S llabus

Course Code Course Nan,e Credits

ILO8022 Financ-e Management 03

Course ObJectives : Students will try to :

1. Overview oflndian financial system. instruments and market

2. Basic concepts of value of money. returns and risks. corpor.atc finance, worlong capital
andl its management
3. Knowledge about sources of finance, capital structure, dividend policy
Course Outcomes :

1. Understand Indian finance system and corporate finance

2. Take investment. finance as well as dividend decisions

Module Detailed Content Hours

01 Overview of lndlan Financial System : Characteristics, 06

Components and Functions of Financial System.
Financial Instruments : MeaD'i ng, Characteristics and Classification
of Basic FinanciaJ lnstrumt>nts-Equity Shares, Preference Shares.
Bonds-Debentures. Certificates of Deposit. and Treasut,' Bills.
Financial Markets : Meaning. Characteristics and Classlficatlon of
FlnandaJ Markets-Capital Market Money Market and Foreign
Currency Market
Flnandal Institutions : Meaning. Characteristics and Classification
of Financial Institutions-Commercial Banks, Investment-Merchant
Banks and Stock Exchanges.

02 Concepts of Returns and Risks : Measurement of Hlst~rical 06

Rewms and Expected Returns of a Single Secuncy and a Two-
securtty Portfolio; Measurement of Historic.al Risk and ExJX"ct:ed Risk
of a Single Security and a Two-security Portfolio.
nme Value of Money : Future Value or a Lump Sum~ Ordinary
Annuity, and Annuity Due; Present Value of~ Lu.mp Sum. Ordinary
AMuity. and Annuity Due: Cononuous Compounding and
Continuous Discounting.
,
--
01 Uv~•tl"w of l.orporate Flttanc~ : Obt('ctlve!. of Corporate Finance;
Fu, \ tlon ol C"rpor.ttl' Ftn,mc, -lnv~tml'nt Decision, Financing
l> h111n. ,111d Ulv1dcnd Declrton

financial RaUo Analysis : Overview of Financial

I
~t;itl'mt'nll 8.ilanu~ Shtrt, Profit and Loss Account, and Cash Flow
Statement. Purpose of Financial Ratio Analysis; Liquidity Ratios;
Effie1ency 01 Activity Ratios; Profitability Ratios; Capital Structure
Ratio,;; Stock Market Ratios, Limitations of Ratio Analysis.
O♦ .

Capital Budgeting : Meaning and Importance of Capital BudgetJng; 10

Inputs for Capit:aJ Budgeting Decisions; Investment Appraisal
Criterion-Accounting Rate of Return, Payback Period. Discounted
Payback Period, Net Present Value(NPV), Profitability Index, Internal
Rate of Retum (IRR), and Modified Internal Rate of Return (MIRR).
Working Capital Management : Concepts of Meaning Working
Capital; Importance of Working Capital Management; Factors
Affecting an Entity's Working Capital Needs; Estimation of Working
Capital Requirements; Management of Inventories; Management of
Receivables; and Management of Cash and Marketable Securities.
OS Sources of Finance : Long Term Sources-Equity, Debt, and Hybrids;
05
Mezzanine Finance; Sources of Short Term Finance-Trade Credit,
Bank Finance, Commercial Paper; Project Finance.
Capital Structure : Factors Affecting an Entity's Capital Structure;
Overview of Capital Structure Theories and Approaches-Net Income
• Approach, Net Operating Income Approach; Traditional Approach,
and Modiglianl·Miller Approach. Relation between Capital Structure
and Corporate Value; Concept of Optimal Capital Structure.
06 Dividend Polley : Meaning and Importance of Dividend Policy; 03
Factors Affecting an Entity's Dividend Decision; Overview of I
Dividend Policy Theories and Approaches-Gordon's Approach,
l
Walter's Approach, and Modigliani-Miller Approach.
J
aoo
 Tablt of Contents

Module l

Chapter 1 : Overview of fndlan Flnanclal System 1-1 to 1--31

1.1 lntrOdu<tJon to Financial System ·-·-····-·· ....._·-··-·-----·--·----·-· ..·•··-----l ·2

t l.l Features/ Characteristics of Financial System ..._., ______ ., ___ · · - - - - - - - · · -..·---·-· l · Z

1.1.2 Function and Rola or the Financial System ...... _.,•...•.- ........--..- · - - - - - - - · - · - - - - I •3

\ .2 Con, pohenl':S of lhe Finandal SysLl'm .......,. _____......._ ..______ _______

1.2.1 Financial Markets- -..···-·•-•·••--·-·...- ........___________ ----··-·--··-·- - - 1-4

t .2.2 Finano;il lnstr1.1ments --·-··-···..- ·-•-·......................._ ..______________ 1.4

1.2.3 Financial lnstltutions----·-···-···-··- · · ··· · - - · • - · • - - - - - - · - - - · - - 1·5

1.3 FinanCUII Markets- - - - - - - -·-·····----··-·-··------·-·-··-·"·---- 1·5

t.3.1 Characteristics and Role of the Financial Market -----..·-----· - - - 1•5

1.3.2 Difference between Money Market and Capital Morkct _. _ _ _ _ _ _ _ _ _.._________ \ ·6

1.4 Money Markel- - - - · - - - -·-·-..··--··--·-··..- · - - - · - · - - l ·6

1.4.l Chancteristlc:s and Role of the Money Market - - - - - -·- - - - - - - - - - - 1•7

L4,2 Money Market Instruments- - - - - - - · - - - - -......_,_________ ,_,.,_ _ 1. 7
Capital M.irkct,_ _ _ __
1.5 - - -..- ·- - - - - - - - - - - -..- - . - - 1·10
1.5.1 FunctJol\iS, Role and lmporunce of Capita.I Markel in lndla ___________.,,..,,._ _ 1 · 11

1.5.2 Capital Market Classlficaoon - - - ·- - - -·----·------···-- 1·11

lndustrlal Securities Marke.___ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _____ J •11
1.5.3
Pnmary Market _ _ _ _ _ _ _ _ _" _ _ _ _ _ __ _ _ _ _ _ - - - 1· 12
1.5.4
LS.4{A) Characteonstics and Role of Primilry Market _ _ _ _ _ _ _ _ _ _ _ _ - - - - 1·12
1 S.4(8} Mtthod.s: of Raising Funds in the Primvy Market - -- - - - - · - - - · - - - 1-12

l.S.4(C) P~un ofRa1S1ng Funds by Way of IPO · - - - - - - - - - - - · - - - - 1·13

1.5.4(0) Fmancal lntennedl.anes involved m the IPO Process - - - - - - - - - - · - - - 1· 16

1.5.S Secondary Market/Stock E.xcha.nge- - - -- - - - -- - - - - - - · - - - - 1-16

l.S.S(A) Charactertstic:sorstod< Exchange_ ._ ___ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1-17

1.5.S(B) Role and Functions of Stock Exchanges. l · 17

1 S.6 GO\·em.ment Secunties Mamt. ---------------------- 1- 17

1.5 7 l.ong-trnn Lo3ns M~ ------ ----------------1·18

• Fl0.1nce Managt"menl (MUJ
2

1.s 7lA) Term Loan Markct - . - - - - · · - - ·..··-·---·-...--•·- ...............-•..-·· ............- - - ·..· - · - -- ..... l·I 9
TabIt" of Conten ts

-
1 S.7(8) Mortgage Market- -..-....._ ..___...._.........- .............................................................- ............. - - - •- l·l9

--• . ••••H•• ............-,,-,,.,.-H♦----•-... 1•19

Forejgn Exchange Market/Forex Man,et -..-••-·-·--·······-·- ...-••"--
1.6
Orgamiutlon of Foreign EX-change Markel-.-•-----··.........- ............- ...- ......................_ .___ 1· l 9
1.6. 1
Tennlnologies used ln Foreign Exchange Market ._ ...............-•-·-..-·.............................."~'"·'--•- 1· 19
1.6.2

1.7 Fina ncl a I Instruments-···---...- ....·-·-·······...........- .............-•......- ..---····-··- ·..........................._ .. 1· 20

1.7.1 Money Market Instruments _ _ _............-.-....................................- .............--·-·..· -··""'··• ...... -......_ 1-20

1.7.2 Capital Market Instruments - - - - - - -..··.....- -.......-.-................................................................_._ 1·2\

1.7.2(A) Equity Shares.........................- ........................- ......_ .. _ _ _ _ ......................................- ....·-·-·-..............._. l · 21

1.7.2(8) Preft"rence Shares - · - - -...- ........- ............- ....-------..--............- ..- ....- ..................__ l •2 I
l.7.2(C) Bonds and Debentures. _ _ _.._ ...._.........................- -...- ..........................•- - · - -..... __ 1·22

1.7.2(0) Derivatives - -.......w .......- . .........- - - · ...- ................... - - . - ·...........- ..... ........... - ..- -. . . ; ........ l •22
1.8 Finan cial Instltutions--·-··-..····-... .....- -........ ........................- ................. _._.................. _ l ·23

1.8.1 Role and Function or Financial Institutions.--...- - -..- ·......- ....·-·-··..··...- ..- -..---·-· l ·23

1.8.2 Classification of Flnanctal lnstitutions-·-····-·-·---·-··..- ·-·-··-..............- ....___·_· .._ l · 23

1.8.3 8anlang lnstitutioos-- - -- - - - - - · -·- - -- ..•··..-·---·--·......_____ 1-24

1.8.3(1') Commercial Banking- - - - - - - - ·...............- - -·--··-··--....•-···--·... 1.25

1.8.3(8) Funcdons and Role or Commercial Banks ..- · - - - - ·..- ..- -•· · - -..- -..····· - · - - - 1·2S
1.8.4 Types of COfflffl~l'ffll Bffiks _ _ _ _ _ - - - - ·---··-·-·-·--··- - ....... 1·26
1.8.4(A) Public Sector Banks- - - - · - - - - - - - - - - · - -..· - - - - - -.. 1·26

1.8.4{8) Private Sector Banks- -- - -- - - - - - - - · - · - - · - · - - - · - - - - - l·Zf

1.8.♦(C) Foreign Banks - - - - - - - - -- - -- - - - - · - -·-···--···-··- - 1·26
1.8.4(0) R~nal Rural Banks f RRB) 1•27
1.8.S Cooperaove Banks.. . 1•?7

1.8.6 Other Banks ....- - l ·li

1.9 Non,BanJtlng Flrun~ lnstm11fon.s _ _ _ _ _ _ _ _ _· - - - · - · - ·..- -- ---•·21
J.9.1 Merdunt Banks - 1•?8
1.9 J (A) Role and FunC'Oon of Merdunt Ban-- - : - - - - - - - - - - - - - - -- - 1·2'
1.9.l(B) ~ of Merchant Banlcrr is Public lssue \ ·JI

1.9.l(C) Ca~nes of Mm:hant &token 1-Jlf

Stodc ~nges _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __ _ __ 1-Jf
.
19.2
• Finance Management (MU) 3 Table of Contents

M o d u le 2

Chapter 2 : Return and Risk 2-1 to 2-16

2.1 Concepts of Return and Risk -·---··---··-··- -- --- ·- - -

2• Lt Historical Returns· Return on Assel of a Single Security Portfoho- --··-- ··-·-···-----·-·-.... 2· 1
2.12 Average Rate of Rerum.· - - · - --- ···----·-·--··- · - - - -·- - -··- ···-- · - -··--2·3
2.1.3 Holding Pertod Return .---...-··- -- - ·- -·- - - - - -- - --·-·- --- - ··-· 2·4
2.1.4 Measures of Risk for One Security - -·-····- ·-·· -··- - - - - - - -- - ·--- - -·--······· 2-4
2.1.S Expected Returns of Single Secunty _ · -- - -- ··· - - - - --····· 2·6
2.1.6 Expected Risk of Single Security - - - - -·- ··· - - - - - - - -- · -- - - -···· 2·7
Use of Standard Deviation and Normal Dlslribullon _____________________________2. 7
2.1.7
2.1.s Two Secunty PortfoUo •.- - - - ·- - - - ··- · · - - · · - - - ---- -·---···--·---- ··-- 2·9
2.1.B(A) RetumS in Two Security Portfolio· Historical.____,___ - ·- ·····---·--···- 2·9
2.1.8(8) Expe<tt?d Return of Two Secunty Portfolio _ _ _ _ _ _ - -- - ·--- -- - - · - - - 2-10
2.1.9 Measuring Portfolio Risk for Two Secunty Portfolio _ _ _ _ _ _ __ ,______ ,________ 2-11

2.1.10 Dive:rsmcanon and Reducoon of Risk _ 2-12

2.Ul Solved Examples ..-- ----···-·- · · - · - -.. 2·13

Chapter 3 : Time Value of Money 3•1 to 3-20
3.1 Concept orT,me Value of Money - - - - - - - - - - - -- - - - -· -·-- ·---··-·-3· 1
3.1.1 Future \'alue __, ___3.2

311 Simple lnternt and Concept of Compoundmg....- - - - - - - - - - -- - · - -- --·-3·2

RateofRetum __,_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _______ _ 3.3
3 1.3
31 4 One-<trne ln\·esting/Lwnp Sum Investing _ _ 3.4
3.15 Futun V..tue of Annuity (Ordinary Annuity) •..•. 3-6
3.1.6 Sinking fund _ _ __ 3.9
3 17 Annuity Due _ _ _ ·-3·10
3 LB Present Value of Money - 3-10
319 Pr~nt Value of Annuity (Onimary Annuity) --- 3-13
3 1 10 Present Value of Annuity D 3· 15
3.111 Mulb Period Compounding / Co,npoundlng for more ~ on~ a YNr 3-16
3 I 12 Cofltinuous Compound1n 3-17
3 J 13 ~ n t V&lue Using Conunuous Oiscounung 3 · 17
31 14 Sol\-ed Eumplrs (Refer to Fututt and P~nt Value Tables) 3-19
• fuuna; Man.gtmentlMU)

-
4 Table of Ccntoni.

Module• 3

Chapt• 4 : Financial Management 4-1 to 4-27

4.1 lntroduCllOn to Flnanc!al Mana11ementc - - - - - - - - - · - - - - - - - · - · - - - --4-1
4,\ .1 F1nandal Manag~mrnl Dttrttons ...- - - - - · · ..- - - - · - - - - - - - - - 4-2
4.l l (J\) lnvtS1ml'tll Oed.llonS - - - - - - · - - - - - - - - - - - - - - - 4-2
4 .1 l (S) Financing OrdslOM . -4-l
<1.1 l(Cl Oivld,nd Ott1slons- - - - - - - - - - - - - - - - - - - - · - - - - -4-3
4. 1.2 ObltttlveofCorpora1efln111ce- - - - - - - - · - - - - · - - - -·- · - - 4•4
4.1 .2(J\) Sharebolden' Wealth Ma•lmlullon,. -· -- - · - - - - - - - - - - - - - - - - 4•5
4. 1.3 ~ency Problems _ _ _ __ · - - - - - -· · - · - - - - · - - · - - - . - - .4•S

4. 1 4 0 ,c1nlulfon ofFlr,ance Function - - - - - - - - ·- · -..- - - -4·6

4.2 Flnand:al Slatffllents ••- - - - - - - - - - - -·- - · - - - · - - · - - • -4-7
<1..2..1 & lancr Sheet _ ,_ __
· - - - - · · - · - · - - -..- - - · - - - - - - - ----4-7
4.2.2 Prvfl1&Lon Aca,un1_ _ __
- -----·-·-·--·---4-10
4.2.3 C.uhf\ow Sg1emen1 _ ____________ ·- - - · - - - · - - --- - -- -4-l!
♦.3 Finand.'ll R.llfo Analysis. _ __ _ __ __ _ ___,_ __ _ - - - - - - -- 4-l3

4.3.1 Uquldlty R.atlos - - 4- 13

4.3.l{AJ CWTffllRal!o_ - - - - - · - - - -..- - -4-14

4.3.t(B) Quldt Rado _ _, _ _ _ _ __
4.3.2 Effioency or Aa!vity Ratios _ _ _ _ _ _ _ _ __

4.3.l(A) lnventoryl'umover_ _ _ _ _ 4-16

4.3.2(8} DeblXln Tum.o ver_ _ _ _ _ - - - - - - · - - - - ·- - - - - - - - - -- 4-17

4.3.l(C) AgelngSdledule- - - - - - - - - - · - · - - · · - - - - - - - · - -4-18
4.3.2(0) " - ' t T u -r Ratl 4-18
4.3.3 Prorll3b011yR.at10____ _ _ 4.\9
4.3.l(A) C.rou Profit Margin 4-19
4.3.3(8) Operating Profit Margin _ _ _ _ _ _ _ _ _ _ _,_ _ _ _ _ _ _ _ _ __ _ _ 4-19

4.3.l(C) PBDIT/EBITOA MIJ'lln 4-19

4.3.3{0) Hef Proftt Margin_,_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 4-10

4.3A Capllal Sll'ucturt Ratios . 4-~

4.3.4{AJ ~l~qulty Ratio 4-21
4.3.4(8) Toca! ~b< Raoo 4-21
 s r.1,1,. o<Content1
4 3.S Rc1ur11 RaUo• _ _ 4· 21
4.3 S(A) Return on Equity (ROF.) _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 4·2l
4.3 ~(B) Return on lnve•tmrnl (ROI) _ _ _ _ _ _ _ _ _.,._.. _ _ _ _ _ _ 4· 2 I

4.J.6 Stock Market R•tlns (Voluation lutJos) _ _ _ _ _ _ _ _ _ _ ·- ·••- - - - - - 4•22

4.3.6(A) Price llJ Earning, RJiOo (P/ E Ratio)- 4-2?
4.3.6(8) Prtce to Book Ratio [l'/13 RAlloJ -
4.3.6(C) rrtceto S..IC$ (P/S RlllloJ. - - - -·- - - - - - - - - - · - · - -·- - - - - +-22
4.3.7 Use of Rialto AnaJy~IJ- -··- · - - - - - - - - - - -·- - - • - - - - - - 4·23
4.3.8 Limillllions or Rdllo Analysis_ 4·24
4.3.9 Solved Examples ---·--- -·- - -- - -- - - - - -- - · - · - - -- - 4·25

