Unit 5

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Business
Organisations
Notes
FORMS OF BUSINESS
ORGANISATION
Y ou have studied in the first lesson about the business, its significance and the
classification of business activities. You are also aware that these activities are carried
out by individuals in an organised form of a business house having different patterns of
ownership and management. A single individual may own the business or a number of
individuals may come together to own the business jointly. So, based on ownership, we
have different forms of business organisation like a proprietary concern, a partnership firm
or a company. In this lesson, you will learn about the various forms of business organisation
(excluding a joint stock company), their characteristics, merits and limitations, suitability
and the steps involved in their formation.
OBJECTIVES
After studying this lesson, you will be able to:
• explain the concept of business organisation;

• state the meaning and characteristics of Sole Proprietorship, Partnership, Joint Hindu
Family Business and Cooperative Societies.
• identify the merits and limitations of these forms of business organisation;
• describe the suitability of these forms of business organisation; and
• explain the steps in the formation of these business organisation.
5.1 BUSINESS ORGANISATION

You have already learnt about the meaning of business and the various types of business
activities like industry, trade, transport, banking, insurance etc. If you observe these business
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activities carefully, you will realise that whatever business activity one may take up, he has
to bring together various resources like men, money, materials, machines, technology, etc.
to carryout that activity successfully. Not only that these resources are to be put into action
in a systematic manner to achieve the objectives of business.
Notes
Let us take the example of a rice mill. First, the owner will have to acquire a land, construct
a building, buy machines and install them, employ labour to work, buy paddy and then
process the paddy to produce rice that will be sold to the customers. Thus, to produce
rice from paddy you need to assemble resources like land, building, machinery, labour
etc., and put these resources together in action in a systematic way. Then only it becomes
possible to produce rice and sell it to the customers, and earn profit.
Thus, to carry out any business and achieve its objective of earning profit it is required to
bring together all the resources and put them into action in a systematic way, and coordinate
and control these activities properly. This arrangement is known as business organisation.
5.2 FORMS OF BUSINESS ORGANISATION

Have you ever thought who brings the required capital, takes the responsibility of arranging
other resources, puts them into action, and coordinates and controls the activities to earn
the desired profits? If you look around, you will find that a small grocery shop is owned
and run by a single individual who performs all these activities. But, in big businesses, it
may not be possible for a single person to perform all these activities. So in such cases two
or more persons join hands to finance and manage the business properly and share its
profit as per their agreement. Thus, business organisations may be owned and managed
by a single individual or group of individuals who may form a partnership firm or a joint
stock company. Such arrangement of ownership and management is termed as a form of
business organisation. A business organisation usually takes the following forms in India:
(1) Sole proprietorship
(2) Partnership
(3) Joint Hindu Family
(4) Cooperative Society
(5) Joint Stock Company
Let us now learn in detail the exact nature of these forms of business organisation, excluding
Joint Stock Company which will be taken up in the next lesson.
5.3 SOLE PROPRIETORSHIP

Gopal runs a grocery shop in the local market. He buys goods from the wholesale market
and sells it to the customers as per their requirement. By doing so he earns some profit.
He had started his business two years ago by investing Rs. 1 lakh, which he had borrowed
from his friend. Today, he is running his business successfully, earning a good profit, and
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has been able to pay back the borrowed money. He has also employed two persons to
help him in the shop. Gopal says, he is the owner of a sole proprietor concern.
Do you agree?
Before giving answer to this question, let us first know the exact nature of ‘sole Notes
proprietorship’.
The term ‘sole’ means single and ‘proprietorship’ means ‘ownership’. So, only one person A sole proprietor
is the owner of the business organisation. This means, that a form of business organisation contributes and
organises the
in which a single individual owns and manages the business, takes the profits and bears the
resources in a
losses, is known as sole proprietorship form of business organisation. systematic way
and controls the
Gopal is doing exactly the same thing. So, you can say that Gopal is running a sole activities with the
proprietorship business, and is known as a sole proprietor or a sole trader. objective of
earning profit.
You must have seen many more such business organisations in and around your locality.
Could you now make a list of such concerns engaged in different types of businesses?
1. Supreme Drycleaners
2. _______________________________
3. _______________________________
4. _______________________________
5. _______________________________
Definition of Sole Proprietorship
J.L. Hanson: “A type of business unit where one person is solely responsible for
providing the capital and bearing the risk of the enterprise, and for the management
of the business.”
Thus, ‘Sole Proprietorship’ from of business organisation refers to a business
enterprise exclusively owned, managed and controlled by a single person
with all authority, responsibility and risk.
Now you can workout certain characteristics of sole proprietorship form of business
Characteristics
organisation. § Single Ownership
§ No Separation of
5.3.1 CHARACTERISTICS OF SOLE PROPRIETORSHIP FORM OF BUSINESS Ownership and
ORGANISATION Management
§ Less Legal
(a) Single Ownership: The sole proprietorship form of business organisation has a single Formalities
owner who himself/herself starts the business by bringing together all the resources. § No Separate Entity
§ No Sharing of
(b) No Separation of Ownership and Management: The owner himself/herself manages Profit and Loss
the business as per his/her own skill and intelligence. There is no separation of ownership § Unlimited Liability
§ One-man Control
and management as is the case with company form of business organisation.
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(c) Less Legal Formalities: The formation and operation of a sole proprietorship form
of business organisation does not involve any legal formalities. Thus, its formation is
quite easy and simple.
(d) No Separate Entity: The business unit does not have an entity separate from the
Notes
owner. The businessman and the business enterprise are one and the same, and the
businessman is responsible for everything that happens in his business unit.
(e) No Sharing of Profit and Loss: The sole proprietor enjoys the profits alone. At the
same time, the entire loss is also borne by him. No other person is there to share the
profits and losses of the business. He alone bears the risks and reaps the profits.
(f) Unlimited Liability: The liability of the sole proprietor is unlimited. In case of loss, if
his business assets are not enough to pay the business liabilities, his personal property
can also be utilised to pay off the liabilities of the business.
(g) One-man Control: The controlling power of the sole proprietorship business always
remains with the owner. He/she runs the business as per his/her own will.
Gopal is happy in running his business in sole proprietorship form because

he enjoys many benefits in doing this business. At the same time, he also
comes across many difficulties. Would you like to know the merits and
limitations of this form of business organisation? Let us discuss.
5.3.2 MERITS OF SOLE PROPRIETORSHIP FORM OF BUSINESS ORGANISATION

Merits (a) Easy to Form and Wind Up: It is very easy and simple to form a sole proprietorship
§ Easy to Form form of business organisation. No legal formalities are required to be observed. Similarly,
and Wind Up
the business can be wind up any time if the proprietor so decides.
§ Quick Decision
and Prompt (b) Quick Decision and Prompt Action: As stated earlier, nobody interferes in the
Action
affairs of the sole proprietary organisation. So he/she can take quick decisions on the
§ Direct
Motivation various issues relating to business and accordingly prompt action can be taken.
§ Flexibility in
(c) Direct Motivation: In sole proprietorship form of business organisations. the entire
Operation
§ Maintenance of profit of the business goes to the owner. This motivates the proprietor to work hard
Business and run the business efficiently.
Secrets
§ Personal Touch (d) Flexibility in Operation: It is very easy to effect changes as per the requirements of
the business. The expansion or curtailment of business activities does not require many
“Business Secrets” formalities as in the case of other forms of business organisation.
refers to keeping the
future plans, (e) Maintenance of Business Secrets: The business secrets are known only to the
technical proprietor. He is not required to disclose any information to others unless and until he
competencies, himself so decides. He is also not bound to publish his business accounts.
business strategies
etc. secret from (f) Personal Touch: Since the proprietor himself handles everything relating to business,
outsiders and it is easy to maintain a good personal contact with the customers and employees. By
competitors. knowing the likes, dislikes and tastes of the customers, the proprietor can adjust his
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operations accordingly. Similarly, as the employees are few and work directly under
the proprietor, it helps in maintaining a harmonious relationship with them, and run the
business smoothly.
After knowing the various merits of sole proprietorship form of business organisation let
us discuss its limitations. Notes
5.3.3 LIMITATIONS OF SOLE PROPRIETORSHIP FORM OF BUSINESS

ORGANISATION
(a) Limited Resources: The resources of a sole proprietor are always limited. Being
the single owner it is not always possible to arrange sufficient funds from his own
sources. Again borrowing funds from friends and relatives or from banks has its own
implications. So, the proprietor has a limited capacity to raise funds for his business.
(b) Lack of Continuity: The continuity of the business is linked with the life of the
proprietor. Illness, death or insolvency of the proprietor can lead to closure of the
business. Thus, the continuity of business is uncertain.
(c) Unlimited Liability: You have already learnt that there is no separate entity of the
business from its owner. In the eyes of law the proprietor and the business are one and
the same. So personal properties of the owner can also be used to meet the business
Limitations
obligations and debts. § Limited
(d) Not Suitable for Large Scale Operations : Since the resources and the managerial Resources
§ Lack of
ability is limited, sole proprietorship form of business organisation is not suitable for Continuity
large-scale business. § Unlimited
Liability
(e) Limited Managerial Expertise: A sole proprietorship from of business organisation § Not Suitable for
always suffers from lack of managerial expertise. A single person may not be an expert Large Scale
in all fields like, purchasing, selling, financing etc. Again, because of limited financial Operation
resources, and the size of the business it is also not possible to engage the professional § Limited
Managerial
managers in sole proprietorship form of business organisations. Expertise
Now you must have a clear idea about Gopal’s business and its merits and
limitations. Take the example of any other sole proprietorship form of
business organisation of your locality analyse its activities and try to find
out whether the points discussed above are applicable to it or not. Application
of book knowledge in real life situations will definitely help you to
comprehend and remember the facts about sole proprietorship form of
business organisation in a better way.
5.3.4 SUITABILITY OF SOLE PROPRIETORSHIP FORM OF BUSINESS

ORGANISATION
You learnt about the meaning, characteristics, merits and limitations of sole proprietorship
form of business organisations. After such a detailed study, it should now be easier for you
to identify areas in which sole proprietorship form of business organisation is most suitable.
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To assist you in such exercise, it can be stated that the sole proprietorship is suitable where
the market is limited, localised and the customers give importance to personal attention. It
is also considered suitable where the capital requirement is small and risk involved is
limited. It is also considered suitable for the production of goods and services which
Notes involve manual skill e.g., handicrafts, filigree work, jewelry, tailoring, haircutting etc.
Move around your locality and make a list of different types of business
being run by sole proprietors and then categories them under the above
points.
5.3.5 FORMATION OF SOLE PROPRIETORSHIP FORM OF BUSINESS

ORGANISATION
It is very simple to establish a sole proprietary concern. Any person who is willing to start
Are you now a business and has the necessary resources can set up this form of business organisation.
interested to start To start and operate the business in this form, practically does not require any legal formalities
your own sole to be fulfilled. In some cases like restaurant, chemist shop etc. however, permission from
proprietorship the competent authority is required to be obtained before starting the business. Similarly,
business?
setting up a factory may involve taking permission from the local authority. But, formation
of business unit as such does not involve any complexities.
INTEXT QUESTIONS 5A
1. Define ‘Sole Proprietorship’ in your own words.
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
2. Below are given the merits and limitations of sole proprietorship form of business
organisation. Write ‘M’ against Merits and ‘L’ against Limitations in the space provided
against each.
(a) A sole proprietorship business is easy to form.
(b) A sole proprietor is personally liable for all the liabilities of the business.
(c) A sole proprietor has a limited capacity to raise funds for his business.
(d) A sole proprietor can maintain secrecy about the affairs of his business.
(e) A sole proprietor maintains good personal contact with the customers.
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3. Match the following with reference to sole proprietorship business.
Column - A Column - B
(a) Liability (i) Easy
Notes
(b) Formation (ii) minimum
(c) Resource (iii) prompt
(d) Decision making (iv) Unlimited
(e) Legal formalities (v) Limited
5.4 PARTNERSHIP
A textile factory is going to be started in the nearby area where Gopal is
carrying on his business. As a businessman, he is now in a jubilant mood. He
is thinking that once the textile factory is set up, he will get more customers;
the sales will increase and he will earn more profit. But, for all these, he will
have to expand his business, and for this he needs more money.
The major problem is how to arrange the additional funds. He has the option
of getting loans from the banks. But the fear of loss comes to his mind again
and again. He does not want to take that risk. Another option is that he may
join hands with some other person. By doing so, more resources can be raised,
work can be shared, and business can be run in a better way. The risk of loss
will also be shared. But this involves a new form of business organisation
known as Partnership organisation. Gopal has to gain clarity on the exact
nature of this form of business organisation, its pros and cons before he goes
in for it.
‘Partnership’ is an association of two or more persons who pool their financial and managerial
resources and agree to carry on a business, and share its profit. The persons who form a
partnership are individually known as partners and collectively a firm or partnership
firm. Partnership Deed
contains the terms
Let’s assume that Gopal joins hand with Rahim to start a big grocery shop. Here both and conditions for
Gopal and Rahim are called partners who are running the partnership firm jointly. Both of starting and
them will pool their resources and carry on business by applying their expertise. They will continuing the
partnership firm
share the profits and losses in the agreed ratio. In fact, for all terms and conditions of their
working, they have to sit together to decide about all aspects. There must be an agreement
between them. The agreement may be in oral, written or implied. When the agreement is It is always better to
in writing it is termed as partnership deed. However, in the absence of an agreement, the insist on a written
agreement in order
provisions of the Indian Partnership Act 1932 shall apply. to avoid future
litigation.
Partnership form of business organisation in India is governed by the Indian Partnership
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Act, 1932 which defines partnership as “the relation between persons who have agreed to
share the profits of the business carried on by all or any of them acting for all”.
5.4.1 CHARACTERISTICS OF PARTNERSHIP FORM OF BUSINESS

Notes ORGANISATION
Based on the definition of partnership as given above, the various characteristics of
partnership form of business organisation, can be summarised as follows:
(a) Two or More Persons: To form a partnership firm atleast two persons are required.
The maximum limit on the number of persons is ten for banking business and 20 for
other businesses. If the number exceeds the above limit, the partnership becomes
illegal and the relationship among them cannot be called partnership.
Characteristics:
§ Two or More (b) Contractual Relationship: Partnership is created by an agreement among the persons
Persons who have agreed to join hands. Such persons must be competent to contract. Thus,
§ Contractual minors, lunatics and insolvent persons are not eligible to become the partners. However,
Relationship
§ Sharing profits of a minor can be admitted to the benefits of partnership firm i.e., he can have share in the
business profits without any obligation for losses.
§ Existence of
Lawful Business (c) Sharing Profits and Business: There must be an agreement among the partners to
§ Principal Agent share the profits and losses of the business of the partnership firm. If two or more
Relationship persons share the income of jointly owned property, it is not regarded as partnership.
§ Unlimited
Liabilities (d) Existence of Lawful Business: The business of which the persons have agreed to
§ Voluntary share the profit must be lawful. Any agreement to indulge in smuggling, black marketing
Registration etc. cannot be called partnership business in the eyes of law.
(e) Principal Agent Relationship: There must be an agency relationship between the
partners. Every partner is the principal as well as the agent of the firm. When a partner
deals with other parties he/she acts as an agent of other partners, and at the same time
the other partners become the principal.
(f) Unlimited Liability: The partners of the firm have unlimited liability. They are jointly
as well as individually liable for the debts and obligations of the firms. If the assets of
the firm are insufficient to meet the firm’s liabilities, the personal properties of the
partners can also be utilised for this purpose. However, the liability of a minor partner
is limited to the extent of his share in the profits.
(g) Voluntary Registration: The registration of partnership firm is not compulsory. But
an unregistered firm suffers from some limitations which makes it virtually compulsory
to be registered. Following are the limitations of an unregistered firm.
(i) The firm cannot sue outsiders, although the outsiders can sue it.
(ii) In case of any dispute among the partners, it is not possible to settle the dispute
through court of law.
(iii) The firm cannot claim adjustments for amount payable to, or receivable from, any
other parties.
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5.4.2 MERITS OF PARTNERSHIP FORM OF BUSINESS ORGANISATION
(a) Easy to Form: A partnership can be formed easily without many legal formalities.
Since it is not compulsory to get the firm registered, a simple agreement, either in oral,
writing or implied is sufficient to create a partnership firm.
Notes
(b) Availability of Larger Resources: Since two or more partners join hands to start
partnership firm it may be possible to pool more resources as compared to sole
Merits
proprietorship form of business organisation. § Easy to Form
(c) Better Decisions: In partnership firm each partner has a right to take part in the § Flexibility in
management of the business. All major decisions are taken in consultation with and Operation
§ Availability of
with the consent of all partners. Thus, collective wisdom prevails and there is less Larger Resources
scope for reckless and hasty decisions. § Better Decision
(d) Flexibility: The partnership firm is a flexible organisation. At any time the partners § Sharing of Risk
§ Active Participation
can decide to change the size or nature of business or area of its operation after taking § Benefits of
the necessary consent of all the partners. Specialisation
§ Protection of
(e) Sharing of Risks: The losses of the firm are shared by all the partners equally or as
Interest
per the agreed ratio. § Secrecy
(f) Keen Interest: Since partners share the profit and bear the losses, they take keen
interest in the affairs of the business.
(g) Benefits of Specialisation: All partners actively participate in the business as per
their specialisation and knowledge. In a partnership firm providing legal consultancy
to people, one partner may deal with civil cases, one in criminal cases, another in
labour cases and so on as per their area of specialisation. Similarly two or more
doctors of different specialisation may start a clinic in partnership.
(h) Protection of Interest: In partnership form of business organisation, the rights of
each partner and his/her interests are fully protected. If a partner is dissatisfied with
any decision, he can ask for dissolution of the firm or can withdraw from the partnership.
(i) Secrecy: Business secrets of the firm are only known to the partners. It is not required
to disclose any information to the outsiders. It is also not mandatory to publish the
annual accounts of the firm.
Having learnt about the nature and merits of the partnership form of
business organisation, now Gopal has decided to expand his business
by starting a partnership form of business. One day, in a happy mood,
he met Rahim (who also runs a grocery shop in the same locality) and
explained to him about the concept, characteristics and merits of partnership
form of business organisation. Rahim heard Gopal very carefully and asked
Gopal about the limitations (if any) of this form of business organisation.
Gopal had no idea about any limitations. Let him now have an idea about
the limitations of partnership form of business organisation.
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5.4.3 LIMITATIONS OF PARTNERSHIP FORM OF BUSINESS ORGANISATION
A partnership firm also suffers from certain limitations. These are as follows:
(a) Unlimited Liability: The most important drawback of partnership firm is that the
Notes liability of the partners is unlimited i.e., the partners are personally liable for the debt
and obligations of the firm. In other words, their personal property can also be utilised
Limitations for payment of firm’s liabilities.
§ Instability
(b) Instability: Every partnership firm has uncertain life. The death, insolvency, incapacity
§ Unlimited Liability
§ Non- or the retirement of any partner brings the firm to an end. Not only that any dissenting
transferability of partner can give notice at any time for dissolution of partnership.
share
§ Limited capital (c) Limited Capital: Since the total number of partners cannot exceed 20, the capacity
§ Possibility of to raise funds remains limited as compared to a joint stock company where there is no
conflicts limit on the number of share holders.
(d) Non-transferability of share: The share of interest of any partner cannot be
transferred to other partners or to the outsiders. So it creates inconvenience for the
partner who wants to transfer his share to others fully and partly. The only alternative
is dissolution of the firm.
(e) Possibility of Conflicts: You know that in partnership firm every partner has an
equal right to participate in the management. Also every partner can place his or her
opinion or viewpoint before the management regarding any matter at any time. Because
of this, sometimes there is friction and quarrel among the partners. Difference of opinion
may give rise to quarrels and lead to dissolution of the firm.
5.4.4 TYPES OF PARTNERS

