inventory it has to bear
costs namely ordering costs and inventory carrying costs.
andinclude costs to prepare a
! © Ordering Costs are the costs associated with placing the order
t of order, storing, cost of issuing
purchase order, cost of transportation, inspecting, movemen
with increase in number of order
payments etc. These costs are fixed per order andincrease
and reduce with increase is size per order.
holding and storing unsold goods. These include
* Carrying Costs are the costs associated with ion,
taxes, and insurance, depreciat
costs of warehousing, salaries, transportation and handling,
the increase in the level of inventory.
shrinkage etc. The inventory carrying cost increases with
 611 Working Capital Manageman

lc ul at e mo st ec on o! : quantity ¢
ca
de r qua nti ty I s a scientific method to
Ec on om ic or ts. There are 3 variablesinvolve
e total of ordering and cal rrying cos
inventory that minimize th
e the:
incalculation of ECQ. These ar ca st ed to be sold over a given
t du ct fo re
e number ofunits of the pro
1, Demand of product : Th
pressed as A.
time period (usually a year), ex O.
: Or de ri ng co st pe r pu rc ha se order expres: sed as
2. Ordering cost riod,
pe r uni t, as su mi ng th e it em is in stock for entire pe
cost
3. Carrying cost : Carrying
expressedas Cc.
ll be
ror, thenthe total ordering cost fora yearwi
If Q is the order quantity per purchase orde
Ax0
TOC = “Q
each period, then
If the usage of inventory is constant for

average inventory can be expressed as g

t per unit x Average inventory
Total carrying cost (TCC) = Carrying cos
rec = SKE
and total carrying cost.
Total Inventory Cost (TC) is the sum of total ordering cost
TC = TOC+TCC

TC = Al, ae)
As discussed above, EOQ refers to the quantity Q, where TC is minimized. We can use calculus
to find the lowestpointon thetotalinventory cost curve. The resulting EOQis,

> Formula :0 =» [242

Mustration
Let'stake an example on use of EOQ method. Suppose that usage of an inventory itemis 2000
in a year and ordering costs and carrying costs are Rs. 100 per order and are Rs. 10 per unit
respectively, The EOQ expressed as is calculated as below:

9 = «/7zo00Li00}
10
= 2 {2000)(100}

= 200 units.
 Finance Management (MU 612
i Working Capital Manage
\

Fig. 6.2.1
« Inthe Fig. 6.2.1, we haveplotted total ordering
casts: total carrying costs; and total inventory
costs (which is sum of thefirst two costs). :
» We see that whereastotal carrying costs vary directly with the
size ofthe order, total ordering
costs vary inversely with order size. The total inventory costs sum total
of ordering and
carrying costs declineatfirst as the fixed costs of ordering are reduced with larger orders.
However, the total inventory costs start rising when the additional carrying costs start
offsetting decreasein total ordering costs due to a larger averageinventory.
« The point EOQ, represents the economic order quantity, which minimizes the total cost of
inventory.
6.2.1(B) Reorder Point (When to Order?)
« In addition to knowing how much to order, when to order or reorder point is‘ another
important decision in inventory management function. To calculate the reorder point, we need
to consider the time elapsed between placement of order of an item to receipt in the inventory,
also called as Lead time. Reorderpoint can be calculated as below
Reorder point = Lead time x Average usage
© Suppose it takes 5 days between the placement andreceipt of an order. The EOQ ordersize
was 200 units and a daily usage of 20 units, resulting in an order being placed (andfilled)
every 10 days. The reorder pointfor the firm will be expressed as,
Reorder point = $x 20 = 100 units.
as it will take 5 days
* So the firm needsto place an order whenthe inventory falls to 100 units,
to receive inventory by whichtime the existing stock will be exhausted.
6.2.1(C) Safety Stock
lead time and average usage are always
© The calculation of reorder point assumes that the
known with certainty.
 Working Capital Mana Remeny
nance
:
Manaj ement (MU)

od uc t as de sc ri be ' d by usage and the lead time are 9,

mand for pr
© In pracuice, however the de te d 4 or if the lead time is higher
th,
er th an es ti ma
tual usageis high
entirely certain. If the ac
a situation of stock out
expected, a firm may face in demang
ma in ta in a sa fe ty st oc k to allow for uncertainty
imperative to
« Therefore, it becomes alculated to account {o,
Hence, reorder point need to rec
for inventory as well as in lead time.
the satety stock.
erage usage * Safety stock
Reorder Point = Lead time x Av r
ct ed sto ck ou t qua nti ty ts 5 units per day. Then the reorde
«In the above example, if the expe
cks of 25 (5 5) ie. 125 units.
ty sto
point will be 100 units plus safe
6.2.2 Inventory Control Systems
and man age men tof inv ent ory is a comp lica tedt ask, hence @ firm need to have formally
Control t popular
inve ntor y cont rol sys tem suit able with its scale of operations. The mos
monitored
w:
inventory control systems are as mentioned belo
trol
6.2.2(A) ABC Method of Inventory Con
ntory of a variety of items depending on the
° A manufacturing firm needs to maintain inve
number of items can be in thousands of
product. In some cases,like automobile firms, the
inventory value is typically accounted
parts depending on models. However, most of the total
firm to focus more attention in
byrelatively small proportion of (tems. It advisable for the
controlling the more valuable items.
d inventory
© This is accomplished by using ABC method ofinventory control. In this metho
items are classified in A, B and C categories.
© A category items are most valuable and account for majority of inventory value. These items
are monitored strictly and more frequently.
© Category B items account for lower portion of total inventory value and involved moderate
control and monitoring.

Category C contains large number of items, even smaller portion of inventory value and hence
involve minimal monitoring. For the firm described by below Fig. 6.2.2, “A” items reflect the
fact that roughly 15 percent of the items in inventory account for 70 percent of inventory
value.

The next 30 percent of the tems, group “B,” ” account for 20 percent of inventory value Aad
more than haif, or 55 percent, of the items explain only10 percent of total inventory value
 anaganvent MT Workin
Mere)

'

=
g wl ” ~

ol
|
*|
I
810 4 feo Fa TH “*

C analysis
Fig. 6.2.2 Graphic presentation of AB

Ju st in Time (JIT)
6.2.2(8)
ota
kn ow n as Toy ota pro duc tio n system wa pioneered by Toy
a fart fa cme (HT) alo ded at
aims to maintain just enough inventory nee
Caorginrsal be BO 1970 As the name implies !F
ane Hine OF MAN TACHIDR,
ir
agement aligns raw-material orders with the
In [EE eyatont at taventory Management Man
peel On achedules
ing
se waste and reduce inventory cost by receiv
4 {hetthem to HHCbedne efficiency, decrea
tion process. which reduces inventory costs.
geviele only a they yeod thenfor the produc
ent
LT req uir es a ver y acc uta te pro duc tio n and inventory information system and very effici
8
and yottable ebain to muceed.
fer
ded, which seems to suggest that ]IT will suf
+ {IT prescrthes ordering quantities [st as nee
trum very bigh order Hig casts
wor k, JEP ia abo acc omp ani ed wit h ste ps taken to reduce ordering costs by reducing
+ tv eeal
or tion , Logi stic s Cor ts bY: dev elo pin g hig hlyef ficient supplier base. Otherwise it can Cause
sanp
eat the
d with last minute arrangements and def
dock ouls and Increayed costs associate
t
HP In pra cti ce lar ge fir ms use hig hly sophisticated Supply Chain Managemen
Parpaws of
m and
eduling. estimate requirement of each ite
(YOM) Syatoma which belp in production sch
iidering ayatenn
ed in the management of inventories. Due to
A liManeial manager in not directly invelv

far go ryv eat men t of fun ds in inv ent ory , fin anc e Man ager must be aware of inventory
setaively
HAHagEMONE and control Lechniques
 Working Capital Ma,
nay Len
Mu 6-15
Finance Management in inventory, the lower the optimal vg
vested i
s im in
cos! of fu nd s
she optimal order q ua
ntity, all other things held Constant yy
© The greater the opportunity
r
ty stock needed, and the lower the
average inventory and the lows , the lower the sa fe
© Thelower the averagelead time things held constant. To. reflect change in .cost of abi%
her
investment in Invenio shad higher or lower. Accordingly, EOQ value will also deena,.
carrying cost need to be a
lower.

ceivables
6.3 Management of Re
ren t assets and arise due° to Sale g
con sti tue nt of cur
© i ables is second maj jor
Receiv
stomers. These are also called as account receivables or trade
product/service on credit to cu
receivables or trade debtors.
es as soon asi t raises invoice for sale on Customer
* Acompanyrecords thesale of ‘goods/sel rvic .
ve rthe tr an sa ct io n is no t co mp le te ti 11 the time it realises consideration for the same
howe
mpanytosell products o,
© One may arguethatunlike inventory itis en tirely the choice of the co
credit and in fact there are manybusinesses like retail whoneednotsell any product on creqiy
© The amountof trade receivables for a company will depend on percentage ofcredit sales ty
the company and credit period. For example, if a company has an average dailysales
Rs. 50,000 and sells 50% of products on credit at an average credit period of 45 days, The
accountreceivables will be 50000 x 50% x 45 = 11,25,000.
© There are many reasons for a business to sell products on credit like prevalent industy
practice, meet short sales target, expansion in new area of business/geography etc., clearance
of non-moving stocketc. The funds blocked in receivables need to be financed which implies
cost for the company. Further, company need to incur additional costs like collection and
potential bad debts due non-repayment. Hence, receivables need to be managed carefully.
© There are three major aspects to management ofreceivables:
1. Credit Policy
2. Credit Evaluation and Decision
3. Receivables Monitoring
eo at ole Working Capital Management
63-4 Credit Policy

The amountof trade receivables. period oftrade receivables and terms related to credit are
rned by the credit policy ofthe firm. Thecredit policy of a companyis based on following
variables
1 Credit standards
2, Credit terms
3, Collection policy.
Credit policy are expected to have bearing onsales of the company, bad debt, discounts etc.
Le’s examine these variable independently. The goal of the credit policy is to enhance
shareholders’ wealth by striking a balance between highersales andrisk.

6.3-1(A) Credit Standards

» Credit standards define the minimumcriteria for extending the credit to customers. Based
on credit standards company will decide which customers can avail credit from the company.
Tight credit standardswill limit the numberof customers eligible for credit sales, but will also
reduce the probability of bad debt and collection costs. Lenient credit standards will increase
numberof customers andsales butwill also increase risk of bad debtand collection costs.
Finance manager plays role in credit analysis to determine credit worthiness of a customer.
Creditworthiness dependson 3Csi.e. Character, Capacity and Collateral. Collateral or security
for granting the credit is generally provided by customers to banksfor availing loans and may
notbe relevant for granting trade credit in mostcases.
© Character refers to willingness of customer to pay and is moral factor responsible for
repayment. Capacity refers to the ability of the customer to pay and is determined by the
financial strength of the customer. Company can use tools such as credit references, credit
rating, analysis of financial statements, past repayment track record etc. for
determining the creditworthiness of a customer. Thisis explained in more details in later
part ofthe chapter.
6.3.1(B) Credit Terms
y to its
© Credit terms refer to the terms on which trade credit provided by the compan
nt
customers. These include credit period, cash discount, penal charges or delayed payme
charges.
credit
© Credit period refers to the length of time period for which credit is provided. Longer
sales for the
period means higher flexibility for customers and hence can lead to higher
n receivables
company. Higher sales and longer credit will also leadto increasein investmenti
amount
 . Working Capital Management
nce Manage! (MU) 6-1
set increased cost t due to higher
‘ m highe! r sales can offset i i
* If the incre. ase in operating profit frot is! . ll have a favourable impac t on profit Of the
les, higher cre dit period wi
investment in receivab
company
- . te’ a
¢ Credit period is mentioned as ‘net dat
30 a days for Payment
Ear \ 30" means customer has a maximum credit period of
For example, ‘net 3 0ihcus
e so meers fore
tom earla t
y pay ment
is th e di sc ou nt of fe re d byy th e S
co mp a
a ny t
: sh di
Ca scou nt discou
Company mayneed to provide credit to cus
to!

mn ‘ discount to custom ers it encourages customers to pay ea: rly an * d reduce in

provid ing cash
the
cash discount and credit period will be state
investment in receivables. Credit terms having
term
cash discountrate, period ofcash discount for example,‘2/5, net 60 refers to thecredit
offering a cash discount of 2% for payment made within 5 days and credit period of 60 days,
delay in repayment by
Credit terms sometimesalso mention delayed payment charges to avoid
t charged by
customers. Penal rate or delayed paymentchargesreferred to rate of interes
companies to customers for any delay in payment.