Module 4

Chapter 5 : C.pttal Budgeting 5-1 to 5-1 5

SI Capital Budgrtlng Decisions .._ _ _ _ _ ·- - - - - - --- - - - - - · ···5· 1
~I. I lmporuna, of Capital Budgcling- - - - - - - - - - - - - · - - - - - - - 5 ·2
,_ _ _ 5.2
5.1.2 Typesoflnvestmcnl ProfectS- - - - - -
5.2 lnvcstme.nt Appraisal • Capital Budgrtln11 Techniques- - - --·- ··- - - - - - 5 ·3
S.2. l Accounbng Rate of Return (ARR)- - - - - - - - - - - - · · -······· _______ 5.3
5.2.2 Payback Period · - - - - - - - - - - - -·-·-..······- - - - - - · · ·5·5
5.23 Discounted Payback l'l'rlod . . .---------------·- ··-·- - - - - -5·6
5.2.4 Ne! Pnesent Value Method (NPVJ - -·- - - - - - - - · -,............_______ 5. 7
5.2.S lnwnul Rate of Return (IRRl - - - - - - - - - - - - -·..·- ·"·- _______ S·B
5.2.6 NPV Profile-...--·····--···---- ·- - - - - - · - - - ··--..-·----·-S·9
5.2.7 Modified Internal Rate of Re!Um (MIRR) - - - - - - -..- - - - · - · - - · - - - - - 5· 10
5.2.8 Profitability Index (Pl),- - -- - - - - - - - - - - · - · ·.. --,------S· U
5.2.9 capital Rationing _ .._.._______,,_ _ _ _ _ _ __.___ _ _ _,_____,_ _ _ _ _ _ S · t 2

5.2.10 Project Monitoring and Audit- S· 13

5.2.lO(A) Solved Example _ ..__, -- S-1 3
Chapter 6 : Working Capital Management 6-1 to 6-33
6.1 Introduction ID Working Capital Managemen< - - - - - - - - - - -- - - -6-1

6.1.1 Concept of Cross Working Capital and Net Woridng Capltal- - - ~ - - - - - - - -6·2

6.1.2 Operatlng Cyde - - · - 6-2

 Finam·I'! Man&gl'lll<!lll (MU) 6 Table of Contents

f..1.3 Importance of Working Capit.11 Management ................... - ........... _ ......-••----...- .................... - ........, - .6·3

6.1.4 Pt-,manonl and Variable Working Capital............- ...................... _..___... _ .................--•·-····..... ·---6·4

6.1.S Factors Affecting Wonting Capital Needs .....- .•,...........- .....................,............. _ ................... _·---....... 6 4

6.1.6 Issue~ In Working Capit:il Manogement.- ....·-·-..-·..·•..···· ·- - - - - - -..---·-··-··•...., .... _ .. ·- 6-6

6.1.7 Ei.timatlon ol Wonting C.1pit:.1I Requirement. ........._, _____.....................................-•--•--..---•-6-7

Management or llwentortes ._..........- ..........- ..--.........._,__ ... - - • - -··--....- ........ - - -6-9

621 lnvt'ntory Management Techniques ···---..·..- - - - ..............__ ............._ ,__......................._ _. _ 6-10
6.2.ltA) Economic Order Quantity (ECQ) (How much to Ordcr?).--·-·---··..·•......._ ..................._ ,_ 6-10

6.2.1 (B) Rt-order Point (\Yhen 10 Order?) - ...--.--.. ......- .............-··-···-···-·-....._ ....._ .. _ ..,,_ 6· 12

6.2 l (C) Safety Stock ....- - . - -..- - · · - - - - ··....··--···--··--·---""•-..-·--....,_ _ ,_____ 6 . L2

6 :!.2 I1wenlory Cont-rot Systems ··-·-·-·----•-··-.................__,___ .. _ _ _... _._··--- 6· 13

6 2..2(A) ABC Method or lnwntol') ConlTOI--·-- - - - - -
1
- - · - · - - - - -..··•-............ 6· 13
6.2.2(8) Just In Time QIT) -·----------·-··--·..· - - - - · · - - - -..--·----..--.... 6-14
6.3 M.ina_gcment of Rrceivabll"S- .•.._ _ _ _ _ _ __
- - - · · · · - - ·...· - · - - · · - ~ 6 1S
6.3.1 Cre-d1t Policy._..._ .._._ __
·---· ----·-----·--·-----··---6·16
63.l (A) Cn!dit Standard5 _ _ _ _ _ __
- - · · - - - - · - • - -..- · - 6 · 16
63.1(8) Credit TeffllS _ _ _ _ _ _ _ _ _ _ _ _ __

63.l(C} Collection Policy and Efforts •.- - - - - - - - - - - - - - - - - · - - · - - - - - 6•17

6.3.2 TradH>IT- - · - - - - - - - - - - - - - - - - - - - - - -..·----..- ..... 6· 18

6.33 Evaluat1on or lndlYldua\ Account tor ~ '- - - - · - - - - - - - · - - · - - - - 6-20
6.3.J{A) Credi\ lnfonnanon. 6 -20

6.3.J{Bli C™11t An:aly5ts ·-·- 6-20

6.3.J(C) Credit Decision and Credit Um1, . _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 6·21

6.3 ♦ MorutortngorRecr,vables _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 6,21

6.3.♦(A} Avl'ra,:t CoUecUon Penod (ACP) _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ - 6-ZI

6J 4(8) .Agl"J Schedule . 6·21
6J ♦ (C) Coll«tlon Expenenc:e Ma 6-·ZZ
6 .3 ♦{DJ Cr?d.1 UttUuuon Repon._ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __
--b·23
6J.S 5.1k o ( Rt-tt1vat>Jt>S/f.1<1.onng_, _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __
 7 Table of Contf'nt!

M,1nogcmcnt uf Cash and Markt't.lble Securities.______ _ ..._ .. _ _ _ _ _ 6 24

c,.4
Motives for Holding Cash---" - - -...._ ·-·-·- .. _ _ _ _ _ __ - - - -..·-- b·2·l
6 4.2 Cash M:ut:ijl'ml.'nl Process - - • · ··-·-- "·----··-··..- -...·--·-..- - ...- - · - · -6·25
6 4 2(A) Forecasting Cash Flows•.- ...·-··-·•--..- ...... _. --·-·..~-·-·....----·•..........- ._--·--· 6·2S
6 4.z(B) Managing Cash Collccllons and Disbursements .......- . -...- .........·---..····-·"-··..·- - ··..- - 6-27

6.4 2(C) Investment In Marketable Securit1es.........,., ___........_ ____,....- ...·-·--...,.__ .__ .___ r,..2s

6.4.3 Ca sh Balances to Ma intain ........- ........... - ........- ...............__···- - - - - · ·..- - - - · - - · 6-29

6.4.J(A) lntemun ing Optimal Cash Balance under Conditions of

Certainty• Wllllam Baumol's Cash Model ..--····--·..--···..·-· .....·--···..·-··-··-·----·-..·- 6·30

6.4.J(B) Oelerminlng Optimal Cash Balancr Under Conditions or

Uncertainty • Miller-Orr's Cash Model ·--....··-·-..- ........____·•·····•···..·····-·-··-····-··- ·- ·· - · - ·..·•· 6-3 t

M od ule 5

Chapter 7 : Sources of Finance and Capital Structure

7.1

7.2 Long Term Sourns of Flnanclng--···..· · - - - ···-·-··-·-·-·..···•·•·•..· -.........____........... _ _ •• 7. 2

7.2.1 Equit}' -•-·--..-··--·---······..·---·-- - · - · · · - - ·..·····-···-···-····-····---···········-·..- - - · 7 -2

7.2.l(A) Salient Features of Equity Shares---·-..- · - - - · " · · - · -..........- ...- ......_ .. _._____ 7.3

7.2.l(B) Means of Ralslng Eqully- - · - · -..-··- - · · - · · -..·-----·-..·..··-"·--·--...- ......___._ 7 • S

7.2.2(A) Debentures - - -..·--·- - - - · - ··- - - - -..-··~···..·-----········-····-·-..- -............. 7-6

7.2.2(8) Tenn Loans. - - - - - -..------·--·---·--··········..···-..···---···--•"""·"-· 7 •7

7.2.3 Hybrid Financng - - · - - · - - - - - - - ·..- - · - - - - · - - - -.........._ _.,.................. 7•7

7.23(A) Preference Shares--- - - - - · · - - - - - - - - - -·- - - - · " " · - - - - - · - - - · - - 7-8

7.2.3(8 ) Convertlble Debentures -·--..- - · - - - - - · · - · -··-·----· - - - - - - - - · - · · · · " -7-8

7.2.3{C) Warrants.•.___,,_______________________________ 7-9

7.2.4
7.3 Sources of Shon-term financing .._ _ _ _ _ · - - - - · - · · · - - · - - - - - - - - - ' •10
Tr1de Credit _ _ _ _ _ _ _ _ _ _ _ _ _ _.. _ _ _ _ _ ___________ 7-11
7.3.]

732
Bank Fina.nee .. _ _ _ _..____._.___________________ 7-U

• Ml a ti
• I I f I t • f
 •1 i1 lJAl
..... 1'4U)

U'fC I:.-~ - - - - -

------------------
---------------
T.ablr of ront c nts

- - - - - 7-12
-
'7 Z{II} ON- n!r - - - - - - - • - - - - • - 7-13

7 l(Cl
, "'"' 11nr1 -- -- -- -- --_______ - - • · - - - - - · - - - -·- 7-H
_..

74
J 1,0l!! llYm 31 P<1pn' [C,s )

l"rl-4t'C1 F111mcr - - - - - - - - - -
-----------
------
- - - · · · - - 1. 13

· - - - · - - - · 7•] 4
- - - ·--
7..S Capital qNC tul'l'- - - - - - · · ··-- ·-· ·-· -- 7 .17
------
751 f.tet on AIT«tin1 Capi tal Stru etur e or the Com · - - -- · - - - - - 7•17
p;any -· - - -
7 S.2 Capital Srni rturt Thro rirs - - - - - - · -
· · · · · - - - · · · · - - · · - -·- - - - -·- ···- ··- 7• 18
7.S.2(A) Net I ncome Approac-h,_ _ _ --- - • - - - -·- ··- ·- 7•18
------·-------
7 S Z(B) Nel Ope rabn g 1nc-ome (Nol } - · - - -
- - - - ·..···- ·- - · - - -· ---- ··- --· -·· -· 7•20
7.S.2(C) ...._d
, , ., ltlon, I Ap p roa ch - - - · ·······..····-· -··"··-······
..-····..--- ·-·· --- ··· - ..·-··· ·-··· ··-·· -···· ·- 7 ·21
7.5 2(0) Mod1ghanl · Miller App roach to Capi
tal Stru ctur e- -·- ··..........--• --· ·...- ..-..
- ............... ...... 7•22
7.53 Elem-ts
._::t 1 of Capita I Stru
. cture ..•....,•••••••---•• •M•,.-• ,.. -.,...,. ••-••• •••u••" '"'..,
tt ♦H•
••••-....................·-··..··--······-·
___• ..
-· 7 ·22
7.S.4 Optimum Capital Structure..........................................
.........................- ........ .............................- ......•.......• ....•• 7-23

M odu le 6

Chapter 8 : Dividend Policy

8-1 to 8-9
8.1 ·1ntroduction tx> Dividend Policy··· ---· ···· ····
···· ···· ·-··..···················-······........................................
..... 8· 1
8.1.1 Types of Dividend Policy · · - - -- .......·-- -·-
··· ·············..············- -··.............................................
8·2
8.1:J. Factors Affecting Dividend Decision - ......................-
· · ·····················-· ·······················..·········-················· 8·2
8.1.3 Dividend Policy Theortes-...-·- ··- --· ···
·-·········-·......_.____.........._ ......................................
8·3
8.1.4 Dividend Discount Models (DOM)- ...--•·- - - -·· --· -·· -·......................._ ........
.................... 8-4
8.1.5 Walter's Mode' - ··- - · · - - - · · · - · - - - •
- • O O•-··..···..·••oo••···-············-··-···--······-· ..···8·4
8.1.6
Gordon's Model. · - · · - - - · · · · · · - - -.....
............__ ..........._ _.........- ........................·-······
8.1.7 8•6
Divid end Irrelevance - Modiglia ni• Miller appr
oach (MM) --- ·-· ·-- ···· ·•-..······....... ......._ ....... S·S

□a □
 Overview of Indian
Financial System

av.r-.-.w of Inclan Financial System : Characteristics, Components and Functions of Financial

System.
Flnandal 1nstnNMftt1 : Meaning, Characteristics and Classification of Basic Financial Instruments -
Equity Shares, Pmerence Shares, Bonds-Debentures, Certificates of Deposit, and Treasury Bills.

Financial Markets : Meaning. Charactfflstics and Classification of Financial Markets - Capital

Market Money Market and Foreign Currency Market.
Financial lnstltu1lonl : Meaning. Characteristics and Classification o f Financial Institutions -
Commercial Banks. Investment-Merchant Banks and Stock Exchanges.

We have read stories about the global financial crisis of 2008 that almost brought banks, stock
markets, regulators, governments, international financial Institutions all on their knees. Banks
started to lose confidence to provide loans and it threatened to halt the economic activity.
Crisis in one country Impacted the whole world and it rt!quired a coordinated response of all
the governments and central banks to bring back economy on track, while some countries in
Western Europe are still struggling to come out. It is Important to understand what a financial
system Is all about and what are their constituents. Upon successful completion of this chapter,
you will understand following

Leaming Objectlva
• Financial system, role and functions and components.
• Financial Markets, role and importance of the flnanctal markets, categories of financial markets
i.e. money market, capital market. foreign exchange.
• FlnandaJ Institutions, commercial banks, merchant banks, stock exchanges.
• Financial Instruments, ~ s of financial Instruments and advantages.
 1·2 Overvjew of Indian Plnan nal S le rr,
FlMll'-~ M.anil. ment MU

1.1 Introduction to Flnanclal System

-
5tru
• Every economic activity starting from purchase of any goods or ~rvice to con ct1on of l.irg11
Infrastructure projects such as airport.5. highways requlre funds and Involves now of funds
The financial system of a country. also called as the flnanclal sector, Is a sy5tem responsible for

transfer and supply of funds In an economy.

• The financial system comprises of many con:stlwents such as banks, stock markets, regulaton.
merchant bankers etc. The flnandal system can be defined as an ecosySlem consisting of
financial tnstitut1ons, Instruments and markets to facilitate the savings and transfer of funds.
• Financial gystem provides an ecosystem which enables the availability of funds, movement of
funds and repayment of funds . Ir facilitates effideot transfer of money from areas of the
economy having surplus to the areas having deficit and provides funds for investment.
• wtwn we deposit our surplus funds or savings with the bank, the bank pools savings of many
such depositors and lends It onwards to businesses or other household borrowers. The bank
also gives Interest to the depositors for depositing the money and charges Interest from th,
borrowers for the use of money.
• A country with well-developed financial system also Invariably has strong and stable economy.
The success of financial system for the benefit of overall economy can be gauged by study of
multiple parameters such as the depth of financial system, accesstbrlity of the financiaJ system
to the people, efficiency of the system and stabtUty.

• In India .traditionally the penetration and reach of the :financial system has been limited due to
various factors such as in adequate Infrastructure, llllteracy. lower Income levels etc. In the
recent past. access to financial system has Improved significantly driven by increase In
penetratlon of Internet, rollout of Aadhar, adoption of technology by ftnanclaJ Institutions,
demonetization etc.

1.1.1 Features/Characteristics of Financial System

• Financial system acts as linkage between sa~ers and borrowers.
• It consists of ftnandil Institutions or lntennedlarles, financial markets, financial Instruments
and involves ftnandal transa.ctlons.
• It ls applicable at ftnn level, regional level, national level and International level.
• It encourages nvinrs and Investment In the economy.
 Fln•ncr ~ rment MU 1-3 Overview ofJndlan Financial S stem
.
1.1.2 Function and Role of the Financial Syatem
Financial sys tem of a count ry provides an efficient mechanis m for channeliz ing savings for
creation of asset3 and plays a crl tlcal role In economic developm ent of the country by performin g
followlng functions.
• Uquldlty function : Financial system factllt.ates conversio n of monetary assets fixed
deposits, s hares. debentur es etc. Into money minimizing bss of value and In the process
provides liquidity. lbr example. stock market offers platform to sell shares of company,
banks allow easy redempti on of fixed deposits.
• Savings function : Financial sys tem encourag es savings In the economy by providing
regulated mechanis m for deployme nt of surplus funds. For eumple, when a deposito r parks
funds with banks they earn Interest Income, thus encou.rag lng more savings.
• C.,ltal formation : Flnanctal system acts as lntennedlary and provides funding for Investment
In new projects. new products , expansio n etc. thereby leading to formation of capital,
which ts essential for sustainable economic growth.
• Payment function : The ftnanclal system offers convenie nt rellable and cost effective mode
of payment for goods and services. EJectronic fu nd tran.s fer, cheque sys tem, credit cards etc.
are some oft.be commonly used payment options.
• Risk function : Financial sys tem is constantl y evolving and has built In checks and balances
for arrying out various financial transactio ns and helps In improvin g safety of the
Investme nt The financial system also provides options to lnsure risk against llfe, property,
frauds, burglary etc.
• Lower cost of transaction : Finand.al system enables transactio ns at low cost thus encourag ing
more transactio ns and economic growth.

1.2 Components of the Flnanclal System

fllwKlal Sy1..m

l
'
Financial
Mal'bl5
•
Finanaal
lll9tl'Umentl
Financial
lnllllutiona

Fig. U .1

Firw,clal system ~ s three major compone nts. These are ftnandal marttets
(capital rNTk~ money marttet etc.), financial instrume nts (shaTes. debentl.lr H etc.) and financial
lnsr!tudons (banks, stock exchangt> etc.). In the following paragrap hs these compone nts are
explained In more det1Us.
1.2 .1 F1nancial Ma rke ta
-
o v11 rvuiw of lnd111Jl F1nancwl Systr rn

crea tion and e.xc h ange o f tlnan cial asse ts like shares.
F1nanc1aJ mark-rt ls th, marke-t for
, I gn cu rrency etc. It Is not a phys1cill
debe ntur e1. bonds. trea~ury b!lls, com merctaJ pape n. ,ore ca
refer s to the arra ngem ent for deal • Into Rnanci a I as~e
ing , ts. The fina noal mark et.c; 11
mari cet but
ndin g on the types of fl nancial instr ume nts that · d
are trade
be d~l fied into 3 majo r mark ets depe
eL
1.e. Mon ey mar k~. Capital martcet and Foreign exchange mark
(a) Moaey ma ~t : ll deals with shor t term debt
securities (in the natu re of Joans) having a
maturity of l~s than 1 year. Money mark et has orga
nized and unor gani zed components.
ss funds availa ble for shor t term and
Money mari tet Is used by Investors for Investment of exce
ents. Orga nized mon ey mar ket is
by bor row en for mee ting their shor t-term funding requ irem
money mark et inclu des corporates,
mamly dom inated by banks. Other participants In the
ey mar ket Is oper ated by the likes of
insurance companies, mutual funds etc. Unorganized mon
money~nden..
es. bond s etc. having a matu rlty of more
(b) Capital market: It deals with secu rities such as shar
ary mar ket and seco ndar y mark et
than 1 ~ar. This market Is further divided Into prim
as equi ty shar es, pref erence shares.
Primary mark et deals with new financial Instr ume nts such
a platf orm for deaUng Into previously
bonds e<c. Secondary mark et or stock exchang,es prov ide
nts In thes e mar kets are foreign
issued secu ntfe s such as shares, bonds etc. Part icipa
es, lndlvlduaJs, brok ers, merchant
Institutions, mutual funds, Insurance companies, corp orat
bankers ttc.