You have learnt that normally every partner in a firm contributes to its capital, participates
in the day-to-day management of firm’s activities, and shares its profits and losses in the
agreed ratio. In other words all partners are supposed to be active partners. However, in
certain cases there are partners who play a limited role. They may contribute capital and
such partners cannot be termed as active partners. Similarly, some persons may simply
lend their name to the firm and make no contribution to capital of the firm. Such persons
are partners only in name. Thus, depending upon the extent of participation and the sharing
of profits, liability etc., partners can be classified into various categories. These are
summarised here under.
(A) Based on the extent of participation in the day-to-day management of the firm
partners can be classified as ‘Active Partners’ and ‘Sleeping Partners’. The partners
who actively participate in the day-to-day operations of the business are known as
active partners or working partners. Those partners who do not participate in the
day-to-day activities of the business are known as sleeping or dormant partners. Such
partners simply contribute capital and share the profits and losses.
(B) Based on sharing of profits, the partners may be classified as ‘Nominal Partners’
and ‘Partners in Profits’. Nominal partners allow the firm to use their name as partner.
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They neither invest any capital nor participate in the day-to-day operations. They are
not entitled to share the profits of the firm. However, they are liable to third parties for
all the acts of the firm. A person who shares the profits of the business without being
liable for the losses is known as partner in profits. This is applicable only to the minors
who are admitted to the benefits of the firm and their liability is limited to their capital Notes
contribution.
(C) Based on Liability, the partners can be classified as ‘Limited Partners’ and ‘General
Partners’. The liability of limited partners is limited to the extent of their capital
contribution. This type of partners is found in Limited Partnership firms in some European
countries and USA. So far, it is not allowed in India. However, the Limited liability
Partnership Act is very much under consideration of the Parliament. The partners
having unlimited liability are called as general partners or Partners with unlimited liability.
It may be noted that every partner who is not a limited partner is treated as a general
partner.
(D) Based on the behaviour and conduct exhibited, there are two more types of
partners besides the ones discussed above. These are (a) Partner by Estoppel; and
(b) Partner by Holding out. A person who behaves in the public in such a way as to
give an impression that he/she is a partner of the firm, is called ‘partner by estoppel’.
Such partners are not entitled to share the profits of the firm, but are fully liable if some
body suffers because of his/her false representation. Similarly, if a partner or partnership
firm declares that a particular person is a partner of their firm, and such a person does
not disclaim it, then he/she is known as ‘Partner by Holding out’. Such partners are
not entitled to profits but are fully liable as regards the firm’s debts.
Based on extent of participation Active Partners

Sleeping Partners
Based on sharing of profit Nominal Partners

Partners in Profits
Partners
Based on liability
Limited Partners
General Partners
Based on nature of behaviour

Partners by Estoppel
Partners by Holding Out
One of Gopal’s friends Rahul comes to his shop and sits there for hours
together. In Gopal’s absence, he attends to the customers and deals with his
suppliers. Under the impression that Rahul is a partner (although he is not),
a supplier finalised a deal which Gopal does not accept. In the process, the
supplier suffers some loss. Can he claim the compensation from Rahul? What
type of partner Rahul is?
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5.4.5 SUITABILITY OF PARTNERSHIP FORM OF BUSINESS ORGANISATION
We have already learnt that persons having different ability, skill or expertise can join
hands to form a partnership firm to carry on the business. Business activities like construction,
Notes providing legal services, medical services etc. can be successfully run under this form of
business organisation. It is also considered suitable where capital requirement is of a medium
size. Thus, business like a wholesale trade, professional services, mercantile houses and
small manufacturing units can be successfully run by partnership firms.
5.4.6 FORMATION OF PARTNERSHIP FORM OF BUSINESS ORGANISATION

The following steps are to be taken in order to form a partnership firm:
(a) Minimum two members are required to form a partnership. The maximum limit is ten
in banking and 20 in other businesses.
(b) Select the like-minded persons keeping in view the nature and objectives of the
business.
(c) There must be an agreement among the partners to carry on the business and share
the profits and losses. This agreement must preferably be in writing and duly signed by
the all the partners. The agreement, i.e., the partnership deed must contain the following:
(i) Name of the firm
(ii) Nature of the business
(iii) Names and addresses of partners
(iv) Location of business
(v) Duration of partnership, if decided
(vi) Amount of capital to be contributed by each partner
(vii) Profit and loss sharing ratio
(viii) Duties, powers and obligations of partners.
(ix) Salaries and withdrawals of the partners
(x) Preparation of accounts and their auditing.
(xi) Procedure for dissolution of the firm etc.
(xii) Procedure for settlement of disputes
(d) The partners should get their firm registered with the Registrar of Firms of the concerned
state. Although registration is not compulsory, but to avoid the consequences of non-
registration, it is advisable to get it registered when it is setup or at any time during its
existence. The procedure for registration of a firm is as follows.
(i) The firm will have to apply to the Registrar of Firms of the concerned state in the
prescribed form.
(ii) The duly filled in form must be signed by all the partners.
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(iii) The filled in form along with prescribed registration fee must be deposited in the
office of the Registrar of Firms.
(iv) The Registrar will scrutinise the application, and if he is satisfied that all formalities
relating to registration have been duly complied with, he will put the name of the
Notes
firm in his register and issue the Certificate of Registration.
Gopal is now running the partnership firm along with Rahim as a partner.
They are earning good profit and managing their business smoothly.
Gopal’s father also runs a wholesale business in the same locality. That
business was earlier being managed by Gopal’s grand father. One-day Gopal’s
father revealed that Gopal and his younger brother and sister have an equal
share in his wholesale business. It is a family business and Gopal can continue
his own partnership business without losing his position in this family business.
Gopal was confused. His father explained to him that under Hindu Law it is
a Joint Hindu Family business. Let us know in detail about Joint Hindu Family
form of business organisation.
INTEXT QUESTIONS 5B
1. State the position of minors in relation to a partnership firm.
______________________________________________________________
______________________________________________________________
2. Following are the statements related to partnership form of business organisation.
Rewrite the statement in correct form if found wrong.
(a) Maximum 20 partners can join in a partnership firm running banking business.
___________________________________________________________
___________________________________________________________
(b) Partnership Deed may be either oral or in writing.
___________________________________________________________
___________________________________________________________
(c) There is an employer-employee relationship among the partners.
___________________________________________________________
___________________________________________________________
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(d) In a partnership firm Hari and Madhu contributed Rs. 10,000 each Madhu’s liability
would be limited to Rs. 10,000 in case of losses in firm’s business.
___________________________________________________________
Notes
___________________________________________________________
(e) A person acquired interest in a partnership firm by virtue of his relationship with
the existing partners.
___________________________________________________________
___________________________________________________________
3. Identify the type of partners in the following situation:
(a) The liability of Sridhar, a 25 years old partner is limited to the extent of his capital
contribution.
(b) Madan has neither contributed any capital nor shares the profits of the firm though
he is treated as a partner.
(c) Sunita has been admitted to the benefits of the firm at the age of 15.
(d) Sudhir had contributed to capital and shares the profit and loss of the firm. But he
does not take part in the day-to-day activities.
(e) A firm declares that Sachin is a partner of their firm. Knowing the declaration
Sachin did not disclaim it.
5.5 JOINT HINDU FAMILY FORM OF BUSINESS ORGANISATION

After knowing about sole proprietorship and partnership forms of business organisation
let us now discuss about a unique form of business organisation that prevails only in India
and that too among the Hindus. The Joint Hindu Family (JHF) business is a form of business
organisation run by Hindu Undivided Family (HUF), where the family members of three
successive generations own the business jointly. The head of the family known as Karta
manages the business. The other members are called co-parceners and all of them have
equal ownership right over the properties of the business.
The membership of the JHF is acquired by virtue of birth in the same family. There is no
restriction for minors to become the members of the business. As per Dayabhaga system
of Hindu Law, both male and female members are the joint owners. But Mitakashara
system of Hindu Law says only male members of the family can become the coparceners.
While the Dayabhaga system is applicable to the state of West Bengal, Mitakshara system
of Hindu Law is applicable to the rest of the country.

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5.5.1 CHARACTERISTICS OF JHF FORM OF BUSINESS ORGANISATION
From the above discussion, it must have been clear to you that the Joint Hindu family
business has certain special characteristics which are as follows:
Notes
(a) Formation: In JHF business there must be at least two members in the family, and
family should have some ancestral property. It is not created by an agreement but by
Characteristics:
operation of law.
§ Formation
§ Legal Status
(b) Legal Status: The JHF business is a jointly owned business. It is governed by the
§ Membership
Hindu Succession Act 1956. § Profit Sharing
§ Management
(c) Membership: In JHF business outsiders are not allowed to become the coparcener. § Liability
Only the members of undivided family acquire co-parcenership rights by birth.. § Continuity
(d) Profit Sharing: All coparceners have equal share in the profits of the business.
(e) Management: The business is managed by the senior most member of the family
known as Karta. Other members do not have the right to participate in the management.
The Karta has the authority to manage the business as per his own will and his ways of
managing cannot be questioned. If the coparceners are not satisfied, the only remedy
is to get the HUF status of the family dissolved by mutual agreement.
(f) Liability: The liability of coparceners is limited to the extent of their share in the
business. But the Karta has an unlimited liability. His personal property can also be
utilised to meet the business liability.
(g) Continuity: Death of any coparceners does not affect the continuity of business.
Even on the death of the Karta, it continues to exist as the eldest of the coparceners
takes position of Karta. However, JHF business can be dissolved either through mutual
agreement or by partition suit in the court.
5.5.2 MERITS OF JHF FORM OF BUSINESS ORGANISATION

Since Joint Hindu Family business has certain peculiar features as discussed above, it has
Merits
the following merits. § Assured Shares
(a) Assured Shares in Profits: Every coparcener is assured of an equal share in the in Profits
§ Quick Decision
profits irrespective of his participation in the running of the business. This safeguards § Sharing of
the interest of minor, sick, physically and mentally challenged coparceners. Knowledge and
Experience
(b) Quick Decision: The Karta enjoys full freedom in managing the business. It enables § Limited Liability
him to take quick decisions without any interference. of Members
§ Unlimited
(c) Sharing of Knowledge and Experience: A JHF business provides opportunity for Liability of the
the young members of the family to get the benefits of knowledge and experience of Karta
the elder members. It also helps in inculcating virtues like discipline, self-sacrifice, § Continued
tolerance etc. Existence

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(d) Limited Liability of Members: The liability of the coparceners except the Karta is
limited to the extent of his share in the business. This enables the members to run the
business freely just by following the instructions or direction of the Karta.
(e) Unlimited Liability of the Karta: Because of the unlimited liability of the Karta, his
Notes
personal properties are at stake in case the business fails to pay the creditors. This
clause of JHF business makes the Karta to manage business most carefully and efficiently.
(f) Continued Existence: The death or insolvency of any member does not affect the
continuity of the business. So it can continue for a long period of time.
(g) Tax Benefits: HUF is regarded as an independent assessee for tax purposes. The
share of coparceners is not to be included in their individual income for tax purposes.
After knowing the merits let us see the limitations of Joint Hindu Family form of business
organisation.
5.5.3 LIMITATION OF JHF FORM OF BUSINESS ORGANISATION

(a) Limited Resources: JHF business has generally limited financial and managerial
Limitations
resource. Therefore, it is not considered suitable for large business.
§ Limited
Resources (b) Lack of Motivation: The coparceners get equal share in the profits of the business
§ Lack of
irrespective of their participation. So generally they are not motivated to put in their
Motivation
§ Scope for best.
Misuse of Power
(c) Scope for Misuse of Power: Since the Karta has absolute freedom to manage the
§ Instability
business, there is scope for him to misuse it for his personal gains. Moreover, he may
have his own limitations.
(d) Instability: The continuity of JHF business is always under threat. A small rift within
the family may lead to seeking partition.
5.5.4 SUITABILITY OF JHF FORM OF BUSINESS ORGANISATION

The Joint Hindu Family form of business organisation is suitable where the family inherits a
running business and the members of the family want to continue that business jointly as a
family business. Even otherwise, this form of business organisation is considered suitable
for a business that requires limited financial and managerial resources and having a very
limited area of operation. It is found that JHF are usually engaged in trading business,
indigenous banking, small industry, and crafts etc.
5.5.5 FORMATION OF JHF FORM OF BUSINESS ORGANISATION

A Joint Hindu Family business is formed as per the provision of Hindu law. It comes into
existence on the death of the person who established the business. His successor
automatically become the coparceners if they decide to continue it as a joint family business.
The children become its members by birth. The senior most member of the family will
become the Karta of the business. No legal formalities are required for its establishment.

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But it has to be registered with the Income tax department to avail the tax concessions
involved.
INTEXT QUESTIONS 5C Notes
1. Why should the liability of Karta be unlimited?

______________________________________________________________
______________________________________________________________
2. State whether it is a merit or a limitation of Joint Hindu Family business. Write ‘M’ for
merit and ‘L’ for limitation in the box given against each statement.
(a) Young family member gains knowledge and experiences from other
members.
(b) The death or insolvency of member does not affect the continuity of the
business.
(c) The coparceners are not motivated to put their best efforts.
(d) The members get equal share in the profits irrespective of their
participation.
(e) The Karta takes quick decision without any interference.
3. Distinguish between partnership and Joint Hindu Family business on the basis of
membership.
5.6 COOPERATIVE SOCIETY

You have learnt about Sole Proprietorship, Partnership and Joint Hindu Family as different
forms of business organisation. You must have noticed that while there are many differences
among them in respect of their formation, operation, capital contribution and liabilities, The important
there is one similarity that they all are engaged in business to earn profit. However, there objectives of
are certain organisations which undertake business activities with the prime objective of cooperative society
form of business
providing service to the members. Although they also earn some amount of profit, but their organisation are
main intention is to look after some common interest of its members. They pool available service in place of
resources from the members, utilise the same in the best possible manner and share the profit, Mutual help
benefits. These organisations are known as Cooperative Societies. Let us learn in detail in place of
competition, Self
about this form of business organisation. help in place of
dependence, and
The term cooperation is derived from the Latin word ‘co-operari’, where the word ‘Co’
moral solidarity in
means ‘with’ and ‘operari’ mean ‘to work’. Thus, the term cooperation means working place of unethical
together. So those who want to work together with some common economic objectives business practices.
can form a society, which is termed as cooperative society.

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It is a voluntary association of persons who work together to promote their economic
interest. It works on the principle of self-help and mutual help. The primary objective is to
provide support to the members. People come forward as a group, pool their individual
resources, utilise them in the best possible manner and derive some common benefits out
Notes of it.
The Section 4 of the Indian Cooperative Societies Act 1912 defines

Cooperative Society as “a society, which has its objectives for the promotion
of economic interests of its members in accordance with cooperative
principles.”
5.6.1 CHARACTERISTICS OF COOPERATIVE SOCIETY

Based on the above definition we can identify the following characteristics of cooperative
society form of business organisation:
(a) Voluntary Association: Members join the cooperative society voluntarily i.e., by
their own choice. Persons having common economic objective can join the society as
and when they like, continue as long as they like and leave the society and when they
want.
Cooperative
Societies having (b) Open Membership: The membership is open to all those having a common economic
area of operation interest. Any person can become a member irrespective of his/her caste, creed, religion,
in more than one colour, sex etc.
state are known
as Multi-state (c) Number of Members: A minimum of 10 members are required to form a cooperative
Cooperative society. In case of multi-state cooperative societies the minimum number of members
Societies.
should be 50 from each state in case the members are individuals. The Cooperative
Society Act does not specify the maximum number of members for any cooperative
society. However, after the formation of the society, the member may specify the
maximum member of members.
(d) Registration of the Society: In India, cooperative societies are registered under the
Cooperative Societies Act 1912 or under the State Cooperative Societies Act. The
Multi-state Cooperative Societies are registered under the Multi-state Cooperative
Societies Act 2002. Once registered, the society becomes a separate legal entity and
attain certain characteristics. These are as follows.
(i) The society enjoys perpetual succession
(ii) It has its own common seal
(iii) It can enter into agreements with others
(iv) It can sue others in a court of law
(v) It can own properties in its name
(e) State Control: Since registration of cooperative societies is compulsory, every
cooperative society comes under the control and supervision of the government. The

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cooperative department keeps a watch on the functioning of the societies. Every society
has to get its accounts audited from the cooperative department of the government.
(f) Capital: The capital of the cooperative society is contributed by its members. Since,
the members contribution is very limited, it often depends on the loan from government.
and apex cooperative institutions or by way of grants and assistance from state and Notes
Central Government.
(g) Democratic Set Up: The cooperative societies are managed in a democratic manner. Characteristics
Every member has a right to take part in the management of the society. However, the § Voluntary
association
society elects a managing committee for its effective management. The members of
§ Open membership
the managing committee are elected on the basis of one-man one-vote irrespective of § Number of
the number of shares held by any member. It is the general body of the society which members
lays down the broad framework within which the managing committee functions. § Registration
§ State control
(h) Service Motive: The primary objective of all cooperative societies is to provide § Capital
services to its members. § Democratic set up
§ Service motive
(i) Return on Capital Investment: The members get return on their capital investment § Return on capital
in the form of dividend. § Investment
§ Distribution of
(j) Distribution of Surplus: After giving a limited dividend to the members of the society, surplus
the surplus profit is distributed in the form of bonus, keeping aside a certain percentage
as reserve and for general welfare of the society.
5.6.2 TYPES OF COOPERATIVE SOCIETIES

You know cooperative organisations are set up in different fields to promote the economic
well-being of different sections of the society. So, according to the needs of the people,
we find different types of cooperative societies in India. Some of the important types are
given below.
(a) Consumers’ Cooperative Societies: These societies are formed to protect the
interest of consumers by making available consumer goods of high quality at reasonable
price.
(b) Producer’s Cooperative Societies: These societies are formed to protect the interest
of small producers and artisans by making available items of their need for production,
like raw materials, tools and equipments etc.
(c) Marketing Cooperative Societies: To solve the problem of marketing the products,
small producers join hand to form marketing cooperative societies.
(d) Housing Cooperative Societies: To provide residential houses to the members,
housing cooperative societies are formed generally in urban areas.
(e) Farming Cooperative Societies: These societies are formed by the small farmers to
get the benefit of large-scale farming.
(f) Credit Cooperative Societies: These societies are started by persons who are in
need of credit. They accept deposits from the members and grant them loans at
reasonable rate of interest.