6.3.1(C) Collection Policy and Efforts

. Collection policy refers to the set of collection procedures to ensure collection of trade
receivables on due date. Having provided credit to customers, companycan't simply expect all
customers to pay on due date.
Some customers delay the payments due to genuine or maybe habitual late payers.

The policy should be explicitly fix the responsibility of collection andfollow up.Collection can
be handed as a part of accounts or sales team.
In anycase efficientcollection requires coordination between sales and accounts department.
Sales department should use inputs from accounts department while granting credit to
customers.

* Accounts department should coordinate with sales for recovering delayed

payments. Some
companies offer cash discounts to encourage customer to make
payments before due date and
also charge penal interest charges in case of delay in payment.
© The policy should Prescribe setof actions for
reminding customers to make regular payments,
follow upfor delayed payments and separate Process
to collect old and delinquent dues. Some
customers have thehabit of delaying the payments,
regular follow up can discipline such
customers to pay on time.
* Some customers mayhave genuine issues due
to business downturn etc. and hadto be handled
carefully. An email should be promptly sent to Customers
in case of delay requesting to make
the payment immediately.
 (Mu)
vi 6-18
Working Capital M:
lanagement
e
| Te sam e can befollowing oY by mem,ail from senior member
ronal visits and legal notice if required, Direct 4 le Bal actionS ef collection team, letters and
eve the real purpose of collection. Wh,neen
is generally costly
and may not
Papar yments cannot be co
llected, a comprom
s ettlement can be made tocollect a percen Be o f to tal due amount.
ise

6.3-2 trade-off

cost-benefit analysis.
ed to con:
. Manageme net . < sider a trade-off between the returns from additional sales or lost
sales vs additional cost or savings dueto increase or decrease in receivables, impact on bad
debts etc. The below chart explains the trade-off between tight andloose
credit policy.
Cost of administration and
bad-debit loss
Costs and benefits

Opportunity

Tight «— Credit policy —» Loose

Fig. 6.3.2

Let’s take an example.

Mustration - Changein credit standards

before
A firm is selling product for Rs. 100 per unit, of which Rs. 80 represents variable costs
240 Lakh and credit
taxes. Currently, annual credit sales to select customers are at a level of Rs.
expected to increase
terms include credit period of 1 month. Therelaxation in credit standards is
sales to Rs. 300 Lakh annually. Current bad debtratio is 2%, whichis expected to increase to 3%.
Rate of tax is 25% and post-tax opportunity cost of carrying additional receivables is 20%.
dueto the additional
Let us evaluate the trade-off between the expected additional profitability
in receivables.
sales and the opportunity costof theii increased investment
* Contribution from additional sales = Contribution margin x Additional sales
~ 100-80
Too * 60 = 0.20 x 60 = Rs. 12 Lakh
oss on existing sales +
Additional cost dueto increase bad debt losses = increase in bad debtl
bad debt on additional sales = 3% ~ 24 x 240 + 3% * 60= 24 + 18-42 Lakh.
 ment (MU)

Net changein ope ting profit gher Contributior

.

© After tax change in operatingprofit = 7.8 (1 - 25) = Rs. 5.85 Lakh

© Additional receivables = O01 Rs 5 Lakh

© Investment in additionalreceivables = Expense ratio x Additional receivables
= 08<5=4Lakh
Required Return on investment= Cost of capital x Additional investment = 0,2 x 4 ~ 08 Ly
Profitability from additional sales is substantially higher than the required return on Alten,
investment,hence it is advised to provideto additional customers.
Illustration 2 - Change in credit terms

‘Let's assume in the above firm has an option to increase credit period forexisting Customer
60 days, which is expected to result an increase in sales from Rs. 240 Lakh to Rs, 360 lak,
Current bad debt ratio is 2%, which is expected to increase
to 4%. Rate of tax is 25% and Poste,
Opportunity cost of carrying additional receivables is 20%.
Let's evaluate the trade-off based on proposed changein credit terms
* Contribution from additionalsales = Contribution margin x Additional sales

= fo. 360,00 - 240,00 = 0.20 x 120,000 = Rs. 24 Lakh.

Additional cost due to increase bad debtlosses = 1% x 240 + 4% x 120

=7.2 Lakh.
Increase in operatingprofit = 24 - 7.2 = 16.8 Lakh.
After tax change in operatingprofit = 16.8 x 1 - 0.25 = Rs. 12.6 Lakh.
|
Investmentin additionalreceivables associated with newsales Variable cost
= ~atiable
Selling price
x Additional sales x “edit period in months _ 390% 1202 = 0.80 x 120 «B= 16 lath
Investmentin additional receivables associated with
Variabl - changein credit period onexisting sales |
= Satine ee x Existing sales x Additi onal credit period iin months |
12
= 0.80% 240x25 = 16 Lakh,
* Total increasein receivables = Rs. 32
Lakh, |
© Expected return at 20% = 0.20 x |
32 = Rs. 6.4 Lakh. |
|

After tax change in ‘operating profitis higher

than the expected return, hence, the trade-of's
favourable.
 os nce Mana jement (MU) 0
‘orking Capital Management

63°3
evaluation of Individual Accountfor Credit
| fore offering credit terms to any customer, company should perform credit evaluation
Be
of
juat customer The credit evaluation involves following steps
width
credit Information
4 creait Analysts
credit Decision and Credit Limit

63 3(A) Credit Information

The first step for credit evaluation is to obtain credit information. Commonly
used sources of
edit information in India are asfollows :
financial statement: Financial statements are one uf the most sourcesoffinancial position of
the company. In India public limited companies andprvatelimited companies are required tofile
fnancial statements with the registrar of companies. These can be accessed by the firm planning
to grant credit for paymentofcertain fees. In addition, there are some third party providers that
provide the financial information in moreuser friendly format. Companycan usethis information.
jn case of proprietorship, partnership firms financial information is not publicly available,
companyneedto seekthe financial informationfrom the customer willing to avail thecredit.
Trade references : Company can ask customers to provide reference of other parties having
trade relationships. Companycan check from these references track record of the customers. This
isan easy and free resourcefor checking credit worthiness.
Credit rating : Companies can check the credit rating of the customers if available. Credit
rating are the ratings on thecredit worthiness provided by third party credit rating agencies such
as Dun & Bradstreet, CRISL, ICRA etc. These are used by companiesto avail financing, but may not
be available for all customers.
Past track record : Company can check the record of past dealings for existing or old
customer.
6.3.3(B) Credit Analysis

Havingcollected credit information,the firm must makea credit analysis of the applicant. Ratio
_ alysis offinancial statements, credit rating etc. are used to understand repayment capacity.
Information on Management of the customer and trade reference can be used understand
-feputationof the customer. Some companies have developed internalcredit scoring system based
0m financial ratio analysis, management analysis, past payment track etc. to decide on credit
Worthiness.
 d Credit Limit
6.3.3(C) Credit Decision an
be reached about thi e grant of credit. The decision,
Once credit analysis, ad ecision must € anset a credit limit for a customer,
in,
whi
the credit can befor a single transaction or a
company
unt the firm n will permit to be owed at anyonetime
represents a maximum limit onthe amo

6.3.4 Monitoring of Receivables

that the receivables are Rett,
A firmneed to regularly monitor the receivables to ensure g methogs *
the bad debt losses. Followin
collected as per the credit term and minimize
monitoring of recetvables are commonly used.

Receivables Monitoring

Collection
Average Coliectionl aging cea | Experience weet |
Pernod Matrix

6.3.4(A) Average Collection Period (ACP)

sales and compares the
© In this method.firm computesthe average collection period ofcredit
same with the credit policy.
~ Debtors x 360
Average Collection period (ACP) = “Credit

© Average collection period is compared with the credit period as perthe policy to judgethe
credit period as
efficiencyof collection policy. If the average collection period is morethan the
perthe policy, then the collection policy and efforts needs to improved.
© The above method provides an overall pictureof the efficacy of collection efforts. However,
are due for
average collection period suffers from lack ofspecific details on amounts that
Jonger than averageperiod to takeaction.
of seasonal
The early paying accounts can mask performanceof slow paying accounts. Impact
variations in sales on the collection period is not factoredin.

6.3.4(B) Aging Schedule

@ Inthis method, receivables are classified into different bands of aging or aging buckets. Agia
refers to the length of time for which receivables is outstanding.
 nagement (MU) 6-22 Working Capital Management
pinance Ms
sre agin analysis provides a clearer picture of the slow moving accounts and provide early
* yorms 0” risk of default. Following is the aging schedule of receivables having credit period of
30 days
the table shows 6% amount
he averabe collection period may be close 35 days. However,
i.
outstanding for more than 45 days and 3% of the amount is outstanding for more than 60 days,

n. Agi ng sch edu le pro vid es an ide a about the amount atrisk of
which may Pose risk for collec tio
take remedial actions.
default and help
| . Aging schedule does not compare the receivables with the sales.
Aging (Days) Outstanding Percentage

0-30 5,00,000 61

31-45 2,50,000 30 |

46-60 50,000 6

61 and above 25,000 3

Total 8,25,000

6.3.4(C) Collection Experience Matrix

This
In this technique, receivables arising from the sales are plotted againstthe sales of period.
same period. In the
helps to compare collection experienceofreceivables with the sales of the
are shown horizontally.
collection experience matrix sales are plotted horizontally andreceivables
Following table shows an example of collection experience matrix
Months January February March April
Amountin Rs. Lakhs
6000 6000 7500 $000
Sales
Receivables
January 3500

February 2000 3500

| 1000 2500 5000

March

| 500 1500 3000 4000

April
500 2000 2500
| May | 200

—_| 200 0 1000 2000

june
 ina cnn (mt) 623 Working Capital Mang,
nce
% sales ap
Thereceivables are also expr essedas a

Amount in Rs. Lakhs March Apri

5000
Sales

Receivables a

February | 3% | 58% |
17% 42% 67% 0%
March
8% 25% 40% 80%
_ April

3% 8% 27% 50%
| May

June 3% 0% 13% 40%

6.3.4(D) Credit Utilization Report

In this report, details of the total limit of credit offered to each customer andtheextentto
whichit is utilized is plotted and reviewed on periodical basis. This provides the information on
the extent to whichtotal limits being utilized.

Customer | Credit Limit (Rs. Lakh) Limit Utilized (Rs. Lakh) % Utilization

A 2000 1500 75

B 1500 1400 93

c 1000 800 80

Total 4500 3700

6.3.5 Sale of Receivables/Factoring

© Assignmentorsaleofreceivables is one of the most commonly used methodsforrealisation of

early payment and reducereceivables. In this transaction, company sells its receivables to
banks or specialised financial institutions.
This transaction is called Factoring or assignment of receivables. There are specialised
financial institutions who engaged in purchaseof receivables called as Factors.

A Factor or bank deducts discount and factoring charges from the receivables amount and pays
the balance amountto the company.
On the due date Factor collects.the moneydirectly from the customers.In a typical factoring
transaction,to mitigaterisk ofdefault or delay, factors require companies to compensate the™
up to fixed percentage ofreceivables.
 utntanding receivabl of Rs 500 Lal e after 60
pinto a factoring transaction with» Factor or a beok

spe vane wil dedu ct disc ount charges of say Rs 12 Lakh (about 2.4%) and pay Rs. 488 Lakh to
company 0 due date, the bank or factor will collect the payment directly from the
o
poeoe!
os
+“ management of Cash and Marketable Securitie
nt assets, as idle cash does not
os probably the least productive asset among Curre
ate any return Even in cases where cash is Invested in the bank deposits or short term
canvetable securities returns are generally much lower than cost of capital, However, it is
sbably most critical IN many aspects, as it used to meet payment obligations We have seen
ds of BrowINR cash balances on the balance sheets, This can be attributed to many reasons
ch as increasing uncertainties, shortened business cycles, rapid disruption in business and black
van events like global financial crisis of 2008, demonetization, pandemiclike COVID 19 etc.