(c) Por elp eub ang e market or Forex market:

It deals wtth the tran sact ion in curr encies of
Involve exch ange of one curr ency to
diffe rent coun tries. As mos t International tran sact ions
ket globally by tran sact ion vaJue.
anot her, the fore ign exchange mar ket is the largest ·mar
orat es, brok ers etc.
Participa nts Into this mar kets are com merciaJ bank s, corp
1.2 .2 Financial Ins tru me nts

Financial instr ume nts are the financial prod ucts

thro ugh which corp orat es and institutions
raise funds. Financial instr uments can be broa dly
classified into two types; Sho rt tenn a nd Long
term.
a matu rtty of Jess than
C•) Shon term or money market lns~ men ts : Thes e inst ruments have
e of depo sits and form part of money
1 year such as commercial pape r, trea sury bills, certificat
ey mar ket discussion.
marltet. The details of thes e instr ume nts are cove red in mon
(b) Loq term Instruments : Thesedinstr ...z ume nts have a matu rity of mor e than 1 year. Examples
.
or long term Instruments are bo ce shar es, equi ty shar es and may or may not have
n s, prc1eren
a fiUd matu rity such as shar es etc.
• ~ "4•r4'. 4 (NU) 1-5 O\'e.J"\'V'W of I....th m F1mxnt Sysu.,,:

1.2.3 Financial Institutions

F'mand~ U!Stitutxms a.ct ~ i n t e l ' l ! I ~ ~-em the s.v~ and ·a:ser5 of ftmds Co=.!
banks. tnvesnnem bann, filWICing compamr:s etc. tall m the at~gory of fin.mm! UlSOtl.'UOZ
rm.nc'.ai i ~ iiT'P dassilitd mm a~ras of banlong .J>d noo-b:annng msonmons.
(1) Bauldng bastttlltioas : It 111durles p-Jblx sector banks. pnvatt banks, foragn banks, reg10.ul
l"UT1l! banks. roc>per.nvt ba.nla. [l)ilymffll b:anks. small ll o.i11C't banks ete. ilsd provide b.nlar.g
Wl"V\c.a State Bmk of lr.dfa, KDFC Ban);. 100 Sank. SVC Cooper-a~ Bank cs 5"1'!'.M! o1 the
n::ampies of banitint institmions. ~ ....., r~~ttd t,y IDdi•·s. Central bank. IN' R~~
Bank of lndia ~ c.il.e d as RBl.
(b)No,--hentrtea lmtilldiolu : It 1ndudes non-banking financul I.DSDO.IDOm tnp?(l .:i

p~'iding ~ such as housing t i , ~. consumer !inaoce. v ~ tmaon.,-,g, smdc ~

mach.mt bmlcill&, mutual funds. dt•,,eopment fi:i.oang co m ~ ttc. ~ on the
Kmi ry nion-bmttng tmntvtJOaS ..~ r!gllbtfd by b.lnnng rtgUbw RBI. apr...l marnu
n-g-.da.!OT SEBl. msur.mct ~ tor lRDA t"tc.

1.3 FINllldal Markets

In the atl(M .e-cuon, - undffstood tti.,- COIKept of finandaJ markt-t. Wt will d:lscuss in mon
citQil in b e l o w ~

1.3.l. ,C harad• lstlcs Mid Role of the Financial Market

• F• IPt ◄ I• p1kr N uuy : F:im~ nwm pnMdes ;acaita.tt aad ci:M:l)' ~ & n ffll
tbt priced me finaPd;d aseu to 1hr buYffS and wDen.
• Pn;lle 111 i 3f§y ID ft +WM t : Fbwidal niaru<s provide highly tfficit'lll imd liquid
pi.t!Drnl fw ~ ~ ~ me fiNDCRI - emumig mf.Jumum lass 111 vuue ,of asset
a;iancnnwuaan = ash.
• nt I a ae c.r of bb-1K1:1fdla11m111 : Flmnda.l rmruu fadliuce salt .mod ~ o/
feCUJ'11ties •t low cr.msacnoo C01t.
• Notis: ◄1 a Ill uwtap : Ftivndal 'Ulbu bring i:oceu,er CM S3'<'ff"S and busmess.es IIOlfe!hlc.
md 1111 me- ptOCHS prorridel ;1YmOeS to i1IVeS[ w AYinp. Ir provjde:s a rc-g->lbted pl.ltorm for
m"t E I h."D'

• ,\l! c :,: a Jd' wubap lap, N11w £1 1 , :• '9'S . As marittu prc,vlM ll!format!oa o< rerurns ~
~ al various ~ SitOOl"J ff'- tnveruin ~n tab informed dtt:m<>J>S on
fu•at- 11! In qnou.s llfttOl'l/ s.ecurma. llliS It pr-gyld~ mechanism for alloca-OOll ~
iAto DOSI p;odut:d •~ s«tan,,
 t flAocc, Man3_,,,., (MU) 1-6 Oven,lr# oflndla:n Financial sem
1.3.2 Difference between Mon,ey Merket end Cepltal Market

Sr. No. NoaeyMll'bt Capital Market

I. Thls Is :1 market for s hort lenn This ls a m:arlc..1 for long term instruments.
lnstnnnents.

2. MoMy market Is used to meet short Capital mar1cet Is used for Jong term fun~lng
tenn n,quln,ments or corporations. requirements.
banks and GovemmenL

3. BIii of exchange, Treasury bills, Equity shares, Pn,ference shares. Debentures.

Commercial papers etc. are some of Government securities etc. are the Instruments
common instruments that are dealt In that are dealt In this lllllrket
thls market

4. Commercial banb are the largest Mutual funds, Foreign Institutional investors,
partldpants in this market Insurance companies are the majo
partidpants ln this market.

s. Seco11dary market ls not as large as Secondary market ls much larger than primary
pnmary market due to short term market.
. nature of lnsmunents.

6. Transactions are generally done Transartions 31'/ generally done through stock
through ~lephone or malls. exchange.

.4 Money Market

Money market is a market for dealing (sale and purchast') In s'hon lt'rm St'CUrltles whk h ha\-r
a maturity period of upto one year. This market Is used by Investors to pan their surplus funds
for short term basis. Due to large ticket· slz.e of transactions. money market is ryplai!Y
domln:ired by lnstlrutlons such as Banks. Insurance companies ere.. however ind lvldll,lls OIi
,1lso !nvM tunw In 1hr money rmrktt lbroul,h mutial funds.
Mo ney market In India b reguu~ by thr country's un.tr.tl !bank Le Rt-s nv" 8.lnlc ol 1ndll
( RBJ) RBI a.bo partlcip~rts In the., m~rlct'C from om" ID Umr ro trllllla&f liqwdlil)' In uw qt!f'lt
and rilJl t fund} for thcr Go~mmfflt of 11\di,.
! Finance Mluloifment (MU) 1-7 Offrvlew of lndi.an Financial sr:em

1.4.l Charac.teristlca and Role of the Money Market

Characteristics and Role or the money market Is as follows:

• Money market deals tn hlllflly liquid s hort-term debt securities or m~.turity between 1 day to
orieyear.
• Money market eaten, to the working capital and short-term requirements of firms and the
governments, banks a.n d financial Institutions.
• The money market fwllls the borrowing and Investment requirements of providers and users
of short-tenn funds a:nd balances the demand for and s upply of short-term funds.
• Money market offers a hlper degi ee of safety, compared to other markets.
• Rate or return or Interest rate on the ln,,estmcnt Is comparatively lowe-r than other llnanctal
•
markets due to shorter maturity.
• It serves as a one of the preferred ma~ets for the Reserve Bank of lndia•s (RBl's) Intervention
In the market to manage money flow In the system and short-term interest rates.
• Generally, transactions take place through oral communication (for e.g. phone or mobile) in the
money market The exchange of relevant documents and written communications take piace
subsequendy. There 1s no fonnai place for the trading (like a stock excharige).
• Partldpants In the money market are RBI, Commerctal Banks. Non-banking ftnanclal
companies, Mutual Funds. Corporate bodle-s etc. Commercial banks are the most dominant
participants of this market.
1.4.2 Money Market Instrum...ta •

1. can rnartlet (call money)

• Call Money. Notice Money and Term Money markets are sub-mari<ets of the Indian money
market. Call Mone y refers to the borrowinl or lending of funds for l day, Notice Money 2·
14 days and Term Money more than 14 days upta l year. Call Money/ notice money martcet
Is also known as I nrer-Bank mari<et
• Lendln, a.n d borrowln& rake place on unsecured or non-collaterallzed basis. The !Tades are
. conducted both o.n telephone as well as on dle NOS Call system. w.hlcb Is an t>lectronlc
scnien based system set up by tht> RBI for negothil:lng M<>ney martle< dea!J ~twttn
entitles permitted to operate In thl' money markrt.
• The entities perm itted to p,ar1id pate both as lendt'r .ind borrower 1n !tit' all/noucr money
ma rket are Sched uled a,mmtrd•I banks lcxdudlog Reglo lllll RunJ banlu). UH>pu ~ttve
Banks and Prima ry ~k~ (PDs). S.-IC'C1 nnand:,I lnn!rudons. insu n na rom,»nJ1e1 1nd
m utual funds can p,utld pate only ai lender:L
 18 QwrvkW of Indian f inancial sr~ll
• ~ M::::c-:="' (WI/) z
l"nma,Y l)olen ( POI ) a~ OtKOunt and Flnanct Housr of lndla Ltd. (OFHI) ~nd Secur1t1ei
0
,._ of lnd la (STCI) were rsubllshed In 1988 and 1994 rrspectlvely to
u-.dlna tvt pora .....n
~op tJw ~ nd&ry markrt for money marlurt Instruments.
1

2-n rv ...
• Treuury bW alto known as T-blll Is an Instrument or short tenn borrowing for

Go¥emment o(lndla.
• Treuury bills an lssUed by the Central bank (RBI) on behalf or Government of lndla to
meet short m,n fundlng requirements of the Government and to manage liquidity In tile
ftnand al system. Treasury btlls are not Issued by state governments. Treasury bills are
iuUed of mainly 3 maturities, namely 91 days, 182 day and 364 day treasury bills.
• Treasury bills are Issued through auctions at a discount and repaid at par at the time of
maturity (same as face value). For example, a Treasury bill having a maturity of 364 days
and face value of Rs.100 will be Issued at a price lower than 100, let's say Rs.96 and at lilt
maturity Rs.100 will be paid to the Investor by the Government. The difference between
Rs.100 and Rs.96 will be the return by the Investor.
• As the Treasury bills are Issued by Government of India, there Is no risk or default The
minimum amount In which they can be traded Is Rs 25,000.

3. Commeu 1•1111118
• Comnie~I bill refers to an accepted bill raised by seller on buyer and duly accepted by
the buyer. When goods are sold on credit the seller draws a bill of exchange on the buyer
for the amount due. The b_u yer accepts It and returns to the seller.
• The accepted bills signify unconditional agreement to repay the seller agreed amount it
the end of credit period.
• When trade bllls are accepted by commercial banks, they are called commercial bills. Thest
are negotiable lnsttuments and are generally Issued for 30 days to 120 days.
• The seller may either retain the bill till maturity or due date or getIt discounted from somt
banker and get Immediate cash. The amount discounted Is repayable on matu rity of tht
bill.
• In case of need for funds, the bank can redlscount the blll l.n the money market •nd JC<
rady money. In India. the participants of the commercial bOI market .a re b;inks , nd
financial t:nsunation5. The bill market In India Is not well developed.

•· t ■ tlfkatie .of d 1, a It■:

• Certlflcat.e of Deposits •lso known as CO. haw I maturity penod bdwHn 7 d.la)-. to I vYfl
Most common trnor of CDs are 3, 6 and 12 monms Cfx art ltrwed In a denu\l!f\.s.r-
rorm, at II d1JCOUnt to faa v11lue and redttmecl al bee va-lue.
• .... · 1·'1

• It Is a nqottable fflOMJ IUl'tt~ lnstrwnenl like a promissory note (Promissory denotes a

~ promise to pay the lender certain amount at the end of agreed credit period)..
• All scheduled commercial banks exdudJng 'Reclonal Rural Banks (RRBs) and Local Area
Banks (LAB1) and all India Plnancul lnsttwtlons Pff111ltted by RBI are ellglble to Issue
Cfflilkates of deposlta. CDs are ma1n1y subscribed to by banks, mutual funds, provident
and pension fllnd1 and lnsuranc-e companies,
• The minimum amount of a CD Is Rs. 1 Lie an.d In multiples of Rs l Lac therearter.

I_ Com.,... Id r ,.,
•
-
Commercial paper Is another money mark.e t Instrument In the form of promissory note
and popularly referred to as CP. It Is a short-term unsecured money market Instrument. of
maturity from 7 days to 1 year. These are Issued at a discount to face value and redeemed
at par.
• Corporates. Primary Dealers (PDs), and all-India flnancial Institutions (Fis) that have been
permitted to l"alse short-term resources by Reserve Bank of India are eUglble to Issue CP. It
Is a very popular avenue for ralstng short term funds for corporates. Thes-e can be Issued In
denominations of Rs.5 lakh or multiples thereof.
• All ellglble lsauen art required to obtain a credit rating for Issuance of Commercial Paper
from a credit rating agency as may be spectfled by the Reserve Bank of India Jrom time to
time.
6. Moner marut mutual funds (MMMPs)
• The money-market mutual funds were Introduced by RBI In 199Z and since ZOOO they are
brought under the regulation of SEBL
• It is an open-ended murual fund which Invests In short-term debt securities. This provides
an additional sbort-cvm Investment avenue for corporate and Individuals.

7. Pap:;t and the :eHCI I l"IPO maket

• Repo means "Re~n:base Ag. eem...nt" and refers to selling specified securities under an
agreement to repurchase It at a predete, mlued date and rate. Under repo, the seller gets
tmmedlate funds by selling specified securities With an agreement to repurchase the same
at a mutually dedded future date and price.
• A repo transaction for one counterparty becomes a reverse repo tranActlon for the other
COllnter party. At present. securities acaptable under repo tnnsac:t1ons Centnl
Government dated securities (G·Secs). Treuwy em, (T-Bllls). State Oewlopment Loam
(SDI.I) and Corporate Bonds. The endtles pmnitted to undertake repo lnnsactions
llldude Scheduled Commercial Banks. Co-operative Banks. Prlnwy Oealen. Mutual Funds.
Insurance Companies and corporate eartties.
 I • 10 Overvl- of Indian Financial sri..111
a

8 . a,a,,-ce1pa.wtil D111alft.
• An lnrer•Corpon te Dt!poslt (ICD) 1s an unsecured borrowln1 by corporates a.n d Flnanda:
lmtmldons l'tom other corporate enddes recistened under the Companies Act 1956 on
uJU«11red basts. The corponte b.lvtng surplus funds: a n lend to another corporate In llee(I
otfunds.
.
• 11w atiort term ~ It rallng or tM borrowing corporate would determine the rate at which
It would be able to borrow funds. The tenor or ICD may range rrom I day to 1 year, but the
most common tenor or borl"OWfng Is for 90 days. Primary Dealers are permitted to borrow
In the ICf> marbt. Primary i!>ealus cannot lend In the ICD maricet
•• DtllCOunt and Finance HOI.II I of llldl• (DFHI)
• It Is a primal}' dealer and deals in treasury blUs, commercial bills, CDs, CPs, short tenn
deposits, call money market and government securities. It was established In 1988 by RBI
and Is now brought under control or SBI.
• Establishment or DFHJ has helped to develop an active secondary marl<et in Money Marllet
In~~-

1.s capital Market

• Capital market Is a market when buyers and sellers engage In creallon and trade or financial
securllles having a maturity or more lhan 1 year. Trading of the securilles generally take plact
on screen.
• Capital martcet provides platform for trading of debt as well as eq11lty securities.
• Capital martcet consists of primary market and secondary market. Primary market deals wim
ISSllance of new securities, whereas secondary market provides platform fOf' dealing al
prevtousfy-lsSlled securities.

• Primary market provides new capilal while secondaJy marlcet provides nec~ry liquidity fc,
the saJ.e and purchase of prfflously Issued securities. Existing holders of securities an sel
tMir holdlnp In the secondary nwtcet. thus frffln& up funds for lnvestmen1 In primatl'
market Issue$. Thus, a well-functioning seconcwy ~ Is kl!)' to development of pr1111111
marlcet.

• MaJor l.nvestors In the capllal mariu!t a~ Insurance cornpanll!S. foreign port1~Uo 1nves&~
mutual 6•nd• c,,m....r.cul banks:. non-banldq finandal lnstltutlotu, p ravldrnt fund.
funds.
""'"'°'
• ~=-e 1(Mu1 1·11 Onrvlew of Indian Flruinml Sy,tem

1.s.1 Puncttons, Role and Importance of Capital Market In India

l . MobiliuUon of savings for llnanclng lo"I term lnvl!!s tmenL

2. Pnwtcle llqukllty by ffl&bllna sale of securities without any loss of value.

3. Provide Ion& tenn risk apltal to entrepreneurs.
4. Allocation of capital to productive sectors of the economy as capital market transfers savings
to well-functioning companies.

S. Capital Markets provide runds for projects In backward areas through competitive pricing
mechanism facilitating development economic development or backward areas.
6. Capital markets make It possible for companies to attract foreign capital by Issuance of bonds.
shares etc.
7. Provide Insurance against maricet risk using derivative instruments.
8. Capital market serves as a rella.ble guide to the perfonnance and financial position or
corporate. and thereby promotes efficiency.

1.s.2 Cllpltal Market a ...1t1catlon

Based on the type of securities that are traded. capl.tal market Is divided Into Industrial
securities market and Government securities market However, primary classtlication capital
market Is still between primary and second markets.

C..-.11 1111
I
1 1
lndullrlals-.ttlN Qo.ee1w1•1t Securttiea,
Mal1cet Mania!