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DO AND LEARN
Based on the above discussion as well as your understanding so far about the cooperative
society form of business organisation, now you can try to fill up the following table.
Notes
Types of cooperative Who form the Objectives of Function of
Societies Society the Society the Society
1. Consumers’
Cooperative
Societies
2. Producer’s
Cooperative
Societies
3. Marketing
Cooperative
Societies
4. Housing
Cooperative
Societies
5. Farming
Cooperative
Societies
6. Credit
Cooperative
Societies
5.6.3 MERITS OF COOPERATIVE SOCIETY
The cooperative society is the only form of business organisation which gives utmost
Merits: importance to its members rather than maximising its own profits. After studying its
§ Easy to form characteristics and different types, we may now study the merits of this form of business
§ Limited liability organisation.
§ Open
Membership (a) Easy to Form: Any ten adult members can voluntarily form an association get it
§ State Assistance
§ Stable life
registered with the Registrar of Cooperative Societies. The registration is very simple
§ Tax concessions and it does not require much legal formalities.
§ Democratic
Management (b) Limited Liability: The liability of the members of the cooperative societies is limited
upto their capital contribution. They are not personally liable for the debt of the society.
(c) Open Membership: Any competent like-minded person can join the cooperative
society any time he likes. There is no restriction on the grounds of caste, creed, gender,
colour etc. The time of entry and exit is also generally kept open.
(d) State Assistance: The need for country’s growth has necessitated the growth of the
economic status of the weaker sections. Therefore, cooperative societies always get

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assistance in the forms of loans, grants, subsidies etc. from the state as well as Central
Government.
(e) Stable Life: The cooperative society enjoys the benefit of perpetual succession. The
death, resignation, insolvency of any member does not affect the existence of the
Notes
society because of its separate legal entity.
(f) Tax Concession: To encourage people to form co-operative societies the government
generally provides tax concessions and exemptions, which keep on changing from
time to time.
(g) Democratic Management: The cooperative societies are managed by the Managing
Committee, which is elected by the members. The members decide their own rules
and regulations within the limits set by the law.
5.6.4 LIMITATIONS OF COOPERATIVE SOCIETY

Although the basic aim of forming a cooperative society is to develop a system of mutual
help and cooperation among its members, yet the feeling of cooperation does not remain
for long. Cooperative societies usually suffer from the following limitations.
(a) Limited Capital: Most of the cooperative societies suffer from lack of capital. Since
the members of the society come from a limited area or class and usually have limited
means, it is not possible to collect huge capital from them. Again, government’s Limitations:
§ Limited Capital
assistance is often inadequate for them. § Lack of Mana-
(b) Lack of Managerial Expertise: The Managing Committee of a cooperative society gerial Expertise
§ Less Motiva-
is not always able to manage the society in an effective and efficient way due to lack of tion
managerial expertise. Again due to lack of funds they are also not able to derive the § Lack of Interest
benefits of professional management. § Dependence on
Govt.
(c) Less Motivation: Since the rate of return on capital investment is less, the members
do not always feel involved in the affairs of the society.
(d) Lack of Interest: Once the first wave of enthusiasm to start and run the business is
exhausted, intrigue and factionalism arise among members. This makes the cooperative
lifeless and inactive.
(e) Corruption: Inspite of government’s regulation and periodical audit of the accounts
of the cooperative society, the corrupt practices in the management cannot be
completely ignored.
5.6.5 SUITABILITY OF COOPERATIVE SOCIETY

You have already learnt that cooperative society form of business organisations is a voluntary
association of person who are not financially strong and cannot stand on their own legs to
start and run the business individually. So to solve the common problem or to meet the
common requirements this form of business organisation is most suitable. Thus, people

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can join hands to get the consumer products, to build residential houses, for marketing the
products, to provide loans and advances etc. This form of business organisation is generally
suitable for small and medium size business operation.
Notes 5.6.6 FORMATION OF COOPERATIVE SOCIETY

A cooperative society can be formed as per the provisions of the Cooperative Societies
Act, 1912, or under the Cooperative Societies Acts of the respective states. The various
common requirements prescribed for registration of a cooperative society are as follows:
(a) There must be at least ten persons having common economic interest and must be
capable of entering into contract. For multi-state cooperative societies at least 50
individual members from each state should be present.
(b) A suitable name should be proposed for the society.
(c) The draft bye-laws of the society should be prepared.
(d) After completing the above formalities, the society should go for its registration.
(e) For registration, application in prescribed form should be made to the Registrar of
Cooperative Societies of the state in which the society is to be formed.
(f) The application for registration shall be accompanied by four copies of the proposed
bye-laws of the society.
(g) The application must be signed by every member of the society.
(h) After scrutinising of the application and the bye-laws, the registrar issues the registration
certificate.
(i) The society can start its operation after getting the certificate of registration.
INTEXT QUESTIONS 5D
1. Define ‘Cooperative Society’ in your own words.
______________________________________________________________
______________________________________________________________
2. Answer the followings in one or two words.
(a) Who manages the cooperative society?
(b) How many members are required to start a multistate cooperative society?
(c) Which type of cooperative society is formed to solve the credit need of the people?
(d) To whom the application should be made for seeking registration of a cooperative
society?
(e) What is the maximum limit of membership in a cooperative society?

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3. Match the following:
Column A Column B
(a) Registration (i) Limited
Notes
(b) Membership (ii) Management
(c) Return on capital (iii) Open to all
(d) Democratic (iv) Compulsory
(e) Liability (v) Dividend
5.7 WHAT YOU HAVE LEARNT

On the basis of ownership and management there are different forms of business
organisation. They are Sole Proprietorship, Partnership, Joint Hindu Family, Cooperative
Society and Joint Stock Company.
Sole proprietorship refers to a form of business organisation where a single individual
owns and manages the business. He/she takes the profits and bears the losses. Merits of
this form of business organisation include, easy to form and wind up, quick decision and
prompt action, direct motivation, flexibility in operation. The businessman himself can give
personal touch to each and every matter of the business that enables him to maintain the
secrets of his business. Inspite of all these merits, this form also suffers from the limitations
of limited resources, lack of continuity, unlimited liability of the owner, limited managerial
expertise. This form is not suitable for large-scale operations.
Partnership is a form of business organisation in which two or more competent persons
join hands to carry on any lawful business after entering into an agreement to share the
profit and loss of the business. A partnership firm is easy to form and also flexible in its
operation. It pools resources from the partners, makes their optimum utilisation by taking
better decisions. It protects the interest of each and every partner and gets benefit out of
the specialised knowledge and skills of individual partner. Since partners share the profits
and losses they show keen interest in the affairs of the business. The major limitations of
partnership form of business organisation are: unlimited liability, instability, limited capital,
non-transferability of share and lack of harmony among the partners.
In partnership firm we find different types of partners like Active partners, Sleeping partners,
Nominal partners, Partners in profits, Limited partners, General partners. Partners by
Estoppel and Partners by holding out.
Joint Hindu Family form of business organisation is governed by Hindu Law. The members
of the Hindu undivided family jointly own the business and the eldest member called Karta
manages the business in the best possible manner. Every member called co-parcener gets
an assured share in profit irrespective of their participation. The liability of co-parceners
except the Karta is limited. The death or insolvency of any member does not affect the

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continuity of the business. This form of business organisation too suffers from certain
limitations like limited resources, lack of motivation, scope for misuse of power by Karta
and instability.
Cooperative society is a voluntary association of persons who work together to promote
Notes
their economic interest. It works on the principle of self-help and mutual help. The
membership of cooperative societies is voluntary and open to all. It has separate legal
existence and is democratically managed. The cooperative societies are easy to form and
have a stable life. They get assistance from the government in the form of loan, grants and
subsidies. The government also provides tax concession. The liability of the members is
limited upto their capital contribution. Inspite of all these advantages, it also suffers from
various limitations like insufficient capital, lack of managerial expertise. There is also lack
of motivation in members due to absence of direct reward for individual effort.
According to the need of the people we find different types of cooperative societies in our
country. Some of the important types are – Consumers cooperative societies, Producers’
cooperative societies, Marketing cooperative societies, Housing cooperative societies,
Farming cooperative societies and credit cooperative societies.
Suitability: Sole proprietorship is suitable for simple business involving less capital and
low risk. Business requiring manual skill like handicraft, filigree work, jewelry etc. are
generally organised the form of sole proprietorship. Partnership form of business is suitable
for construction business, providing legal services, medical services etc. It is also suitable
where capital requirement is medium. Business like wholesale trade, professional services,
mercantile houses and small manufacturing units can be run in partnership form. Joint
Hindu Family form of business organisation is suitable where the family inherits a running
business and the members want to continue the business jointly. It is generally found that
some of the trading business, banking and finance in unorganised sector, small industry, art
and crafts etc. are run in the form of Joint Hindu family business. Cooperative Society
form of business organisation is generally started to solve the common economic problems
or to meet the common requirements of the weaker sections of the community. It is suitable
for getting consumer goods at cheaper price, building houses, marketing products, providing
loans and advances to the members etc.
Formation: The formation of Sole Proprietorship form of business organisation does not
require any specific legal formalities except where permission of the local authority is
required to be obtained. In partnership, a simple agreement is enough to start a business.
The registration of the firm is also not compulsory. A Joint Hindu Family business is
formed as per the provisions of the Hindu Law. No specific legal formalities are required
for establishing the business. However, a simple registration with the income tax department
is required. A cooperative society follows the provisions of the Cooperative Societies Act
for its registration. It is mandatory for each society to be registered with the Registrar of
Cooperative Societies. After the registration, the society becomes a body corporate with
separate legal entity and enjoys perpetual succession.

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5.8 KEY TERMS

Business Organisation Karta Partnership
Cooperative Society Partner Partnership Deed Notes
Coparcener Partner by Estoppel Sole proprietorship

Firm Partner by Holding Out Unlimited Liability
Joint Hindu Family Business
5.9 TERMINAL QUESTIONS

Very Short Answer Type Questions
1. Define sole proprietorship.
2. List any two situations in which sole proprietorship form of business organisation is
found to be most suitable
3. Who is a partner by estoppel?
4. Distinguish between partnership and sole proprietorship business on the basis of
membership.
5. State the meaning of the term ‘Coparcener’.
Short Answer Type Questions
6. State the suitability of sole proprietorship form of business organisation.
7. Explain any two limitations of partnership form of business organisation.
8. What is meant by ‘partnership deed’? Is it essential for partnership?
9. Compare the status of a minor in partnership firm with that in a Joint Hindu Family
business.
10. Mention any four characteristics a cooperative society gets after getting the registration
certificate.
Long Answer Type Questions
11. Describe any four different types of partners.
12. What is a Joint Hindu Family business? Describe its main characteristics.
13. Explain the various merits of a Joint Hindu Family form of business organisation.
14. Give the definition of cooperative society as per the Indian Cooperative Societies Act
1912. State any two characteristics of cooperative society form of business organisation.
15. State the different types of cooperative societies that exist in India.

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5.10 ANSWERS TO INTEXT QUESTIONS
5A 2. (a) M (b) L (c) L
(d) M (e) M
Notes
3. (a) - (iv) (b) - (i) (c) - (v)
(d) - (iii) (e) - (ii)
5B
1. A minor can only share the profits of the business. In case of loss, the liability of the
minor is limited to his capital contribution.
2. (a) Maximum 10 members can join a banking business in partnership form.
(b) Partnership deed is always in the form of writing.
(c) There is a principal agent relationship among the partners.
(d) In a partnership Hari and Madhu contributed Rs. 10,000 each Madhus’s liability
would be unlimited in case of losses in firm’s business..
(e) A person can acquires interest in a partnership firm by entering into an agreement.
3. (a) Limited partner
(b) Nominal Partner
(c) Partner in profit or Minor partner
(d) Sleeping Partner/dormant partner
(e) Partner by holding out.
5C
1. Since Karta has absolute power to manage the business as per his own will, he may
misuse the authority for his personal gain. The clause unlimited liability restricts the
Karta to do harm to the business.
2. (a) M (b) M (c) M
(d) M (e) M
3. (a) Minimum two members are required in both the cases.
(b) Maximum 10 for banking and 20 for other business in case of partnership. Whereas
there is no such limit fixed for Joint Hindu Family business.
(c) Membership is acquired by entering into agreement in partnership business. In
Joint Hindu Family the membership is acquired by virtue of birth in the same
family.

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5D
2. (a) Managing committee
(b) 50 (Individual members)
Notes
(c) Credit Cooperative society
(d) Registrar of Cooperative societies
(e) Maximum limit is not fixed by the Act. It is the members who can decide about the
maximum limit of membership in the society if they so want.
3. (a) - (iv)
(b) - (iii)
(c) - (v)
(d) - (ii)
(e) - (i)
DO AND LEARN
Make a survey of twenty business organisations in and around your locality. Classify them
under the four categories you have learnt in this lesson. Analyse their nature of business,
size of the business, number of owners etc. in a tabular form.
LEARN AND PLAY

Kamal and Nirmal are two friends. Nirmal wanted to start a wholesale business in
partnership with Kamal. Kamal did not accept his proposal and started his own shop of
selling readymade garments in a different locality. Nirmal started his business in partnership
with another friend Vimal. One day both Kamla and Nirmal met in a function. Here is an
extract of the conversion that took place between them.
Nirmal : Hello, Kamal! How are you?
Kamal : Hello, I am fine. How is your partnership working?
Nirmal : It is running smoothly. Vimal is very sincere and cooperative. We are earning
very good profit. But, still I miss you. Are you still not interested in partnership?
Kamal : No, I am happy as a sole proprietor.
(Nirmal talked about the merits of partnership and limitations of sole proprietorship; whereas
Kamal highlighted the merits of sole proprietorship and limitations of partnership)
Put yourself in place of Nirmal and a friend in place of Kamal and continue the dialogue.

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Chapter at a Glance
Notes 5.1 Business Organisation

5.2 Forms of Business Organisation (BO)
5.3 Sole Proprietorship form
5.3.1 Characteristics
5.3.2 Merits
5.3.3 Limitations
5.3.4 Suitability
5.3.5 Formation
5.4 Partnership form of Business Organisation
5.4.2 Merits
5.4.3 Limitations
5.4.4 Types of Partners
5.4.5 Suitability
5.4.7 Formation
5.5 Joint Hindu Family form of Business Organisation
5.5.2 Merits
5.5.3 Limitation
5.5.4 Suitability
5.5.5 Formation
5.6 Cooperative Society
5.6.2 Types
5.6.3 Merits
5.6.4 Limitations
5.6.5 Suitability
5.6.6 Formation

FIN 301 Class Notes
Chapter 4: Time Value of Money
The concept of Time Value of Money:
An amount of money received today is worth more than the same dollar
value received a year from now. Why?
Do you prefer a $100 today or a $100 one year from now? why?
- Consumption forgone has value

- Investment lost has opportunity cost
- Inflation may increase and purchasing power decrease
Now,
Do you prefer a $100 today or $110 one year from now? Why?
You will ask yourself one question:

- Do I have any thing better to do with that $100 than lending it for $10
extra?
- What if I take $100 now and invest it, would I make more or less than
$110 in one year?
Note:
Two elements are important in valuation of cash flows:
- What interest rate (opportunity rate, discount rate, required rate of
return) do you want to evaluate the cash flow based on?
- At what time do these the cash flows occur and at what time do you need
to evaluate them?
1
Time Lines:
Show the timing of cash flows.

Tick marks occur at the end of periods, so Time 0 is today; Time 1 is the
end of the first period (year, month, etc.) or the beginning of the second
period.
0 1 2 3
i%
CF0 CF1 CF2 CF3
Example 1 : $100 lump sum due in 2 years
0 1 2
i
100
Today End of End of

Period 1 Period 2
(1 period (2 periods
form now) form now)
Example 2 : $10 repeated at the end of next three years (ordinary annuity )
0 1 2 3
i
10 10 10
2
Calculations of the value of money problems:
The value of money problems may be solved using
1- Formulas.
2- Interest Factor Tables. (see p.684)
3- Financial Calculators (Basic keys: N, I/Y, PV, PMT, FV).
I use BAII Plus calculator
4- Spreadsheet Software (Basic functions: PV, FV, PMT, NPER,RATE).
I use Microsoft Excel.
3
FUTUR VALUE OF A SINGLE CASH FLOW
Examples:
• You deposited $1000 today in a saving account at BancFirst that pays
you 3% interest per year. How much money you will get at the end of the
first year ?
i=3% FV1
0 1
$1000
• You lend your friend $500 at 5% interest provided that she pays you
back the $500 dollars plus interest after 2 years. How much she should
pay you?
i=5% FV2
0 1 2
$500
• You borrowed $10,000 from a bank and you agree to pay off the loan after
5 years from now and during that period you pay 13% interest on loan.
$10,000
0 1 2 3 4 5
FV5
i=13%
Investment
Present Future
Value of Compounding Value of
Money Money
4
Detailed calculation:
Simple example:
Invest $100 now at 5%. How much will you have after a year?
FV1 = PV + INT
= PV + (PV × i)
= PV × (1 + i)
FV1 = $100 + INT

= $100 + ($100 × .05)
= $100 + $5
= $105
Or
FV1 = $100 × (1+0.05)

= $100 × (1.05)
= $105
5
Another example: Invest $100 at 5% (per year) for 4 years.
0 1 2 3 4
PV = $100 FV1 = $105 FV2 = $110.25 FV3 = $115.76 FV4 = $121.55

× 1.05 × 1.05 × 1.05 × 1.05
Interest added: + $5.00 + $5.25 + $5.51 + $5.79
FV1= 100 × (1.05) = $105
FV2= 105 × (1.05) = $110.25

= 100 × (1.05) × (1.05) = $110.25
= 100 × (1.05)2 = $110.25
FV3= 110.25 × (1.05) = $115.76

= 100 × (1.05) × (1.05) × (1.05)= $115.76
= 100 × (1.05)3 = $115.76
FV4 = $100 × (1.05) × (1.05) × (1.05) × (1.05)

= PV × (1+i) × (1+i) × (1+i) × (1+i)
= PV × (1+i)4
In general, the future value of an initial lump sum is: FVn = PV × (1+i)n
6
To solve for FV, You need
1- Present Value (PV)
2- Interest rate per period (i)
3- Number of periods (n)
Remarks: As PVÇ, FVnÇ.

As iÇ, FVnÇ.
As nÇ, FVnÇ.
1- By Formula FV n = PV 0 (1 + i ) n
2- By Table I FV n = PV 0 (FV IFi ,n )
⇒ FVIFi ,n = (1 + i )n
3- By calculator (BAII Plus)
Clean the memory: CLR TVM Î CE/C 2nd FV
INPUTS 3 10 -100 0
N I/Y PV PMT
OUTPUT 133.10
CPT FV
Notes:
- To enter (i) in the calculator, you have to enter it in % form.
- Use +/- To change the sign of a number.

For example, to enter -100: 100 +/-
- To solve the problems in the calculator or excel, PV and FV cannot have the
same sign. If PV is positive then FV has to be negative.
7
Example:
Jack deposited $1000 in saving account earning 6% interest rate.