642 Motives for Holding Cash

Companies hold sufficient cash balance for various reasons, There are three major motives for
holding cash
+ Transaction Motive : In the normal course of business, company need to make various such
as purchase of goods, salaries to employees, utility payments, instalment of loans, interest
expenses, dividend etc. Companyalso receive cash from sale of good, however the need to hold
cash arises because the timing mismatches betweencash receipts from sale and expenses. This
is motive for holding the cash in transaction motive. Company can choose to maintain cash for
immediate payments and balance in the marketable securities and time the conversion of
securities to cash with the payments.
+ Precautionary Motive : A firm may hold cash to meet contingencies of the future. These
amounts to guard off against unexpected fund requirements. These mayarise due to sudden
sharp fall in sales or higher than expected payments etc. As these funds may notbe required in
normal course companycan invest such funds in liquid marketable securities such as short
term fixed deposits, money market mutual funds. If the company has an access to short term
funds or unutilized credit lines etc. it can choose to borrow the funds instead of holding the
cash.
of investment
Speculative Motive : Sometimes companies hold cash to take advantage
prices, holding
opportunities such as advance materia! purchase in anticipation offall in input
funds to invest in marketable securities or borrowing andholding cash in anticipation ofrise in
common.
Interest rates in near future. Speculative motives are generally not
 Working Capital Manage,

s
6.4.2 Cash Management Proces
t pro r
cese s invo lves th e management of cash and cash equivalents, the,
The cash manage men
liq’ uidated into cash quickly,
Cash Managemen,
tie s tha t ca n be
includes marketable sec uri
deficits and investines,
en t of cas h, financing s hort term
concerned with collection of cash, paym n
ess.
sh management proc
of cash surplus. Followingpict ur e ca pt ur es , th e ca

Cash collection

Business
operations Deficit Borrow
L Surplus Invest
Information
and control
Cash payment

Fig. 6.4.1: Cash managementcycle

Cash management processconsists of following steps

1. Forecasting cash flows
2. Managingcash collections and disbursements
3. Investmentin marketablesecurities
6.4.2(A) Forecasting Cash Flows

© Thisis the starting point of the cash managementprocess. Cash forecasting is donefor various
periods. Companies prepare cash forecast for daily, weekly, monthly, quarterly and annual
period and these are considered short term forecasts also called as cash budget.

« Cash budget helps company

1. To determine requirement of operating cash
2. Plan and negotiate short term borrowings
3. Invest surplus cash
* Accurate cash forecasting can help companytoprioritize payments, borrowings, minimize idle
cash and borrowings.
* Long term cash flow forecasting of 3 to 5 years helpsin finalizing financing and investment
strategies.
* Daily, weekly and monthly cash budget are prepared by forec
astingall the receipts and
disburse ments (payments). The receipts consist
of cash inflows from operating and nom
operating activities.
 ng Capital Management
sand ac nities consist of collections from
business activities 5 such as sales and services
yerat
ing cash inflowsconsist of other collections such as rental income, interest
| aie 000-0P
cS some, 10 me from sale of asset such as land, building etc. Disbursals consist of all the
5 such as payments to be madefor
erating activities such as purchaseof material, taxes, salaries, overheads etc
) OP
jyNon-operating, activities such as capital expenditure, interest payment, principal repayment
© oflong term loansetc "

rhe difference between receipts and disbursals is the net cash shortfall or surplus. Followingis
on cash.
snexample of monthly cash budget of company having 90% sales on credit and 10%
company collects 80% of credit sales in next month and 20% in the monthafter. Further,
company also buys raw materials on credit with credit period of 30 days. So the purchase of
month.
th
the current month is paid in next
nt in Rs. Thousands February| March} April/May |June|July |August|Sept]
irotal Sales 375 525 450 |525/375/300| 375 |450
reat sales @90% 338 473 405 [473]338|270] 338 405
38 53 45 53 38 30 38 45

45 152.5/37.5| 30 37.5 45
378 |324|378]270| 216 |270
\go% of last month'scredit sales
[20% of 2-monthold credit sales 67.5 |94.5| 81 [94.5] 67.5 54
total sales receipts 491 |471| 497/395] 321 |369
225 315 270 |315|225|180] 225 |270
|Purchases
Disbursement for purchases and other}
joperating expenses
315 |270|315]225| 180 |225
100% last month purchases
45 |52.5]37.5| 30 37.5 45
Salaries and Wages
(Other expenses 45 |52.5]37.5| 30| 37.5 45
{Total Operating disbursals 405 |375|390|285| 255 |315

(Capital expenditure 50] 75

\dvancetax 45 37
405 |425|510|285} 255 [352
(Total Cash disbursal
Net cash flow 86 46 |-14]110] 66 17
Beginning cash balance 150 |236] 282|268] 378 |444
[Total cash 236 |282|268|378| 444 |461
Porrowing -|}rpr dc - -
Interest on, borrowings ~ Typ - -

Fepayment of borrowing 7 yy ye - ~
{losing balance 236 |282|268|378| 444 |461
 Working Capital Mana, men,
62
Finance Management (MUJ
ti ion of cash flow statements using
adjusteq net
involves .
prepara
«Long t erm cash for ecasting 1B atement prepared using forecasted Profit an
projected cash flow st
income method. IC is 4
loss.
j
from the projected p rofit and loss Statemeny
© Net profit, depreciation, interest etc. are used
re is tak en fro m the cap ita l bud get . The working capital changes ane
Capit al expenditu st and the same is extrapolateq for
using ratio of working capital to sales in the pi pa
estimated
term cashforecas ts
future periods. Long term cash forecast is madefor 2 to 5 years. Long
future and finalize financingstrategies,
usedfor estimating financing requirements in the
sements
6.4.2(B) Managing Cash Collections and Disbur
Finance manager need to carefully manage cash flows in accordance with the cash budget
cash
Finance Manager need to prioritize or accelerate the collections and delay or postpone
disbursals whereverfeasible.
1. Accelerate Cash Collection .
© Thefirm will like to speed up collection of accounts receivable so that it can use the cash
earlier to make paymentor conserve for future payments. Someof the methods to speed up
the collections are

1. Expedite preparing and mailing of the invoice.

2. Reduce time forcollection of payment instruments from customers- This helpsto reduce
mailfloat i.e. the time taken by the customer chequesto reach thefirm.

3. Reduce the time for processing the payment - The time required for Processing the
Payments internally as well as with the bankiscalled as processing float. Companyneeds to
expedite the processing of collected cheques or payment instruments to reduce the
Processing float. The mail float and processing float are together known as collection
or
deposit float.

Companycan use decentralizedcollection system,lockbox system to

reduce the deposit floats.
¢ Decentralized collections: Company can have decentralized
collection centresthat collects
the paymentinstruments such as chequesordrafts from
the nearby customers anddeposit the
same in the local bank accounts.

* This helps to reduce mailing and Processing time forrealisation

of payments. Funds from local
bank accounts to centralized orconcentration bank accountus
ing electronic fundtransfer.
 6-28
penance Management (MU)
¢

with the advent of electronic fund transfers and online ba

nents coming down drastically. inking 1g th the use of cheques etc. for the

7 control Disbursements
seme is essential for success of efficient
. Control of disbursements : cash
management. This involves in
slowing down payments to conservecash and reduce borrowing requirements. The company
shouldutilize the tradecredit available for purchase and delay the payments to the duedate.
» Company should make the payments early only where it earns the cash
discounts. Unlike
collection which involves decentralized collections for accelerate collections, the disbursement
is centralized from one bankaccount.

« This helps the companyto effectively control payments.The disbursementbank accountis also
the concentration bank account where all the balances are transferred from the local bank
accounts. Sometimes the companies have issued chequesand the books of the company shows
the payment, however due to mailing and processing time the cheque may notprocessed. In
such cases company’s bank balance will be higher than the book balance, because as per
accounting books entry is passed when chequeissued. This difference is called as payment
float or disbursement float. -

6.4.2(C) Investment in Marketable Securities

Generally, firms try to maintain target level of cash or optimum levelof cash. Excess cash over
and above optimum level is invested in short-term marketable securities. In this section wewill
understand the firm’s use of marketable securities. Investmentin marketable securities held for
cash needs for precautionary motive,controllable outflows such as dividend, tax payments etc. In
choosing the marketable securities the firm should examinebasic features of security such as
on short
* Safety : The firm is investing cash in marketable securities for use at a later date
notice. Hencethe firm will invest funds onlyin very short term securities offering high degree
of safety and very low defaultrisk.
* Marketability : Marketability refers to the liquidity of the marketable security; it indicates the
speed and convenience by which security or investmentis converted into cash. The securities

for investment should be highly marketable.

 Working Capita} tne
(MU) 6-29
Finance Management

for repayment of principal and interest Ast

¢ Maturity : Matunty refers to the time pr eriod
ease s and the liq ul dity reduce
nd s. Theprice of long term secu
maturity incr ease s the risk incr
volatility in price ensure safety, thefirms invest
varies with interest rates. To avoid
cash surplus into short termsecurities.

Types of Short term instruments

© Treasury Bills (T-bill) : These are short term government securities and regardeq a8 the
safest and one of the most liquid security. Treasury bills issued by central government and
haveoriginal maturity of 91 days, 182 days. 364 days.
© Commercial papers (CP) : These are short term unsecured debt instruments generally issueq
by large companies. Theseinstrumenthavehigh liquidity. In line with Treasury bills these ate
alsoissued ata discount and redeemed atpar.
© Bank deposits : These are fixed deposits held with the bank and varies between 7 days to 365
days or more.

* Certificate of deposits (CD) : These are unsecured debt instruments issued by the banks t
raise short term funds. These are issued at discount and redeemed at par. They are highly
liquid instruments.
* Inter-corporate deposits (ICD) : This is short deposit parked by one corporate entity with
another. Generally, companiesinvest the ICDs with their sister concerns or subsidiaries, On the
due date companyreceivesprincipal andinterest.

¢ Money Market MutualFunds : This is one of the most popular instruments for parking short
term funds. Money market mutual funds invest funds in the money market instruments such as
treasury bills, commercial papers,certificate of deposits. Companies can invest fundsin money
market mutual funds and redeemthe units as and when required.
6.4.3 Cash Balances to Maintain
* Most companiesestablish an optimum targetof cash balances to maintain. Excess
cash can be
invested in marketable securities and interest can be earned, Idle cash meansloss of
opportunity to earn interest from investment. Higher the interest
rate, larger will be
opportunity cost of maintaining idle cash. At the same time the company needs
sufficient cash
to meetday to day requirements.