..
-PrinwyMaltlel
- ....,.
,-.u.1
.

1.5.3 lnclustrlal Secviltt.. Martlet

lndustnal securhies market Is the marlcet for dealln« In wres and bonds of exist1ng and nl!!W
companies. this ~ Is furttler divided Into pr1rnary and secondary mnet wtikh a ~
•
discussed below In dru!L
 I lZ

1.5.4
• The pr1m.1ry matbt 1J I nwrli-111 whert lu\la.!Kr or new ~ritlfl iake place and Is al~ CllUCd
- 1uu,. nwritrt It deals with l:he n - securldff wt.Jct, were not pn!'Ylously avallabl@ for
tn ~L Corpontr enurprtsn ind Goftmment can raise long term funds from the
pnl!U-ry CMrbl by luutna lone term secvr1tles. These securities nuiy be In the form of equity
di.Ire. prefetnt!IQ shares. d~tures. right Issues, deposits d.c.
• Bodin.,.., and du, c,xisd ng companies can l.ssue new securities In the primary market. In the
primary mllrlcet.. new Issues or equity and debt are amanged In the form of Initial Public
Offering (IPO or via private plaamient or In the form of rights Issue to existing shareholders.

1.SA(A) Cha,acturiatlca and Role of Primary Market

• It Is a m&rket for the fresh Issue of shares. debentures, etc.
.
• It helps companies to raise capital and long-term loans.
• It Includes various llnandal Institutions that support the fresh Issue of securities.
• It enables formation of capital by channelizing the savings of the public.
• It provides risk and non-risk capital to companies that encourages setting up and expansion ct
new business and creation of Jobs.

1.5.4(8) Methods of Raising Funds In the ftrlmary Market

1. Publlclaua
Under this method company raises funds from general public, by Issuing a pros~
Securities Issued by this method are generally listed on stock exchanges and available for salt
and purchase on exchanges. The prospectus contains Information about the company such as
the purpose for whkb funds are being raised, past Hnancial performance of the company,
badcground. future plans, risks, gr6wth prospects of company etc. This Information helps tilt
prospective Investors to take decision regardln11 Investment Publk Js:un can bt of followtnc
typeS

(a)lnlUal Publk Offertq (IPO): This Is an olfertng by an unllsted company for thcr Rrs1 lilllf
In Its life co the general public. It contains either I fresh Issue of securities or an otfff Jiir
s:ale of existing securities or both.

(b)Follcnli Publk o&rilll (PPO) : This Is an offer for sale of secur1des by ,n , lrudy ~
DD

co.mpany throup an offer document to the gene aJ public. Ir can ridM-r be • ~ Wl.11 J
s«11tfdes or an off« for saJcr of existlna securtlles.
fn 1·13

2. Offwfar ....

Utlder *H• T hod "'fflllttiet lf't DOC Wllff dlrtetly 10 Ult' publk 1>111 AR offend for w,
dttoucfl llltffmedla11ff lib lA'11"11 ~ or stock brokers. Under this method. the sale of
HCVr1tles tabs place In two 1:11 In 1he ftm nage. the Issuing company sells the shares to
die lntenMCHan.es tudl as Issue houses and broken at an agreed price. In the second stage.
the latennedlarles reMII the NC:Ur1tles to die ultJmate Investors at a market related price. This
price Is senerally hi&tter and lhe dlffenna between tht purchase price and the Issue price
~resents proftt for the lntermed.laries. This method l.s not common In India.

Private placement Is the allotment of securtttes by a company to Institutional Investors and

some selected lndlvlduals. It helps to raise capital more quickly than a public Issue. This
lnvolve5 Issuance of $«Uritle5 to less than SO persons without Issuing prospectus letter of
offer· and Without seeking permission fo·r fisting for the securities. The Issuers could be public
limit companies or private limited companies. These secu:ritles may be listed or unlisted.

4. Right.- TM•,e
This .Is a, method of raising of funds through Issuance of new shares by the company to existing
shareholders. Tbe shareholders are offi:1 eel the "right' to buy new shares In proportion to the
number of shares they already possess The existing shareholders may accept or ~ect the
right. Shareholden who do not wish ID take up the right sham can sell their rights ID another
person. If the shareholders neither subscribe the Shire$ nor tr.1nsfer their rights, then the
company can offer the shares to publk.

1,S.4(C) Procedure of Raising Funda by Way of IPO

Under. public Issue, the new shares/debentures may be offered either directly to the public
through a prospectus (offer document) or indlr'Kdy through an offer for sa!~ An IPO muld be
structured for 2 reasons. Flndy, the company may be looking for fresh funds to finance Its
e~nslon and dlversiftcation plan. This will increase the sbaJ,e capital of the compa,ny.
Secondly, the company could also structure It In !he form of 1n Offer ror Sale (OrS). Here there
Is no addltlo:n to shares but l)le existing shareholders offload part of their hotdlngs In the unlisted
company through the marl<et and get It listed IJI the pnxess Quite often It Is a combination of a
fresh Issue and an OFS. Tbe main steps Involved In public Issue are ;u follows.:

1. Appol'1tment of M•dlant 9ankera/lftt u lt unt benkerl

The company nffds to choo~ merchant banker to maM,e the IPO. They act as Intermediaries
between ,com~ny and lnvest0rs. Merchant b.lnker does die due dlllpnce, to pre~rw the offer
dCICllmffll whlcb contains ,ti ~ deaifls about the cotDJNny.
 o,,.,,v;- o ( l ndl•n 't'lnan<l•I S)'!<lt'III
I 14
•
They art' .., n!Sporulbk (or en,ur1n& compllance with the leg;il formalities ln the entire isSUf
11
.... . ..._.,ng or the 1uue Som.-tintt'S underwriters arr appolnte<I to ensurr fiill
ptOCC!U .an d 1u l nu, ~~u · ·
su~poon. underwrtt~ ,re ruponslbl• for w bscr1ptlon of lht Issue In !:ase of a ny

)hontllll.
1. . . .I tsltOII ror lllO and Plllnt of Draft rro■puctu•
• Any company mutns a public lss~ or a rights Issue or securities ol value more than Rs so
laklu Is ~uln!d to file a draft offer doculllf.nl with SEBI for Its observations. Tot
m•rchant bankor and the company prepare a registration statement and a draft

prospectus.
• The registration statement tndudes the detailed report of Its fiscal health and business
plans and Is submlaed to die regulator of capital markets In India the Security and
Exchange Board or lndla (SEBI). SEBI tssu.a Its observations by way of observation leltfr.
The validity period or SEBrs observation letter is lZ months only I.e. the company has to
open Its issue within the period of twelve months starting from the date of lssuh-.i lh,
observation.
• Post submlsslon or registration document draft prospectus abo called as 'Draft Red
Herring Prospec111S" Is submitted to the S!EBI. It Includes detailed ftnandal records, futurt
plans and the specification or expected share price ranae. 'This prospectus Is meant for
prospectlve Investors who would be Interested In buying the stock

J. 1181 Appto.al
SEBI verifies the filcts dlsdosed by the company. It looks for errors, omissions. and
discrepancies. Only after s·EBI approves the application can the company set a date for the IPO.
The company can open Its Issue within 3 months from the date or SEBl's approval. SEBl's
approval Is also called observation letter.

• Once the prosp«tu.e Is ready, underwriters and company officials So on countrywidt

' roadshows', c:onduct Investor meets and bralcer meet& across India IO sell the lclP u,
retail HNI Investors. instlbltlonal Investors.
• Addition.ally. companies looking at global Investors also conduct road shows ,1 kef
Onanctal centers across the worid like New York. Boston, London. Slnpport , .nd Honl
Kong. ln,..estors ~re proVided with detailed infonl\lltion rqardin& comiuny's futu rr pL.i,1
and 1rowth potentL1L Tb.ey get a feel of Investor rHpOrue throuch these toun.
 • Fina11ci: Mnn.i11c111er, t (MU) I · l 'i

5, Fln:1llz1tlon of Price Band • Sha re Number

Alte r IJ1e Roadshows, SEBI :1pprova l. th e t. ompany. w ith 11s!J l'(IIHl !..C fro m the lnv u.Mnw nt
ba n kers nnd undcrwr llt!rs decides 0 11 th e price 1,a nd of th e ~h,irtes and ali,o rladdtts th"
number of s ha res tu be s old. Tht!rl" a rc two typ es o f lsi. uc:s: f'lx!..-d Prl<.c IPO a nd Flook Bulldln1,
IPO.
l. Fixed Prtce IPO: In a Fixed price i,sue - rhc compa ny d ccld ~ t hu price of t he share Iss ue
and the number of shares belnt,: s old.
Ex. : XYZ Ltd pub l1<· Issue or 10 lakh sha r e•; of tan' value k s. HJ/ uach a t :1 prl c,e o f R11.6S/ ·
ea ch to the publlc.
2. Book Building I PO : In thl&meth od . t.:o mpa ny 11~cs book bu Ud ing proct-.si. tu r1l!lcover t htt
price of th e issue, The com pa ny decides a price ba nd ;111<1 It gtv~s the Inver.tor 111 11 option to
choose the price at w h ich he/ ~he wis hes t o bid for the n unpa n y sha r es
h : XYZ Ltd tssuo or 10 J;1kh ~hare~ of l.;\u, 11.iluc- Rs.10/ · eJ c h .t i a p rice band of R:. 6 0 LO
Rs.70/ - is ava Uable to t·kc public t.h e rchy genl.'rn tihit u~ilo ll!..7 Crr,re111. H,1ro t ho amount
generated thro ugh t·h e issue would d e pe nd o n th,. highest amount bid by m o.,t itwe-s ln rs

6. Available to Public for Purc,haM

On th P dates mentioned In che pros pectus. !h e ll hare:1 :ir e- avJ llahlc to puhllc. lnvl•~to~ c.in fill
out t he IPO for m a nd s11eclly the price a l w hlc'h they wis h Lo make t he purcha se on d su hmfl th e
application.

7. Allut.n..nt of Shara
• ·o nce th e subscriptl o ·n perio d Is over, m e mh oni or
th e underw n tlng ba nk.~. s h 11re is<111i ng
,co mpany ct r . will meet a nd 'determine till, price at whl r h sha r.-, art' to be allotted to th e
·p rospcctlve Investors.
• The p rice would b e· d lrertJy d etermined by the de ma nd a nd the hid p rice qllu ft-d by
!nveswrs. Once the pri ce is finalized, s h ares are alloned lo investors b.1scd on t he bid
amounts and the sh111n.-s available. lo c;u;e c,f OVl!rsubscribed 1~su,-.,, 1th,1res arc, not alloth:d
, to illl apph~Jl ts.
'
[ • lw,,esto~ who have appl~ d diroagh ASBA & w whom shan,~ wt're ullottw would gtfl 1h r
~ sh.a.r,:s credJted tO thf:1r DE.M AT a c.councs & their fu n ds Jff:ttlng d 1:hu.ed rrom th1•1r bank
~ aC'tl>un:t o r else fo r tbo s~ fnv~tors to whom the sha:r tt were n ot allotted. fu.nch would v.c1
unblocked In tf\11,lr bank account
~ ._ u.ttng
~
~ 1'he la'it n e p Is the li)'bng In the S11,cil Elld1;,nges . Pina.Hy. thine Is the actual ll•iting uf thr• , tock
~- wh idl convert., !ht- !PO In to a soco nd;lfy m .ar ke t pli1v f rom t ha 1 ~y. lhc ~,t,d. c.;n ~
~.~-
i
pvr d u1s·~ .and $0Jd on tht- ~ep1lrl3ry m.arket.
 Overview of I ndian Finannal !>r.,it-rn

1.5.4(0) Flnancial Intermediaries involved in the IPO Process

Ffnanc1al lntermedi.a ries involved in the IPO process a r e as follows:
J. Merchant Banks : Merchant banks act as issue m an agers. lead managers OT co-managers.
Me rchant banks are respons ible for compliance a nd marketing of th e issue.
2. Registrar., to the Issue: Registrars are Intermediaries who undertake all activities connected
with new 1ssue management such as allotment of s hares. They are appointed by th e company
In con~ultation with the merchant bankers to the issue.
3. Bankers : Some commercia l banks act as c ollecting agents and some act as co-ordinating
bankers. They· play an Important role in transfer. transmis sion and s afe custody of fu nd!i.
4. Brokers : They act as lntennediaries In purchase and sale of securities in th e pri ma ry and
secondary markl'ts. They have a network of s u b brokers spread throug hout the l,e ngth and
breadth of the country.
5. Underwriters : Generally. investment bankers also act a s u nderwrite rs. They ag ree to take a
s pecified number of shares or deben1ures offered to the public, if the is sue is not fulty
subscribed by the pubUc. Company needs to p ay a separate fees ca lled underwriti ng fees.
Underwriters may be Anandal insdtu tion s, banks. mut ual funds. bro kers etc.

1.5.5 Secondary Market/Stock Exchange

• Secondary marl<et is a market for sale and purchase o f existing securities. Secondary market
generally means organized s tock exchanges as they prov ide a con ti nu ou s a nd regular market
for buying a nd selling of securities In S<Jme ~a se!-, unlis ted s ecur1t1es are trad e d over tilt
phone. however It represents s mall po n lon of equity market.
• Stock exchanges In India are n-gulated under the Securities Con1racts (Regulation) Act l 9 56.
Under the Securltl~ Contracts (Regula tion) Act. 1956 a stock exchange 15 defin-ed ,111 ·an
assodatio~ organ!i.itlon or body of individuals. whether incorporated or not, established for
rh4I purpose ,,f assisting, rt!gulatlng and cont r olllng business ol buyi ng. selling .md deaHng 10
s«uritiH. Securities ca-n be listed a nd traded o n multiple stol·k exchange~.

• In lnd!a, OJrrendy there are 6 stock exchange as ltsted by SEBI. Ther e are BSE Ltd or BombaJ
Scod( Exc:han,e. Nationaf Stock Exchange of India Ltd known NSE, Calcutt.I St ock Exc-hange Ltci
lndla tntematwoal Exchange (lndfa INX), NSE IF'SC Ltd, Metroix,lltan Stock F.xrhan~l' o f lndb
l.rrl, 8Sf. .ind NSE •~ the ~ o of the largt-st :stock exchanges tn India. B~E ts a l~ tlv.> old~
!todt exch~.nge In Alia .ind h.as the distinction of the largest nurnben. of h<.ted <"um p;u1,.,.., :n tbt
world. Howt:ver, Nadon:al Stoe'k £icchan~t> or NSE ts the largest scock e}LC'hange 1n lod t.J In ttnllf
of the diaUy tumm<•.r and counts as all ma)'>r Fm.anna l ln1>dtu lloru as lnves.to.N>.. INX and IFSC
are based m Gffldblnapr and only provide dc-rlvat:J'lt.' servJC(.-S.
 • Fmanct Mano ,rment ( MU) I • 17 Ov1•1 vlt•w nl lnJ,,,n hnt1m·1J I !,ys11•1n

1.5.S(A) Characteristics of Stock Exchange

l. Stock exchange provides a continuous a11d rl'RUla r ma rket for huylnit anr1 ~elllng vf sc,ur lll~~.
2. Stock market allows trading of only listed securltle!>. Each lis ted scru rlty hns unique ticker o r
code provided by the exchange.
3. Stock marke ts provides periodic Informatio n related lu Lracllng or securi ties ~uch as price,
volume etc.
... Trading in the stock ma rket takes place through the a ulhoriscd stuck brokers.
5. Interest of the participants are protected thro ugh a s urvl'lllance mechanism on the trad ing
activity ca pable of detecting any abnonnal t rading activity.
6. Stock exchange are considered as a n lnd l<:ator of the curTt-nt .1nd future of Lhe eco11o mil
activities or the country.

1.5.5(8) Role and Functions of Stock Exchanges

l. Stock exchanges provide liquidity through 3 condnuous and r eady mnrket.
2. Stock exchanges ensurt> m ccha ni<lm for safe ond un111tcrru ptcd tradi ng and trans fer o f
securltles.
3. Stock exchange encourage long tenn S-1vings In the economy by providing a liquid, accessible
and long tl"rm securllies market.
4. Stock exchanges p rovide mecha n ism for new ~ pltal fo, matlon a\ for existing holde~ can
easily s&II the-It' securities and can pamctp.ste In now publk ls su('<;.
S. Stock ,ex~nges enable allocatio n of funds from unproductJve sector<; of t.he economy to
productive secto~
6 . Entrepreneurs or existing businesse<. c-an use stock ext·Mnge lnfo rmc1t1on a., an 11nportant
parametN' for d eciding Investment.$ In new businesses
7. Pu.bUdy tistt'd com~nles on stock exchanges have an a dded adva ntagt• of crcatlnr, la~r
brand awareness as mult1ple1nv~ors trade on stock exchanges.
8. Listed companies on stock t'xdl.ange< need to provltle period ic updates on the- Ir nnunc1al a nd
!, b u s i n e s s ~ ~- This litlso pu~ pressure o n the managemtnl t o d isclose Info rmation and
Opt'tate efficiently.