How much will jack money be worth at the end of 3 years?
Time line
0 1 2 3
6%
?
1000
Before solving the problem, List all inputs:

I = 6% or 0.06
N= 3
PV= 1000
PMT= 0
Solution:
By formula: FVn = PV × (1+i)n

FV3 = $1000 × (1+0.06)3
= $1000 ×(1.06)3
= $1000 ×1.191
= $ 1,191
By Table: FVn= PV × FVIFi,n

FV3 = $1000 × FVIF6%,3
= $1000 × 1.191
= $ 1,191
8
By calculator:
INPUTS 3 6 -1000 0
N I/Y PV PMT
OUTPUT 1,191.02
CPT FV
By Excel:
=FV (0.06, 3, 0,-1000, 0)
9
PRESENT VALUE OF A SINGLE CASH FLOW
Examples:
• You need $10,000 for your tuition expenses in 5 years how much should
you deposit today in a saving account that pays 3% per year?
$10,000
0 1 2 3 4 5
PV0 FV5
i=3%
• One year from now, you agree to receive $1000 for your car that you sold
today.
How much that $1000 worth today if you use 5% interest rate?
$1000
0 i=5% 1 FV1
PV0
Discounting
Present
Future
Value of
Value of
Money
Money
10
Detailed calculation
FV n = PV (1 + i ) n
FV n
⇒ PV 0 =
(1 + i ) n
1
⇒ PV 0 = FV n ×
(1 + i ) n
Example:
0 1 2 3 4
$100 $105 $110.25 $115.76 = $121.55
÷ 1.05 ÷ 1.05 ÷ 1.05 ÷ 1.05
PV4= FV4 = $121.55
PV3= FV4× [1/(1+i)]

= $121.55× [1/(1.05)]
= $115.76
PV2= FV4× [1/(1+i)(1+i)]

= $121.55× [1/(1.05)(1.05)]
= $121.55× [1/(1.05)2]
= $110.25
11
Or
PV2= FV3× [1/ (1+i)]
= $115.76× [1/ (1.05)]
= $110.25
PV1= FV4× [1/(1+i)(1+i) (1+i)]

= $121.55× [1/(1.05)(1.05) (1.05)]
= $121.55× [1/(1.05)3]
= $105
Or
PV1= FV2× [1/ (1+i)]
= $110.25× [1/ (1.05)]
= $105
PV0 = FV4× [1/ (1+i) (1+i) (1+i) (1+i)]

= FV4× [1/(1+i)4]
= $121.55× [1/(1.05)(1.05) (1.05) (1.05)]
= $121.55× [1/(1.05)4]
= $100
In general, the present value of an initial lump sum is: PV0 = FVn× [1/(1+i) n]
12
To solve for PV, You need
4- Future Value (FV)
5- Interest rate per period (i)
6- Number of periods (n)
Remarks: As FVn Ç, PVÇ

As iÇ, PVÈ
As nÇ, PVÈ
1
1- By Formula PV 0 = FV n ×
(1 + i ) n
2- By Table II PV 0 = FV n (PV IFi ,n )
1
⇒ PV IFi , n =
(1 + i ) n
3- By calculator (BAII Plus)
INPUTS 3 10 133.10 0
N I/Y FV
PV PMT
OUTPUT -100
CPT PV
13
Example:
Jack needed a $1191 in 3 years to be off some debt. How much should jack
put in a saving account that earns 6% today?
Time line
0 1 2 3
$1191
6%
?
I = 6% or 0.06
N= 3
FV= $1191
PMT= 0
Solution:
By formula: PV0 = FV3 × [1/(1+i) n]

PV0 = $1,191 × [1/(1+0.06) 3]
= $1,191 × [1/(1.06) 3]
= $1,191 × (1/1.191)
= $1,191 × 0.8396
= $1000
By Table: = FVn × PVIFi,n

PV0 = $1,191 × PVIF6%,3
= $1,191 × 0.840
= $ 1000
14
By calculator:
INPUTS 3 6 1191 0
N I/Y FV
PV PMT
OUTPUT -1000
CPT PV
By Excel:
=PV (0.06, 3, 0, 1191, 0)
15
Solving for the interest rate i
You can buy a security now for $1000 and it will pay you $1,191 three years from
now. What annual rate of return are you earning?
By Formula: ⎡
i=⎢
FVn ⎤ n
−1
⎣ PV ⎦⎥
1
⎡ 1191 ⎤ 3
i =⎢ − 1 = 0.06
⎣1000 ⎥⎦
By Table: FV n = PV 0 ( FV IFi , n )
FV n
⇒ FV IFi ,n =
PV 0
1191
FV IFi ,3 = = 1.191
1000
From the Table I at n=3 we find that the interest rate that yield 1.191 FVIF is 6%
Or PV 0 = FV n ( PV IFi ,n )
PV 0
⇒ PV IFi ,n =
FV n
1000
PV IFi ,3 = = 0.8396
1191
From the Table II at n=3 we find that the interest rate that yield 0.8396 PVIF is 6%
16
By calculator:
INPUTS 3 -1000 1191 0

N PV FV
PV PMT
OUTPUT 5.9995
CPT I/Y
17
Solving for n:
Your friend deposits $100,000 into an account paying 8% per year. She wants
to know how long it will take before the interest makes her a millionaire.
n=
( Ln FV n ) − ( ln PV )
By Formula:
Ln (1 + i )
FV n = $1, 000, 000 PV = $100,000 1 + i = 1.08
ln (1, 000, 000 ) − ln (100, 000 )

n=
ln(1.08)
13.82 − 11.51
= = 30 years
0.077
By Table: FV n = PV 0 ( FV IFi , n )
FV n
⇒ FV IFi ,n =
PV 0
1, 000, 000
FV IF8,n = = 10
100, 000
From the Table I at i=8 we find that the number of periods that yield 10 FVIF is 30
Or PV 0 = FV n ( PV IFi , n )
PV 0
⇒ PV IFi , n =
FV n
100, 000
PV IF8, n = = 0.1
1, 000, 000
From the Table II at i=8 we find that the number of periods that yield 0.1 PVIF is 30
18
By calculator:
INPUTS 8 -100,000 1,000,000 0

I/Y PV FV PMT
OUTPUT 29.9188
CPT N
FUTURE VALUE OF ANNUTIES
An annuity is a series of equal payments at fixed intervals for a specified

number of periods.
PMT = the amount of periodic payment
Ordinary (deferred) annuity: Payments occur at the end of each period.
Annuity due: Payments occur at the beginning of each period.
19
Ordinary
0 1 2 3
i
PM PM PM
Due
0 1 2 3
i
PM PM PM
Example: Suppose you deposit $100 at the end of each year into a savings
account paying 5% interest for 3 years. How much will you have in the
account after 3 years?
0 1 2 3
5%
100 100 100.00

105.00
110.25
$315.25
Time 0 1 2 3 4 n-1 n
PMT PMT PMT PMT PMT PMT
FV A N n = PMT (1 + i ) + PMT (1 + i )
n −1 n −2
+ .... + PMT
(Hard to use this formula)
20
⎡ (1 + i )n − 1 ⎤
FV AN n = PMT ⎢ ⎥
⎢⎣ i ⎥⎦
= PMT (FV IFA i ,n )
Future Value Interest
Factor for an Annuity
Note: For an annuity due, simply multiply the answer above by (1+i).
So FV AND n (annuity due) = PMT (FV IFA i ,n )(1 + i ).

⎡ (1 + i )n − 1 ⎤
= PMT ⎢ ⎥ (1 + i )
⎢⎣ i ⎥⎦
Annuity:
21
Annuity Due:
22
Remark:
FV IFA i ,3 = FV IFi ,2 + FV IFi ,1 + FV IFi ,0

To solve for the future value of Annuities, You need:
1-Payemnt or annuity amount (PMT)
2-Interest rate per period (i)
3-Number of periods (n)
1-BY Formula:
⎡ (1 + i )n − 1 ⎤
FV AN n = PMT ⎢ ⎥ ==Î Ordinary Annuity
⎢⎣ i ⎥⎦
⎡ (1 + i )n − 1 ⎤
FV AND n = PMT ⎢ ⎥ (1 + i ) ==Î Annuity Due
⎢⎣ i ⎥⎦
FVANDn = FVAN n (1 + i )
2- BY Table III:
FV A N n = PMT ( FV IFA i ,n ) ==Î Ordinary Annuity
FVAND n = PMT (FVIFAi ,n ) (1 + i ) ==Î Annuity Due
23
3- BY calculator:
Ordinary Annuity:
1- Clean the memory: CLR TVMÎ CE/C 2nd FV
2- Set payment mode to END of period: BGN Î 2nd PMT

SET Î
2nd ENTER
3- Make sure you can see END written on the screen then press CE/C
NOTE: If you do not see BGN written on the upper right side of the screen,
you can skip
Step 2 and 3.
INPUTS 3 5 0 -100
N I/Y PMT
PV
OUTPUT FV 315.25
CPT
24
Annuity Due:
Set payment mode to BGN of period: BGN Î 2nd PMT
SET Î
2nd ENTER
Make sure you can see BGN written on the screen then press CE/C
INPUTS 3 5 0 -100
N I/Y PMT
PV
OUTPUT FV 331.10
CPT
25
Example:
You agree to deposit $500 at the end of every year for 3 years in an investment
fund that earns 6%.
Time line
0 1 2 3
$500 $500 $500
6%
FV=?

I = 6% or 0.06
N= 3
PMT=500
PV= 0
FV=?
Solution:
⎡ (1 + i )n − 1 ⎤
By formula:
FV AN n = PMT ⎢ ⎥
⎢⎣ i ⎥⎦
⎡ (1 + 0.06)3 − 1 ⎤ ⎡1.191 − 1 ⎤
= 500 ⎢ ⎥ = 500 ⎢ ⎥ = 1,591.80
⎣ 0.06 ⎦ ⎣ 0.06 ⎦
By Table: FV AN n = PMT (FV IFA i ,n )

FV A N 3 = 500( FV IFA 6,3 )
= 500(3.184) = 1,592
26
By calculator:
Clean the memory: CLR TVMÎ CE/C 2nd FV

Make sure you do not see BGN written on the upper right side of the screen.
INPUTS 3 6 0 -500
N I/Y PMT
PV
OUTPUT FV 1,591.80
CPT
By Excel: =FV (0.06, 3, -500, 0, 0)
27
Now assume that you deposit the $500 at the beginning of the year not at the
end of the year.
Time line
0 1 2 3
$500 $500 $500 FV=?
6%

I = 6% or 0.06
N= 3
PMT=500 (beg)
PV= 0
FV=?
Solution:
⎡ (1 + i )n − 1 ⎤
By formula: FV AND n = PMT ⎢ ⎥ (1 + i )
⎢⎣ i ⎥⎦
⎡ (1 + 0.06 )n − 1 ⎤
FV AND 3 = 500 ⎢ ⎥ (1 + 0.06)
⎢⎣ 0.06 ⎥⎦
⎡ 0.191 ⎤
= 500 ⎢ ⎥ (1.06) = 1, 687.30
⎣ 0.06 ⎦
By Table: FV AND n = PMT (FVIFAi ,n ) (1 + i )

FV AND 3 = 500(FV IFA 6,3 ) (1 + 0.06 )
= 500(3.184)(1.06) = 1, 687.52
28
By calculator:

SET Î
2nd ENTER
INPUTS 3 6 0 -500
N I/Y PMT
PV
OUTPUT FV 1,687.31
CPT
By Excel: =FV (0.06, 3, -500, 0, 1)
29
PRESENT VALUE OF ANNUTIES
Problem: You have a choice

a) $100 paid to you at the end of each of the next 3 years or
b) a lump sum today.
i = 5%, since you would invest the money at this rate if you had it.
How big does the lump sum have to be to make the choices equally good?
0 1 2 3
Time
100 100 100
÷1.05
95.24 ÷1.052
90.70 ÷1.053
86.38
PVAN3 = 272.32
Formula:
PMT PMT PMT

PVA n = 1 + 2 + .... +
(1 + i ) (1 + i ) (1 + i )n
⎡1 − 1 ⎤
⎢ (1 + i )n ⎥
= PMT ⎢ ⎥
⎢ i ⎥
⎢⎣ ⎥⎦
= PMT (PVIFAi ,n ) Present Value Interest Factor
30
⎡1 − 1 ⎤
⎢ 3⎥
PVA 3 = $100⎢ 1.05 ⎥
.05
⎢ ⎥
⎣ ⎦
= $100(2.7232) = $272.32
Note: For annuities due, simply multiply the answer above by (1+i)
PVANDn (annuity due) = PMT (PVIFAi,n) (1+i)
To solve for the present value of Annuities, You need:

1-Payemnt or annuity amount (PMT)
2-Interest rate per period (i)
3-Number of periods (n)
1- BY Formula:
⎡ 1 ⎤
⎢ 1 − n ⎥
PVAN n = PMT ⎢
(1 + i ) ⎥
⎢ i ⎥ ==Î Ordinary Annuity
⎢ ⎥
⎣ ⎦
⎡ 1 ⎤
⎢ 1 − ⎥
( + )
n
1 i ⎥ (1 + i )
PVANDn = PMT ⎢
⎢ i ⎥ ==Î Annuity Due
⎢ ⎥
⎣ ⎦
PVANDn = PVAN n (1 + i )
31
2- BY Table IV:
PVAN n = PMT ( PVIFAi , n ) ==Î Ordinary Annuity
PVANDn = PMT ( PVIFAi ,n ) (1 + i ) ==Î Annuity Due
3- BY calculator:
Ordinary Annuity:
INPUTS 3 5 0 -100
N I/Y FV PMT
OUTPUT PV 272.32
CPT
32
Annuity Due:
SET Î
2nd ENTER
INPUTS 3 5 0 -100
N I/Y FV PMT
OUTPUT PV 285.94
CPT
33
Example:
You agree to receive $500 at the end of every year for 3 years in an investment
fund that earns 6%.
Time line
0 1 2 3
PV=? $500 $500 $500
6%

I = 6% or 0.06
N= 3
PMT=500
FV= 0
PV=?
Solution:
⎡ 1 ⎤
⎢ 1 − ⎥
( + )
n
1 i
PVAN n = PMT ⎢ ⎥
By formula: ⎢ i ⎥
⎢ ⎥
⎣ ⎦
⎡ 1 ⎤
⎢ 1 − ⎥ ⎡ 1 ⎤
( + )
3
1 0.06 1−
PVAN n = 500 ⎢ ⎥ ⎢ 1.191 ⎥
⎢ 0.06 ⎥ = 500 ⎢ ⎥ = $1, 336.51
⎢ 0.06 ⎥
⎢ ⎥
⎣ ⎦ ⎣ ⎦
34
By Table: PVAN n = PMT ( PVIFAi , n )
PVAN 3 = 500( PVIFA6,3 )
= 500(2.673) = 1, 336.51
By calculator:
INPUTS 3 6 0 -500
N I/Y FV PMT
OUTPUT PV 1,336.51
CPT
By Excel: =PV (0.06, 3, -500, 0, 0)
35
Now assume that you receive the $500 at the beginning of the year not at the
end of the year.
Time line
0 1 2 3
$500 $500 $500
6%
PV=?

I = 6% or 0.06
N= 3
PMT=500 (beg)
FV= 0
PV=?
Solution
⎡ 1 ⎤
⎢ 1 − ⎥
( + )
n
1 i ⎥ (1 + i )
PVANDn = PMT ⎢
By formula: ⎢ i ⎥
⎢ ⎥
⎣ ⎦
⎡ 1 ⎤ ⎡ 1 ⎤
⎢ 1 − 3 ⎥ −
PVANDn = 500 ⎢
(1 + 0.06 ) ⎥ (1 + 0.06) ⎢ 1 ⎥
= 500 ⎢ 1.191 ⎥ (1.06)
⎢ 0.06 ⎥
⎢ ⎥ ⎢ 0.06 ⎥
⎣ ⎦ ⎣ ⎦
= 1, 416.70
36
By Table: PVANDn = PMT ( PVIFAi ,n ) (1 + i )
PVAND3 = 500( PVIFA6,3 ) (1 + 0.06 )
= 500(2.673)(1.06) = 1, 416.69
By calculator:

SET Î
2nd ENTER
INPUTS 3 6 0 -500
N I/Y FV PMT
OUTPUT PV 1,416.69
CPT
By Excel: =PV (0.06, 3, -500, 0, 1)
37
Perpetuities
A perpetuity is an annuity that continues forever.

⎡ 1 ⎤
1 −
⎢ (1 + i ) n ⎥
PVAN n = PMT ⎢ ⎥
⎢ i ⎥
⎢⎣ ⎥⎦
1
As n gets very large, →0
(1 + i )
n
⎡1 − 0 ⎤ = PMT × ⎛ 1 ⎞ = PMT
PVPER0 ( perpetuity ) = PMT × ⎢ ⎥ ⎜ ⎟
⎣ i ⎦ ⎝i⎠ i
Formula:
PMT
PVPER0 =
i
38
UNEVEN CASH FLOWS
How do we get PV and FV when the periodic payments are unequal?
Present Value
0 1 2 3
100 50 200
95.24 ÷1.05 ÷1.05 2
45.35
÷1.053
172.77
$313.36
CF1 CF2 CFn

PV = CF0 + + + .... +
1 + i (1 + i ) (1 + i )n
2
Future Value
0 1 2 3
5%
100 50 200.00
×1.05
52.50
×1.052
110.25
$362.75
FV = CF0 (1 + i ) + CF1 (1 + i ) + .... + CFn (1 + i )

n n −1 0
39
Example:
Present Value of Uneven Cash Flows
40
By Calculator:
Clean the memory: CF 2nd CE/C
Input cash flows in the calculator’s CF register:

CF0 = 0 Î 0 ENTER
CF1 = 100 Î C01 100 ENTER F01 1 ENTER
Press NPV , then the it will ask you to enter the Interest rate (I)
Enter I = 10 Î 10 ENTER
Use to get to the NPV on the screen

When you read NPV on the screen, press CPT
You will get NPV = $481.59 (Here NPV = PV.)
NOTE:
To calculate the future value of uneven cash flows, it is much easier to start by
calculating the Present value of the cash flows using NPV function then
calculate the future value using the future value of a single cash flow rules. The
single cash flow in this case will be the present value.
41
Simple and Compound Interest
Simple Interest
¾ Interest paid on the principal sum only
Compound Interest
¾ Interest paid on the principal and on interest
Example:
Calculate the future value of $1000 deposited in a saving account for 3 years earning
6% . Also, calculate the simple interest, the interest on interest, and the compound
interest.
FV3 = 1000 (1.06) 3 = $1,191.02
Principal = PV = $1000
Compound interest = FV – PV = 1191.02 – 1000 = 191.02
Simple Interest = PV * i * n =1000 * 0.06 * 3 = $180
Interest on interest = Compound interest - Simple Interest = 191.02 – 180 =
11.02
42
Effect of Compounding over Time
Other Compounding Periods
So far, our problems have used annual compounding. In practice, interest is

usually compounded more frequently.
43
Example: You invest $100 today at 5% interest for 3 years.
Under annual compounding, the future value is:

FV3 = PV (1 + i )
3
= $100(1.05)3
= $100(1.1576)
= $115.76
What if interest is compounded semi-annually (twice a year)?
Then the periods on the time line are no longer years, but half-years!
6 months
Time: 0 1 2 3 4 5 6
2.5%
PV=100
FV6=?
5%
i = Periodic interest rate = = 2.5%
2
n = No. of periods = 3 × 2 = 6
FVn = PV (1 + i ) n
FV6 = $100(1.025)6
= $100(1.1597)
= $115.97
Note: the final value is slightly higher due to more frequent compounding.
44
Will the FV of a lump sum be larger or
smaller if compounded more often,
holding the stated I% constant?
LARGER, as the more frequently compounding
occurs, interest is earned on interest more often.
0 1 2 3
10%
100 133.10
Annually: FV3 = $100(1.10)3 = $133.10
0 1 2 3
0 1 2 3 4 5 6
5%
100 134.01
Semiannually: FV6 = $100(1.05)6 = $134.01
6-24
Important: When working any time value problem, make sure you keep
straight what the relevant periods are!
n = the number of periods
i = the periodic interest rate
From now on:

n = m*n
i = i/m
Where m = 1 for annual compounding

m=2 for semiannual compounding
m=4 for quarterly compounding
m = 12 for monthly compounding
m = 52 for weekly compounding
m = 365 for daily compounding
For continuously compounding: (1+i) n = e in

=Î FVn = PV (e) in
=Î PV = FVn (e) -
45
EFFECTIVE INTREST RATE
You have two choices:

1- 11% annual compounded rate of return on CD
2- 10% monthly compounded rate of return on CD
How can you compare these two nominal rates?
A nominal interest rate is just a stated (quoted) rate. An APR (annual

percentage rate) is a nominal rate.
For every nominal interest rate, there is an effective rate.
The effective annual rate is the interest rate actually being earned per year.
To compare among different nominal rates or to know what is the actual rate
that you’re getting on any investment you have to use the Effective annual
interest rate.
m
⎛ i ⎞
Effective Annual Rate:
i eff = ⎜1 + ⎟ − 1
⎝ m⎠
To compare the two rates in the example,
1
⎛ 0.11 ⎞
1- i eff = ⎜1 + ⎟ − 1 = 0.11 or 11% (Nominal and Effective rates are equal in annual
⎝ 1 ⎠
compounding)
12
⎛ 0.10 ⎞
2- i eff = ⎜1 + ⎟ − 1 = 0.1047 or 10.47 %
⎝ 12 ⎠
You should choose the first investment.
46
To compute effective rate using calculator:
ICONV Î 2nd 2
Enter Nominal Rate Î NOM 10 ENTER
Enter compounding frequency per year (m) Î C/Y 12 ENTER
Compute the Effective rate Î EFF CPT
Nominal Versus Real Interest Rate
Nominal rate rf is a function of:
¾ Inflation premium i n :compensation for inflation and lower

purchasing power.
¾ Real risk-free rate rf′ : compensation for postponing consumption.
(1 + rf ) = (1 + rf′ )(1 + i n )
rf = rf′ + i n + rf′i n
rf ≈ rf′ + i n
47
Amortized Loans
An amortized loan is repaid in equal payments over its life.
Example: You borrow $10,000 today and will repay the loan in equal installments at
the end of the next 4 years. How much is your annual payment if the interest rate is
9%?
Time 0 9% 1 2 3 4
PVA N= $10,000 PMT PMT PMT PMT
Inputs:
The periods are years. (m=1)

n=4
i = 9%
PVAN4 = $10,000
FV =0
PMT = ?
PV AN 4 = PMT (PV IFA 9%,4 )