© The optimal balance should balance the twin objectives the ability to invest
the excess cash for
a return and ensure sufficient liquidity for future needs.
How much cash is optimum cash”
There are two methods for estimating optim
um cash.
eee
 nance Mana ement (MU) 6-30
Worki ital Management
Determining
rel) Certainty - Wi Optimal Cash Balanc
llia m Baumol’s C er
ash Model Conditions of
gumol’s model
the B is based on th
e assum,
. curately and the paymen
ts are made Unifory ‘ash needs are forecasted
ac . mly over a Peri
od of time.
company incurs transaction cos
The t when "ver it co
nverts marketable
jso incurs holdingcost for keeping the idle c s ecurities to cash and
also ‘ash balance

« The company’s holding cost is interest Cc

forgone on the average cash balance i.e.
k (§). where k
is the interest rate for the period. Let's assume
that the companyincurs a transaction costo
f¢
per transaction.

i
« Then cost for making total payment ofT is c x ®)

Total Cost = kx

Using calculus, the C is minimum when

=
> Formula :¢* =» [2
Where
£- Optimal Cash balance
T-Total cash needed during the peri
od
S- Cost per transaction
‘Opportunitycast holding cash for the period
Mastration
AAfirm
firm estimated a cash
s requirement of Rs. 40000 over a month, wheredisbursement are made
“constant rate. Opportunity interest rate is 8 percent ction cost is Rs.
per annum. The transacti 100
 Cappital m,
Working Ca
64
Finance yement (MU)
65
000) ee ss 32
OptimumCash Balance C
= 000)
(4“B 0.75
12
40000 43 7
3265,
No. of transactions ina month =

Total costs
3
3

Minumum
Cash balance
Transaction costs

c Cash balance

Fig. 6.4.2 : Optimal cash balance

6.4.3(B) Determining Optimal Cash Balance Under Conditions y

Uncertainty - Miller-Orr’s Cash Model
© Baumol’s model is based on the assumption that payments can be accurately Predicted,
However,in practice cash inflows and outflows are uncertain. The model assumescash inflows
and cash outflows are stochastic i.e, each day a business may have both different cash
payments anddifferent cash receipts and the daily cash balanceis normally distributed. '

The Miller-Orr modelplaces an upper and lowerlimit for cash balances. Whenthe upperlimit
is reached,a transferof cash to marketable securities is made. Whenthe lowerlimit is reached,
a transfer from securities to cash occurs. A transaction will not occur as long as thecash
balancefalls within the limits. Securities are sold for the value such so thatthe cash balance
rises to the Return Point |
Return Point = Lower Limit + ix Spread

UpperLimit = Lower Limit + Spread

The equation forcalculation spreadis as follows :
3
3) (0) (c)
Spread = 3x ‘Axk

Where
C- cost pertransaction cost
k- opportunity cost of holding cash
o° - variance ofa daily cash balance.
ee
 management (MU) 6-32
w
nae
forking
plainedby 'Y bel ch, . of cash b;
below chart Capital Management
mille
' t n balance with time

}
Upper trenit

Return point
+~ Sale of securities

Lowar limit

Time:
Fig. 6.4.3 : Chart

When the actual cash balance drops to the

lower limit, cash balanceis increased
return point, which can be done byselling inve
stments in marketablesecur ities, mente te
+ When the actual cash balance touchesthe upper limit. In
such cases, it is necessary to bi
marketable
° securities and restore the cash balance down to the return point. The am 101rn tte
be
invested is the difference between the upper limit and return point.
mone
tiustration
The management of a company has set a-safety cash balanceof Rs. 750,000. The standard
deviation (0) ofthe daily cash balance during the last year was 375,000, andthe transaction cost
was Rs. 1000. The company also hasthe opportunity to invest idle cash in marketable securities at
anannualinterest rate of 8%.

Daiily interest rate = 8%

365 = 0.022%

3
Spread = 3x 3) (375000: S500 1000)

(gs)
Spread = 506481
Return Point = Lower Limit + 4x Spread

750,000 + Soest = 918827

Upper limit Lower Limit + Spread

750,000 + 506481 = 1,256,481
 inance Mat gement (MU) 6 Working Capital Man,

Q.1 Explain the concept of working capital, gross working capital and net working capita),
a2 Explain the concept of operating cycle and cash cycle.
a3 Explain the importance of working capital management.
.
a4 List the tactors affecting working capital and explain in bref
ntory management, oat
as Explain the trade-offs in optimum working capital management, inve
management, receivables management.
economic order aun,
aé Whatis economic order quantity and whatis the trade-off for deciding
or EOQ?
Q.7 Whatare the motives for holding cash balance?

as Whatare the three elements of credit policy in receivables management?

ag What are the different types of short-term investments available for finance Manager fc
investmentof excess cash?

Qag
 Sources of Finance
and Capital Structure

A of Finance : Long Term Sources - Equity, Debt, and

Hybrids; Mezzanine Finance: Sources of
got TTD Finance - Trade Credit, Bank Finance, Commercial Paper, Project Finance.
structure : Factors Affecting an Entity’s Capital Structure; Overview of Capital Structure
and Approaches - Net Income Approach, Net Operating Income Approach; Traditional

n, and Modigliani-Miller Approach. Relation between Capital Structure and Corporate

vebes Concept of Optimal Capital Structure.

company needs to survive the down cycle andbeagile enoughto seize growth opportunities
anupcycle. Debt capital can be easier and faster to arrange than equity, however long-term
pact on the flexibility and survival needs to be well understood. This chapter provides
standing about the conceptofcapitalstructure anddifferent sources offinancing.
ing objectives
Long Term Sources of finance -Equity, Debt, and Hybrid, Mezzaninefinancing
Sources of Short-term finance - Trade Credit, Bank Finance, Commercial Paper
Project Finance

.1 Introduction to Sources of Finance

In the previous chapter we discussed in detail the long term and short-term investment
decision considerations for carrying out the investmentfunction offinance manager.In this
section, we will discuss the various sources offinancing and financing considerations to carry
outthe financing function.
Sources offinancing can beclassified into two broadcategories i.e.
1. Short term financing
2 Long term financi ing.
 Sources of Finance & Capital Siructure
Management (MU
a period of
finance that al re repayable within
© Short term financing includes the sources of
e than
1 year. Long term financing includes the sourc es of fina
nce that have maturity of mor
such as equity, perpetual debt etc,
1 year and include sources that have nofixed maturity
© Fig, 7.1.1 shows the typesof financing.

Fig. 7.1.1 : Types of financing

7.2 Long Term Sourcesof Financing

© Long term sources of financing are used by the companies to fund their long term or
permanentfund requirements. These are the mostcritical source offinancing for business as
these provide the necessary capital for investment required for sustained growth of the
company.
© Long term sources of finances are typically costlier than the short-term financing, however
provides more flexibility to the company.
© These are used for funding long term outlays such as purchaseofplant and machinery,land,
building, investment in permanent working capital, expansion, acquisition of companies,
assets, providerisk capital for new ventures etc.
The most commonlyused sources for long term financingare as below.

7.2.1 Equity

© Equity capitalis also called as the ownership capital or shareholders capital. It consists of
funds raised from existing and new shareholders of the company and earnings retained in the
company.
 (MU) ,
'
Se eS! Finance & Capital Structure
q
~ are re also known
_——ordi nary share: 's/common
qt ‘ stock Shareholders capital
hare premium is sum of
and retained earnings
"

from Rs. 1, Rs. S. Rs. 10 oF Rs. 100.

— company raise
ise funds and Issue
s! shares, equity capital that has been
subscribed and paid
wythe shareholders of the company iscalled asissued
and paid capital. It is equal to number of
shares that have been issued andthe face value
of shares.
«Generally, company issues new sharesto investors it issues at a
Premium to the face value to
rect the perceived market value of the company. Share Premium represents the difference
the issue price and the face value of shares, For example,issue price of IRCTC share was
Rs. 320 per share vs face valueof Rs. 10.
« Another important component of share capital is retained earnings.It represents the total

profits retained by the companyin the business after paying outthe dividend to shareholders
of the company. Retained earnings are not a source of new capital; however, it forms part of

ownership capital. As company has retained the earnings instead of distributing it to

shareholders it is considered asa part of shareholders’ capital.

7.2.1(A) Salient Features of Equity Shares

he|
* Ownership and voting rights : Each equity share represents proportionate ownershipoft
their shareholding.
company. Equity shareholders have voting rights in proportion to
ectors on the|
Shareholders are expected to vote on multiple matters such as appointment ofdir
modern times,
board of the company, new fund raising, acquisition or merger’ etc. In
s to conduct annual general
shareholders can also vote using e-voting option. A company need
onc e a yea r, whe re dir ect ors ele cte d based on majority votes.
Meeting of shareholders proxy voting. To}
t another person to vote called as
Investors can vote in person or appoin
ers , the re are reg ist ere d investment management]
old
Safeguard rights of minority shareh h net worth
xy vot es on beh alf of mut ual fun d shareholders or hig
Companies that cast pro
investors,
W Finance Management (MU) 7-4 sources of Finance & Capital Strucey

e control over the managementth

© Control over management : Shareholders can exercis:
board ofdirectors, voting on managerial compensation etc.
a residualclaim ontheassets of the compay
© Claim on assets : Equity shareholders have
the case ofliquidation.
of debt holders, financiers, gove
© At the time ofliquidation of company, claims
employees, tradecreditors are first paid off. The shareholders are paid off only the
amount.
© Limited liability : As a companyis separate legal person, shareholders of the companyare
ny
required to share any liabilities of the company. So in case offailure of the compa
financial distress etc. shareholders are not required to contribute any shortfall etc.
o
shareholderis holding the risk only to the amount that they haveinvested in the shares
company.
eright to receive
© Dividend : Whenever a companydeclares a dividend,all shareholders haveth
dividends in proportion to their shareholding.
equity share of pub!
e Freely transferable : Generally, there are no restriction on sale of
listed companies, henceshareholders caneasily sell equity shares and convert to cash.

Advantages of Equity Funding

1. Itis a source of permanentcapital for the company.It provides company flexibility to take up
riskier and long gestation projects.
2. Equity shares donotcarry anyfixed paymentsuch as interest or coupon. Paymentof dividend
is entirely at the discretion of the company.

3. Equity share capital provides leverage to raise.additional debt at moreattractive terms;

well capitalized companies are considered less risky by the financiers.
4. Equity funding allows the companyto increase shareholder base and brand nameof th
company.

Disadvantages of Equity Funding

1. Fund raising through equity can lead to dilution of the ownership and control ofthe}
promoters.
2. Fund raising through equity is costlier due to compliance cost associated with fundraising
from public.
3. Dividend paid out to the shareholders are not tax deductible, hence vis-a-vis debtit a less tax
efficient sourceoffinancing.

4. Costofequity is generally higher than debt, as investor expects higherreturnsfor the risk.
ow roance Management ent ( (MU, z
2-5 Sources of Finance & Capital Structure
A 2.1(8) Meansof Raising Equity

1, Public
under this method, the companyis raising equity capital by issuing shares to general public.
Company prepares a Prospectus containing details such as the purpose for which funds are
being raised, past financial performanceof the company, background andfuture prospects of
company.This information helps the general public to decide whetherto invest or notin this
company. Securities issued by this method are generally listed on stock exchanges and

available for sale and purchase on exchanges. There are two typesoffunding through public
issuance.
a. Initial Public Offering (IPO) : Thisis an offering by an unlisted companyforthe first time
in its life to the general public. It contains eithera fresh issue ofshares.

p. Follow-on Public Offering (FPO): This is an offer of sale of shares by an alreadylisted

companythrough anoffer documentto the generalpublic.

2. Rights Issue
This is a method ofraising of funds through issuance of new shares by the companyto existing
tion to the
shareholders. The shareholders are offered the‘right’ to buy new shares in propor
ers may accept or reject the
number of shares they already possess. The existing sharehold
hts to another
right Shareholders who do notwishto take up the right sharescanselltheir rig
er ir rights, then the
person. If the shareholders neither subscribe the shares nortransf the
companycan offerthe shares to public.

3. Private Placement
and someselected individuals.
In this method, companyallots sharestoinstitutional investors
issuanceof securities to
Ithelps to raise capital more quickly than a public issue. This involves
and without seeking permission
less than 50 persons withoutissuing prospectus Jeter of offer
limit companies or private limited
for listing for the shares. The issuers could be public
d.
companies. These securities may be listed orunliste

4. Offer for Sale

ugh-intermediaries like issuing houses or
Under this method, shares are offered for sale thro
resell the securities to the ultimate
stock brokers at pre agreed price. These intermediaries
ference between
at a mar ket rel ate d pri ce. Thi s price is generally higher and the dif
investors method is
es. This
ri ce and the iss ue pri ce rep resents profit for the intermediari
the purchasep
hot commonin India.
 Sources of Finance & Capital s:, ity

id consists of debe.
ebenty
common source of long-term finance an
Debi yt capital tal rey represents most
and term loans.