;.. i.s. 1 Government Securities Market

', 1'
Govemment tecwides a.l1io cal~ as 'GUt edged' S\'nlrluc1, markeL ·me ll.'rm ·gllt ~dged· mun~
iok4 edtecf t.nd men to the ~ t quality
!
th~ In thL" context of SKUnurs Smcr Gt.>vtmm 'lt
~ bav~ nH d ~-l'N uf the risk of dtbuJt so t.h~r an CJ1l11>d gllt •edged Sce,- u1i ll(M, It 15, .1
market whett Gov,nunt!'nt secu~s ,, rr tnded. Cov-e-rnmf'nl tSsues bol.h loni lc:r m ind 1.ho"
terms l'l'«Uri rits.
 On•rvl l'W o l Indi an F:n.,n, 1.al ';y~•e 111
1 1
• Fm J nl·t' M,1n11~crrwnt (MU) !:I "'

, ..- ,Jso rJ lled (; •sec a:-r ll adecJ In tbt\

d b c tr41 I Guve, n nu·11 I ,. 1 " • •
• The long term ~ccurir,t•s issut· Y en bills c1re traded in tht' monc,,y
markeL Shon term Govcnu11ent s1.>t1Jrlue, called as rrea,;ury

~ •
market.
The G•!>ec market Is J
f
source o Iong- m1
re iund.s ro the Government of Ind ia and c;Latt
.,~ rltics having a ftxeJ date or matunry and are-
Govemments The Government bonw. arc secu '
.issued to raise medium
· ., lt.'nn loans In the open market. G-sec .tre ,ssued by
and lon"·

0 Central Government
0 State Govemmt>nts
0 Semi Government authorities like City Corporations, municipalities
0 Autonomous bodes su,h Airports. Port T rusts ctr
0 State Government entities such as Transport corporations. St.1te Electncity lloa rd.S
0 Public Sector Enterprises
0 All India a.nd State level finandal institutions etc.
• G-sec market in fndla for all practical puirposes represents securities issues by Central
Government. G-Secs art> st'ruriONi issuNi for a tenor ranging from S yean to 40 year.;. Theu
are .urned at financing the shortfalls in fiscal balances
• G-Secs carry a coupon rate or interest rate which ls paid half-yeo1rly a nd .tre redeemed iii

maturity at par value on maruriry date. The r.-Seo issuances are managed by the RBI which
Issues them on behalf of the CA.-otre by au1.1Jon method. The tol4J auction size generally nmgt:,
between Rs. 15,000 - Rs 18,000 Cr

• Considering such large issuance stz.e. they arr uoderwnnen by Primary Dealers. Commerctal
banks, Prim2ry D~le~ lnsunina Companie-!>. Provident Fun~. Mutual funds .ire the pn mJn>
In vestor.. In the G-se< market. G-St'a havt> a very hqwd :.nd vlhnnt secondary market
1.5.7 Lone-term Loans Market

In addition to primary and secondary rnMkm, some~ml'~ long term mdrket is also refern.-d as
a part oft.be capltli market Commercial ban.ks and oon-banlong ll.n.ancfal comp.antes prO'nd.- long
tenn loam r.o corpome and lndlvtdu.il customers.. Long ttnn Loan~ markt>t ts further (l,.s,;ified
tnto·

(.al Term ~n Marker

[ b) Mortgages Martuit
(r) FlnanciAI CllarantM>S Marktt
 l · IY Ovc rviecw of tndtan f ln.inciai System

1.S.7 ( A) Term Loan Market

Tenn loan,; are lrmg term loans offered by flna nd al institution,; fo r businesses to meet their
lot1g tl•r01 requirements and generally having rnalurlty of more th,m 3 years. Governmen( of India
had cri,ated ind ust1ial financing 1n.stitutwns s uch as !CIC!. IDBI. !FCI to provide long te-rm loans to
corporave customers. The primary object ive was to provide loans for setting up and expansion of
new proJects. However, over the years, the role of these instltutio ns have diminished as iCJC! and
IDBI has converted into a bank and commercial banks now are the main pro viders of long term
loans.

1.S.7(B) Mortgage Market

This market consists of the Institutions which s upply mortgage loan. A mortgage loan Is a loan
agaJnst t'he secutity of immovable property like real estate. T he term ·mortgage refers to the
transfer of interest In a specific immovable property to secure a foan. Many non-banking fin.andng
Institutions s uch as HDFC, LIC Housing Finance, Tata Capital Housing and all major comme re1al
banks su,ch as SBI, Bank of Baroda, JCICI Bank provide mortgages to individual and non- ind ivid ual
customers.

1.6 Foreign Exchange Market/Forex Market

Foreign exchange market deals w ith the transaction in currencies of different countries. The
rate at which one currency is converted Into another is called as Exchange rate. Foreign e,ccihange
market provides mechanism for exchanging one currency Into another.

1.6.1 Organization of Foreign Exchange Market

• The foreign exchange market is also kn.o wn ~ forex, FX. or 'the currency ma rket. It Is an over-
the-counter (OTC) global market that detennlnes the exchange rate for currencies around the
world.
• Participants are able to buy, sefl. exchange, aod speculate on ,c urrencies.
• Parndpaots in the Fore.Igo exchange markets are banks, forex dealers, corporates. central
banks, Investment managem~t firms etc.
• It Is the largest and most liquid financial market In the world.
• Foreign exchange markets are _screen based and comprises of a global network of financial
centres. It has no physlcnJ location and operates 24 hours a day.

1.6.2 Terminologies used in Foreign Exchange Market

Cu~adcs are alway, trad~ In ~lrs, so th1;> ·value• or one of the ru rrcnctes m that pair ,s
relaUv<' tD the value of tfle otl1er. For example. USOINR means value of 1 IJSD 1n terms of Rupee
which ls currently previlJJng in the range 73-75,
 ()11rrv11:w of lnd1:;m Financta l !>y~tcm
1 20 1'
• flnan<e r,ot.n,1f<nwnt (Mll)
hi . is the rna ln fun ction o f 1he fort>ign ext.hang e ma rket USO ht•lng a
Esubllih rng rht• i<latw n, p .
rid exchang e rates o f other currencies are quolE.'d r elaove ro llSO
~ pfVC, lUrfflll) ' ol I h t! WO • •
ency into anot her not Involvin g USO 1 s callt"'1 cross curre ncy rate.
Convl!rs lon rare o( o nr curr
Thr ~ arr rwo main typ~s of exchangl' trades: a) Spot b) Forward
• Spot : A spot transa1.tion refers to exchang e of currencies with a standar d settlement
t1mefram e of two days or T+2. The price of a currency at th e point of excha nge for a different
currency In the FX market is referred to as a spot rate.
• forward : In a Forwa.rd transaction, a buyer and seller agree on an exchang e ra te for any da te
fn the futt.ire, and the transaction occurs on that date. This provides certaint y to both the buyer
and seller of the foreign currency as the exchang e rates are fixed regardless of w hat the market
rates are then. The duration of the trade can be one day. a few days, months or years.
The types of FX rates offers are called Interban k. Merchan t and Card Rates dependi ng on the
market.
• The inter-bank rate entails the foreign exchang e trading price between banks w ithin the Indian
forex market The foreign exchange of currenc ies between banks is usually centrallzed by a
commercial bank which conducts the trade and detennines the inter-bank rates to other banks
such as central banks and nationalized banks among others.
• Merchant rates, on the other hand, consist of the foreign currenc y prices offered to merchants
or the import and e'(port business es within the lndian market These mercha nts get their
merchan t rates from any of the numero us commer cial banks that deal in the Indian forex
market
• Card rates are currency prices that are designe d for basic and minor forex transac tions such as
tourism and hospitality transact ions. For example, when a Foreign To urists walk into any bank
and asks for conversion of USD Into Rupees, they will be offered exchang e at card rates.

1.7 Flnanclal Instr umen ts

Financla.l Instruments or products comprise of short tenn and long tenn instrum ents. Short
term Instruments are aJso called mon ey market instrum· • ·
ents. We have been discu·s sed in detan
about money market lnstnun e11ts In th e money market section 1.4.2 of the financial markets,
hence we. have. only listed only these Instrum ents in the below p aragrap hs. Long term or capitaI
.
· phs
mark.e t lnstnun eots are discusse d In more details ln ,,oJI ow1 ng paragra

1.7.l Money Marke t Instru ments

l . Call money/ notice money
2. Treasw y bills
3. Commercial Pappr
 t ln.1ru:-e Man.11 ~nt (MIi} l l 1 Overva"' or lndlan rln•nctal:, em

4 Commerc-l.al Bill
s RF.PO
t, C"nlfk3te of ~po!>h
7 Money Markee Mutual Fund
These instnJments have been d iscussed In detail in the money market section.

1.7.2 Capital Market Instruments

Capl1aj Markat lnatruments

1 1
Equity/Hybrid Instrument Debi Instrument Derivatives
e.g Equity, Preference e.g. Bonds. e.g. Future&. Optfons.
Shares Debentures Swaps

Fig. 1.7.1

1.7.2(A) Equity Shares

• Equity shares also called ordinary shares of a company and represent proportionate
ownership in the company. Share capital also called as ownership capital of the company. is
divided into a number of equity shares and each share represents ownership in the company.
• A company issues new shares when it requires long term funds. Equity share capital is the
source of risk capit;iil for the company.
• Equity share issuance is the most preferred route for ralsing long term risk capital for the
companies as this provides access to capital without any fixed commitment like Interest
payment etc. Company makes payment of dividend to the shareholders only after servicing the
interest and tax payments.
• Equity share are lowest in l¥fflS of clalms over the assets and earnings of the company. In case
the company suffers heavy losses and ends up bankrupt, the holders of the equity shares are
the last ones to get their money back after creditors, bondholders, and holders of preference
shareholders.
• Shares of listed public companies can be bought and sold the on stock exchanges thus
providing liquidity to the shareholders.

1.7.2(8) Preference Shares

• Preference shares are also part of the share capital of the compa.ny. They carry preferential
right over the dividend In comparison to equity shares of the company.
• 'Preference shareholders generally get fixed dividend which Is much higher than equtty
shareholders.
 t f'IIUl mP ,,1i1n11n1111111nt ( MUJ I 1.
2
ovcrvlrw of Indian Financial Systt'llJ
1¾

• Pn,f1•rttn<.t' ~h.,, ,•hohfo•~ do11·1· M'' I vorlng rights In the compa11y. ,

i ·e share holders are paid before equll)o
• In Lll l l' ,t lh1u1d,1Llon or rhc L'ompany, pre ercn< . ; I d operation creditors of h
i huraholdc t •· hul art• tower tn priority compnn•d to flnanc a an I e

comp,111y
1.7.2(C) Bond• and Debenture•
• 'J'he icrm,. b<Jnd u11d de!-benruru are used lnlcn:hangeably on many occasions a.nd represent
lonR term debt 1ni-.rruments (In th e natu re loan) of m or e than 1. year.
• 'rhc•,ic are ls:iued by Corpor.ttes, Government. Autonomous bodies, Municipalities, Financial
lnNtlrurlon~ etc. to n1c:et their long term funding requirements.
• Dt-hcnrures b,s ued by Government are culled Government Securities or G-sec, while
dr•henturell ls&ued by Corporates are call~(.! Corporate bonds.
• 8011d/debenturcs Issuers pay lntert-st also called as coupon at regula r lntervals (monthly,
1&cml ,,111nually or 11n11ually) and principal amou nts on maturity to the holders of thest
lnr.trurrwnl!l.
• Ronds gcnernlly lmve a n:xed maturity period (repaym1mt period). However someti mes highly
rated companies Issue bonds without a,ny nx.r d malurlty called as perpetual bonds. In case of
perpetual bonds, company needs to only st-rvice l.n terest to the bondholders at rhe fixed
Interval.
They are either sec-ured oy a collateral or claims over assets of the company or unsecured in
n.attJ l'l',

Boncu/ debrnturt"S .are free ly transforablti and may or may not be listed on stock exchanges.
ffonds/Debenturl!S also dasslfied as convertible and non-convertible debentures/bonds. A
convertlbh: lnstrumrnt can be convened Into equity after a fixed maturity.

. 7.2(D) Derivative•
A Derivative~ ln11trumcmt derives Its value from one or more Its underlying assets such a:s
~ulty shartt, bonds, forl"tgn currency tote. It reprt-st-nts contract over thr future estimated marut
aliJe of an underlying securities. Futurt-s/Forwards, Options and Swaps are the most common
ur1vativo contraru
Fuhitff : Thes(' .ate flnanclal contracts In whk h both parties agree to buy and sell rhe
underlying asffi/srt'\lrlty a1 11 pre-agreed price on a Spt>clfit-d future date. Future contnCO:
trade un stock txcbanges Por ngmplt-, future contract of Rehan cl' Industries shares dated !
monrJis from current date lndtone.s the rate prlct- 31 which a buyer and s.eller are ready to bll1
or !'it'll at ii lutun, datt'. Similarly contracts when entered In c,. ise of ru rre-nci~ or ro mmodit.!t5
thfly M't' callt d ,u forw"rds Both the buyi ng and selling parry .1re bound by the contr,le1.
• Puunce MAa: ,t"tnent (MU) 1-23 Overvtrw or Indian Financial System

• Option ; Options contncts are Ins truments that give the holder of the instrument the right to
buy or sell the underlying asset at a pre-agr~ price at a future date. Buyer of the option has
w pay a premium for nght to buy or !>ell the secunty. Seller of this option also called optio n
\\'Tlter recE'!ves the premium for agreeing to sell or buy the asset at a pre-agreed price at a
future date. An option to buy is called as Call option. while an option to sell is called Put option.
Whe n the price of underlying security on futu;re da te is higher than the pre-agreed price, the
holder of the option can buy the asset at a pre-.agreed price and sell at higher price. In case the
priCf! at a future date Is lower, then holder option does not buy the asset

1.8 Financial Institutions

Ftnancial Institutions provide financial services such as deposit. fund transfer, lending.
investing etc. The term "financial institutions~ refers to all kinds of organlzations which
intermediate and facllitate financial transactions of both Individual and corporate customers.
Fi nancial Institutions are integral to the financial sector of the economy. Strong financial
tnsdrutions s11pport economic growth of the country while weaker financial institutions lead to
inadequate funding for the economic activities.

1.8.1 Role and Function of Financial Institutions

1. MobWze savings : Flnancial institution provide multiple avenues for Investment of surplus
funds for individual and corporate function.
z. Supply of Credit : Financial institutions extend loans to the individual and corporate
borrowers.
3. Transfer of Funds : They provide fund transfer services in very cost effective manner thus
enabling flow of goods and services in the economy.
4. Risk Mltiption : Financial institutions extends credit to diversified customer base, helping to
mitigate the large scale risk of default
S. Flow of Funds: Financial institution due to their diversified presence ensures flow of credit to
all the geographies of the country.
6. Flnandal Inclusion : Financial Institutions through their widespread network facilitate
ftnandal inclusion.

1.a.2 Claulficatlon of Ftnanclal Institutions

(a) Banking institutions
(b) Non-banking financial institutions
 o vervtew of Indian Financial Syne111
1-24 -¾
• Finan~ ~ l (MU')

F1,w,cl.ll !fllltitution•

I
I
Banttf'lg InJtitutionS '
Non-Banlling Financtaf
tnstltlJIJOns
.

I _ Regula ted bv RBI·NBFCs

I 1
Regu1a1ed by SEBI -Stoel<
eor,,meroat cooperative '-- E.-.change. t,,<le rctia,,I Bank.
Banks
Banks Venture Cal)!tal. Stock
B roking Companies
- P\Jbt1c Sector Banks .._ Regulated by I ROA
Insurance Companies
.._ Prtval8 SectOf Banks

- Foreign BankS
.._ Regional Rural Banks
F'tg. Ll .1

1.8.3 Banking Institutions

According to the Banking Regulations Act. a banking Inst itution is an institution that does the
business of banking. The term banking business is defined as the accepti ng of deposits of money
fro.m the public for the purpose or lending or investment a.nd repayable o n demand. A banking
institution mobili%es the savings of the public through accepting of deposits of money and lends
the same to the individual and corporate customers to meet their short term, medium term and
long term financial requirements and invests the surpl us amount in various securities.

Cemnl Ranks ~ Central banks are the financial institutions responsible for monitoring and
regulation of banking institutions in the country. Reserve Bank or India is India's centra l bank wa.s
set up in 1935 by RBI act and is head- quartered in Mumbai. Res erve Bank of lndwa per forms
Important functjons of inflation management by setting up benchmark interest rates and
controUlng flow of money in the economy. Lower Interest rates lead to h igher Inflow of money,
drives up demand of goods and services and leads to higher inflation. Higher Interest rates lead to
higher cost of funds and hence tempers the demand and puts brakes on infla tion.

Reserve Ba.nlc of India also ~intains stability In the foreign exchange markets. It also acts as
banker to the Government by Issuing the Government securities and buying and selllng of
Government securities.
 I •••j

s .l .J(A) Comrnerclal Banking

11111111w 1 11,,1 h,111k11 ,., ,, tin, h,11 llht11 w 111 1111• 111111,,,, 0 11111 , 1,, I ··)"th 111 I h••v " ', "II' ''" "''"" • 1·n ,,,1
, 1 ,. 11 , ,,, 1,.,, ,11r 1 11 •, 11111w1~ ,11111 lr111I 111.- f111l1h 1,, , ,,,.,11 .11111 ,1,11)"' " '''1 11,,111 11,,.r,. f11 r 1111'11
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1ur ,,I t,11nk,

t .8.J(B) ,unction• and Role of Commerdal llank•

,,tmary Punctton,
I. Acw-,pl d~poilllt, : Co111 11w1 1 lul h 1rnk ~ 11ri t•p l 1h1pr, ~l1, I rum p11l,l k Tlu,11t• 1fr p11, IIJ1 ,in • In lhr•
ro, tl1 of IHlVlnl(/1il••11vd t••. limf' 1h•p11~11 - .11111 ( llrl ,, ,., , t ,•1111\11 11
(•)S•vlna dt•po1IL!l 1 1 h r1,1• .11 l' ,,,.. clrpo~II ~ mJ dt• I ll 1h11 •..t Vtnl(, 11( 1 lll1l fll •j th ,tl ,I pcr1on llllf'',
t,1 drpo~II lllHJ wll htlr ,1w nwnlr•, wit hu111 ,m y ,·,•~Ir lC'l.1011 , , Any r,111 m n I ompot(!nt lo

rnn1 ro,·1 , ;an o p1• r111 ~.1vln1,111 .1u 111inl a 111t d(r111,• II fu111h 111 th,• ,111 111111~ H.tnkli pay lntun:iil to
,leposllors Int 1hr .in111un1-. lyh,H 111 thu , .ivtnM, 111 r n1 111t.. l,l'11••r.1lly, l11dlvhl11als u,w uavlnRS
h1111k 11cru11n1.s lor dt•1•ni ltl111t s hort tt•rrn ~J vl n11, fur nw,•llnl( , l'l~ul;1r \'X pt•mw~. A ,,aVI IIAS
.1rco11111 i:.in rtlso ht• 1111c111•d In t hr n ,IIIH' I)( duly lurrn,1d d uh, llt)t lo ly, pr11vlllr11t 11111<1 ,and
1n1r.t. !l~vi11Ks :ic, ountll f(rtw r,1lly h:1vc• ,t llmlt 011 numlwr n( trnn'l:u·tlo11~ and ch,,rijc•s .arc
p11yJhlr fnr adtlltlnn.,I tr,1n1111cUun~.
(b)Tlmr depo1lt.N : Thest• an • dcr1U11IL~ fur .1 lho ,1 period of tlrnc ,rml g,mer,11ly carry higher
rntc ur lntoro~t llrn11 1,1tvl n1t tlc1mnlh. Typlnilly hanks ofter llnic clupuslu ror 7 dnys and
nwrr period. Bttnki; KCnc-mlly put rr$trlctlo11~ on cnrly wllhdr.i wnl o f deposi ts by charl(lnM
penalty otc.
(c) Current aa:ounl : Current JCcount Is J typti of honk acrount lor those who w unt to muke
large numhttr or tnmsactlc,ns on J rugular b,nls. Unltkc snvlnMS account t her e Ir, g(•ncr.1lly
no tt'lln sactton l lmlt llopoi:lts made In th ese 11ccounL'i I.e. currcnl depo11lts do not ~am any
lntc~ sl Thcllt' nrc used by protus11lom1I, buslncsiuis 1.mtlllca. for nrnnaglng day to doy cash
flow.