$10, 000 = PMT (3.240)
$10, 000
PMT = = $3, 087
3.240
48
Interest amount = Beginning balance * i
Principal reduction = annual payment - Interest amount
Ending balance = Beginning balance - Principal reduction
Beginning balance: Start with principal amount and then equal to previous
year’s ending balance.
As a loan is paid off:
• at the beginning, much of each payment is for interest.
• later on, less of each payment is used for interest, and more of it is applied
to paying off the principal.
49
“Ovidius” University Annals, Economic Sciences Series
Volume XVII, Issue 2 /2017
The Time Value of Money in Financial Management
Munteanu Irena
„Ovidius” University of Constanta
irena.munteanu@yahoo.com
Bacula Mariana
“Traian” Theoretical High School, Constanta
baculamariana@yahoo.com
Abstract
The Time Value of Money is a important concept in financial management. The Time Value of
Money (TVM) includes the concepts of future value and discounted value. It is mandatory for a
financial professional to know and operate the specific techniques of TVM. Within the present
article we present the basic notions and illustrate their application in the field of investment
projects. The case studies presented are valuable for an efficient financial management.
Key words: time value of money, present value, future value

J.E.L. classification: G21; G32; M21
1. Introduction
The concept of Time Value of Money (TVM) has a large applicability in the financial
management of companies, in banking, on the capital market and in day to day life.
Damodaran sed: ,,There are three reasons why a dollar tomorrow is worth less than a dollar today:
 Individuals prefer present consumption to future consumption. To induce people to give up
present consumption you have to offer them more in the future.
 When there is monetary inflation, the value of currency decreases over time. The greater
the inflation, the greater the difference in value between a dollar today and a dollar
tomorrow.
 If there is any uncertainty (risk) associated with the cash flow in the future, the less that
cash flow will be valued”. (Damodaran, 2010)
But why is TVM concept necessary in banking?
 People with spare funds and the desire to invest them could decide to directly lend them to
borrowers in exchange for periodic repayments of the principal and interests. However, this
would involve resources and costs for both the lender and the borrower:
(1) On the one hand, it is extremely difficult for the lender to have an accurate picturs of the
borrower’s situation in terms of guarantee, so lender would have to monitor the borrower so as
to assess the security of the investment;
(2) On the other hand, the borrower might want a larger loan than the lender is able to provide
or perhaps needs the money for a longer period of time than the lender can afford. (Paniego,
Muñoz MLM, 2015 p 4)
The concept of TVM is used in financial management and within the selections methods of
investment projects.
2. The concept of Time Value of Money
The TVM is the concept according to which a sum of money owned in the present has a greater
value than the value of the same sum received at a moment in the future. Thus, it is taken into
account the opportunity of the one presently owning the sum of money to invest it and to obtain
future gains such as interest or profit. The techniques used in order to make possible comparing and
593
calculating the time value of money include: Compounding, Discounting, Capitalization, Indexing.
Within the present paper we shall focus on the first two techniques.
,,In fact, most of Time Value of Money formulas are closely related. When introducing TVM
formulas, the author can classify them under different conditions and link their relationships to
organize them”. (Chen J. K, 2009, p 77)
Compounding represents the conversion of a current (today) amount of money into a future (a
future year) amount of money, through the compounding factor or the compounded interest factor.
The formula is:
V n = V o × (1 + k)n , where:
V o = the initial invested capital (the present day sum of money);
k = the profitability rate requested / expected by the investor;
n = the time interval existing between the present moment and the future moment for
which the future value of the capital is estimated
V n = the value of the capital estimated for a certain future moment;
(1+k)n = represents the compounding factor.
,,Future Value is the value at some future time of a present amount of money, or a series of
payments, evaluated at a given interest rate”. (Kuhlemeyer, 2008)
,,Discounting is the technique that calculates the present value of a future sum of money (that
can be received or paid). Discounting requires computing the discounted (present) value of the
amount of money (cash flows) that are going to be received at future moments in time.
1
V0 = Vn ×
(1 + k )n
Present Value is the current value of a future amount of money, or a series of payments, evaluated
at a given interest rate”. (Kuhlemeyer, 2008)
3. Applying discounting in the selection methods of investment projects
The evaluation of investment projects of companies is an important part of the efficient financial
management and presumes taking the following mandatory steps:
1. Quantifying the costs of the investment project is the initial deciding step, with
important effects over the next steps and over the final selection decision.
2. Estimating the cash flows (CF) that will result following the implementation of the
investment project.
3. Determining the cost of capital or the discount rate
4. Discounting the cash flow generated by the exploitation of the investment.
5. Comparing the present value of the estimated cash flows with the prior computed costs
of the project. If the present discounted value of cash flows of the respective project is larger than
the implementation costs, then the project may be accepted as being profitable. Otherwise, the
project is not to be implemented.
In order to select the profitable investment projects we can use the payback period (PP)
method or the NPV (net present value) method.
Case study 1. A model of determining the discounted payback period
In a company it is sought to increase productivity by acquiring a new technological line. There

are two options to make this investment and the incoming and outgoing flows are synthesized in
594
Figure no. 1. Investment options \

- thousands of lei -
Discounted cash-flow
Year
Option A Option B
Initial cost -3500000 -3500000
1 1500000 1475000
2 1800000 1680000
3 2000000 1500000
4 1150000 +930000 1450000 + 930000
Source: own calculations
The negative value represents the costs of the initial investment and the flows in year 4 are
cumulated with the residual value of the company at the time, 930000 thousands of lei.
In the following lines we shall answer the question: “Which of the two projects should be
chosen using the project selection method PP?”
For the purpose of determining the PP of the investments there must be determined the
cumulated discounted cash-flows for the two options. (Figure 2)
Figure no. 2. Cumulated discounted CF

-thousands of lei-
Cumulated cash-flow
Year Opt. A Opt. B
Initial costs -3500000 -3500000
1 -2000000 -2025000
2 - 200000 - 345000
3 1800000 1155000
4 3880000 3535000
Substantiating the decision in financial management is realized after computing the payback
period for each project:
Project A:
The 3500000 thousands of lei initially invested are paid back in two years plus a period of t1
days that we shall determine. In the third year we recuperate 1800000 thousands of lei. We
calculate the daily cash flow for year 3.
2 000 000
CF3 / zi = 5 479 , 45 thousands of lei / day
365
The 200000 thousands of lei that remain at the end of year 2, will be recuperated in:
200 000 lei
t1 = = 36 ,5 days ≈ 37 days
5 479 , 45 lei / day
For project A it results a payback period of:
PBP = 2 years & 37 days.
Project B:
After 2 years, the initial investment is not fully covered. Again, we calculate the daily cash flow
for year 3:
1 500 000
365
The 345.000 thousands of lei that remain unpaid at the end of year 2.
595
345 000 lei

t2 = = 83 , 95 zile ≈ 84 zile
4109 , 58 lei / zi
PBP = 2 years and 84 days.
We choise project A for implementation. Project A is the one that proves again as being more
effective for the company.
Case study 2. Model of determining the NPV of the investment
The financial flows generated by implementing an investment project are produced at different
moments in time. In order to determine the profitability of an investment, we must compare the
financial flows, at the same moment, a process realized taking into account the TVM. This may be
accomplished through the discounting procedure by which all the generated flows of the
investment are mathematically translated to the initial moment of implementation of the project.
The method used in selecting the profitable project is the Net Present Value (NPV).
If we have several projects that have positive NVP, we will implement the one with the greater
net present value. If the NVPs are close, we will choose the project requiring a smaller initial
investment.
For the calculation of NVP we have the formula:
NPV = Net discounted cash flows - initial investment
and
n
CFi CF1 CF2 CFn
Vnetpresent = ∑ = + + ........ +
i =1 (1 + k ) (1 + k ) (1 + k ) (1 + k ) n
i 1 2
Thus, the NVP method does not offer decision makers any certain information regarding the
order of acceptance for financing various analyzed investment projects, it only answers the
question: “Are the projects acceptable?”.
We must decide, by using the NPV method, if the following project is profitable taking into
account the data:
Initial investment costs = 100000 EUR; Cash flow in the next 4 years: Year 1: 60000 EUR;
Year 2: 80000 EUR; Year 3: 80000 EUR; Year 4: 100000 EUR. Discount rate: 12%.
We discount the estimated cash flows and we compare them with the prior computed costs of
the investment. (Fig 3)
Figure no. 3. Net present value -EUR-

Discounted rate Discounted
Year Cash flow
(1+k)i cash flow
1 60000 0.8928 53568
2 80000 0.7972 63776
3 80000 0.7118 56944
4 100000 0.6355 63550
TOTAL: 237838
Initial investment: 100000
NPV = 237838 EUR - 100000 EUR = 137838 EUR > 0, the project is profitable and may be
implemented.
596
4. Conclusions
TVM concept stands at the basis of the profitability analyses in financial management. As the
PP represents the period at the end of which the initial investment equals that of the total cash flow
generated by the investment project, we may say that this method is connected to the notion of
investment liquidity. The investment liquidity is greater as the payback period is shorter.
Discounting, as a financial technique, allows the comparison of the revenue obtained at different
moments in time with the initial costs necessary for the implementation of an investment. This
technique is useful in determining the profitable projects, as it was presented in the case study no 2.
Damodaran sed: ,,Present value remains one of the simplest and most powerful techniques in
finance, providing a wide range of applications in both personal and business decisions. Cash flow
can be moved back to present value terms by discounting and moved forward by compounding.
The discount rate at which the discounting and compounding are done reflect three factors: (1) the
preference for current consumption, (2) expected inflation and (3) the uncertainty associated with
the cash flows being discounted”. (Damodaran, 2016).
5. References
• Chen J. K, Time Value Of Money And Its Applications In Corporate Finance: A Technical Note On
Linking Relationships Between Formulas, American Journal of Business Education – September
2009, Volume 2, Number 6, p.77
• Damodaran, A., A Primer on the Time Value of
Money http://pages.stern.nyu.edu/~adamodar/New_Home_Page/PVPrimer/pvprimer.htm (accessed
10.12.2017)
• Kuhlemeyer G. A., Fundamentals of Financial Management, 12/e, Chapter 3, Time Value of Money,
© Pearson Education Limited 2008, wps.pearsoned.co.uk/wps/media/objects/.../VW13E-03.pptx,
(accessed 28.11.2017)
• Paniego MP, Muñoz MLM, International Banking Regulation: the Basel Accords and EU
implementation of Basel III, 2015, g. 4, eprints.ucm.es (accessed 28.11.2017)
597
The Time Value of Money in Financial Management
Munteanu Irena
„Ovidius” University of Constanta
irena.munteanu@yahoo.com
Bacula Mariana
“Traian” Theoretical High School, Constanta
baculamariana@yahoo.com
Abstract
The Time Value of Money is a important concept in financial management. The Time Value of
Money (TVM) includes the concepts of future value and discounted value. It is mandatory for a
financial professional to know and operate the specific techniques of TVM. Within the present
article we present the basic notions and illustrate their application in the field of investment
projects. The case studies presented are valuable for an efficient financial management.
Key words: time value of money, present value, future value

J.E.L. classification: G21; G32; M21
1. Introduction
The concept of Time Value of Money (TVM) has a large applicability in the financial
management of companies, in banking, on the capital market and in day to day life.
Damodaran sed: ,,There are three reasons why a dollar tomorrow is worth less than a dollar today:
 Individuals prefer present consumption to future consumption. To induce people to give up
present consumption you have to offer them more in the future.
 When there is monetary inflation, the value of currency decreases over time. The greater
the inflation, the greater the difference in value between a dollar today and a dollar
tomorrow.
 If there is any uncertainty (risk) associated with the cash flow in the future, the less that
cash flow will be valued”. (Damodaran, 2010)
But why is TVM concept necessary in banking?
 People with spare funds and the desire to invest them could decide to directly lend them to
borrowers in exchange for periodic repayments of the principal and interests. However, this
would involve resources and costs for both the lender and the borrower:
(1) On the one hand, it is extremely difficult for the lender to have an accurate picturs of the
borrower’s situation in terms of guarantee, so lender would have to monitor the borrower so as
to assess the security of the investment;
(2) On the other hand, the borrower might want a larger loan than the lender is able to provide
or perhaps needs the money for a longer period of time than the lender can afford. (Paniego,
Muñoz MLM, 2015 p 4)
The concept of TVM is used in financial management and within the selections methods of
investment projects.
2. The concept of Time Value of Money
The TVM is the concept according to which a sum of money owned in the present has a greater
value than the value of the same sum received at a moment in the future. Thus, it is taken into
account the opportunity of the one presently owning the sum of money to invest it and to obtain
future gains such as interest or profit. The techniques used in order to make possible comparing and
593
calculating the time value of money include: Compounding, Discounting, Capitalization, Indexing.
Within the present paper we shall focus on the first two techniques.
,,In fact, most of Time Value of Money formulas are closely related. When introducing TVM
formulas, the author can classify them under different conditions and link their relationships to
organize them”. (Chen J. K, 2009, p 77)
Compounding represents the conversion of a current (today) amount of money into a future (a
future year) amount of money, through the compounding factor or the compounded interest factor.
The formula is:
V n = V o × (1 + k)n , where:
V o = the initial invested capital (the present day sum of money);
k = the profitability rate requested / expected by the investor;
n = the time interval existing between the present moment and the future moment for
which the future value of the capital is estimated
V n = the value of the capital estimated for a certain future moment;
(1+k)n = represents the compounding factor.
,,Future Value is the value at some future time of a present amount of money, or a series of
payments, evaluated at a given interest rate”. (Kuhlemeyer, 2008)
,,Discounting is the technique that calculates the present value of a future sum of money (that
can be received or paid). Discounting requires computing the discounted (present) value of the
amount of money (cash flows) that are going to be received at future moments in time.
1
V0 = Vn ×
(1 + k )n
Present Value is the current value of a future amount of money, or a series of payments, evaluated
at a given interest rate”. (Kuhlemeyer, 2008)
3. Applying discounting in the selection methods of investment projects
The evaluation of investment projects of companies is an important part of the efficient financial
management and presumes taking the following mandatory steps:
1. Quantifying the costs of the investment project is the initial deciding step, with
important effects over the next steps and over the final selection decision.
2. Estimating the cash flows (CF) that will result following the implementation of the
investment project.
3. Determining the cost of capital or the discount rate
4. Discounting the cash flow generated by the exploitation of the investment.
5. Comparing the present value of the estimated cash flows with the prior computed costs
of the project. If the present discounted value of cash flows of the respective project is larger than
the implementation costs, then the project may be accepted as being profitable. Otherwise, the
project is not to be implemented.
In order to select the profitable investment projects we can use the payback period (PP)
method or the NPV (net present value) method.
Case study 1. A model of determining the discounted payback period
In a company it is sought to increase productivity by acquiring a new technological line. There

are two options to make this investment and the incoming and outgoing flows are synthesized in
594
Figure no. 1. Investment options \

- thousands of lei -
Discounted cash-flow
Year
Option A Option B
Initial cost -3500000 -3500000
1 1500000 1475000
2 1800000 1680000
3 2000000 1500000
4 1150000 +930000 1450000 + 930000
The negative value represents the costs of the initial investment and the flows in year 4 are
cumulated with the residual value of the company at the time, 930000 thousands of lei.
In the following lines we shall answer the question: “Which of the two projects should be
chosen using the project selection method PP?”
For the purpose of determining the PP of the investments there must be determined the
cumulated discounted cash-flows for the two options. (Figure 2)
Figure no. 2. Cumulated discounted CF

-thousands of lei-
Cumulated cash-flow
Year Opt. A Opt. B
Initial costs -3500000 -3500000
1 -2000000 -2025000
2 - 200000 - 345000
3 1800000 1155000
4 3880000 3535000
Substantiating the decision in financial management is realized after computing the payback
period for each project:
Project A:
The 3500000 thousands of lei initially invested are paid back in two years plus a period of t1
days that we shall determine. In the third year we recuperate 1800000 thousands of lei. We
calculate the daily cash flow for year 3.
2 000 000
365
The 200000 thousands of lei that remain at the end of year 2, will be recuperated in:
200 000 lei
t1 = = 36 ,5 days ≈ 37 days
5 479 , 45 lei / day
For project A it results a payback period of:
PBP = 2 years & 37 days.
Project B:
After 2 years, the initial investment is not fully covered. Again, we calculate the daily cash flow
for year 3:
1 500 000
365
The 345.000 thousands of lei that remain unpaid at the end of year 2.
595
345 000 lei

t2 = = 83 , 95 zile ≈ 84 zile
4109 , 58 lei / zi
PBP = 2 years and 84 days.
We choise project A for implementation. Project A is the one that proves again as being more
effective for the company.
Case study 2. Model of determining the NPV of the investment
The financial flows generated by implementing an investment project are produced at different
moments in time. In order to determine the profitability of an investment, we must compare the
financial flows, at the same moment, a process realized taking into account the TVM. This may be
accomplished through the discounting procedure by which all the generated flows of the
investment are mathematically translated to the initial moment of implementation of the project.
The method used in selecting the profitable project is the Net Present Value (NPV).
If we have several projects that have positive NVP, we will implement the one with the greater
net present value. If the NVPs are close, we will choose the project requiring a smaller initial
investment.
For the calculation of NVP we have the formula:
NPV = Net discounted cash flows - initial investment
and
n
CFi CF1 CF2 CFn
Vnetpresent = ∑ = + + ........ +
i =1 (1 + k ) (1 + k ) (1 + k ) (1 + k ) n
i 1 2
Thus, the NVP method does not offer decision makers any certain information regarding the
order of acceptance for financing various analyzed investment projects, it only answers the
question: “Are the projects acceptable?”.
We must decide, by using the NPV method, if the following project is profitable taking into
account the data:
Initial investment costs = 100000 EUR; Cash flow in the next 4 years: Year 1: 60000 EUR;
Year 2: 80000 EUR; Year 3: 80000 EUR; Year 4: 100000 EUR. Discount rate: 12%.
We discount the estimated cash flows and we compare them with the prior computed costs of
the investment. (Fig 3)
Figure no. 3. Net present value -EUR-