7.2.2(A) Debentures
financing for high rated cy,
attractive source of long-term
is are an
Debentures or bone! compi anies to banks or”institutig,
worthy companies. These are generally issu ed by the .
assified into twobr,
investors such as mutual funds, insurance companies etc. Debenturesarecl
Debentures (NCD) and Convertible Debentu res. mon-convert
types Non-convertible
debentures form part of debt financing while convertible debenture are considered hybrid soy

of finance.
Non-convertible debentures (NCDs)
© NCDsare long term debtinstruments and are repayable on maturity.
© Interest on the debentures is paid by the issuing company on monthly, quarterly, sey
annually or annually at fixed or a variable rate as agreed at the time ofissuance of
company.
© NCDsare either secured by the assets of the companyor unsecured.

¢ Insomecases,insteadofinterest payment, the NCDsare issued ata discountto thefaceval

of the debenture and are redeemed at paror face value. Thedifference betweenissueprice
face value represents the incomeforthe investors.
© NCDs are freely transferable and traded on stock exchangeor overthe counter market.

Advantages of NCDs

© Cost effective sourceoffinancing as NCDstypically lowerinterest rates due to

liquidity.
© NCDscan be structured to suit cash flows of the companysuch as zero coupon bonds,
mont
or annual interest payment, full repayment on maturity and
intermediate period etc.
Ownership is notdiluted in NCD issuance.
© Interest paid on NCDs is nottax deductible.

Disadvantages
¢ NCD is attractive sourceof finance only
for highly rated ‘companies.
NCD hasfixed interest and repayment
obligations. Delay in servicing of NCD inte
impact reputation of companyas inform rest can
ation ‘onlisted NCDsis freely availabl
e.
© Many NCDs have terms and condit
ions that m ‘ay impact
critical decisions. company’s
pany’s flexibility
flexibility in in undertaking
unde!
 Sources of Finance & Capital

“7.2(8) Term Loans

erm loans are oneof the most popularsourcesof long-term financ ing for medium and small
companies and are used for purposes such as for business expansion, purchase equipment,
land. building, managing cash flow etc

|, te rm loans havefixed maturity and repayable over the maturity period in regular payments.
Term loan have maturity of more than 1 year and depends on the purpose of financing

for example, term loans for capital projects are for a period of more than 5 years, while
working capital term are generally for a period of3 years.
the
Term loans can be secured or unsecured in nature. Secured term loansare the ones where
Joan Is secured by fixed asset security such as land, building, plant and machinery etc. and
these are most common.
In India, term loans are provided by banks and Non-Banking Finance Companies (NBFCs).
Unsecured term loansare provided for a smaller amounts and shortertenor.
‘The company taking a loanis called as borrower and bank or NBFC providing theloanis called
as lender. In some cases, lenders provide time of 6 months to 2 years, before recovering
regular repayments called moratorium period, to provide time for construction and
| commencement of production.
|
Advantages
« Term loans are directly negotiated between borrower and lender and are processed faster
comparedto otherlong term sourceof financing.
« Borrowerneed notrequire creditrating etc. for availing term loan.
* Information regarding delay on term loan servicing is confidential between lender and
borrower.
© Ownership ts notdiluted.
© Interest paid on term loansis tax deductible.

Disadvantage

* Term loans generally carry highercost of borrowing compared to NCDs.

* Term loans require regular repayment, hence less flexible.
company mayfind difficult to comply.
* Lending terms mayinclude restrictive covenants that
7.2.3 Hybrid Financing
as well
Hybrid financing refers to the financing instrument thathas some properties of debt
for the
‘uty. These are tailor made to balance flexibility for the company andrisk protection
lnvestors,
Bc
 e & Capit
sources of Financ
78
Finance Management ('
are
e im po rt an t fo rm s of hybrid Financing
Th

1. Preference shares,
2. Convertible debentures,
3. Warrants etc
es
7.2.3(A) Preference Shar
Prof
ri ty a! ind fix ed rat e of dividend, payable from the
ed ma tu
Preference shares carry fix div idends and assets of the co
mpany
carry pre fer ent tia l rig hts on
made by the company. These y does not make profits, it can ski
p the
e sha res . In the yea r com pan
he led as preferenc
e forthe
r the amount is added to dividend payabl
dinde ni‘ate preference shareholders, , howeve any.
pre fer enc e sha res fo rm par t ofthe net worth of the comp
next year. The
Advantages
pany, hence help improve the leverage
© Preference sl hares form part of the net worth of the com
position.
ders in the eventofloss, henceis more
¢ Company can skip dividend to preference sharehol
flexible compared to other sources of debt.
© There is nodilution of ownership or voting rights.
Disadvantages
© Preference shares generally carry higher rate than traditional debt instruments such as NCDs,
term loans etc.
© Dividend paid on preference shares is not tax-deductible.
© In some cases, preference shareholders may have right to convert to equity shares if company
skips dividend payment for some period.
7.2.3(B) Convertible Debentures
© Convertible Debentures are a type of debentures that can be converted into the equity
of the company after a stipulated timeperiod at the option of the debenture holder.In 5]
cases, issuer can also haveoption to convert debentures into equity shares.
© During the tenor of the debentures,issuer company pays interest or couponatthe pre-at
rate ofinterest.
The terms ofissuance such as conversion Price into equity share,
tenor, interest pa
frequency etc. are fixed at the timeof issuance. Convertible
debentures are mainly of 3 types:

into equity shares at the end of tenor (maturity)of the debenture. For listed companies 5
maximum conversiontenor isfixed at 18
month: s. Fe
debe ntur es can be high
re er. sc an be hi orpriv
gh er ate limited the tenor of conve!
—teb en tu
 t (MU ) 7-4 9 Sources of Finance & Capital Structure

2 convertible debentures (OCD) These debentures can be converted into equity

pF= x the end of tenor (maturity) of the debenture at the option of debenture holders. For a
° company, the maximum tenor for OCDs is 36 months
«nt
/ convertible debentures : In case of partly convertible debentures, some portion of
ar qcres can be converted into equity shares. These are not very popular.

poratages
a ple debentures help attract funding during uncertain times. It is a popular source of
song for start-ups.
. cones jsorily convertible debentures help in reducingfinancial leverageof the company.

pisodvantages
- case of optionally convertible debentures, conversion to equity dependsat the option of
deoenture holder and company mayhaveto plan for redemption.
conversion to equity can result in dilution of ownership.
Golke equity. company has to pay couponon the debentures during the tenor.

7.2.3(C) Warrants

« A warrant is a derivative instrument which provides the holder of warrants right to buy the
shares of the issuing companyata fixed pricecalled exercise price untilthe expiry date.
» Warrants be traded in the secondary market bytheinvestors.
¢ There two main types of warrants known as call and put warrants. Callable warrants entitle
investors with the right to buy shares of a companyfrom that companyata pre agreed price at
2 future date prior to expiration. When a warrant holder decides to exercise the right, company
issues the shares to the warrant holder.
¢ A Puttable warrants offer investors therightto sell shares of a companybackto that company
2.2 specific price at a future date prior to expiration.
* Warrants are sometimes issued with the preference shares or bonds to make the issue
tractive for investors and reduce the rate of dividendor interest rate’as applicable. These
warrants are detachable meaning they can be separated from preference shares or bonds can
sold separately.
Advantages

* Awarrant does not offer any votingrights to investor..

* isan instrument to attract investors during uncertaintimes.
 ; ‘on.
sion.
. Warrants are dilutive post conver equity infusior
° Due to uncertainty on conversion it may not result in new
7.2.4 Mezzanine Finance
. nine fnancing is a by debt and equity which provides the financernj,

convert mezzanine debt to equity in case of default

riskier projects and is typically used in fina

Features of mezzanine financing

to senior debt, but
© In terms of seniority of repayment mezzanine loans are subordinate
in priority over equity shareholders.
rate of interest than debt
© Mezzanine loans are unsecured in nature and carry higher
to convert into equity at pre agreed price, in
. Mezzanine lenders generally receive warrant
ty.
mezzanine loans are not repaid atthe time of maturi
debt by the company.
. Mezzanine loans can be restructured into senior

Advantages
. Interest paid on mezzanine debt is tax deductible.
n funding in
. It is an unsecured source of funding for the borrower and help obtai
projects.
. Mezzanine financing offer flexibility of structuring repayment as per cash flows.
© Owners may not lose control or dilution ifthe company meets obligations.
© Many times mezzanine financiers also bring expertise to manage business.
Disadvantages

© Lender may. put restrictive covenants on the company.

© Interest rates on mezzanine debt are typically very high.

7.3 Sources of Short-term Financing

Short term sources of finance are repayable within a period of 1 year and are used for
day today or working capital requirements such as purchase of inputs for
extending credit to customers, paymentof salaries, overheads etc.
 Finance Management (MU) TAL
Sources of Finance C: ital Structure
ommo! used sources of short
, The most commonly term financing are
4. Trade credit
2. Bank finance
3, Commercial paper.
4 Short term sources of financing are generally cheaper i available,
.
and easily hence there is a
tendency to use short term sources wherever possible. However, this
strategy offinancing is
fraught with risk. Use of short term sources for funding long term resources can lead to
shortage of fundsat the time of repayment.

+ This leads to mismatch in payment obligationsoffacilities and cash inflows from long term
investments.If the sameis not refinanced in timecan lead to financial distress, default and
bankruptcy in somecases.
» Use of short term sources to provide long term loans havebeenidentified as oneof the reasons
for somerecentfailures of the companies. Board of directions and managementshould avoid
such temptation.

7.3.1 Trade Credit

« Trade credit is an important source of short-term funding and arises due to the credit period
availed by the companyfrom their suppliers for payment.
* Credit period depends upon the industry norms,credit policy of the suppliers and credit .
worthiness of the company. Sometimes suppliers offer cash discount for early payment of
trade credit to expedite the collection.

* Depending on the amountof cash discount and availability of funding, a companycan decide
whetherto avail trade credit or pay in cash. Credit terms include cash discountrate, discount
period andcredit period. For example, “2/5, net 45’ meanscredit period of 45 days and cash
discount of 2 percent for payment within 5 days. Some companies purchase goods oncredit
capital.
andsell on cash to end customers, thus operating without any investment in working

Advantages
* Companies neednotenterinto any formal agreement orprovide anysecurity foravailing trade
credit.
grow sales.
* Itis can be availed quickly, hence fastest way to
or external debt.
* Ithelps companyto reducefinancial leverage
Disadvantages
ce to accountf or credit period interest.
* Suppliers may increase pri
A
 7-12 Sources of Finance & Capital Structuy
Finance Management (MU.

* New companiesfindit difficult to get credit

© Credit period offered in trade credit is generally short.
7.3.2 Bank Finance
. Bank finance is the second most common source of short-term finance. Many large
cre dit due to cheaper rates.
creditworthy companies prefer bankfinance over utilizing
© In this modeoffinancing, banks assess the credit requirement of customersafter analyzing
sales, current assets and trade credit position and provide a credit limit to the customer
y as collateral security.
againstthe security of accounts receivables or inventor
ar. Following are the
© Credit limit is generally set for a period of 1 year and renewed eachye
mostused short facilities provided by the banks.
7.3.2(A) Cash Credit
Cash credit or CC is a working capital facility offered by the banks. In this, banks sanction a
credit limit to the business depending on the credit worthiness and position ofcurrent assets,
Followingare the featuresofcashcredit facility.

Features of cash credit facility

© Cash credit or CC limit is the credit limit granted by banks to business for meeting their
working capital needs.
¢ Cash creditlimit is sanctioned for a year of up to 1 year and must be renewed every year bythe
borrower.
© Generally, banks require collateralin the form ofland, building, fixed deposits etc. for granting
CCfacility.
© Borrowercan withdrawfunds upto the credit limit and repay as per their requirement. There
are norestrictions on the numberof withdrawals or repayments,asthis is a revolvinglimit.
© Interest is charged onthe daily outstanding balance andnotontotal limit.