2. Naktna loans andl advance• : C:ommcrrl.il banks provide l11.rn11 a nd advances for short term
a.11d lontc term lund rc-1.1ulrf' n1011t11 to lr11Jlvlduals Jr1c.l 11on •l11dlvld11als for vrirlous needs,
3. Ttinlfer of fund1' : 8ankJ form p.irt of payment and :un tlerncnt 11ystem In the country and
enablt t:J'U n8fcr of fu nds fro m Ont' pcr:r,on 10 ,mother.

ltcondary Punctlon1

l. Overdr1ft facility : ll ir, a11 advJnct alven to a cu stomer hy keeping 1·hu current ,tccounl ro
overdraw up rn the given llmll.
 _ <> ()vc rv1ew o f Indian Fin,1ncr.1I Sy~telb
! f ll'...fflC~ ~ 41\,llml..nl (~ LI)
1 2
~
L Is a co rnmN rial blll a cknowledging lh
ch . fMI of exc,,:inge e
2 Obc.ouotllll blllJ of ' 11' ari,e · f ture against the goods purchased. Bank_;
• be "d at a later date 1n u
of moM)' to
;,tn0\11>t pa, II b • d iscounting t he bill of exchange.
lt1 Of r ly payment to the ~e er ,
proVlde t:sa Y ea bill pay me nt. tax consu ltancy etc.
. Collection or ta.Xes, fllln~ of ta.JC rerurns.
3. Utfltcy 5ffV1ce5 . . . rovide foreign currency t>Xcha nge services to the
4. Fon:f,n e•cban1e services . Banks p
au tomen by buyfng and selling roreign curre ncie s. . .
th ltles , It offers s ervices of selling and buying the
s. PurchasinJ and seHlnc of e secur ·
seru rltl es.
. id"" lockers fa cility to the customers for safe keepimg of valuable
6. Locker fadlitJes : Ban k prov "" ·
Items, documen ts etc.

1.8.4 Types of Commercial Banks

Commercial banks are classitied into public sector banks, private sector banks, foreign banks, and
region.ii tural ba.nks.

1.8.4(A) Public Sector Banks

• Public sector banks are the banks that are majority (more than 50%) o wned by Government of
Jnd:la. As of April 2020, India had 12 public se<:tor banks, largest of them is State bank of India
also called as. SBL Other large public sector banks are Punjab National Bank, Bank of Baroda,
Canara Bank, Bank of India, Union Bank of lndia, Central Bank of India etc. Public sector banks
dominate share of public deposits and loans, however it has down rapidly in recent years.
• The public sector banks came into existence, whee Reserve Bank of India acquired 60% stake
in erstwhile Imperial Bank of India ~nd renamed It as State Bank of India. Further
nationalization took place when in a major d.ecision, Government of India nationaJized 14
malor private banks ln 1969and 6 more in 1980 to Increase penetration of banking in India.

1.8.4(B) Private Sector Banks

These lndud.e ban.ks in which m.ajor shareholcting is held by private shareholders. In India at
present there are 22 privat.e sector banks. HDFC Bank, ICICI Bank. Kotak Bank, lnduslnd bank, Yes
Bank. Federal Bank are am,ong the largest private sector banks in India. IDBI Bank also classified
as private sector bank; however, Life Insurance Co,r poration of India (LIC of India) holds majority
stake In IDBI Bank LIC is at present 100% owned by the Government of India.

1.8.4(C) Foreign Banks

These are the banks that need to follow regulations in thelr ho me country a.s well as in the
country of operations. In India, currendy there are 46 foreign banks operating in India through
branch.es are wholly owned s ubsidiaries as on May 31. 2020.
 Ovt-rv1t>w 01 Indian Ftnanc13I System

Ho-·er tttev tuve hmtted presence and each b.tnk only operate through few branches.
$QlUiard Chartered Clobank. HSBC are among the l.1rgesl foreign banks operaong in India.

1.8.4(0) Regional Rural Banks (RRB)

ittil1onal rural b.lnks an> srheduled commercial b.lnks oper ating al regional level i n different
~..atts. They· a.re estabhshed to pr :ide credit (loa ns) to weaker sections of the society. They
pro\ride banking to rural and sem1-urhan areas_ The RRBs ha ve 3 s hareholders l.e central
gtwernme nt of India. sponsor bank and st.lte government in the raao of 50.35.15 res pectively.
Spon5-0r bank c.an be any commernal banks: boweYer currently only public sector banks are the
spo41sor banks. Currently t here are about 43 functi oning RR Bs in india. Exam ples of RRBs
operanng tn Maharashtra .Jre Vldha rbha Konkan Gramm Bank and Maharashtra Gramln Bank and
are sponsored by Bank of Ind ia and Bank of Maharashtra respectively.

1.s.s Cooperative Banks

• These banks are established on the cooperative basis and o wned by its members. They are
registered under Cooperative Societies Act. 1912 a n d are run by a managing commi ttee,
elected by the me m bers. They we re established with the objective of promoting savings and
pronng credit in the rural areas.
• Cooperative banks are further divided into urban cooperative banks and state co-o perative
banks. Urban co-oJrerative bank refer to the cooperative banks located In urban and semi-
urban areas. The primary customer base of these banks are small b usi nessmen. a group of
communities etc. State co-operative banks act as custodian of the cooperating banking the
state. Currently there a~ abou t 1482 urban cooperative banks and 58 state cooperative banks
tD the country.

• Cooperative banks were rra d.iti.o naJly under th.e dual control of cooperative societies as well as
RBI. Cooperative society overlooked incorporation. regi.s tration. management a udit,
supersession o f board of directors and liquida tion. RBI \-\'3S responsible for regulatory
funrnons.. Cooperative banking sector has ~en traditionally plagued wfth number of frauds.
Recendy Government of I ndia brought cooperative banks under the RBI supervision to
improve tile functio n1ng of cooperative banks and safegua rd the de posits In the cooperative

banks.

1.8.6 Other Banks

• In additio n to the rom mercial a nd cooperating banking. RBI has tn re-ce nt past granted licenses
to sm.D finance banks an.d payment banks. Sm.II finance ban.ks play role in serving under
banked secnons of society to improve the financial Inclusio n in che country
 Overview of India n Financial Syste ...
1-28 "'
• !'mane~ Man.agemenl (M U) ~
k are some of the example of s ma ll fl nanee
u·1 · . SmaU Fina nce Ban
• Au SmaJI f inance Bank. I ,wan ' ct d deposits, cu rrently upto Rs . 1 Lakh Pet
!lowed to accept r estn e . .
banks. Payment banks are a . b nking. mob ile ban king, debit cards et<_
l'ke fund transfer vi.a net a
r u'itomer and offer services • k . t he coun try. Paytm Payment bank. lndla
I
There are currently on Y anh dful payment ban s in

Post Payment Bank are examp Ies of paymen t banks.

Banks can also be classified on the basis. o f Sc Iie d u led a nd Non-Scheduled Ba n ks. Scheduled
• ·
banks are covered under the 2 nd Sche d u Ie of the Reserve Ba nk of India Act, 1934. Most of the
banks lndla are scheduled commercial banks .

• Scheduled Banks are covere d un d e r th e d e positor insurance progrdm of Deposit Insurance and
Cred it Guaran tee Co rpora ti.on (DICGC) , which is beneficia l fo r all the a ccount holders holding a
savings and fixed; recurring depos it a ccount Under DICGC, bank deposits of up to Rs 5 lakh
are insured.

1.9 Non-Banking Finance Institutions

• Non-banking institutions do not hold banking license, however, facilitate finan ce related
services.

• RBI defl.nes non-banking finance company as a company registered under the Companies Act,
1956 engaged In the business of loans and advances, acquisition of
shares/stocks/bonds/ debentures/securities issued by Government or locaJ authority or other
marketable securitie~ of a like nature, leasing. hire-purchase, insurance.

• NBFCs are regu.lated by different regulators depending on the type activities carried. These
l.ndude a) Non-banking finance companies or NBFCs (e.g. Sundaram Finance. Tata Capital)
regulated by RBI b) Insurance Companies (e.g. LIC, New India, HDFC Life) regulated by
insurance regulator IRDA c)entities regulated by SEBI such as Mutual Funds (SBI Mutual Fund.
ICICI Prud~tial Mutual Fund), Merchant Banks (e.g. Axis Capital, Kotak Mahindra), Venture
Capital Funds, Stock Exchanges etc, d) housing finance companies (e.g, lndiabuUs Housing
Finance, Magm.i Home Finance) regulated by Na tional Housing Bank or NHB.
th
• For .e sc-0pe of this book. we will study Merchant banks and stock exchanges In more detaff
and also understand briefly about NBFCs regulated by the RBI.
1.9.1 Merchant Banks

• The name merchant bank is derived from the bank1ng services Id d • bv

· p rov e in medieval rimes .
the merchants In Europe for financing of commodities Toda tcb b ff ·"
· Y me ant anks o er muu•
br oader ra nge of se rvices and more popularly known as Investment ban ks.
 Ovcrv1t·w o f Indian Financial System
,rjr Finance M.1n,1gNnfnt ( MU)

• Merchant Banker in India is Jetined as, any perso n who Is engaged m the bu,;111ess of issue
m,rnageme nl either by making a rrange me nts regarding selling, buyi ng, or !>Ubscrihlng to the
securities as man;,igcr, tons ultant. adviser in relation to s uch an issue ma nagement.
• Merchan t Banks are the fl na nclal fns titutions which provlcie a wide range of financial services
such as issue manageme nt. financial advisory. portfo lio management. consulting services to
large corpora te houses or individuals.
• Goldman Sachs, Morgan St.o nley, Credit Suisse, Cl.SA a re some of the well-known global
merchant banks. In India. Axis Capital, Kota k Ma hindra Capital Company, S81 Capital Markets,
are examples of some of the large merchant bankers.

1.9.l(A) Role and Function of Merchant Bank

Merchant Banks provide a range of services, although not every merchant ba nker offers all the
services. Following is list of important functio ns/services provided by mercha nt banks.
1. Issue management : Merchant Bankers advise on the Issuance of differe nt types of securities
such as equity shares, preference s hares and debe ntures. lss-ue management services involve
functions such as public issue, underwriti ng, marketing, pricing of Issues.
z. Underwriting of public lssue : Mercha nt bankers coordinate a nd participate in underwriting
of public Issues, coordination with other underwriters etc.
3. Loan syndication : The Me rchant Banks arra nge loans for the clie nts for their projects by
fonnJ ng a consortium of fi nanciers.
4. Portfolio management : Me rchant Banks help their clients in Investing a nd ma naging
Inves tment portfolio by investing funds into vario us asset classes such as equity, debt etc.
depending on th e ris k appetite of the clients.
S. Broking : Many Merchant Banks act as broke rs of stock exchan ges. They buy and sell sh ares
and other listed secu rities on behalf of their clients.
6. Advisory on mergers/ acquisitions : Some Mercha nt Ba nks provide cons ultation a nd
advisory services to the clients on strategic decisions s uch as expa nsion, me rgers. acq uisitions,
takeovers, sale of business etc.
7. Valuation : Me rchant bankers provide va.luatlon services for various pu rpose s uch as
investment In unlisted securities. merger a nd acquisitions of business or a d ivision of bus iness.
brand etc.
8. Project appralsaJ : Merchant bankers provide services related to project appraisals fro m
different angles of investment. technology, location, marketi ng etc.
9. Leulnt services : Some Merchant Banks are engaged in leasing servkes in which less or
allows the use of specific assets to the lessee for a certain period for payment of rentals .
 ove rview of lndlan Flnanc1al s~
1-30
• f inan ce Managment (MU)

1.9 .l(B ) Role of Merchant Ba nke r is Public

Iss ue
"
diligence to prep are the offer doc ume nt Whici:
•
,,_ Mer chant ban ker does th e dTh
ue .
are also resp onsi ble for ens uring compliallct
1. Due di -.-nee : ey
contains all the tfetalls abo ut the company.
wirh the legal form alities In the enti re issue process. e. Depending {ih
oint und erw rite rs for the issu
. . . ,
2.
u d rwrldng : Sometimes company may app rcha nt ban ker on its own or tn synd1cat 1on WitJi
n e ker a me
the size or issue merchan t ban actS
. . ss with und erw riter s.
othe r underwriter s and coor dina te the issu e proc e
'ble for mar keti ng of the issu e. Merchan t bankers
Mar keting : Merchant bankers are respons,
3.
ffl • J meet the pros pect ive inve stor s and gauge tht
arra nge road show s, whe re company o c1a
resp onse of the investors. nd1
ing : Mer chan t bank ers advi se the man agem ent on pricing o( the Issu e dep e ng on tht
4. Pric
mar ket cond itions, response from inve stor s etc.

1.9 .l{C ) Categories of Me rch ant Ba nke rs

chan t bank s in India are regu late d by the Secu rities and Exchange Boa rd of India (SEBil
·• Mer
h has classifie d mer chan t ban kers into four cate gories Category I, Cate gory II, Category Ill
whic
and Category rv merchan t ban kers.
e Managers, Con sult ants , Advisor s. Portfolio
• Category I merchan t ban ker can act as Issu
ban ker can not act as an issu e manager bu,
Managers and Und erw riter s. Category II mer chan t
ker can not act as Issu er or prov ide portfolio
can act as a co-manager. Category Ill mer cha nt ban
can only act as adv isor or con sult ant for
managem ent services. Category rv mer cha nt ban kers
e of capi tal. At pres ent ther e are mor e than 200 mer cha nt ban kers regi ster ed With SEBI.
lssu

1.9 .2 Sto ck Exchanges

nda ry mar ket sub -sec tion of the capital
Stock exCMnge has been explained in details In the seco
market section.

I Review Qu11tlon• I
o. 1 Ex.plain lhe meaning of Financial System and char
ac1eristica of financial syatem.

0. 2 Explain lhe role of flnaJ'ICial system.

Q. 3 Wti..r are lhe components of financial system?
types of financial mar kets?
0 . .. Wha t are lhe finaOC1al markets and wha t are the

Q, 5 Wha t the characteristicS of hnan aal market and

role of the tinanaa1 marker?

o. 6 Otstlnguish betw een capital mali ter and mon ey

mar llet
 Return and Risk

concepts of R.-cum and Rllli : Measurement of Historical Returns and Expected Returns of a
Single Security and a Two-security p,ortfolio: Measurement of Historical Risk and Expected Risk of a
Single Security and a Two-security Portfolio.

We come across the sentences such as 'higher the risk, higher the reward' or 'no r isk, no gair.
'in our everyday conversations. While intuitively we know the concept of risk and return. we wt!:
learn how ·to measure the risk and return in this chapter. We will also learn how to minimize ns~
for a required return or maximize returns for an acceptable level of risk.

Leaming Objectives
• Components of return. measurement of historical and expected return.
• Understanding risk, measurement of risk on historical and expected returns, nonna.
distributlon curve.
• Measurement of historical and expected return of two security portfolio.
• Measurement of historical and expected risk of two security portfolio.

2.1 Concepts of Return and Risk

2.1.1 Hlstorlcal Returns - Retum on Asset of a Slngle Security

Portfolio

When we invest funds In financial assets such as fixed dep,osits, mutual funds, sharcs
debentures etc., we earn returns in two forms
1. lncome from the asset in the form of lntere.st or dividend
2. Change in the price of asset known as capital gain or loss

So the total return is sum total of Interest/dividend Lncome and capital gain o r loss.
• l'ln,UtfC Man,1 ,mcrtl MU J 'J. · l Return ant! Risk

Returr, ls l(l!llt'rally .-xpre't\ ed In percn 11aw• terms ant! rnlru lated a<; tot.it I return dlvfd(.>d by the
htglnol ntc 1nves ttncnt ret urn c,1r n e d In the form of dividend Income is c.a lled cl1vidend yield,
reru m In U\(! form of Interest htlome Is ca lled lnt1:re\t yield and return frotn change in price is
, ailed laplta l gain yield. Thus, total return expressed in pt!rcentage te rms Is s um of capita] gain
y1eld and lnterei;t yield or dividend y1eld.
Illustration : Le t u <, consider an example. Let's ass;ume we Invested money in the ·s ha res of
Reliance lndu,1.rlcs Limited at the cost of Rs.2000 per share one year ago. T oday after 1 year. price
of Reliance shares appred ates to Rs.3000. During the yea r. Reliance a lso paid a d ividend of
Rs. 100. Calculate the rate of return.
(3000 - 2000) + 100
, Return R = 2000
1100
= 2000;: 55%>
100 3000 - 2000
Here R = 2000 +
2000
R = 0.05 + o.so
R = 0.5S or 55%
Here, So/o is known as divide nd yield and SO% is known as capital gain yield.
In ge:neral, the return R for a year is can be calculated as below:
DIV 1 + (P 1 - P0 )
R =
Po
DIV, 1 P0 - P
R = --+---------
Po Po
...(2.1.1)

where
DIV 1- Dividend received during the year
P1- Price at the end of the period
P0 • Price at the beginning of period
R - Return for the period.
Illuatratlon 2 ne9atlve returns
Let's take one more example. Assume that you invest funds in shares of Suzlon Energy L.imJted
at a price of Rs.7 per share. Company Is making a loss and hence does not dedare any dividend.
Further at the end of the year price of share drops to Rs.5. Calculate the rate of return
DIV1 P1 - Po
R = -♦
P0 Po
0 5-7 -2
= 7♦7 = 7 = - 28.6%

The Investment In shares of Suzlon yielded returns of - 28.6% conslstlng of - 28.6% capital
gain yield anrl 0% dividend yteld.
-
'/. j

• .averane Rate of Return

J. t . J "' • investmrnls . Many lnv,•,•tor\ h{,1...
krt fur Jong term "l
on~iJ,,r-ctl 11~ mitr "e rate o f retum ovrr " h1~tori"'-,
, .,rual "'"' i.:.-1 t, l h investors ,wern,. ...,
th O one y,•11r h Jr ~uc m The average r.ite of return reJ"
lllf' • 1111 m,,rr .1 . a I· year ret u · t
'" ur , 1 pittut e of I ctunl 5 l 1,,m ge rate of r erurn is as follows
1u11 hKl ' ,,,,vfl'V ;i <,11 r , l rl d The formula for ave,d
( 1 jrl\J lr,r 1'.tCh P<' o
111 tlw ,wrr.tljl' o rr I .!. f R ...(2.1-2)
R ,. L ,
0
I• I