Discounted rate Discounted
Year Cash flow
(1+k)i cash flow
1 60000 0.8928 53568
2 80000 0.7972 63776
3 80000 0.7118 56944
4 100000 0.6355 63550
TOTAL: 237838
Initial investment: 100000
NPV = 237838 EUR - 100000 EUR = 137838 EUR > 0, the project is profitable and may be
implemented.
596
4. Conclusions
TVM concept stands at the basis of the profitability analyses in financial management. As the
PP represents the period at the end of which the initial investment equals that of the total cash flow
generated by the investment project, we may say that this method is connected to the notion of
investment liquidity. The investment liquidity is greater as the payback period is shorter.
Discounting, as a financial technique, allows the comparison of the revenue obtained at different
moments in time with the initial costs necessary for the implementation of an investment. This
technique is useful in determining the profitable projects, as it was presented in the case study no 2.
Damodaran sed: ,,Present value remains one of the simplest and most powerful techniques in
finance, providing a wide range of applications in both personal and business decisions. Cash flow
can be moved back to present value terms by discounting and moved forward by compounding.
The discount rate at which the discounting and compounding are done reflect three factors: (1) the
preference for current consumption, (2) expected inflation and (3) the uncertainty associated with
the cash flows being discounted”. (Damodaran, 2016).
5. References
• Chen J. K, Time Value Of Money And Its Applications In Corporate Finance: A Technical Note On
Linking Relationships Between Formulas, American Journal of Business Education – September
2009, Volume 2, Number 6, p.77
• Damodaran, A., A Primer on the Time Value of
Money http://pages.stern.nyu.edu/~adamodar/New_Home_Page/PVPrimer/pvprimer.htm (accessed
10.12.2017)
• Kuhlemeyer G. A., Fundamentals of Financial Management, 12/e, Chapter 3, Time Value of Money,
© Pearson Education Limited 2008, wps.pearsoned.co.uk/wps/media/objects/.../VW13E-03.pptx,
(accessed 28.11.2017)
• Paniego MP, Muñoz MLM, International Banking Regulation: the Basel Accords and EU
implementation of Basel III, 2015, g. 4, eprints.ucm.es (accessed 28.11.2017)
597
Budgets and budgetory control
DEFINITION OF BUDGET
The Chartered Institute of Management Accountants, England, defines a 'budget' as
under:
" A financial and/or quantitative statement, prepared and approved prior to define
period of time, of the policy to be persued during that period for the purpose of
attaining a given objective."
According to Brown and Howard of Management Accountant "a budget is a
predetermined statement of managerial policy during the given period which provides a
standard for comparison with the results actually achieved.
Essentials of a Budget
An analysis of the above said definitions reveal the following essentials of a budget:
(1) It is prepared for a definite future period.
(2) It is a statement prepared prior to a defined period of time.
(3) The Budget is monetary and I or quantitative statement of policy.
(4) The Budget is a predetermined statement and its purpose is to attain a given objective.
A budget, therefore, be taken as a document which is closely related to both the managerial as
well as
accounting functions of an organization.
Forecast Vs Budget
Forecast is mainly concerned with an assessment of probable future events. Budget
is a planned result that an enterprise aims to attain.
Forecasting precedes preparation of a budget as it is an important part of the

budgeting process. It is said that the budgetary process is more a test of forecasting
skill than anything else. A budget is both a mechanism for profit planning and
technique of operating cost control.
In order to establish a budget it is essential to forecast various important variables

like sales, selling prices,availability of materials, prices of materials, wage rates etc.
TYPE OF BUDGETS
• Operating Budget: Operating budget consists of plans for all those income
generating
• activities that makes up the normal operations of the organization.
• The main components of an organization’s operating budgets are sales,
• production, inventory, materials, labour, overhead and research and
• development budgets.
• • Financial budget: Financial budget is used to control the financial aspects
of
• the business. In effect, it reveals the influence of the operating budgets on the
financial position of the organization and its earnings potential at end of the
budget period. They include a cash budget, capital expenditure budget and
proforma balance sheet and income statement.
Budget
budget
Budget charecteristics
Budget at its roles
• A budget, if created and used properly, can provide valuable
information about the direction, resources and expectations of the
organisation.
• Budget is described as an integral part of management control
systems that aims at promoting coordination and communication
among subunits within the company, provides a framework for
judging performance and finally motivating managers and other
employees
Budget and its roles
• To serve as an effective tool, budget pursues different tasks such as
planning, forecasting,
controlling, coordinating, communicating, instructing, authorizing,
motivating,delegating, educating, evaluating performance, facilitating
decision making and managing subordinates.
•
Some possible roles involve budgets being used as a:

1.Means of Forecasting and Planning:One of the functions served by most budgets is that of
forecasting and planning. Forecasting refers to the prediction of events over which the
organisation has little or no control of while planning is the attempt to shape the future by
altering those uncontrollable factors in the light of available forecasts.
• Given a set of forecast, the budget model is able to operate in an optimising role,
attempting to ascertain which plan of action will result in the greatest benefit of the
organisation.
• Since planning is at the heart of a budgeting process, by employing the budgeting process
diligently, companies can plan extensively on the best course of action to achieve the
organization’s goals.
• As a planning aid, budgets allows forthe refinement and quantification of the long-term
business plan into short-termaction plans whereby alternative planning scenarios may be
examined and a“what-if” analysis applied.
• Without the annual budgeting process, the pressures of day-today operating problems may
tempt managers not to plan for future operations (Drury, 2001).
• The budgeting process encourages managers to anticipate problems before they arise, and
hasty decisions that are made on the spur of the moment, based on expediency rather than
reasoned judgement, will be minimised.
• 2.System for Authorisation: The responsibility of each manager is made amply
clear as the budget would usually describe the amount of resources and
degree ofauthority managers need and have to achieve the organization’s
goals.
• Thus,budgets serve as a formal authorisation for a manager to spend a given
amount of money on specific activities.
• In this respect, budgets is used to ensure that organisational resources is
utilised in the most productive and profitable way, to
achieve efficiency required for the business operations thereby reducing
costs and raising profitability (Australian Society of CPA, 1999).
• Such a system of authorisation must be supported by a suitable responsibility
structure adopted by the organization.
• 3.Channel for Communication and Coordination:
• Evidently, budgets are an important channel of communicating certain type of information that will enable
managers in different parts of the organisation to be fully informed of the plan and policies, and constraints,
to which the organisation is expected to conform.
• Through the budgeting process, top management communicates its expectations to the lower level
management, so that members of the organisation may understand these expectations and can coordinate
their activities to attain them (Drury, 2001).
• In essence, preparation of the budgets facilitates the transfer of vital information among all levels in the
organisation and thus, level of interaction are more enhance during the budgeting process.
• The co-ordination of business activities will be aided through the budgeting process.
• Considering that all actions of the different parts of the organisation are brought together and reconciled
into a common plan, the budgeting process assist to bind an organisation together towards the achievement
the organisation’s goal.
• Without any guidance, managers may each make their own decisions, believing
that they are working in the best interest of the organisation
Capital investment decisions
Capital investment
• Capital investments are funds invested in a firm or enterprise for the
purposes of furthering its business objectives.
• Capital investment may also refer to a firm's acquisition of capital
assets or fixed assets such as manufacturing plants and machinery
that are expected to be productive over many years.
• Sources of capital investment are manifold and can include equity
investors, banks, financial institutions, venture capital and angel
investors.
• While capital investment is usually earmarked for capital or long-life
assets, a portion may also be used for working capital purposes.
• Capital investment encompasses a wide variety of funding options.
• While funding for capital investment is generally in the form of

common or preferred equity issuance, it may also be through straight
or convertible debt.
• Funding may range from an amount very less in seed financing for a
start-up to amounts in the hundreds of millions for massive projects
in capital-intensive sectors like mining, utilities and infrastructure.
Capital budgeting is vital in marketing decisions. Decisions on investment, which take
time to mature, have to be based on the returns which that investment will make.
Unless the project is for social reasons only, if the investment is unprofitable in the long
run, it is unwise to invest in it now.
Often, it would be good to know what the present value of the future investment is, or
how long it will take to mature (give returns). It could be much more profitable putting
the planned investment money in the bank and earning interest, or investing in an
alternative project.
Typical investment decisions include the decision to build another grain silo, cotton gin
or cold store or invest in a new distribution depot. At a lower level, marketers may wish
to evaluate whether to spend more on advertising or increase the sales force, although
it is difficult to measure the sales to advertising ratio.
IMPORTANCE OF CAPITAL BUDGETING
1) Long term investments involve risks: Capital expenditures are long term investments which
involve more financial risks. That is why proper planning through capital budgeting is needed
.2) Huge investments and irreversible ones: As the investments are huge but the funds are limited,
proper planning through capital expenditure is a pre-requisite.
Also, the capital investment decisions are irreversible in nature, i.e. once a permanent asset is
purchased its disposal shall incur losses.
3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in
the profitability of the company. It helps avoid over or under investments.
Proper planning and analysis of the projects helps in the long run.
SIGNIFICANCE OF CAPITAL BUDGETING
•Capital budgeting is an essential tool in financial management
•Capital budgeting provides a wide scope for financial managers to evaluate different projects in
terms of their viability to be taken up for investments
•It helps in exposing the risk and uncertainty of different projects
•It helps in keeping a check on over or under investments
•The management is provided with an effective control on cost of capital expenditure projects
•Ultimately the fate of a business is decided on how optimally the available resources are used
• The economic evaluation of investment proposals
• The analysis stipulates a decision rule for:
• I) accepting or
II) rejecting investment projects
Capital budgeting versus current expenditures
A capital investment project can be distinguished from current expenditures by two features :
a) such projects are relatively large
b) a significant period of time (more than one year) elapses between the investment
outlay and the receipt of the benefits..
As a result, most medium-sized and large organisations have developed special
procedures and methods for dealing with these decisions.
A systematic approach to capital budgeting implies:

a) the formulation of long-term goals
b) the creative search for and identification of new investment opportunities
c) classification of projects and recognition of economically and/or statistically dependent
proposals
d) the estimation and forecasting of current and future cash flows
e) a suitable administrative framework capable of transferring the required information to
the decision level
f) the controlling of expenditures and careful monitoring of crucial aspects of project
execution
g) a set of decision rules which can differentiate acceptable from unacceptable
alternatives is required.
THE CLASSIFICATION OF INVESTMENT PROJECTS
a) By project size
Small projects may be approved by departmental managers.
More careful analysis and Board of Directors' approval is needed for large projects involving huge money .
b) By type of benefit to the firm

· an increase in cash flow
· a decrease in risk
· an indirect benefit (showers for workers, etc).
c) By degree of dependence
· mutually exclusive projects (can execute project A or B, but not both)
· complementary projects: taking project A increases the cash flow of project B.
· substitute projects: taking project A decreases the cash flow of project B.
d) By degree of statistical dependence
· Positive dependence
· Negative dependence
· Statistical independence.
e) By type of cash flow
· Conventional cash flow: only one change in the cash flow sign
e.g. -/++++ or +/----, etc
· Non-conventional cash flows: more than one change in the cash flow sign,
e.g. +/-/+++ or -/+/-/++++, etc.
Methods of capital
investment decision
CAPITAL BUDGETING TECHNIQUES / METHODS
There are different methods adopted for capital budgeting.
The traditional methods or non discount methods include:

1, Payback period
and 2. Accounting rate of return method.
The discounted cash flow method includes the

1. NPV method,
2. profitability index method and
3.IRR.
Advantages and disadvantages of this method
•Accounting rate of return method (ARR):
•This method helps to overcome the disadvantages of the payback period method.
• The rate of return is expressed as a percentage of the earnings of the investment in a particular
project
•. It works on the criteria that any project having ARR higher than the minimum rate established
by the management will be considered and those below the predetermined rate are rejected.
•This method takes into account the entire economic life of a project providing a better means
of comparison.
•It also ensures compensation of expected profitability of projects through the concept of net earnings
•. However, this method also ignores time value of money and doesn’t consider the length of life of
the projects.
• Also it is not consistent with the firm’s objective of maximizing the market value of shares.
•Discounted cash flow method:
The discounted cash flow technique calculates the cash inflow and outflow
through the life of an asset.
These are then discounted through a discounting factor. The discounted

cash inflows and outflows are then compared.
This technique takes into account the interest factor and the return after the
payback period.
•Payback period method:
As the name suggests, this method refers to the period in which the proposal will generate
cash to recover the initial investment made.
It purely emphasizes on the cash inflows, economic life of the project and the investment made
in the project, with no consideration to time value of money.
Through this method selection of a proposal is based on the earning capacity of the project.
With simple calculations, selection or rejection of the project can be done,

with results that will help gauge the risks involved.
However, as the method is based on thumb rule, it does not consider the
importance of time value of money and so the relevant dimensions of profitability.
What is Net Present Value (NPV)?
Net present value (NPV) is the difference between the present value of cash inflows and the present
value of cash outflows over a period of time. NPV is used in capital budgeting and investment
planning to analyze the profitability of a projected investment or project.

Rt = net cash inflow-outflows during a single period t
i = discount rate or return that could be earned in alternative
investments
t = number of time periods
NPV = (Today’s value of the expected cash

flows) – (Today’s value of invested cash)
•Net present Value (NPV) Method:
This is one of the widely used methods for evaluating capital investment proposals.
In this technique the cash inflow that is expected at different periods of time is discounted at a
particular rate.
The present values of the cash inflow are compared to the original investment.
If the difference between them is positive (+) then it is accepted or otherwise rejected.
This method considers the time value of money and is consistent with the objective of maximizing
profits for the owners.
However, understanding the concept of cost of capital is not an easy task.

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost
of the investment proposal and n is the expected life of the proposal
. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present,
value cannot be known.
A positive net present value indicates that the projected earnings generated by a
project or investment - in present money- exceeds the anticipated costs, also in
present money
It is assumed that an investment with a positive NPV will be profitable, and an

investment with a negative NPV will result in a net loss.
This concept is the basis for the Net Present Value Rule, which dictates that only
investments with positive NPV values should be considered.
Net present value (NPV) is the calculation used to find today’s value of a future stream of
payments. It accounts for the time value of money and can be used to compare
investment alternatives that are similar.
The NPV relies on a discount rate of return that may be derived from the cost of the
capital required to make the investment, and any project or investment with a negative
NPV should be avoided.
An important drawback of using an NPV analysis is that it makes assumptions about

future events that may not be reliable.
Net Present Value Drawbacks and Alternatives
• Gauging an investment’s profitability with NPV relies heavily on
assumptions and estimates, so there can be substantial room for
error.
• Estimated factors include investment costs, discount rate, and

projected returns.
• A project may often require unforeseen expenditures to get off the

ground or may require additional expenditures at the project’s end.
• What is a Cash Flow Statement?
• In financial accounting, a cash flow statement (also known as statement of cash flows or
funds flow statement) is a financial statement that shows how changes in balance sheet
accounts and income affect cash and cash equivalents. The cash flow statement, as the
name suggests, provides a picture of how much cash is flowing in and out of the business
during the fiscal year.
• The cash flow is widely believed to be the most important of the three financial
statements because it is useful in determining whether a company will be able to pay its
bills and make the necessary investments. A company may look really great based on the
balance sheet and income statement, but if it doesn’t have enough cash to pay its
suppliers, creditors, and employees, it will go out of business. A positive cash flow means
that more cash is coming into the company than going out, and a negative cash flow
means the opposite.
CASH FLOW
• A statement of cash flows is a financial statement showing how
changes in balance sheet accounts and income affect cash & cash
equivalents.
• It breaks the analysis down to operating, investing, and financing

activities.
• Essentially, the cash flow statement is concerned with the flow of

cash in and out of the business..
CASH FLOW
People and groups interested in cash flow statements include:

(1) Accounting personnel who need to know whether the organization
will be able to cover payroll and other immediate expenses,
(2) potential lenders or creditors who want a clear picture of a

company’s ability to repay,
(3) potential investors who need to judge whether the company is

financially sound,
(4) potential employees or contractors who need to know whether the

company will be able to afford compensation, and
(5) shareholders of the business.

The cash flow statement is intended to:
•Provide information on a firm’s liquidity and solvency

and its ability to change cash flows in future
circumstances provide additional information for
evaluating changes in assets, liabilities, and equity;
•Improve the comparability of different firms’ operating

performance by eliminating the effects of different
accounting methods; and
•Indicate the amount, timing, and probability of future

cash flows.
• The cash flow statement has been adopted as a standard financial
statement,
because it eliminates allocations, which might be derived from
different accounting methods, such as various timeframes for
depreciating fixed assets.
• COMPONENTS OF THE STATEMENT OF CASH FLOWS
• The cash flow statement is partitioned into three segments, namely:

• Cash flow resulting from operating activities
• Cash flow resulting from investing activities
• Cash flow resulting from financing activities.
• It also may include a disclosure of non-cash financing activities.
• Operating activities include the production, sales, and delivery of
the company’s product as well as collecting payments from its
customers. This could include purchasing raw materials, building
inventory, advertising, and shipping the product.
• Investing activities are purchases or sales of assets (land, building,
equipment, marketable securities, etc.), loans made to suppliers
or received from customers, and payments related to mergers
and acquisitions.
• Financing activities include the inflow of cash from investors, such
as banks and shareholders and the outflow of cash to
shareholders as dividends as the company generates income.
Other activities that impact the long-term liabilities and equity of
the company are also listed in the financing activities section of
the cash flow statement.
• Non-cash investing and financing activities are disclosed in
footnotes to the financial statements.),. Non-cash financing
activities may include leasing to purchase an asset, converting
debt to equity, exchanging non-cash assets or liabilities for other
non-cash assets or liabilities, and issuing shares in exchange for
assets.
CASH FLOW FROM FINANCING
• Cash flows from financing activities arise from the borrowing, repaying, or raising
of money.
• This could be from
1. the issuance of shares,
2. buying back shares,
3. paying dividends, or
4. borrowing cash.
• Financing activities can be seen in changes in non-current liabilities and in
changes in equity in the change-in-equity statement.
CASH FLOW FROM FINANCING
•Financing activities can be seen in changes in non-current liabilities and in changes in

equity in the change-in-equity statement.
•A positive financing cash flow could be really great for a company (it just went issued
stock at a great price) or could be due to the company having to take out loans to stay
out of bankruptcy.
•Issuing credit is not a financing activity though taking on credit is. Like all cash flows,
such activities only appear on the cash flow statement when the exchange of money
actually takes place.
a company may take out a loan. Receiving the money is a positive cash flow because cash is
flowing into the company, while each individual payment is a negative cash flow.
However, when a company makes a loan (by extending credit to a customer, for example), it is
not partaking in a financing activity. Extending credit is an investing activity, so all cash flows
related to that loan fall under cash flows from investing activities, not financing activities.
As is the case with operating and investing activities, not all financing activities impact the cash
flow statement — only those that involve the exchange of cash do. For example, a company may
issue a discount which is a financing expense. However, because no cash changes hands, the
discount does not appear on the cash flow statement.
Overall, positive cash flow could mean a company has just raised cash via a stock issuance or the
company borrowed money to pay its obligations, therefore avoiding late payments or even
bankruptcy.
Regardless, the cash flow statement is an important part of analyzing a company’s financial
health, but is not the whole story.
CASH FLOW FROM INVESTING
•Cash flow from investing results from activities related to the purchase
or sale of assets or investments made by the company.
•Assets included in investment activity include land, buildings, and
equipment.
•Receiving dividends from another company’s stock is an investing
activity, although paying dividends on a company’s own stock is not.
•An investing activity only appears on the cash flow statement if there is
an immediate exchange of cash.
Key Terms
investing activity: An activity that causes changes in non-current assets
or involves a return on investment.
merger: The legal union of two or more corporations into a single entity,
typically assets and liabilities being assumed by the buying party.
purchase return: merchandise given back to the seller from the buyer
after the sale in return for a refund
investing activities: actions where money is put into something with the
expectation of gain, usually over a longer term
. An investing activity is anything that has to do with changes in
1.non-current assets —
• including property and equipment,
•and investment of cash into shares of stock,
• foreign currency,
•or government bonds —
2. return on investment —
• including dividends from investment in other entities
•and gains from sale of non-current assets.
These activities are represented in the investing income part of the

income statement.
• It is important to note that investing activity does not concern cash

from outside investors, such as bondholders or shareholders.
• For example, a company may decide to pay out a dividend. A
dividend is often thought of as a payment to those who invested in
the company by buying its stock.
• However, this cash flow is not representative of an investing activity
on the part of the company. The investing activity was undertaken by
the shareholder. Therefore, paying out a dividend is a financing
activity.
• CASH FLOW FROM OPERATIONS
• The operating cash flows refers to all cash flows that
have to do with the actual operations of the business,
such as selling products.
CASH FLOW FROM OPERATIONS
• Operating cash flows refers to the cash a company generates from the
revenues it brings in, excluding costs associated with long-term
investment on capital items or investment in securities (these are
investing or financing activities).
Some activities that are operating cash flows under one system
are financing or investing in another.
• Major operating activities such as manufacturing products or selling a
product may appear on the income statement but not on the cash
flow statement, because cash has not yet changed hands.
•Cash flows from operating activities can be calculated and
disclosed on the cash flow statement using the direct or
indirect method.
• The direct method shows the cash inflows and outflows
affecting all current asset and liability accounts, which largely
make up most of the current operations of the entity.
• Those preparers that use the direct method must also provide
operating cash flows under the indirect method. The indirect
method is a reconciliation of the period ‘s net income to arrive
at cash flows from operations; changes in current asset and
liability accounts are added or subtracted from net income
based on whether the change increased or decreased cash. The
indirect method must be disclosed in the cash flow statement
. The most noticeable cash inflow is cash paid by customers. Cash from
customers is not necessarily the same as revenue, though. For example, if a
company makes all of its sales by extending credit to customers, it will have
generated revenues but not cash flows from customers. It is only when the
company collects cash from customers that it has a cash flow.
Significant cash outflows are salaries paid to employees and purchases of

supplies. Just as with sales, salaries, and the purchase of supplies may
appear on the income statement before appearing on the cash flow
statement.
Operating cash flows, like financing and investing cash flows, are only
accrued when cash actually changes hands, not when the deal is made.
INTERPRETING OVERALL CASH FLOW
•Having positive and large cash flow is a good sign for any business, though does not
by itself mean the business will be successful.
•Having positive cash flows is important because it means that the company has at
least some liquidity and may be solvent.
•A positive cash flow does not guarantee that the company can pay all of its bills,
just as a negative cash flow does not mean that it will miss its payments.
•When preparing the statement of cash flows, analysts must focus on changes in
account balances on the balance sheet.
•Cash flows from operating activities are essential to helping analysts assess the
company’s ability to meet ongoing funding requirements, contribute to long-term
projects and pay a dividend.
•Analysis of cash flow from investing activities focuses on ratios when assessing a
company’s ability to meet future expansion requirements.The free cash flow is
useful when analysts want to see how much cash can be extracted from a company
without causing issues to its day to day operations.
•A positive cash flow does not guarantee that the company can pay all of its bills, just
as a negative cash flow does not mean that it will miss its payments.
•When preparing the statement of cash flows, analysts must focus on changes in
account balances on the balance sheet.
•Cash flows from operating activities are essential to helping analysts assess the
company’s ability to meet ongoing funding requirements, contribute to long-term
projects and pay a dividend
•.
•Analysis of cash flow from investing activities focuses on ratios when assessing a
company’s ability to meet future expansion requirements.
•The free cash flow is useful when analysts want to see how much cash can be
extracted from a company without causing issues to its day to day operations.
•Having positive cash flows is important because it means that the company has at
least some liquidity and may be solvent.
Relationship to Other Financial Statements
When preparing the cash flow statement, one must analyze the balance sheet
and income statement for the coinciding period. If the accrual basis of
accounting is being utilized, accounts must be examined for their cash
components.
Analysts must focus on changes in account balances on the balance sheet.