Advantages
CClimitoffers high degree offlexibility as business can borrow and repay anytime duringthe
year.
Interest is payable on the outstanding amount andnot on thecredit limit.
¢ Noprincipal repaymentrequired and only interest is charged at the end of every on
the
average outstanding balance.
finance Management (MU
(MU) 7-13 Sources of Finance & Capital Structure

pissdvantages
cash credit limit need to be renewed every year
panks generally restrict the limits only upto the extent of net current assets with
a margin of
25%. In case of shortfall in the amount of underlying current assets, banks may require
companies to repaytheshortfall amount and reducethe limit.
Banks may charge a minimum fees or commitment charges to ensureutilization of CC limit.

7.3.2(B) Overdraft

Underthis facility banks allow the customerto draw funds over and abovethe balancein the
current account upto a certain fixed limit, called an overdraft limit. This limit operates similar to
CC facility and need to be renewed every year. The limits granted under this facility are smaller in
size and carry higher rate ofinterest.
7.3.2(C) Bill Discounting
Underthisfacility a companycandiscounttheinvoiceorbills for the goods orservicesbilled to
its customers. Company approaches bankwith thebills accepted by its customers and banks
makes the paymentto the companyafter deducting applicable discount charges.
« On the due date, bank collects the payments from the customer of the company. Before
discounting thebills or invoices bank checks the creditworthinessofthe customerto which the
amountis billed. The bank requires thebills to be duly accepted by the customer.
¢ With large scale of implementation of enterprise resource planning or supply chain
managementsolutions, thebill discounting has movedto electronic platform and acceptance of
this product has increased.

7.3.3 Commercial Paper (CPs)

¢ Commercial paper is a short-term unsecured money market instrument with a maturity

ranging from 7 days to 364 days.
© Companies having a good credit rating can raise workingcapital funds by issuing commercial
papers.
* Accompany issuing commercial paper needto obtain credit rating of the proposed issuance
by banks, mutual funds,
from the credit rating agencies. Commercial papers are subscribed
insurance companies etc.

Features of commercial paper

at face value. The difference
© Commercial papers are issued at a discount and red leemed
incomefor investor .
betweentheissue price andface value represent theinterest
 7-14
Vv Finance Management (MU)
les thereof.
omi nat io ns of Rs . 5 lakh or multip
in den
© Commercial papers are issued
ble.
© Commercial papers arefreely transfera
:
Advantages
e for large companies,
ital financ:
© Commercial paper is cost effective source of working cap
e [tis unsecured in nature.
tie s upt o lye ar dep end i on the req
ing ‘q' uirement
© Itcanbe issued for differ ent mat uri
ty..
riity
i the matutur
ci al pa pe rs do no t re qu ir e an y interest outflowtill
Commer
Disadvantages
and
of com mer cia l pap er invo lves rati ng cha rges, stamping charges, issuing
«Issuance
nancing for smaller com panies.
agentchargesandis notviable source offi
be reported widely and can dent repu
© Anydelay in repaymentof commercial paper can
of the company.

7.4 Project Finance

© Project finance refers to long term financing for infrastructure, industrial projects
funding is mainly provided onthe strength ofthe project cash flows and is secured by
assets ofthe project, including any long-term revenue agreements. Lenders have noreco!
orlimited recourse to the sponsors (investors) of the project, which means thatin casedet
lenders cannot ask the sponsors to make payment. Typical examples of project finance
airports,roads, mines,oil blocks, power plants etc.
© In theproject finance,a separate legal entity called as Special Purpose Vehicle (SPV) is crea
by investors (or sponsors). The SPV owns the project and funding is raised by
the SPV.

Project or pay some fixed penalty f

. some of the important Parties involve in the bss of oe
5 of project are
are the providers of +
sponsors : Thereted
L ina lo p *rs Of theinitial capital for the project in the form of equity
and/or subordinated loans. The sponsor wil normally ve experience in the relevant sector
and will support the project company by Providing
skilled personnel
2. Special Purpose Vehicle (SPV): This is also known as project vehicle and Is set up by the
sponsor specifically for the purposeof the Project and owns th
e project
4. Contractors : These are the entities that the Spy appoints to build and maintain the project
Sometimes SPV also appoints contractors for operating the projects

4, Offtakers : Off-takers are the parties that purchase output from the project. In most ofthe
projects, the SPVs enterinto long term arrangementswith the off takers to sale the outputto
ensure viability and reduce the risk. Manya times such long term contracts are executed with
the government agencies.
5, Banks/Financial Institutions : These are the lenders to the project and generally form a
consortium ofbankers. The cash flows and assets of the project are secured to them.
6. Specialist Advisors : These are the specialists having domain knowledgeof the industry and
provide inputs regarding the planning viability and executionofthe project.

Risks involved in project financing and management of risks

Project financing involves multiple risks such as completion risk, cost overruns, market risk,
environmental risk, foreign exchangerisk, political risk etc. Sponsors and lenders need to assess
these risks and built suitable mitigants to managetherisks.
© Completion risk : Completion risk can be mitigated by awarding turnkey contracts, taking
performance bonds from contractors.
© Cost Overrun In case of cost overruns a standbycredit, facility can be used, or lenders may
require the sponsors to guarantee to fund cost overruns.
© Market risks : Market risk refers to the risks associated with the shortfall in demandor off
take when production commences. To mitigate these, SPVs are required to enter long term
nts
contracts with the off takers or take or pay agreements. Long term purchase agreeme
ensurevisibility of revenues. In case take or pay arrangement off takers need to pay penalty in
case they don’tlift, or off take contacted quantity.
* Environmental/Governmentrisks : Many times, the projects are environmentallysensitive
and need approval from the relevant environmental agencies and regulators. Hence, the
finance documents include necessary representation and warranties regarding the necessary
approvals for the project and in case of misrepresentation the sameis treated as default.
ct. In such
Sometimes change in governmentpolicy can affect the viability of the proje
Sponsors may seek Governmentguarantees.
 DG nance Management (MU) 7.16

where projects a! re fund

© Foreign exchange risks Foreign exchange risk arises
dep
. Sharp ‘oreh
currency and revenues of projects are | in domestic currency
nt of the project and in such cases
foreign
iB!
dotnestic currency can affect repayme
can be covered through convertibility guarante .e fr
om the government Fol

explains the working of praject finance transaction

Sponwors Financial
Nanted by Shareholders Institutions/Banks
of Parent Company)
l
Equity I Debt
Grants, Subsidies Special Purpose Vehiolg]_Purchasers Ti
Hoot Government ondticencen. (sPv) of Produce otf

I 1
senn] [some]
Fig. 7.4.1 : Working of project finance

Advantages of Project Finance

© Lenders have Iimited or no recourse on the sponsor.

© Ability to undertake projects with long gestation periods,

© Project finance \s an off-balance treatmentfor financing for sponsors; so does not
sponsor'sfinancial leverage.
© Allows better tax treatmentfor the project.

© More than one sponsors can be inducted to mitigate therisk of the project.

Disadvantages of Project Finance

© Due to complex nature of projects project finance involves higher cost of

duedill
analysis, legal documentation.
© Itis very time consuming process to tie up funding underthe Project finance.

Generally, the rate of interest Is higher compared to financing with norecourse.

Lenders will generally Incorporate number ofrestrictive covenants that
operational flexibility of the project vehicles,
v Finance Management(MU.
Sourcesof Finance & Capital Structure

7.5 Capital Structure

Capital structure denotesthe wayof companyfinancesitself. Capital structure of the company

js the combination of debt and equity in the total capital of the compa
ny. Composition debt
petweenlong term andshort term debtis also considered in thecapital structure. The use of debt
and preference sharesis described asfinancial leverageortrading on equity, as they are raised on
the basis of equity position.
Theratio debt to totalcapital is called as leverage. Debt capital andpreference shares need to
be serviced with periodic interest and dividend payments. The use of financial leverage
is
double edged sword.If a firm can earn higherreturnsthat costof debt, shareholders’ earnings
will increase and if the rate of return is lower than the costof debt, it will erode shareholders’
earnings.
« Popular measuresto calculate capital structure are Debt ratio and debt to equity ratio and are
calculated as below:
2 Debt D
Debtratio = Totalcapital "D+E
Debt D
Debtto equity ratio = Equity" E

Capital structure has an impact on the shareholders’ earnings and risk and the value of the
company. Henceit is importantto have optimum capitalstructure.

7.5.1 Factors Affecting Capital Structure of the Company

Whenever a finance manager needs to decide on the financing for the investment, they
evaluate multiple financing options and are expected to choose one that enhances the
shareholders’ value. There manyfactors thataffect the capital structure of the company. These are
internal to the companyaswellas external to the company.Importantfactors affecting the capital
structure arelisted below :
Cyclicality/Stability of business : Cyclical business are expected to have large and frequent
fluctuations in sales, such firms mayfind it difficult to have stable earnings to meetfixed
expenses. On the hand,stable businesses with large base offixed assets can have steady stream
of revenues and profits. Such firms can choose to have more leverage. Examples of such
businesses areutilities as electricity companies, telecom operators etc.
Cost : Cost of financing is an important consideration for deciding onfinancialleverage. The
Costs ofraising funds throughdifferent sources offinance are considered and cheaper source
of finance is chosen.
 Struct
Sources of Finance & Capital
W Finance Management(MU) 7-18
ssocl i ising of funds su
Costs : Floatation costs refer to the costs associated with ra ne
Floatation aes ; the prospectus,
prospec
commission, underwriting fees, expenses On
processing fees, broker's
ctive.
Higher the floatation cost of a source, theless attra
q
Control Considerations: If the issuance of mo re shares : tion
may lead to substantial dilu
* je equity issuang
promoter shareholdingorloss of control, company may notconsider th
fund raising and will prefer debt funding.
e : Inte rest is tax dedu ctib le exp ens e, higher the tax rate large is the value
© Tax Rat
on int ere st exp ens e and lowe r is the afte r tax cost of debt. Hence a highertax ra
savings
makedebtrelatively cheaper and moreattractive.
© Capital market condition : When the capital markets are booming, fi irms can find it
valuation. Hence, in booming markets}
raise funds through equity and command higher
ate placement.
firms make a beeline to raise funds through IPO orpriv
intense competition are likely
© Competition : Firms operating in industries with
leverage to avoid the ris!
pressure on earnings, hence are expectedto limit the financial
7.5.2 Capital Structure Theories
capital structure
Capital structure theories aim to establish relationship between
sedas belo
marketvalueofthe firm. Importantcapital structure theories have been discus
7.5.2(A) Net Income Approach

© Net income approach proposed by Durand in 1952, suggests that value ofthe fi
increasedby increasing the financial leverage.

Assumptions

© Cost of debt is generally lower than the cost of equity as the weightageof debtin tote
increases, WACC goes down. ;

¢ Net income approach assumesthatthe cost of equity and cost debt remains con
increase in financial leverage.
¢ Accordingto this approach, cost ofcapital ofthe firm changes with the changein th
leverage. Company’s capital structure has two elements i.e. debt and equity.
© Weighted averagecost ofcapital also known as WACCis thecostofcapitalfor thefi
sum of the weighted averagecost of equity and debt.
WACC= Costof Equity x Equity weight + Costof Debt x Debt weight
In this approach,
Value ofthe firm Value of equity + Value of debt
_ _Net income Interest
~ Costof equity Cost of debt
 Value ofthe firm = -—Net operating income
Weighted averagecost ofcapital
- No
WACC
Where
x,-Cost of Equity
ky- Cost of Debt
wACc - Weighted averagecost ofcapital.

Iilustration
ABCLtd has EBIT(i.e., Net Operating income) is Rs. 50,000;cost
ofequity (ke) at 15% and cost
of debt (ka) at 8%. Total capital is Rs. 400,000. Calculate cost of
capital and valueofthe firm under
different combinations ofcapital structure ie. using leverage (debtto totalcapital) of 20%, 50%,
80% and 100%.