(llultfratlon d s tand the aveTage returns . Table 2

h rice data to un er · ·11
·
l,d ', ht1v,• a look tJ,e hlsro rtcal s ,lrt' P f h year from 20 10 to 2020. Fo r the~
t •don L,, fa nuary o eac
, ll uws the $hc1rr pMu•s ol MRF llm t,v d d d ·tared by the com pany each year.
. •idt'red t he divl en cc
vr· unl1111-<11011dlnJ: wr h !VI' not c.:ons .
Table 2.1.1 : Shire prices of MRF

CapJtaJ 2aln %Return

Date Clostna price
0 1· 0 1-2009 J.63 1
5,668 4,037 248%
01 -01 · 20 10
5,943 275 5%
0 1-01 · 20 J 1
7,782 1,839 31%
01 -01 -201 2
12.975 5,193 67%
0l ·0l -2013
01 -01 -201 4 19,228 6,253 48%

0 1 ·01 ·2015 39,672 20,444 106%

0l-0 1-2016 35,345 - 4,327 - 11°/4

01 -01 -2017 51 ,397 16,052 45%

0 1-01 -2018 67,826 16,429 32°/4

01-01 -2019 61.1 J 9 - 6,707 - 10°k
01 -0J -2020 66,597 5,478 90A,

Averue 52%
R.1scid on rhe Tahit" 2.1.1 Average rate of return for MRF Limited in last 1 0 years will
R = 248+5+31+67+48+1 06+ (-11)+45+32+(-10)+9
10
R = 52%

Not. : Ple.1:w note we have not considered ~ including which the average rate of return wlf
/>fl oven higher Ifs a common practice to calculate average annual return while evalUalirlQ
1119toncal returns.
 Rttum and Rlsk

2.1.J Holdtng Period Return

• In •"'-1 w r);•m1ilt·s w,. , ,,kul;lt~I th e' annual rate or , N um. Wbat tf we wa nt 10 calculate the
, .,_. "' r1'\ufn rur I ht> rc,noJ lnr wh t h '""' Wt't'l' holdlnrc 1h, sKurlry. This return Is referred to
"" 1hr h.11ttln111w1 h-.C retu, 11 or lll'R lloldlng p,f'rlod rt'tum tsexprt>ssed as a percentage and Is
th• h1t"l 1'1!'f\ll n "'' t'h t><l fn•m hold mg ,1n a~~M tl> r portfolio of assets over a period of time.
• Th♦ hokllf\8 ,,c,r h•d r;•t u rn Is cnkuhut-d hy multiplying a notional Investment a mount of l wit.h
f'll(Uf11$ CIII f,-., N,·h l¼•ric"°I (IUd then suh1rr1ct! ng t from the total value.

,...,_...$11
Lei's r1l"t.1l.1ll' tht holdlflll period rerum for MR F Lid betwMn 2015 to 2019, bastd on the
1
,n,"11 ht~«'I')' 11i. provldtod In Tabl~ 2.1. l. Tht> annual ~tums considered for calculation are
~0\5 - ( 1 \~). 20 16 - {45%), 2017 - {32%). 201A - (- 10%). 2019 - (9%)
¥

R • l '< (( l - 10%) ( 1 • 45%) (1 • 32%)

(1 - LO%) (1 + 9%))- 1
• ( 'J) (0.90) ( 1.45) (1 .32) (0.90) (1.09)-1
• 1.69 - l • 0.69 or 69%
• Helilhll ,-rlod for S•)'Nr _,.r1oc1 for MRF Ltd between 201S to 2029 ls 69'M>.
• tr • were to calt'ulate annual rompound rate of retUm for the above penod. we need to
ralcwlte the geometrlc which will be calculated! as follows :

Compound annual rate of return • ~ (0.90) (1.45) (1.32) {0.90) (1.09) - 1

• 1.10 - 1.00•0.10 or 10%

2.1.4 M•••ures of Riek for On• Security

• In s«tton 2.1.2. we calrultted the average return of MRF Limited for 10-year period which was
S2~ p.a. Howe~. tht rare of return in each period was not constant and varied from between
- 9" to Z-t8_%. This variation in rate of return gives rise to the risk. Measurement of this
Y1riatioo o:r uncemlnty Is the measure of risk associated with the lnves~ent There are two
m,u~ of this variation or risk
I. Varian~ iand
2. Standard deviation.
• Variance l:s ralcubttd as the average of sum of square of difference between actual rate of
rttum and .avtrqe rute ofretum. Viartance ls expressed as cil.
• Standard deviadon I• the square root of the vari•nce and Is expressed as a
J "
Variancr (a") • {n _ 1) ~ (Rr- R)
2 ... (2.1.3)
• Fln&nce Me:f'rMnl (MU) 2·5 Return and Ris~
.
Standard Oniadon a • ... (2.1.4)

whe~
R, . Rate of return or secur1ty In Im Interval of period
R- Average rate of return.
llluatrnlon
Let's calculate varian1:e for MRF Limi ted. We will follow the below steps.
1. Calculate the ave. . . rate or return. This ts denoted as ii As seen previously for MRF Limited
R= sz.
2. Then calculated the difference between th• actual rate or return and average rate or return for
each per1od.
3. Calculate square of each of this difference and take sum' of the squares of each of this
difference, which is denoted as L(R- R) 2•
'
4. Lastly divide this sum by n - 1, where n is number of observation in sample data.
We are dividing the sum by n - 1 to account for loss degree of freedom when we consider a
sample data. This is because we are only considering sample from entire population of returns of
the security. Let's calculate the variance for MRF Limited
,.
Dale -
. A■aa■l- leturm~) (R- R) {R,-i)2
01-01-2009
01-01-2010 248 196 38416
01-01-2011 5 -47 2209
.
01-01-2012 31 -21 441
01-01-2013 67 15 225
01-01-2014 48 -4 16
01-01-2015 106 54 2916
01-01-2016 -11 - 63 3969
01-01-2017 45 -7 49
01-01-2018 32 - 20 400
01-01-2019 -10 - 62 3844
01-01-2020 9 -43 1849
TOTAL 54334
AVERAGE RITURN 52
• Finan~ Managl'menl { MU) 2·6 Return and Risk

Varlan<"e o 2 = 6037

Standard Deviation o = ¼6037 = 78

What does this Indicate? MRF shares offered an average annual return of S2, but had a
standard deviation of 78 which Is an indicator of flu(:t'Uation of actual returns from average
returns. This variation o r fluctuations In returns Is quite high and indication of high degree of
volatility in returns. However, klndly note that the standard deviation for 10 years may not
adequate to calculate the implied risk and the risk may be lower if we look at larger population of
.
data. Whenever we Invest in shares for short term, we should be prepared for the volatility in the
prices

2.1.s Expected Returns of Single Security

In the previous examples we calculated risk and returns based on historical Information. We
can also calculate risk and returns based on the expected returns. Por this we· list rate of returns
expected under possible scenarios and assign probability to each of the possible scenarios.
£,tpected return is equal to the weighted average of rate of r-eturns und•e r all the possible
outcomes.
Expected Rate of Return expressed as E(R) can be calculated as below
n
E(R) = LR.Pi ... (2.1.5)
l=-1

Where
P • Probability of the outcome
R - Rate of Return
I • it11 outcome

n - Total number of possible outcomes

llluatratlon

Let's take an example of security XYZ Ltd whose possible returns under various scenarios are
tabulated as below :
 • flnance ,unzmrnt (MU)
2-7
Return and Risk
.
Expected Rate ot
SceUrio Probability (Pi) Rate or Return
Return (~) (RJ Return (Pi) (RJ

-10 (0.20}(- 10)

Negative growth 0.20
10 (0.30)(10)
Stable growth 0.30
(0.50}(20)
High growth o.so 20
11.00
Total 1.00
Based on the Table 2.1.2, expected return wlJI be calculated as below:
E (R) ,. (0.20) (-10) + (0.30) (10) + (0.50) (20) = 11%

Valiance of returns In the above example will be calculated as below:

In section 2.1.4 we calculated the risk of investment based on historical returns. t'he rtsk
measures I.e. variance and standard deviation can aJso be calculated by assigning probabilities to
expected returns. In the above example, returns from Investment In XYZ Ltd are expected to vary
between -10% to 20% under different scenarios. Risk associated with Investment In XYZ Ltd will
be calcuJated as below :
Vartance (a2) = t(0.20) (-10-11) 2 + (0.30) (10-11) 2 + (0.50) (20-11)2
"' 1(0.20) (441} + (0.30) (1) + (0.S0) (81)
., 88.1 + 0.30 + 40.S •128.9
Standard DeYtation (a) "' ✓128.9 = 11.35
For large number or probable outcomes, variance can also be expressed as below:
•
Variance (a2) • P1 (Ri - E(R)) 2• !P:z (R2 - E(R)}2 + P3 (R3- E(R))2+ ...
+ Pn (R,, - E(R)) 2
D

= l: P1(Er E(R))2
lat
•••(2.1.6)

2.1.7 UN of Standard Deviation and Normal Distribution

We have studied the exampl.es where distribution of probabillty wu discrete or returns bad
lunfted number or oukOmes. However, ln practice distribution of stock returns ls more likely to bl
continuous as the 5tOCk returns can take values from a very high positive number en neg:ariYf
number. Such a continuous distribution of returns Is called nomw distribution. Nonna!
dffflibution Is a symmetrfcaJ, cont1nuous, bell shaped curve as shown in Fig. 2.1.1.
-
~ fiPOO M....,.1,unet (MUJ 2-8 Return and Risk

34% 34%
--3 -2 -1 0 1 2 3
Standard deYiations
F1g 2.1.1 : Nom•t D1strtbution Curve

Nof1111.I distribution curve has followtng properties:

t. Area under the curve is equal to 1 and represents the probabillty of all the outcomes.
2. Maxtmurn value of probability under the curve Is at the expected value of distribution.
3. so percent of the area falls within ( +/- ) 0.67 standard deviation (right and left), 68 percent of
the distribution falls within ( +/-) 1 standard deviation (right and left) of the expected return;
95 percent falls within (+/ -) 2 standard deviation$ (right and left); and over 99 percent falls
within (+ /-) 3 standard deviations ( right and left).

llhllballon
Let's take the case where average expected return or mean return is 15% and standard
dfflltion ls 10%. As per normal distribution, 68% of all returns will fall within 1 standard
deviation right and left of the mean return I.e. (+/-) 10% of 15% I.e. between 5% and 25%. This
also means that there ls a 68% probabUJty that returns will fall between 5% to 25%. The normal
pn,bab(lfty table (given at the end of the book) can be referred for determlning area under normal
Cllffl for various standard deviations. For example, the probability of returns having 1 standard
dfflatlon higher than expected return Le. 25% (10% higher than expected return of 15%) will be
represented by the area on the right of 1 standard deviation I.e. 35%.
Nonna! distribution can be standardized using following formula
S ., R- E(R] ...(2.1.7)
a
Where
S ls the difference !between actual return and mean return expressed as multiple of standard
dnlauon
 ~

Hl"l"I. we ne1!d to calculate dtn.1nN S of ~ from the mean ~m of 11% In tenns o! ~ O

d l"VQtf nn.
10 - 11l " _0 97
S ,. 11..15 .

Above value lndlate1 that 0% re-tum will rail area equivalent to 0.97 Slaodard dt!'Viatiofts on
left of from lhe mean return. As discussed above. area covered 1 standard deviation Is 34%. H~
ar~ corresponding to 0.97 standard d~latlo n Is 0.97 times 34% l.e. 32.98%.
Area on the curve on the left or 0.97 standard deviadon will Indicate the probability of nqalh-e
rerum s I.e. l 7.02% (SO - 32.98).

2.1.1 Two Security Portfolio

We have seen how to measure risk and returns for a single security. In practice, investors don't
Invest all funds In a single security but In muJtiple securities with pri.mary objective or diversifyina
their Investment We have heard of an old idiom 'Don't put aJI your eggs in one basket', whkh
effectively mean don't put all investment In one bucket We all intuitively know that dlversificat1on
reduces the risk. Let's see It mathematkatly.

2.1.l(A) Retum1 In Two Security Portfolio - Hlstorlcal

When we Invest funds In a portfolio consisting of two securities, rate of return is caJculated
based on proportion of each security In total Investment and rate of return for each security. Sud!
rate of return Is caJled rate of return on the portfolio and expressed as Ry
R,, = w1R1 + w2R2
Where,
w 1 • Weightage of security 1 In the portfolio

R, • Rate of return for security 1

Wz - Welghtage of security 2 lo the portfolio
R2 • Rate of return for security 2
 2 10

'
111..-111rewd0ffeton
....
ng or two secu ritie s A and B In the prop ortl on
wt' invt ttcd funds In a port folio consisti
(At's UY whi le s h.ares of
__ ., 1 ~ ,-espKt.Jvely Sha rff o f com pan y A prov ided a n~tu m o( 24%
folio.
' (1( 3 ~ -
COfflP'DY proV1dl!d rtru ms. Calculat e the rau of retu rn for the port
a~
8

,1.:u ntr
:,r
R,, = (0.3 0) (24 J + {0. 70) (8)
= 7.2 + 5.6 = 12.8 %

Po rtfo lio
J.l .a( B) Expected Re tur n of Tw o Se cu rtty
port foli o by add ing the wel ghta ge average
Similarly, we can calc ulat e exp «te d retu rn of
refll t'TIS of the port folio In diff eren t scen ario s.
... (2.1.8)
E(R,,) = w E(R .J + (1 - w) B(R1)

Whert!
~., . Wtlgbfalt of secu rity A In the port foli o
_ w . Weight.age of secu rity B In the port foli o
1
·UR.J .ExpeCffil return of security A
E{R,_) -Expecteci retu rn of secu rity B
E(R,) . ~ retu rn of port foli o
any no of secu ritie s.
we can extend the above formula for Expected Ret urn of Por tfol io for

the amo unt In secu rity A and 70% of the amo unt ·ln
we are plan ning to Inve st 30% of
er
of returns of secu rity A and secu rity 8 und
flec111J1,ty e. Table 2.1.3 prov ides txpe cted rate
retu rn of the port foli o.
Ulllfffl.m_t seffl ariO S. Let's calculate the exp ecte d rate of
Tab le 2.1. 3

arn Rat e of Ret urn Por tfol io Exp ecte d Rate of

Sc.lllrio ProbabUfty Rat eof lleby A ofS eau 1ty B Return Ret um of Por tfol io
(PJ of Sec urit
(7° '6) (Pi) fR.)
(3°'61)
,,,,
'
.
(0.3 0) (3) +
2 3 4- (0.7 0) (♦)
,,
10 4.0 0.80
Negative 0.20 -10
.
Ill"- ·· -
20 17.0 5.10
Stabft 0,30 10
---
High
- -

0.50 20 4 8.80 4.40

___ .,.,.
10..30
Total LOO
 • Finance Man•gf't nent (MU) 2- 11

2.1.9 Meaau rtng Portfo lio Rlak for Two Secur ity Portfo lio
While the return of the portfoli o Is equal to the sum of weighte d average returns of lndivldlQJ
security, the ris k calculat ion of portfolio Is little differen t. altho ugh meas ures of risk I.e. standatd
deviatio n and variance is same. This because varianc e of portfoli o depend s on the co-moverneot or
the securltf es m addition to the varia~ce oflndJv ldual securiti es. The co-mov ement or relationship
betwttn the returns of the securiti es 1s express ed by the tenn called as covaria nce.
Covaria nce Is a statistic al measur e of the degree to which the variable s move togethtr
Pos1t1vc co,rariJn re me.ms returns of the securiti es move In similar directio n meanin g when 0 ~
st-curity has pos itive rerums other wfll a ls o ha ve pos itive returns and vice versa. Negative value Of
covaria na- means returns of two securiti es move In opposit e directio ns. Nil covaria nce means
there is no relation ship between returns of one security with other.
er
Variance of the portfoli o is f'X1)f't!Ssed as p
2 2 ... (2.1.9)
Varianc e (a1 p) " w2A a2A + w 8 0 8 +2wA w 8 (CovAe)

where
wA- w 8 represe nt weight.age of security A and B In portfoli o respectively
oA- 0 8 represe nt standa rd deviatio n of s ecurity A and B respectively
Cov.u ~prese nt covari.anet! of security Aand B.

llluatr atton
Let's calculat r varianc e of a portfoli o consisti ng 30% Investm ent In s ecurity A and 70% Ill
security B. A table showing probabi lity and returns under differen t outcom es is provide d below:
Probahillty R.. Re RA-E(R ,J Ra- c,2A a2. Covariance
Scenario
E(RaJ
1
0.2
2
- 10 10
3
•
- 21 0
s (1)(2) 2 (1)(3) 2 (1)(4)( 5)
88.1 0 0
Negativ e growth
Stable growth 0.3 10 20 -1 10 0.3 30 -3

High growth 0.5 20 4 9 -6 40.5 18 -27

11 10 128.9 48 -30

<rp = (0.30) 2 (128.9) + (0.70} 2 (48) + 2 (0.30) (0.70) (- 30) •

= (0.09} (128.9) + (0.49) (48) + 2 (0.21) (- 30)
= 11.60 + 23.52 - 12.60
= 22.52
Standar d d evtation of portfoli o op is ✓22.52= ◄. 74.

relation shi p between Covaria nce of two :securi ties ,....n d

~ uc 9pr~s e In terms of s tandard
L-
.The
.
deVJaoo n of se-cunty A and B as follows:
 l 1l

--- --- --
-- --I--
Uon COt'fflC l enl lJ used lo
ih e rorrt' 11
1 hr r.rrm <.or •• 11 l .. u.,J .n n ,n t'l.al1on , of'ITh-l t'llt
tes
,,,.,,nu~ bt-twtt n rwn va rubln II t.1kt t nlut's bt!tween - J 10 1 Positi ve corTelatlon Indica
w 1 m0"toment of A and 8 arr po<1lllv t'ly cornl atf'<I . whllt' nept1
ve Villu t" lndlca tt-s negative
that thr covar iance of
COTTt'l,1Uun be-tWH n mOVt'f fltnr of A and B This t'x:pres:slon Indica tes
lht' correl ation
panfo lio con ststln, A and B IJ mulrlp llration o f st.Jnda rd d~ad oo of A aod B and

Cov,v
CorAe " {o.J(ae)

Th e varian ce of portfollo can now ht! vcp~ ed as

a1 P .. w2A al,.+ w2 8 0 1 11 +2 (w.J(w a) (o.J(a a)( CorAa)
... (2.1.1 0)

based on hlstor tcal

The above formula can also be used to calculate variance of the portfo lio
2
~ms. In that cast' the variance of securi ty A I.e. a ,.and varian ce of securi
ty 8 I.e. will be era
calculated based on historical return s.
deviat ion depen ds
Kindly note that the risk of the portfo lio measu red varian ce and stand ard
of lavest a&ea t In
upon three factors t) Corre lation of the two ,ecur ltles and 2) Propo rtion
eech SKUr tty 3) standard devia tion of each secur ity.