General rules for this process are as follows.:
• Transactions that result in an increase in assets will always result in a
decrease in cash flow.
• Transactions that result in a decrease in assets will always result in an
increase in cash flow.
• Transactions that result in an increase in liabilities will always result in an
increase in cash flow.
• Transactions that result in a decrease in liabilities will always result in a
decrease in cash flow
Interpretation
•An analyst looking at the cash flow statement will first care about whether the company
has a net positive cash flow.
• Having a positive cash flow is important because it means that the company has at least
some liquidity and may be solvent.
•Regardless of whether the net cash flow is positive or negative, an analyst will want to
know where the cash is coming from or going to.
•The three types of cash flows (operating, investing, and financing) will all be broken down
into their various components and then summed.
• The company may have a positive cash flow from operations, but a negative cash flow
from investing and financing. This sheds important insight into how the company is making
or losing money.
PURPOSE OF CASH FLOW STATEMENTS
•1.Cash flow statements are useful in determining liquidity and identifying the amount
of capital that is free to capture existing market opportunities.
•2. As one of the core financial statements publicly traded organizations release to the
public, it is also useful as a benchmark for investors when considering the capacity for
different organizations within an industry to adapt and capture new opportunities.
In short, we can summarize what cash flows are used for as:
•Measure liquidity and the capacity to change cash flows in future circumstances
•Provide additional information for evaluating changes in assets, liabilities, and equity
•Compare between different firms’ operating performance
•Predict the amount, timing, and probability of future cash flows
Limitations
•However, there can be a number of issues with utilizing the statement of cash flows as
an investor speculating about different organizations.
• The simplest drawback to a cash flow statement is the fact that cash flows can (but not
always) omit certain types of non-cash transactions.
•As the name implies, the statement of cash flows is focused exclusively on tangible
changes in cash and cash equivalents.
• Costs Associated with Constructed Facilities
COSTS OF A CONSTRUCTED FACILITY
initial capital cost operation and

maintenance costs
• The capital cost for a construction project includes the expenses related to the initial establishment of the
facility:
• Land acquisition, including assembly, holding and improvement

• Planning and feasibility studies
• Architectural and engineering design
• Construction, including materials, equipment and labor
• Field supervision of construction
• Construction financing
• Insurance and taxes during construction
• Owner's general office overhead
• Equipment and furnishings not included in construction
• Inspection and testing
Operation and maintenance cost in subsequent years
over the project life cycle
• Land rent, if applicable
• Operating staff
• Labor and material for maintenance and repairs
• Periodic renovations
• Insurance and taxes
• Financing costs
• Utilities
• Owner's other expenses
Cost estimating
• The magnitude of each of these cost components depends on
1.the nature of the project
2. size and location of the project
3. the management organization, among many
considerations.
• The owner is interested in achieving the lowest possible overall

project cost that is consistent with its investment objectives.
Cost estimating
• It is important for design professionals and construction managers to realize that while
the construction cost may be the single largest component of the capital cost, other cost
components are not insignificant.
• For example, land acquisition costs are a major expenditure for building construction in
high-density urban areas, and construction financing costs can reach the same order of
magnitude as the construction cost in large projects such as the construction of nuclear
power plants.
• From the owner's perspective, it is equally important to estimate the corresponding
operation and maintenance cost of each alternative for a proposed facility in order to
analyze the life cycle costs.
• The large expenditures needed for facility maintenance, especially for publicly owned
infrastructure, are reminders of the neglect in the past to consider fully the implications
of operation and maintenance cost in the design stage .
Cost estimating -allowance for contigencies
• In most construction budgets, there is an allowance for contingencies

or unexpected costs occuring during construction. This contingency
amount may be included within each cost item or be included in a
single category of construction contingency. The amount of
contingency is based on historical experience and the expected
difficulty of a particular construction project
Cost estimating –allowance for contingencies
• . For example, one construction firm makes estimates of the expected
cost in five different areas:
• Design development changes,
• Schedule adjustments,
• General administration changes (such as wage rates),
• Differing site conditions for those expected, and
• Third party requirements imposed during construction, such as new
permits.
• Contingent amounts not spent for construction can be released near
the end of construction to the owner or to add additional project
elements.
Approaches to Cost Estimation
• Cost estimating is one of the most important steps in project management.
.
• A cost estimate establishes the base line of the project cost at different
stages of development of the project.
• A cost estimate at a given stage of project development represents a
prediction provided by the cost engineer or estimator on the basis of
available data.
• According to the American Association of Cost Engineers, cost engineering
is defined as that area of engineering practice where engineering judgment
and experience are utilized in the application of scientific principles and
techniques to the problem of cost estimation, cost control and profitability.
• Virtually all cost estimation is performed according to one or some
combination of the following basic approaches:
• 1.Production function.
In microeconomics, the relationship between the output of a
process and the necessary resources is referred to as the production
function.
In construction, the production function may be expressed by the
relationship between the volume of construction and a factor of production
such as labor or capital.
A production function relates the amount or volume of output to the
various inputs of labor, material and equipment
1.Production function(contd)
• For example, the amount of output Q may be derived as a
function of various input factors x1, x2, ..., xn by means of
mathematical and/or statistical methods.
• Thus, for a specified level of output, we may attempt to find a
set of values for the input factors so as to minimize the production
cost.
Example:
The relationship between the size of a building project (expressed in
square feet) to the input labor (expressed in labor hours per square
foot)
• 2.Empirical cost inference.
• Empirical estimation of cost functions requires statistical techniques
which relate the cost of constructing or operating a facility to a few
important characteristics or attributes of the system.
• The role of statistical inference is to estimate the best parameter
values or constants in an assumed cost function. Usually, this is
accomplished by means of regression analysis techniques.
3.Unit costs for bill of quantities.
• A unit cost is assigned to each of the facility components or tasks as represented by the bill of
quantities.
• The total cost is the summation of the products of the quantities multiplied by the
corresponding unit costs.
• The unit cost method is straightforward in principle but quite laborious in application.
• The initial step is to break down or disaggregate a process into a number of tasks.
Collectively, these tasks must be completed for the construction of a facility. Once these tasks
are defined and quantities representing these tasks are assessed, a unit cost is assigned to
each and then the total cost is determined by summing the costs incurred in each task.
• The level of detail in decomposing into tasks will vary considerably from one estimate to
another.
• 4.Allocation of joint costs.
• Allocations of cost from existing accounts may be used to develop a
cost function of an operation.
• The basic idea in this method is that each expenditure item can be
assigned to particular characteristics of the operation. Ideally, the
allocation of joint costs should be causally related to the category of
basic costs in an allocation process.
• In many instances, however, a causal relationship between the
allocation factor and the cost item cannot be identified or may not
exist.
• 4.Allocation of joint costs..
• For example,
• in construction projects, the accounts for basic costs may be classified
according to (1) labor, (2) material, (3) construction equipment, (4)
construction supervision, and (5) general office overhead. These basic
costs may then be allocated proportionally to various tasks which are
subdivisions of a project.
Types of Construction Cost
Estimates
• Introduction
• Construction cost constitutes only a fraction, though a substantial fraction, of the total project
cost.
• However, it is the part of the cost under the control of the construction project manager.
• The required levels of accuracy of construction cost estimates vary at different stages of project
development, ranging from ball park figures in the early stage to fairly reliable figures for budget
control prior to construction.
• Since design decisions made at the beginning stage of a project life cycle are more tentative than
those made at a later stage, the cost estimates made at the earlier stage are expected to be less
accurate
• . Generally, the accuracy of a cost estimate will reflect the information available at the time of
estimation.
Types of Construction Cost Estimates
• Introduction:
• Construction cost estimates may be viewed from different
perspectives because of different institutional requirements.
• In spite of the many types of cost estimates used at different stages of
a project, cost estimates can best be classified into three major
categories according to their functions.
• A construction cost estimate serves one of the three basic functions:
design, bid and control.
• For establishing the financing of a project, either a design estimate or
a bid estimate is used.
• 1. Design Estimates.
• For the owner or its designated design professionals, the types of cost estimates
encountered run parallel with the planning and design as follows:
• Screening estimates (or order of magnitude estimates)
• Preliminary estimates (or conceptual estimates)
• Detailed estimates (or definitive estimates)
• Engineer's estimates based on plans and specifications
Types of Construction Cost
Estimates1.Design estimates
• .At the very early stage, the screening estimate or order of
magnitude estimate is usually made before the facility is designed, and
must therefore rely on the cost data of similar facilities built in the past.
• A preliminary estimate or conceptual estimate is based on the conceptual
design of the facility at the state when the basic technologies for the design
are known.
• The detailed estimate or definitive estimate is made when the scope of
work is clearly defined and the detailed design is in progress so that the
essential features of the facility are identifiable.
• The engineer's estimate is based on the completed plans and
specifications when they are ready for the owner to solicit bids from
construction contractors.
1.Design estimates
• In preparing these estimates, the design professional will include
expected amounts for contractors' overhead and profits.
• The costs associated with a facility may be decomposed into a
hierarchy of levels that are appropriate for the purpose of cost
estimation.
• The level of detail in decomposing the facility into tasks depends on
the type of cost estimate to be prepared.
• For conceptual estimates, for example, the level of detail in defining
tasks is quite coarse; for detailed estimates, the level of detail can be
quite fine.
Types of Construction Cost Estimates1,Design
estimates
• EXAMPLE : THE COST ESTIMATES FOR A PROPOSED BRIDGE ACROSS A RIVER.
• A screening estimate is made for each of the potential alternatives, such as a tied
arch bridge or a cantilever truss bridge.
• As the bridge type is selected, e.g. the technology is chosen to be a tied arch
bridge instead of some new bridge form, a preliminary estimate is made on the
basis of the layout of the selected bridge form on the basis of the preliminary or
conceptual design.
• When the detailed design has progressed to a point when the essential details
are known, a detailed estimate is made on the basis of the well defined scope of
the project.
• When the detailed plans and specifications are completed, an engineer's
estimate can be made on the basis of items and quantities of work.
Types of construction cost estimates: 2.Bid
estimates
• 2. Bid Estimates.
• For the contractor, a bid estimate submitted to the owner either for competitive
bidding or negotiation consists of direct construction cost including field
supervision, plus a markup to cover general overhead and profits.
• The direct cost of construction for bid estimates is usually derived from a
combination of the following approaches.
• Subcontractor quotations
• Quantity takeoffs
• Construction procedures
Types of construction cost estimates:
2.Bid estimates
• The contractor's bid estimates often reflect the desire of the
contractor to secure the job as well as the estimating tools at its
disposal.
• Some contractors have well established cost estimating procedures
while others do not.
• Since only the lowest bidder will be the winner of the contract in
most bidding contests, any effort devoted to cost estimating is a loss
to the contractor who is not a successful bidder. Consequently, the
contractor may put in the least amount of possible effort for making a
cost estimate if it believes that its chance of success is not high.
2.Bid estimates
• If a general contractor intends to use subcontractors in the
construction of a facility, it may solicit price quotations for various
tasks to be subcontracted to specialty subcontractors.
• Thus, the general subcontractor will shift the burden of cost
estimating to subcontractors.
• If all or part of the construction is to be undertaken by the general
contractor, a bid estimate may be prepared on the basis of the
quantity takeoffs from the plans provided by the owner or on the
basis of the construction procedures devised by the contractor for
implementing the project
2.Bid estimates
• . For example, the cost of a footing of a certain type and size may be
found in commercial publications on cost data which can be used to
facilitate cost estimates from quantity takeoffs.
• However, the contractor may want to assess the actual cost of

construction by considering the actual construction procedures to be used
and the associated costs if the project is deemed to be different from
typical designs.
• Hence, items such as labor, material and equipment needed to perform

various tasks may be used as parameters for the cost estimates.
Types of construction cost estimates:3.Control
estimates
• 3. Control Estimates.
• For monitoring the project during construction, a control estimate is derived from
available information to establish:
• Budget estimate for financing
• Budgeted cost after contracting but prior to construction
• Estimated cost to completion during the progress of construction.
• Both the owner and the contractor must adopt some base line for cost control
during the construction.
Types of construction cost estimates:3.Control
estimates
For the owner,
• a budget estimate must be adopted early enough for planning long term
financing of the facility.
• Consequently, the detailed estimate is often used as the budget estimate
since it is sufficient definitive to reflect the project scope and is available
long before the engineer's estimate.
• As the work progresses, the budgeted cost must be revised periodically to
reflect the estimated cost to completion.
• A revised estimated cost is necessary either because of change orders
initiated by the owner or due to unexpected cost overruns or savings.
3.Control estimates
• For the contractor,
• the bid estimate is usually regarded as the budget estimate, which
will be used for control purposes as well as for planning construction
financing.
• The budgeted cost should also be updated periodically to reflect the
estimated cost to completion as well as to insure adequate cash flows
for the completion of the project.
5.4 Effects of Scale on Construction Cost
• Screening cost estimates are often based on a single variable representing

the capacity or some physical measure of the design such as floor area in
buildings, length of highways, volume of storage bins and production
volumes of processing plants.
• Costs do not always vary linearly with respect to different facility sizes.
• Typically, scale economies or diseconomies exist. If the average cost per
unit of capacity is declining, then scale economies exist.
• Conversely, scale diseconomies exist if average costs increase with greater
size.
• Empirical data are sought to establish the economies of scale for various
types of facility, if they exist, in order to take advantage of lower costs per
unit of capacity.
Effects of scale on construction
cost
cost cost
Effects of scale on construction cost
• A nonlinear cost relationship between the facility capacity x and
construction cost y can often be represented in the form
rule.
Effect of scale on construction cost
Effect of scale on construction cost
• Let yn be the known cost of an existing facility with capacity Qn, and y
be the estimated cost of the new facility which has a capacity Q.
Then, from the empirical data, it can be assumed that
• Unit Cost Method of Estimation
• If the design technology for a facility has been specified, the project
can be decomposed into elements at various levels of detail for the
purpose of cost estimation.
• The unit cost for each element in the bill of quantities must be
assessed in order to compute the total construction cost.
• This concept is applicable to both design estimates and bid estimates,
although different elements may be selected in the decomposition.
Unit cost method of estimation
• For design estimates, the unit cost method is commonly used when the
project is decomposed into elements at various levels of a hierarchy as
follows:
• Preliminary Estimates. The project is decomposed into major structural
systems or production equipment items, e.g. the entire floor of a building
or a cooling system for a processing plant.
• Detailed Estimates. The project is decomposed into components of various
major systems, i.e., a single floor panel for a building or a heat exchanger
for a cooling system.
• Engineer's Estimates. The project is decomposed into detailed items of
various components as warranted by the available cost data. Examples of
detailed items are slabs and beams in a floor panel, or the piping and
connections for a heat exchanger.
• For bid estimates, the unit cost method can also be applied even
though the contractor may choose to decompose the project into
different levels in a hierarchy as follows:
• Subcontractor Quotations. The decomposition of a project into
subcontractor items for quotation involves a minimum amount of
work for the general contractor. However, the accuracy of the
resulting estimate depends on the reliability of the subcontractors
since the general contractor selects one among several contractor
quotations submitted for each item of subcontracted work.
• Quantity Takeoffs. The decomposition of a project into items of
quantities that are measured (or taken off) from the engineer's plan
will result in a procedure similar to that adopted for a detailed
estimate or an engineer's estimate by the design professional. The
levels of detail may vary according to the desire of the general
contractor and the availability of cost data.
• Construction Procedures. If the construction procedure of a proposed
project is used as the basis of a cost estimate, the project may be
decomposed into items such as labor, material and equipment
needed to perform various tasks in the projects.
• Formula Based on Labor, Material and Equipment
• Consider the simple case for which costs of labor, material and
equipment are assigned to all tasks. Suppose that a project is
decomposed into n tasks. Let Qi be the quantity of work for task i,
Mi be the unit material cost of task i, Ei be the unit equipment rate for
task i, Li be the units of labor required per unit of Qi, and Wi be the
wage rate associated with Li. In this case, the total cost y is:
5.6 Methods for Allocation of Joint Costs
•The principle of allocating joint costs to various elements in a project is often
used in cost estimating.
•Because of the difficulty in establishing casual relationship between each
element and its associated cost, the joint costs are often prorated in proportion to
the basic costs for various elements.
•One common application is found in the allocation of field supervision cost
among the basic costs of various elements based on labor, material and
equipment costs, and the allocation of the general overhead cost to various
elements according to the basic and field supervision cost.
•Suppose that a project is decomposed into n tasks. Let y be the total basic cost
for the project and yi be the total basic cost for task i. If F is the total field
supervision cost and Fi is the proration of that cost to task i, then a typical
proportional allocation is:
• 5.7 Historical Cost Data
• Preparing cost estimates normally requires the use of historical data
on construction costs. Historical cost data will be useful for cost
estimation only if they are collected and organized in a way that is
compatible with future applications. Organizations which are engaged
in cost estimation continually should keep a file for their own use. The
information must be updated with respect to changes that will
inevitably occur. The format of cost data, such as unit costs for various
items, should be organized according to the current standard of usage
in the organization.
Historical Cost Data
• Construction cost data are published in various forms by a number of
organizations. These publications are useful as references for
comparison. Basically, the following types of information are
available:
Historical cost data
• Catalogs of vendors' data on important features and specifications

relating to their products for which cost quotations are either
published or can be obtained.
• Periodicals containing construction cost data and indices.
• Commercial cost reference manuals for estimating guides.
• Digests of actual project costs. They tions provides descriptions of
design features and costs of actual projects by building type. Once a
week, ENR publishes the bid prices of a project chosen from all types
of construction projects.
• Historical cost data must be used cautiously.