Answer
Investment 400,000 400,000 400,000
Debt ratio 20% 50% 80%
Debt Amount 80,000 2,00,000 3,20,000
Interest rate 8% 8% 8%

Net Operating Income(EBIT) 50,000 50,000 50,000

Less: Interest 6,400 16,000 25,600

Earnings for shareholders (NI) 43,600 34,000 24,400

Cost of Equity (Ke) 15% 15% 15%

Market Value of Equity (NI/Ke) 2,90,667 2,26,667 1,62,667
Market Value of Debt (Debt
amount) 80,000 2,00,000 3,20,000

Total value of the firm (Debt +

Equity) 3,70,667 4,26,667 4,82,667

From the above example,it is clear that the valueoffirm increases at the proportion of low
Cost capital i.e. with increase in debtcapital. Net income approach assumesthatthe costof equity
remains the constantwith the change in leverage.
‘Tock!
 nce & Capit.
sources of Fina
7-20
W Finance Management (MU)
NOI)
7.5.2(B) Net Operating Income ( ing i
he fi rm de pends on net operat
Net operating income theory states that thevalueof t
pital | st ru ct ur e of the firm. This theory
ndent oftheca|
and risk of the business andis indepe
developed by Durand.
Assumptions
operating incom: e and the as sociated business tisk
Valueof the firm is dependent on the
ected by the financial leverage.
firm andboth thesefactors not aff
pit al an d th e va lu e off irm are independ lent ofthe fi
¢ The weighted average costof cal
leverage.
tisk
mes tha t the equi ty inve stor s will dem and higher returns to compensate
© It assu
increase in proportionofleverage.
As perthis approach,

Total Market Valueof the firm (V) = err

V= D+tE
E = V-D
As costof debtis constant

Kw- Overall costoffirm

D- Market value of debt
E - Marketvalueof equity
NOI- Net operating income

Illustration
Debt ratio 20% 50% 80%
Debt Amount 80,000 2,00,000 3,20,000
Net Operating Income(EBIT) 50,000 50,000 50,000
Less: Interest 6,400 16,000 25,600
Earnings for shareholders (NI) 43,600 34,000 24,400
WACC (kw) 11.5% 11.5% 11.5%
Valueof the firm (V) 4,34,783 4,34,783 4,34,783
Market Value of Debt (D) 80,000 2,00,000 3,20,000
Market value of equity E=(V-D) 3,54,783 2,34,783 1,14,783
Cost of equity (NI/E) 12.3% 14.5% 21.3%
 finance Management (MU) 721
Sources of Finance & Capital Structure

In the eeeven under the NOI approach valueof the firm remainsconstant with change
inleverage as the Proportion of low cost debtis offset byincrease in costof equity.
Cost of Equity (k,)

zg
a8
é Weighted Average
3 Cost of Capital
3 (WACC)
3
Costof Debt (Ky)

Lei
Degree of Leverage

Fig. 7.5.1 : Diagrammatic representation of NOI approach

7.5.2(C) Traditional Approach

Traditional approach is intermediate between the net income and net operating income
approach. As per this approach,it is possible to reduce costof capital by using optimum mix of
debt and equity. Cost of capital for the firm will reduce and marketvaluewill increase as the share
of debt in the total capital reaches optimum level, after which costof capital will increase and
market will decline as equity shareholders more returns for the increased risk. Traditional
approach is based on following assumptions :
(a) The cost of debt capital remains constantup toa certain level and thereafter rises.
er
(b) The cost of equity Capital remairis constant more or less up to a certain level and thereaft
increases rapidly.
Traditional approachcanbe illustrated in Fig. 7.5.2.

Cost of
Capital

Ke waoe

Ka

x Levelof Leverage

Fig. 7.5.2: Traditional approach

 Finance Management (MU) +: iP S
Sources of Finance & Capital
W

7.5.2(D) Modigliani - Miller Approach to Capital Structure

Modigliani and Miller approach advocates that the change in capital structure does not
impact on overall cost of capital and value of the firm. This approachis similar to net op
income approach and recognizes only the net operating income and risk of investment as
impactingcost of capital and value of the firm.
Modigliani - Miller approach is based on following assumptions:

© Thereare notaxesi.e, incometax or tax on dividend.

© Therenotransaction cost for buying andselling securities.
© Thereis no bankruptcy cost.
© There is a symmetry of information betweenthe investors and company.
Investors will behaverationally.

Modigliani- Miller approach in real world

In practice however corporations have to pay taxes on income and dividend mayalso be
Further, there are transaction costs involved and information asymmetry also prevails. Hen
the extentof thesefactors, financial leverage reduces WACCandincreasesthe valueofthe fi
7.5.3 Elements of Capital Structure

While planningcapital structure of a company,the finance manager needsto consider va

elements ofthe capital structure. Someofthe important elements are as follows :
© Capital mix : This represents mix between sources offinancei.e. debt and equity. Comy
should decide a target capital mix suitable for its business and try to achieve the same
deciding in financing new investment. With additional debtcostoffinancial distress will
higher and companywill need to incur floatation cost. For issuance of new shares Com
will need to incur floatation costs and may also lead to dilution of control of exi:
shareholders. Hence, in terms of preference, companies will first use retained earni
followed by debt and fresh equity.
e Maturity and priority : This refer to the maturity of debt obliga
tions and priority
repaymentofdebt holders. Longer maturity debtprovides flexibility to the compan
y.Sho!
maturity debt is cheaperbutrestrict the flexibility. Companies prefer to match
the maturiti
of the debt with the cashflows,by financing short term assets using short term
debtandlo:
term assets using longterm debt. However,thereis not always 100% matching and somet
im
companies use short term debt to finance long term assets for
a temporary period ai
gradually refinance using long term debt.
¢ Terms and conditions : This refer to the terms and conditions Prescr
ibed by lenders or
providers when a company avails financing.
 . in gets,
financial targets,
restriction on dividends etc. ani id form part of the agreements. Companies
. need to carefully
negotiate and ensure that the operational
flexibility and strategic objectives of the compan
and interests of shareholders are not compromised. pany
. currency = Companies need not depend on single currency for its financing needs. Large
companies can raise fundsin foreign currencies such as Dollar, Japanese
Yen, Euroetc. to take
advantage of favourable interest rates and depth of the markets. However,currency risk
needs
to be keptin mind and needto be managed by hedging the repaymentobligations. Companies
having large foreign currency income need not actively hedge repayment, others
need to hedge
the exposure in currency market using appropriatefinancial instruments,
+ Financial market segments : This refers to the various market segments which a company
can tap for raising finance to suit its requirements. For example, company use domestic or
foreign market for a long-term financing. Company can raise financing using bilateral
arrangements or consortium of banks. It can choose finance from banks orraise funds by
issuing debentures in the capital market. Companies having large funding requirements prefer
to diversify the sources of funding to avoid dependence onsingle financier or market.

7.5.4 Optimum Capital Structure

The optimum capital structure is that capital structure that leads to the maximization of the
value of the firm and minimizing cost of capital. The use of debt capital in capital structure
increases the earnings pershare asthe interest on debtis tax deductible. However, higherlevels
of debt in capital structure leads to increasein costoffinancial distress and cost of equity, thus
adversely affecting the market value of shares. Optimum capital structure balance trade-off
between higher earnings per share and costof financialdistress to maximize the marketvalue of
the firm.
Following theories provide different approachesfor deciding an optimum capital structure :
(@) EBIT-EPS analysis : EBIT-EPS analysis is an importanttool for designing the optimal capital
structure framework ofthefirm.EPS i.e. earnings per share denotes the earnings available to
shareholders. As per this approach, optimum capitalaims to maximize the EPS for a range of
EBIT {.e. earnings before interest and taxes. EBIT of the companies fluctuate with change in
sales and profit margins. If the interest costs are high for companies havinglarge fluctuations
in EBIT, the EPS can turn negative when EBIT fall substantially. Hence, companies having large
EBIT canuse relatively
fluctuations in EBIT should use less leverage. Companies having stable
higher leverage or debt. Financial break-even pointandfinancial indifference points help in
deciding the leverage.
 7-24 Sourcesof Finance & Capital Stru
wv Finance Management (MU)

's EPS is about 2

s the level of EBIT for which the firm
(b) Financial Break-even : It denote k-even point, companyc
stantially higher than the brea
the estimatedlevel of EBIT is sub
debt to the capital
strug
ref ers to a poi nt wh er e two different capital
(c) Financial Indifference Point : Thi: is
diff eren t leve ls of EBIT . When the EBIT exceeds over the
produce sameEPS for
t
financial indifference, company can fund using more deb
analysis, company Ww!
(d) Cash flow analysis : In the cash flow
ing.
servicing of debt and accordingly plan the fund
flows ie. post-tax EBIT after making adjustment for
ayment of debt as per the repayment sch
includeinterest on the debt and contracted rep .
tool to measure the repayment capacity
Cash flow analysis is a very important
profi t may not alwa ys trans late into cash duriny g that period or decline in profit mi
Net
necessarily impact cash generation. For example, comp:
any may be planning higher sale
funds in higher credit and
profits in coming periods, however it may have to bl lock
into higher cash generatit
inventories. In such cases, higher profit may not transl: late
company may not beable service larger debt payments.
of the forecast period and debt
Cash flows and debt obligations are plotted for each
lated. Debt service coveragei.e.
coverage and debt capacity of the company is calcu
age ratio indicates the capability
cash flows to the debt obligations. Debt service cover
debt that a companycan sel
companyto service debt. Debt capacity represents total
position represents room avail
the period. Difference between debt capacity and debt
companyto raise debtin the case of requirement.

Review Questions |

Sources of finances
.
Qa Compare thefeatures of equity shares, debentures and preference shares
a2 Whatare the characteristics and advantages of equity financing?
a3 Discuss various means ofraising equity financing.
a4 Expiain the features of debentures. What are the types of debentures?
as Explain the pros and cons of debentures.
a6 Explain the advantages and disadvantages ofpreference shares?
a7 Whatis the difference between term loan and debentures?

@.8 Whatis warrant?

@Q.9 Enlist different sources of short term financingfora firm.
Q.10 Compare commercial paperwith cashcredit facility.
 7-25 Sourcesof Finance & Capital Structure
Finance Management (MU)
att Why is commercial paper notsuitable for small companies?
at Why is project financing suitable for financing infrastructure projects?

13 Howis the risk in project finance is managed?

capital structure
at ‘What is capital structure?
unlevered
Why the value oflevered firm (having leverage)is always greater than the value of
a2
firm when corporate profits are taxed?

@.3 Discuss advantages and disadvantages of using equity and debt in the capital structure.
equity of
0.4 Total equity capital of ABC Ltd is Rs. 40 Lakh and Debtcapitalis Rs. 60 Lakh. Costof
e cost of
ABC Ltd is 14%, cost of Debtis 10% and tax rate is 30%. Calculate weighted averag
capital.
as Discuss factors affecting the capital structure of the firm.

@.6 Whatarethe elements of capital structure of the firm?

@.7 What are the approaches to decide capital structure of the firm?
cture.
@8 Whatis the optimum capital structure? Discuss the elements ofcapitalstru
Q00
 8 Dividend Policy

Dividend Policy : Meaning and Ir importance of Dividend Policy; Factors

Affecting an Entitys
s
Decision; Overview of Dividend Policy Theories and Ap} proaches-Gordon' Approach,
Dividend
Walter's Approach, and Modigliani-Miller Approach.

{
Learning Objectives
Meaning and Importance of Dividend Policy
Factors Affecting an Entity’s Dividend Decision
’
Overview of Dividend Policy Theories and Approaches - Gordon's Approach, Walter
4
Approach, and Modigliani-Miller Approach

8.1 Introduction to Dividend Policy

}
Dividends are payments made by a company to the shareholders of the company. Most
dividends are paid in the form of cash. Dividends is the most common approach fol
distribution of profits to the shareholders, other being buybackof shares or bonusshares. Part
of the profitgets distributedto the shareholders. 4
Companies can choose to distribute part of the earnings to shareholders andreinvest the
balance in the company. Theratio of the dividend andthetotal profits is called dividend’
payoutratio andtheratio of reinvested amounttototalprofits is called as retentionratio. i
Board ofdirectors of a companyformulate a dividendpolicy outlining guidelines of dividend
distribution. Dividend policy has the parameters for payment of dividends to shareholders.
such as frequency, amount, timing of dividend and depends on thefinancial position of the
company.
It determines the dividend income that equity shareholders will earn, amountof own equity
available for business requirements. Dividend policy also shapes role in attaining desired
capital structure for the company.
 Finance jement (MU;

importance of dividend Policy

1.

company expects growthin profitsin future.