• Changes in relative prices may have substantial impacts on construction costs
which have increased in relative price.
• Unfortunately, systematic changes over a long period of time for such factors are
difficult to predict. Errors in analysis also serve to introduce uncertainty into cost
estimates.
• It is difficult, of course, to foresee all the problems which may occur in
construction and operation of facilities.
• There is some evidence that estimates of construction and operating costs have
tended to persistently understate the actual costs.
• This is due to the effects of greater than anticipated increases in costs, changes in
design during the construction process, or over optimism.
• Since the future prices of constructed facilities
are influenced by many uncertain factors, it is
important to recognize that this risk must be
borne to some degree by all parties involved, i.e.,
the owner, the design professionals, the
construction contractors, and the financing
institution.
• It is to the best interest of all parties that the risk
sharing scheme implicit in the design/construct
process adopted by the owner is fully
understood by all.
• When inflation adjustment provisions have very
different risk implications to various parties, the
price level changes will also be treated differently
for various situations.
Cost Indices
• Since historical cost data are often used in
making cost estimates, it is important to note
the price level changes over time.
• Trends in price changes can also serve as a basis
for forecasting future costs.
• The input price indices of labor and/or material
reflect the price level changes of such input
components of construction; the output price
indices, where available, reflect the price level
changes of the completed facilities, thus to some
degree also measuring the productivity of
construction.
• A price index is a weighted aggregate measure of constant quantities
of goods and services selected for the package.
• The price index at a subsequent year represents a proportionate

change in the same weighted aggregate measure because of changes
in prices.
Let lt be the price index in year t, and lt+1 be the price index in the
following year t+1. Then, the percent change in price index for
year t+1 is:
• If the price index at the base year t=0 is set at a value of 100, then the
price indices l1, l2...ln for the subsequent years t=1,2...n can be
computed successively from changes in the total price charged for the
package of goods measured in the index.
• The best-known indicators of general price changes are the Gross Domestic Product (GDP)
deflators compiled periodically by the U.S. Department of Commerce, and the consumer price
index (CPI) compiled periodically by the U.S. Department of Labor. They are widely used as broad
gauges of the changes in production costs and in consumer prices for essential goods and
services. Special price indices related to construction are also collected by industry sources since
some input factors for construction and the outputs from construction may disproportionately
outpace or fall behind the general price indices. Examples of special price indices for construction
input factors are the wholesale Building Material Price and Building Trades Union Wages, both
compiled by the U.S. Department of Labor. In addition, the construction cost index and the
building cost index are reported periodically in the Engineering News-Record (ENR). Both ENR cost
indices measure the effects of wage rate and material price trends, but they are not adjusted for
productivity, efficiency, competitive conditions, or technology changes. Consequently, all these
indices measure only the price changes of respective construction input factors as represented by
constant quantities of material and/or labor. On the other hand, the price indices of various types
of completed facilities reflect the price changes of construction output including all pertinent
factors in the construction process. The building construction output indices compiled by Turner
Construction Company and Handy-Whitman Utilities are compiled in the U.S. Statistical
Abstracts published each year.
When the inflation rate is relatively small, i.e., less than 10%, it is convenient to select a
single price index to measure the inflationary conditions in construction and thus to
deal only with a single set of price change rates in forecasting. Let jt be the price change
rate in year t+1 over the price in year t. If the base year is denoted as year 0 (t=0), then
the price change rates at years 1,2,...t are j1,j2,...jt, respectively. Let At be the cost in year
t expressed in base-year dollars and At' be the cost in year t expressed in then-current
dollars. Then:
If the prices of certain key items affecting the estimates of future benefits and
costs are expected to escalate faster than the general price levels, it may
become necessary to consider the differential price changes over and above
the general inflation rate.
Future forecasts of costs will be uncertain: the actual expenses may be much lower or
much higher than those forecasted. This uncertainty arises from technological changes,
changes in relative prices, inaccurate forecasts of underlying socioeconomic conditions,
analytical errors, and other factors
For the purpose of forecasting, it is often sufficient to project the trend of future prices by
using a constant rate j for price changes in each year over a period of t years, then
5.9 Applications of Cost Indices to Estimating
• In the screening estimate of a new facility, a single parameter is often used to describe a cost function. For
example, the cost of a power plant is a function of electricity generating capacity expressed in megawatts, or the
cost of a sewage treatment plant as a function of waste flow expressed in million gallons per day.
• The general conditions for the application of the single parameter cost function for screening estimates are:
1.Exclude special local conditions in historical data
2.Determine new facility cost on basis of specified size or capacity (using the methods described in Sections 5.3 to
5.6)
3.Adjust for inflation index
4.Adjust for local index of construction costs
5.Adjust for different regulatory constraints
6.Adjust for local factors for the new facility
Some of these adjustments may be done using compiled indices, whereas others may require field investigation and
considerable professional judgment to reflect differences between a given project and standard projects performed
in the past.
Allocation of Construction Costs
Over Time
Since construction costs are incurred over the entire
construction phase of a project, it is often necessary to
determine the amounts to be spent in various periods to derive
the cash flow profile, especially for large projects with long
durations.
Consequently, it is important to examine the percentage of
work expected to be completed at various time periods to which
the costs would be charged.
More accurate estimates may be accomplished once the project

is scheduled ,but some rough estimate of the cash flow may be
required prior to this time.
Consider the basic problem in determining the percentage of
work completed during construction.
One common method of estimating percentage of completion is

based on the amount of money spent relative to the total
amount budgeted for the entire project.
This method has the obvious drawback in assuming that the

amount of money spent has been used efficiently for production.
A more reliable method is based on the concept of value of work completed which is
defined as the product of the budgeted labor hours per unit of production and the actual
number of production units completed, and is expressed in budgeted labor hours for the
work completed.
Then, the percentage of completion at any stage is the ratio of the value of work
completed to date and the value of work to be completed for the entire project.
Regardless of the method of measurement, it is informative to understand the trend of

work progress during construction for evaluation and control
In general, the work on a construction project progresses gradually from the time of
mobilization until it reaches a plateau; then the work slows down gradually and finally
stops at the time of completion.
Figure 5-11: Value of Work Completed over Project Time
While the curves shown in Figures 5-10 and 5-11 represent highly idealized
cases, they do suggest the latitude for adjusting the schedules for various
activities in a project.
While the rate of work progress may be changed quite drastically within a
single period, such as the change from rapid mobilization to a slow
mobilization in periods 1, 2 and 3 in Figure 5-10, the effect on the value of
work completed over time will diminish in significance as indicated by the
cumulative percentages for later periods in Figure 5-11.
Thus, adjustment of the scheduling of some activities may improve the

utilization of labor, material and equipment, and any delay caused by such
adjustments for individual activities is not likely to cause problems for the
eventual progress toward the completion of a project.
Financial budget
preparation
• A financial budget is predicting the incomes and expenses of the business on
long-term and short-term basis. Right projections of the cash flow help the business to achieve
its targets in the right way.
• Financial budget preparation includes a detailed budget balance sheet, cash flow budget, the
sources of incomes and expenses of the business, etc.
• The evaluation of incomes and expenses is done on a monthly, quarterly,

half-yearly or annual basis, depending upon the suitability of the organization.
• A financial budget is a very powerful tool to achieve the long-term goals of the business. It
keeps the shareholders and other members of the organization
updated about the functioning of the business.
• WHY IS FINANCIAL BUDGET PREPARED?
• The organizations prepare the financial budget to manage the cash flows in
a better way.
• This budget gives the business a better control and efficient planning
mechanism to manage the inflows and outflows.
• To prepare a financial budget, it is important to prepare the operating
budget first. It is with the help of operating budget that the organization
can predict the sales and the production expenses.
• Therefore, the financial budget is prepared only after the different
financing activities are known in the operating budget.
DIFFERENT SECTIONS OF FINANCIAL BUDGET
CASH BUDGET
The cash budget tells about the inflows and outflows of the business. On the other hand,
the cash flow of the business keeps on changing and with that, the cash budget should
also change. Making cash budget is a dynamic process and not a static process. Any
change in the cash flow should be immediately reflected in the cash budget of the
business.
BUDGETED BALANCE SHEET
The budgeted balance sheet comprises of many other budgets. The major component of
this budget includes production budget and its associated budgets.
CAPITAL EXPENDITURE BUDGET
As the name suggests, the capital expenditure budget is about expenses related to plant
and machinery or any capital asset of the business. This budget determines the expenses
that would be incurred if an existing plant is replaced or any new machinery is bought.
Factors like depreciation, cost of the plant, life of the machinery, etc. are taken into
account while preparing the capital expenditure budget.
FINANCIAL BUDGET PLAN
The financial budget plan comprises of following steps:
• Calculate the expected inflow
• Calculate the expected outflow
• Set the targets
• Divide the expenses into different categories
• Keep the track of components in budget
• Set up the ledger
Steps for preparing financial budget
Here are the basic steps to follow when preparing a budget:
1) Update budget assumptions. Review the assumptions about the company's
business environment that were used as the basis for the last budget, and
update as necessary.
2) Review bottlenecks. Determine the capacity level of the primary bottleneck that
is constraining the company from generating further sales, and define how this
will impact any additional company revenue growth.
3) Estimate Available funding. Determine the most likely amount of funding that
will be available during the budget period, which may limit growth plans.
4) Determine Step costing points. Determine whether any step costs will be
incurred during the likely range of business activity in the upcoming budget
period, and define the amount of these costs and at what activity levels they will
be incurred.
5) Create budget package. Copy forward the basic budgeting instructions from the
instruction packet used in the preceding year. Update it by including the year-to-
date actual expenses incurred in the current year, and also annualise this
information for the full current year. Add a commentary to the packet, stating
step costing information, bottlenecks, and expected funding limitations for the
upcoming budget year.
6) Issue budget package. Issue the budget package personally, where possible, and
answer any questions from recipients. Also state the due date for the first draft
of the budget package.
Steps
7)Obtain revenue forecast. Obtain the revenue forecast from the sales manager, validate it with the
CEO, and then distribute it to the other department managers. They use the revenue information as
the basis for developing their own budgets
8)Obtain department budgets. Obtain the budgets from all departments, check for errors, and
compare to the bottleneck, funding, and step costing constraints. Adjust the budgets as necessary
.9) Obtain capital budget requests. Validate all capital budget requests and forward them to the
senior management team with comments and recommendations.
10)Review the budget. Meet with the senior management team to review the budget. Highlight
possible constraint issues, and any limitations caused by funding problems. Note all comments
made by the management team, and forward this information back to the budget originators, with
requests to modify their budgets.
11) Process budget iterations. Track outstanding budget change requests, and update the budget
model with new iterations as they arrive.
12) Issue the budget. Create a bound version of the budget and distribute it to all authorized
recipients.
13)Load the budget. Load the budget information into the financial software, so that you can
generate budget versus actual reports.
Conclusion
• The financial budget provides a blueprint for the business to move forward. It
addresses not only the financial aspects of the business but also checks the
operational efficiency.
• The extra expenses are cut by emphasizing on cost reduction and improving the
market share.
• With financial budgets, the organization is well prepared to meet the long-term
and short-term expenses.
• A good financial budget helps in achieving the goals and objectives of the
business in the shortest possible span of time.
FORMS OF BUSINESS ORGANIZATION
• These are the basic forms of business ownership:

• 1. Sole Proprietorship
• A sole proprietorship is a business owned by only one person. It is
easy to set-up and is the least costly among all forms of ownership.
• The owner faces unlimited liability; meaning, the creditors of the
business may go after the personal assets of the owner if the business
cannot pay them.
• The sole proprietorship form is usually adopted by small business
entities.
• 2. PARTNERSHIP
• A partnership is a business owned by two or more
persons who contribute resources into
the entity. The partners divide the profits of the business
among themselves.
• In general partnerships, all partners have
unlimited liability.
• In limited partnerships, creditors cannot go after
the personal assets of the limited partners.
Partnership
• Partnership is “the relation between persons who have agreed to
share the profits of the business carried on by all or any one of them
acting for all”.
• It is governed by the Indian Partnership Act 1932
Partnerships
Two major types of partnerships:
• General Partnership: (most common type) all partners are responsible for
management and the financial responsibilities of the partnership.
• Limited Partnership: at least one partner is not active in the day to day running of
the business. They have limited liability.
Articles of Partnership: contract between partners spelling out the rules of

partnership.
Dividing profit
Dividing responsibility
Admitting new partners
Buying out partners
Partnerships
Advantages of Partnerships: Disadvantages of Partnerships
• Ease of establishment
• Unlimited liability
• Ease of Management: each partner has
different things to offer • Limited partner is only
• No special business taxes responsible for his initial
• Easier to raise financial capital investment. He has limited
• Larger than sole proprietorship liability.
• Easier to attract qualified workers • Limited Life
• Conflict between partners

• 3. CORPORATION
• A corporation is a business organization that has a separate legal
personality from its owners. Ownership in a stock corporation is
represented by shares of stock.
• The owners (stockholders) enjoy limited liability but have limited
involvement in the company's operations. The board of directors, an
elected group from the stockholders, controls the activities of the
corporation.
• In addition to those basic forms of business ownership, these are
some other types of organizations that are common today:
Corporation- Set up
• Incorporate: to form a corporation.
• Charter: a document granted by the state giving a corporation the
right to do business
• Stock: shares of ownership in the corporation
• Stockholders (shareholders): owners of stock.
Reasons to own stock:

Dividends: share of corporate profits paid to stockholders
Speculation: buy in hope that price of stock will increase.
Corporation- Ownership
• Common Stock is a basic share of ownership in a corporation
• Have voting rights in the management of the company
• In reality they turn over voting rights to someone else with a proxy: giving someone else the right to vote your
share of stock.
• Preferred Stock:
Non voting shares of ownership
Guaranteed dividend
Liquidation benefit: If corporation goes out of business they are ahead of common stockholders in getting back
money.
• Board of Directors: duty to direct the corporations business by setting board policies and goals
Elected by common stockholders

• Hires a professional management team to run day to day activities. (CEO, CFO….)
Corporations
Advantages of a corporation:
• Disadvantages of a corporation:
• Ease of raising financial capital

(main advantage) • Start up expenses are high.
• Selling stock to investors
• Selling bonds: a written promise
to repay a loan on a specific date • Stockholders (owners) have a limited
• Principal: the amount borrowed
• Interest: the price paid for the use • Profits are taxed
of another’s money
• Borrowing money from banks. • Corporations are subject to more
• Ability to hire
government regulations than sole proprietors or
• Limited liability
partners
• Unlimited life
• Ease of transferring ownership:.
Buying and selling stock is easy and is
done millions of times a day
Mergers and Acquisitions
• 5 Reasons to merge- Make money faster, Increase efficiency, Acquire new
product lines, Catch up or eliminate rivals, Lose a company identity.
• Horizontal Merger- when two or more companies that product the same
kind of product join forces.
• Vertical merger- when two or more firms that are at different steps of
manufacturing process join together.
• Conglomerates- is a firm that has at least four businesses, each making

unrelated products.
• LIMITED LIABILITY COMPANY
• Limited liability companies (LLCs) are hybrid forms of business that
have characteristics of both a corporation and a partnership. An LLC is
not incorporated; hence, it is not considered a corporation.
• Nonetheless, the owners enjoy limited liability like in a corporation.
An LLC may elect to be taxed as a sole proprietorship, a partnership,
or a corporation
• COOPERATIVE
• A cooperative is a business organization owned
by a group of individuals and is operated for their
mutual benefit. The persons making up the
group are called members. Cooperatives may be
incorporated or unincorporated.
• Some examples of cooperatives are: water and

electricity (utility) cooperatives, cooperative
banking, credit unions, and housing
cooperatives.
VARIOUS FORMS OF BUSINESS ENTITIES IN INDIA:
• Private Ltd Company
• Public Ltd Company
• Unlimited Company
• Sole proprietorship
• Joint Hindu Family business
• Partnership
• Cooperatives
• Limited Liability Partnership(LLP) Liaison Office
• Branch Office
• Project Office
• Subsidiary Company
Private Ltd Company
• A private company has the following features:
• Restricts the right of the shareholders to transfer their shares.

• Has a minimum of 2 and maximum of 50 members.
• does not invite public to subscribe to its share capital
• Must have a minimum paid up capital of Rs. 1 lakh or such a higher
amount which may be prescribed from time to time.
Public Ltd Company :
• A public Ltd company has the following characteristics:
• It allows the shareholders to transfer their shares.

• Has a minimum of 7 members, and for maximum there is no limit.
• it invites the general public to subscribe to its shares
• Must have a minimum paid up capital of Rs 5 lakh or such a higher
amount as may be prescribed from time to time.
Unlimited Company
• Unlimited Company is a form of business organization under which
the liability of all its members is unlimited.
• The personal assets of the members can be used to settle the debts.
• It can at any time re-register as a limited company under section 32
of the Companies Act.
Sole proprietorship
• Sole proprietorship is a form of business entity where a single
individual handles the entire business organization.
• He is the sole recipient of all profits and bearer of all loses.
• There is no separate law that governs sole proprietorship.
Joint Hindu Family
• Joint Hindu Family is a form of business organization wherein the
members of a family can only own and manage the business.
• It is governed by Hindu Law
Co-operatives
• Co-operatives is a form of voluntary organization, wherein the

members work together for the promotion of the interests of its
members.
• There is no restriction to the entry or exit of any member.
• It is governed by Cooperative Societies Act 1912.

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Unit 5

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MODULE -2

• explain the concept of business organisation;

5.1 BUSINESS ORGANISATION

5.2 FORMS OF BUSINESS ORGANISATION

5.3 SOLE PROPRIETORSHIP

Gopal is happy in running his business in sole proprietorship form because

5.3.2 MERITS OF SOLE PROPRIETORSHIP FORM OF BUSINESS ORGANISATION

5.3.3 LIMITATIONS OF SOLE PROPRIETORSHIP FORM OF BUSINESS

5.3.4 SUITABILITY OF SOLE PROPRIETORSHIP FORM OF BUSINESS

5.3.5 FORMATION OF SOLE PROPRIETORSHIP FORM OF BUSINESS

5.4.1 CHARACTERISTICS OF PARTNERSHIP FORM OF BUSINESS

5.4.4 TYPES OF PARTNERS

Based on extent of participation Active Partners

Based on sharing of profit Nominal Partners

Based on nature of behaviour

5.4.6 FORMATION OF PARTNERSHIP FORM OF BUSINESS ORGANISATION

100 Senior Secondary

(b) Partnership Deed may be either oral or in writing.

(c) There is an employer-employee relationship among the partners.

Business Studies 101

3. Identify the type of partners in the following situation:

5.5 JOINT HINDU FAMILY FORM OF BUSINESS ORGANISATION

102 Senior Secondary

5.5.2 MERITS OF JHF FORM OF BUSINESS ORGANISATION

Business Studies 103

5.5.3 LIMITATION OF JHF FORM OF BUSINESS ORGANISATION

5.5.4 SUITABILITY OF JHF FORM OF BUSINESS ORGANISATION

5.5.5 FORMATION OF JHF FORM OF BUSINESS ORGANISATION

104 Senior Secondary

INTEXT QUESTIONS 5C Notes

1. Why should the liability of Karta be unlimited?

5.6 COOPERATIVE SOCIETY

Business Studies 105

The Section 4 of the Indian Cooperative Societies Act 1912 defines

5.6.1 CHARACTERISTICS OF COOPERATIVE SOCIETY

106 Senior Secondary

5.6.2 TYPES OF COOPERATIVE SOCIETIES

Business Studies 107

108 Senior Secondary

5.6.4 LIMITATIONS OF COOPERATIVE SOCIETY

5.6.5 SUITABILITY OF COOPERATIVE SOCIETY

Business Studies 109

Notes 5.6.6 FORMATION OF COOPERATIVE SOCIETY

110 Senior Secondary

5.7 WHAT YOU HAVE LEARNT

Business Studies 111

112 Senior Secondary

5.8 KEY TERMS

Coparcener Partner by Estoppel Sole proprietorship

5.9 TERMINAL QUESTIONS

Business Studies 113

114 Senior Secondary

LEARN AND PLAY

Business Studies 115

Notes 5.1 Business Organisation

116 Senior Secondary

Chapter 4: Time Value of Money

The concept of Time Value of Money:

- Consumption forgone has value

You will ask yourself one question:

 Show the timing of cash flows.

CF0 CF1 CF2 CF3

Example 1 : $100 lump sum due in 2 years

Today End of End of

Show the timing of cash flows.