Discipline management: Sound div
idend Policy provides guidelines for div
idend payout and
restrict management from takingreckless outlan
dish investment decisions.
Influences stockprice and value : Dividend Payout Is one of the important
consideration for
valuation of companies, hencea changein dividend Policy influences the share
price.
Influence institutional Investors ; Balanced divided dividend Policy sends strong signals
about the company’scapitalallocation policy and helpattract institutional investors.

8.1.1 Types of Dividend Policy

Constant dividend policy In this policy, the company decidesa fixed amount ofdividend for
the shareholders.In this policy dividend amountdoes not changeperiodically.
Constant payoutpolicy : In this policy, the company pays fixed percentage ofprofit as
dividends. The dividend amountgrowsordeclines with changein profits.
Residual payoutpolicy : In this policy, the company paysresidual amountfrom profits after
accounting for planned capital expenditures.
Irregular dividend policy : In this policy, the company does not have fixed amount or
schedule for dividend payoutandit is at the discretion of the management.

No dividend policy : In this policy, company has policy to retain all the profits for
reinvestmentand doesnot pay any dividends.

8.1.2 Factors Affecting Dividend Decision

Legal rules : Company needsfollow the rules and guidelines per the local government. In
India, Companies Act, 2013 lays rulesfor distribution ofdividends.
Funding requirements : Thefirm should consider the funding requirements and cash flow
position of the companyto decidethe dividend decision. For this purpose, projected cash flows
are of particular importance.
Investment opportunities : One of the significant factors of affecting dividend decision is
availability or lack of investment opportunities.
 8 Dividend poy,
© Firm having attractive investment opportunities are likely to postpone dividend Payments to
future period and reinvest earnings in the business, while firms lacking good investmeng
opportunities will like to have higher payouts.
« Contractual restrictions : Many times loan agreements with lenders restrict the divideng
payment to shareholders, companies need to comply with such restrictions while
announcement ofdividends.
Liquidity position : Liquidity of a companyis an important consideration in many divideng
decisions. Greater the cash position and overall liquidity of a company,the greaterits ability tg
pay a dividend. In the low interest rate environment firms mayprefer to borrow funds and be
more liberal in dividend payout.
* Access to capital market : Firms having easier access to long term capital markets are less
dependent oninternal funds and are moreflexible in dividend decisions.
Stage of the business : In the growth stage, business needs funds for investment and will like:
to reinvest more profits for growth and limit the dividend payout. In the mature stage,
company’s investment requirementis limited and they are likely to pay higher dividend
payout.
Stability of earnings : Companies having stable earnings profile are likely to have larger
dividend payout, compared to companies having large fluctuations in earnings. Hence,
companiesin the industries such as utilities e.g. NTPC Ltd or fast moving consumergoods
companies e.g. Hindustan UnileverLtd arelikely to have larger dividend payout compared to
cyclical companieslike Tata Motors Ltd.
Type ofIndustry : Someindustries are highly cyclical and show largefluctuations in demand,
while some industries have periodic investment requirements due to technological changes.
Companies operating in such industries are likely to have low dividend payoutto safeguard
against uncertainty.

8.1.3 Dividend Policy Theories

© Wehad studied in earlier chapters that equity investors earns returnsin the form of dividend
incomeandcapitalgain.
© When a company declares the dividend, equity shareholders receive the income in current .
period. When a companychooses to reinvest the earnings, equity investors expect to earn from
capital gains in future.
© Some theories propose that the company’s dividendpolicy has an impact on sharepriceof the
company, while Miller-Modigliani proposethe irrelevance of dividend income andshare price.
Let’s study.
 Dividend

Where
P,- Price per share
D,, Dz__D-- Dividendpershare per year

r- Cost of capital
Dividend discount model has two popular variations i.e. Gordon's model and Walter’s model.
8.1.5 Walter’s Model
Walter’s modelof dividend policy proposes that the dividend policy of the compan
y has an
impact on the share price of the company. According to the model proposed by James Walter,

market value of company’s shares depend on dividend payout ratio, internal rate of return and
cost ofcapital for the company.

Assumptions
Walter's model is based onfollowing assumptions.
¢ Internal financing : All investments of the firm are financed from retained earnings of the
company. New equity financingis notavailable.

¢ Constantreturn andcost ofcapital : Company'sinternalrate of return and cost ofcapital are

constant.
e Constant earnings and dividend per share (EPS) and (DIV) : Earning per share and
dividend per share of the companyare constant.
Infinite life : Companyhasinfinite life.
100% payout or 100% retention : Companyeitherdistributes 100% ofprofit or reinvests
100% profit amount.
According to Walter’s model market value per share is sum of presentvalue ofall future
dividend per share and presentvalueof gains on investments from retained earnings.

p (E-DxE
> Formula : Market price per share (Po) = +——____
 Financ: ment (MU) 8-5 Dividend p,

Where,
P- Market price per share
D - Dividend per share
k Cost of capital of the firm
E - Earnings per share
r- Internal rate of return ofthe firm.
Tilustration

The earnings per share of companyare andthe rateof capitalization applicable

to the company
fs 10 and 12% respectively. The companyis evaluating an
option to adopt a payout ratio Of 50% or
75%. Using Walter's formula of dividend payout, calculate the market
value of the company’s
share if the internal rate of return is 15%
Answer
Using Walter's formula
© For payout ratio 50% and RoE of 15%
Dividend pershare = 10 x 0.5 =5
(os x (10-5) )
0.12
Price per share P = (35) + 0.12

=42+52=94
e Forpayout ratio of 75% and RoE of 15%
Dividendper share 10 x 0.75 = 7.5
(e18 10 - 7.5 )
( 7.5 0.12
Price per share P = d1z)* 0.12

=62+26=88
As theinternalrate of return is higher, higheris the retentionratio, higherthe retention higher
will be the shareprice. In fact share price will be maximized whentheretention ratio is 100%.

Implications of Walter's model

¢ For growth firms : In case of growth firms internal rate of return (r)> cost ofcapital (K),
shareholders of such firms will maximize value by reinvesting all the earnings. The optimum
payoutratio for suchfirms is zero.
¢ For normal firms In case of normalfirms, internal rate of return (r)is equalto costof capital
(k). For such firmsdividendpolicy has no impact on share policy and dividend payoutratio is
optimum.

Wissen
 'ernal rate of
the dividends elsewherefor betterp Prefer to have 100% return (r) is less than cost of
eturns, Payout ratio as they can invest
ymitations of Walter's mode

8.1.6 Gordon’s Model

Myron Gordon's model proposesthat the market valueofth
all future stream of dividends. fe shares is sum ofpresent value of
Gordon's modelis based on the assumption that the stream of
future dividends will grow at
some constantrate in the future for aninfinite time. The model is helpful in assessing the value
of
stable businesses with strongcashflow andsteadylevels of dividend growth.
Gordon's modelis based on following assumptions:
« Internal financing : All investments ofthefirm are financed from retained earnings of the
company. New equity financing is notavailable.
¢ Constant return andcost ofcapital : Company’sinternalrate of return and costofcapital are
constant.
¢ Constant retention : Company’s retention ratio i.e. ratio of retained earnings to profits is
constant.

¢ Constantrate of growth : Company's earnings are growing atconstantrate of growth.

¢ Infinite life : Companyhas infinite life.
«Cost ofcapital Is greater than rate ofgrowth : Cost of capital ofthefirm is greater than rate
of growth.

« Notaxes : There are no taxes on earnings.

Dy D2 D3 Po
Py = Ten Gb Gen OW
3 , Dii+
D(i+g) Dire, Dies g)”
D(1 +g)”
Po = ak) * (tke (1K “aen
where,
P- Price per share

D- Dividend per share Waterss

 Di ividend Py : 4
8-7
Finance Management (MU)

g- Rate of growth in dividend

k - Costofcapital

> “Kea+g)
Formula:. Po = Dit (kg)
y =__D s

x Payout ratio
Dividend = Earnings per share
bis the retentionratio.
Payoutratiois 1- retentionratio ie. 1- b, where
J
> Formula : Po= €, =e}

n ratio
Growth rate g can be estimated using return on equity and retentio
g = ROE~ Retention ratio = ROE xb
(r) or
Earningspershare can be expressed as Assets per share (A) x Rateof return
E, rxA

Illustration |
value of Rs:10
A Companyhas totalassets of Rs.500,000 divided into 10,000 shares with face
on
per share. Companyhaspolicy of 50% payout ratio and capitalization rate of 12% and return
y’sshare.
assets of 15%. Using Gordon's method,calculate the market value of the compan

Answer
D :
As per Gordon’s model, share price P= ko
_ E(l-b) |
“ (k-g)
. x (500,000) _=75
_ (0.15)70,000 a
Ei = rxA=

g = bx r=0.50x 0.15 = 00.75 or 7.5%

P= 7.5 (1- 0.5) y
(0.12 - 0.075) .
3.75 ;
* 0.045
P = 83
Price per share is Rs. 83.

Implications of Gordon's model

¢ For growth firms : In case of growth firms internal rate of return (r) > cost ofcapital ®, |
marketprice of share (Po) will increase with increase in retention ratio (b).
 finance Management (MU
Dividend Poli

w- For suchfirms,dividendpolicy has no impact on share poll icy.

for declining firms : In case of declining firm: Ss internal rat
.
capital (K),valueoffirm will decline with increase in retention vrata (0) 5 less than cost of

umitations of Gordon's model

. No external financing : Walter's assumption of no external financingis
not practical. 1 1
world, companies have access to external financing. —!
. constant t rate of return and Cost of capital : Walter’s assumption
of constant costof capital
and internal rate of return for the entire life of companyis unrealistic. Company's marginal
cost of capital or rate of return are subject to change with more competition in real world.
8.1.7 Dividend Irrelevance - Modigliani- Miller Approach (MM)
Modigliani Miller approach putforth by Franco Modigliani and Merton Miller in 1961 states
price
that dividend decisions are irrelevant for the share of the company. According to this theory
of share Is only influenced by earnings per share.

assumptionsof the model

capital markets are perfect i.e. all
Perfect capital markets : This model assumes that the
ors are rational, there are noflotation or
investor have accessto free information, all invest
transaction costs.
atively both dividend andcapital gains are taxed
e No taxes : There are no corporate taxes, altern
at samerate.
capital gains It is assumed that
« Investoris indifferent between dividend income and
andcapital gain income andonly concerned
investoris indifferent between dividend income
abouttotal income.
dends
s can forecast future market prices and divi
¢ No risk or uncertainty : All the investor e
exist. This meansthat discount rate is sam
with uncertainty andrisk of uncertainty does not
for all securities and forall periods.
est ment policy
© Investmentpolicy : Thefirm has fixed inv
Price per share as per MM approach is
: Di+Py
Po = 44k

> Formula : Py = Po (1 +k)— D1

where,
share at the end of a period
P, = Market price ofthe
Wren
 8-9 Dividend p,
a peri og
Py = Market price of the share at the beginningof
k = Cost of capital
period
D, = Dividends received at the ehd ofa

Limitations of Modigliani - Miller Theory

© Perfect capital markets do notexist, information asymmetry exists. Taxes are present in the —
capital markets.
According to this theory, there is no difference between internal and external financing,
However,issuanceof new securities involves floatation costs.
Taxes are present, further is most of the markets capital gains and dividends are taxed
differently.

Qt Why Is it important to have a dividend policy for a firm?

a2 Elaborate the factors affecting dividend policy.

a3 A firm is expected to declare a dividend of Rs.10 next year and has a payout ratio of 60%,
Companyintemal rate of retum is 16% and cost of capital 12%. Calculate the market price of
share using Gordon's model.
a4 What are the assumptions of MM theory on dividend policy? “7
—
gaa