2.1.1 0 Dive rsific ation and Redu ction of Risk

ve correl ation and
• Securities having a correl ation coefficient + I means there Is perfec t positi
ard devia tion.
combining these securi ties may not result in meanlngfuJ reduc tion In stand
A correlation c~ffic lent - 1 means a perfec tly negati ve correl ation
and comb ining these
•
securities may offer highes t reduct ion In risk.
In genera l, combining securi ties with negati ve correl ation will have
highest impac t ln
reduction of risk. white combi ning securi ties with positi ve correl ation wlll
be lower and wUI be
Impacted more by the standa rd deviat ion of each securi ty.
11.,.,.atton
In die above examp le we calcul ated expec ted return s and risk 0 f ·-·..r,ty A. security B and
~ ...
rtfollo consis ting 30% of securi ty A and 70% of securi ty e.

Particulars Security A Secur ttyB POldoUo

Expected Return 11.00 10.00 10.30
Stand ard Devia tion 11.35 6.93 4.74
 ' "' '-,.,._• " • flG lh ...
211 ;:<>11

• fln,arl Man,frmttl (M IJ) '

compa~ d ro t 1.35 ror securtty A
folio , 1 4 'IS Is rnuch lowt'r . illd
o1nJ df!'flallon of port ' . b bing two senirttle !l, risk has reduc,d "'·
S•~nd
... bl p esLS that y com . .""I
QJ «'\~n ty e The .1bovt La c su JI roves that d lverslflca non of lnvts~
6 tum ~ Thi, matht>matJca y p ta
romprom 1s1 n11 mul h on ~
u 1n ~uce nsk of returns In tht' capital marltea.

Mfnlmvm v•n•nce portfotlo lo

, u unent and now wish to creat. a ~
h ftnaltud 2 securldt's ior 1nv
LA!(s assumt we ave I Portfolio variance will change dependlnc on di
such that the portfolio variance will be mln_::um. two other fact.Ors I.e. standard dll!Vl.1tton ~
rt1on of the Investme nt In two secu, • es as
propo P rtli II having minimum variance Is caJled as mlnJrnu,,.
correlatio n are fhctd for tfle s ~riUes. o o o
variance portfolio.
~ loht age or security A can be caJculated using btlo._
In a minimum variance port,o11o, ~ 111o

formula

(48- { - 30})
" (128.9 + 48 - 2 (- 30))
78
• 256.9
• 0.30
Hence, the portfolio consisting or 30% of Investment l.n security A and 70% in security Is also
the minimum variance portfolio.

2.1.11 Solved Examples

Ex. 2.1 .1 : Mr. Rameehwar Praud bought 100 nree of Mahatma Cepffal Ltd for Ra.2SO per lhlrt.
Mahatma Capl1al every yurdeda l'N • dMdend d Ra.5 per Iha,. and la expected lo continue Nmt 1h11
year. F\dler, due lo gfOWlh In oapilal mat1{et, lhare price d Mahatma Cllpltal la eicpected to rMCt1 275
at the end d the y,Nr. Calcutat. tollowlng l1l1Uma b Mr. Pruad.

1. Capllal gain amoutt 2. Capital gain yield

3. OMdendamount "· OMdend) ield

5. Total '9tum amount 6. Total retum In percentage rttuma.
lotn.:

Capital pin per share • Market Value of lnvestme nt ( expected) - Value of original Investment
• 275-250
• 25
 2 14
Rrt:u rn and R1.tlk

Ca plwl pin I n :imo u n t • l25 J ( 1001 • 2500

Capl~I pin y1~ d • ( 2?5 - 2';Q}
250 • 10%

Olvtdend Income :a (Divide nd per share) (No. or ,hares)

= (5) (100)
• 500
Dividend yield = ( ~ )
2 0
= 2%
Total retUrn '"' Capital gain amount+ Dividend amount
= 2500 + 500
= 3000
Total rettlrn In percentage = Total return amount
Original Investment
= Capltal gain yield -t Dividend yield
= 10%+ 2%
= 12%

Ex. 2.1.2 :Calculate Expected Returns and Risk for Security A.

Out:coine Probability Rate of Return_(ll)

Good 30% 15
Normal 50% 10
Bad 20% 5

'
OalUI _, ft'o ~ ,: (R- E-\JlJ)Z·· 'a.(B._lt (-1'})"
- • -• I~ • - ~

Good 30% 15 4.5 4.5 20.25 6.075

Normal 50% 10 5 -0.5 0.25 0.125
Bad 20% s 1 - 5.5 30.25 6.05
100% 10.5 50.75 12.2S
Expected Return 10..5
I Variance 12.15

i ---------------------------------- - ~taodard Deviation 3.5

 . , flellJlf,_ e ncl ~
- IOI

Raliloffle4U'fl(A)
p,c,111bllftY
~
~--
Good JO'
25
10
50"11.
Notm•' 20%
• 10
Bad
1~

tolft. :
-
()llb:d1 ,robablll ty Rate or Return (R)
p,R. R-E(R ) (R- E( R )) 1 P1 (l!-t(l)1

7.5 14.S 2 10.25 63.oe

30% 25
Good 0.25
Normal SO% 10 s.o - 0.5 0.13
- 2.0 - 20.S 420.25 84.os
Bad 20% - 10
10.s 630.7S 147.25
100%
Expected Return 10.S
Variance 147.25
Standard
Oniatlo n 12.13

Ex. 2.1.4 :Calculate expected retum and risk fof Portfolio consiatlng of 50% of Security A and 50\,
Secu,tyB.

Outcome ProbabUlty (p) (R.J (Ra)

Good 30% 15 25
Normal 50% 10 10
Bad 20% s -10
Soln.:
E(Rp)
Outmme Probabll tty (p ) ow (Ra) Pottfoll-, R-ECR.) (R- E(R.))2
p(M
~ PR, CR.))2
Good 30% 15 25 20 6.0 9.5 90.25 27.08
Nomw 50% 10 10 10 5.0 -0.5 0.25 0.13
Bad 20% 5 -10 - 2.S -0.5 -13.0 169 33.8
1004Jil, 10.S 2S9.S 61
Expected
10.S
Return
Variance 61
Standard
7.8
Deviation
 2 - 16

I.&- 1. t .I · Ari ...,_ hu _, • ~ ~ O'I 2s, and fhe 9'8NiaN dc•'Wtoon of s>C I 1t!:I ,..,..,_ ia
\ l S"'II WM! " c,,e ~ of !tie return ol .,.... _. be zero 01 r,euatl'••"
, -, t
R - £CR}
s • (J

,. 0 - 25
12_.S
-= - 2
t,1~ttve ~turns are 2 sta.ndard dmatlons on the l.eft: sid.e from the mean.
In normal distribution area under the curve upto + / - 2 standard deviation from mean ls 9SIM>.
Remaining area Is 5% and Is divided between hl&h positive returns on the rt&ht side and
' negattve returns on the left
Probability .. sr • 2.5%

Q.1 Whllt ii 111tum? Explain the components of retuma.

a. 2 Olfln• holding pertod retum and show how It Is calculated.
Q. 3 E,q)l•ln the concept of rlek. How It la calculated?
Q, 4 What la normal dlatributlon? How It can be UHd for calculating probllbilty of el0Ck ~ ?

Q, I What 16 coeftlcient of correlation? What la the relationship bet\TM1n covertance and coefflci11nt of
oonelation?

a. I Explain how diversification reclJcea rillk.

 Time Value of Money

-
TlfM
v~~ of a wmp Som. o,dNrY Annuity. and A.rwWJity ~ continuous C~
~
y_,. of Ma-, : Futi.n v~ of a Lump Som. Ordinary Arnifty. and MnUity Due: Pr~·
•.: .
Contmuous Oiscounting

i1JM ts Money' ls one of the most common.ty h~rd proverbs since o-ur childhood. In Uni
chapteT we wtll understand the value of time in the coot.ext of investment and learn VffloQs

~pt:s as mentioned.
J
L11 nlng Objecth,•

• Concept of Tame Value. Future Value. Rate of Return. Compounding.

• Future Value of a Lu mp Sum. Ordinary Annuity, and AnnuJty.

• Present Value of a Lump Sum. Ordjnary Annuity. and Annuity Due.

_:_._:_•;_;o
_u_~_
us_Co
...,:P_:_po_;_"_:_ng_m_an_e_dV_
Co_a"_tu_
""
· _:_
o:_D_:_:_"~_:--'
·n::...g._ _ _ _ _ _ _ _ _ _ _ _
1
• If we are given a chance to choose between receiving Rs.10000 today Vs Rs.l 0000 a year ta.cs,
most of us wflJ choose to receive today. There may be multiple reasons for this choice such• ~
need for consumption i.e. meeting expenses at present or avoiding unc.e rtainty of recem11_
money at the end of one year or to avoi<l los:s of investment opportunity.

• The requirement tor consumption may be subjective to each individual and uncertainty of
investment will depend on the type of investment. However, the toss of invesmd l
opportunity wfJI apply to all the situations. I
I
 3-2 l1JN' VaJut> of Money

• nus b lM-c'alllt' -w..- can ,tways lnvn:t the money and t'Xp«t to tam a posit ive r-en,m over this

111~ t " f l t . Slmpltst ttumplt' of ln,'t!.Stmt'nt ls creaUng a fi xed d ~t In a bank for l year.
• Hr1tr'e. most or the nttlo~Jt' human beings will choo~ Rs.100 00 today c,ver rKelvtng the same
.amount a year later.
• This preft-rence for rectt1vfng money now compared to receiving same amount of money at
some laur ~ n od Is a iled the Time Preference fo r Money or Time Value of Money.

3,1.1 future Value

When we choose to receive mo ney In future over present. we wUI naturally expect higher
amount than what we would we receive today. Future Value refers to this higher amount that we
txJ)t'ct to recetve In future. Future Value Is the amount to which a current or a present asset would
grow over time. Investors can evaluate future value expected from dJfferent Investment avenues
and take Informed decisions. This Future Value ls Important for Investors and It aJlows them to
t.ake derisions on their investment.

llluatratlon
Let us con.t inue with our example of Rs.10000 and assume that we decide to Invest the amount
In a I-year bank deposit earning an Interest rate of 7% p.a. In 1 year, at the rate of 7%,we will earn
Interest amount of Rs.700 and we will have Rs.10700 at the end of year 1. Let us represent the
future value at the end of year 1 as FV1. In terms of mathematical formula FV of Rs. 10,000 after 1
year at 7% p.a. can be calculated as below :
FV1 = 10,000 + 10,000 X 7% = 10000 X (1 + 7%) =10, 700.
Simple 1.n terest and Concept of Compounding
In the above example by Investing Rs.10,000 for 1 year, we earned an interest of Rs.700 which
simple interest. What If we choose reinvest interest along with principal at the end of 1 year?
We will earn the interest over the principal of Rs.10,000 and on Rs.700 interest. Interest earned
on the principal is called as simple interest while the Interest income earned on the principal and
Interest amount Is called as the compound interest This process of earnJng Interest on principal
and interest is called as compounding.

What if we reinvest Rs.to,700 for one more year, the amount receivable after year 2 will be as
6:>Hows:
FV2 = 10,700 x (1+7%)=10,000 x (1+7%)2=t1449

Total interest earned in 2 years will be 1449 (the difference between 11,4f9 and 10,000)
 3.3 Time Value of Mo?:J..

3.1.3 Rate of Retum

for 1 year earned Rs.700 as an Interest prO\'ldlh•
• In the above ,xample by Investing Rs •10,000 .,
us a rrtum or 7%. This also means that receiving Rs. 10,000 today, ls equlvaJent to receivl·ric
Rs.1O,700 a year later provided we Invest our mo
ney In fixed deposit.

• So if we are offered an amount or any amount more than Rs.107oo at the e nd of 1 year, we \¥111
prefer to receive money after 1 year. provided there is no uncertainty. What If there 11 ill
element of risk In receiving money after 1 year? Will we expect similar return as 7%? We 'NIU
expect a higher return to compensate for this uncertainty or risk. This rate of return expected
from the Investment will depend on the risk and Is called as required rate of return. Tbe
required rate of return by an Investor Is the rate of return offered by Investing in asset havtaa
equivalent risk and Is same as op~rtunity cost of capital. which.
• What lfwe had invested this amount Rs.10.000 In share market. We will expect a higher retu.l'll
of may be 15% per annum on this Investment This expectation of higher return Is due to
higher risk Involved In share market l'nvestment. This 8% difference between returns of lSIJi
and 7% Is called the risk premium. Risk premium refers to the extra return demanded lby
lnvesto.rs over risk free rate of return for the additional risk taken for investing In riskier
assets.

• What if we are asked to choose between receiving Rs.10,000 today and Rs. 12,000 to be
received In 2 years. assuming opportunity cost of capltaJ of say 7% p.a. As seen above, 10,000
Invested at 7% will become Rs. 11,449 and less than Rs. 12,000. In this scenario we will choose ·
to rece-lve Rs. 12,000 after 2 years than Rs. 10,000 today.

• Thus tr we know required rate of return we cash choose between different caS:b nows at
different pertods. Let's take one more example.
llluatnttlon

Mr. Shah is considering a proposal to invest Rs SO Laich l

b··•u . . . · n a commercial property In. Pune. The
LWUer has promised that at the end of 2 th
years ~ value of property will appreciate to Rs.70 Lakh.
If Mr. Shah has a required rate of retu r
rn ° lS%, kind1Y advise If Mr. Shah should Invest in me
property.

To compare Rs.SO Lakh today and Rs.70 Lakb after 2 •

• . years, let's calculate Future value aft;er J~
years using required rate of lS% p.a. · ,
1.
a
Finance Management (Mil) 3-4 ·nme Y:llue of Money

JlV2 = 50(1 • 15%)2

= 50(1 IS)'=50( J.3Z3) = 66.125

A.~ property offer.; highe r appreciation. Mr. Shah should take favorable decision to Invest fn

cornrncrdal property.

' 3,1.4 One-time Investing/Lump Sum Investing

Investors have an option of Investing money In one go or at different intervals of time. When
the funds are invested in one go, it Is called lumpsum Investing or one time investing. Future value

of lumpsum investment can be calculated as below:

The Future Value FVn can be expressed a s

...(3. 1.1)

where
n = No. of periods

= Rate of return per period

FV O : Future Value at the end of period n

P = Principal amount or original investment amount

The factor (1 + i) 0 is called as Future Value Interest Factor (PVIF) or Compound VaJue Interest

Factor (CVTF). It represents Future Value of Rs.l invested for a period of n at the rate of i

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

FV 0 = PxCV1Fn.1 ...(3.1.2)

where

CVIF11., is the compound value interest factor for period of n at an interes t of i and it represents

Yalue furure value of Rs.l invested for a period of n years at the rate of i% per period.

CVIF or Compound Value Factor makes it easy for calculation of Future Values involving large
um ber of years without using computer or scientific calculator. CVIF table provides value.s for
lfferent combinations of interest rate and no of years.
 J s Ti me Value Of~

IJfUlitnldOfl
"000 Invested for 1 years at the rate of 5·% p.a7
What wlll bt' th, Futurt' VII Iut' o rRs. "

Alww•
Puture valut' at the end of 1 years can be C.Jlcula ted 'by using formula
FV1 .. p X (1 ♦ I)"
7
FV7 :c 5000 >< (l + 5%)

FV 7 ,. 500 0 >< CVIP1.s,.

We ca n reft1r to the CVJF or PVIF table below to calculate Future Value In this example
FV 7 c 5000 x 1.407 = 7028
TabM ) ,1.1 : CW/MF Table

hlllN ...... lnlerwt fllaor of Ra.1 per period at'"' for n perlodl. FVIP0, •>
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 1()% -
J J.010 1.020 1.030 1.040 1.050 1.060 1.070 l.080 1.090 1.100
2 1.020 1.040 1.061 1.082 1.103 1.]24 1.1 45 1.166 1.188 1.210
3 J .030 1.061 1.093 1.125 J.158 1.191 1.225 1.260 1 .295 1.331 I

4 l .04 1 J.082 1.126 1.110 1.216 1.262 1.311 1.360 1.412 1.464 I
I

1.469 1.539
I
5 1.051 1.104 1.159 1.211 1.276 1.338 1.403 1.611
6 l .062 J.126 1.194 1.265 1.340 1.4 19 1.501 1.587 1.677 1.772 I
7 1.012 1.149 1.230 l.316 1.401 1.504 1.606 1.714 1.828 1.949 I
1.083 1.112 1.267 1.369 1.4 11 1.594 1.718 1.851 1.993 2.144
I
8
9 J.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358 I
10 1.105 l.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594
11 :I. JJ6 1.243 1.384 1.539 1.7 10 1.898 2.105 2.332 2.580 2.853
I
12 l .121 1.268 t.426 1.601 t.796 2.012 2.252 2.518 2.813 3.138
I
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452
1.4 J .l -49 1.319 1.51 3 1.132 1.980 2.261 2.579 2.937 3.342 3.797
15 1. 161 J.346 1.558 1.801 2.079 2.391 2.759 3.172 3.642 4.177
'
16 l. l 13 1.313 1.605 l .873 2.183 2.540 2.952 3.426 3.970 4.595
I
17 l.JU.f 1.400 1.653 1.948 2,292 2.693 3.159 3.700 4.328 5.054
1 . ♦ 28
18 l . 196 1.102 2.026 2.-401 2.854 3.380 3.996 4.717 S.560 I
1'J 1.208 1.451 1.754 2.101 2.521 3.026 3.617 4 .316 5.'142 6.116
I
20 1.220 1.486 1.806 2. J 9 ] 2.653 3.207 3.870 4.661 5.604 6.727 JI
t
----::i
... ... -
• C
)
I I
 • I 11unu• Mae ,ttnP nl l"4UJ
•
CVlf <h.>I'\ , ho ~ tht' ,r.alue of 1u t Inv i,-•
• ~t dlne,r•nt l'•tt' of rctu
t-S' => lu
, aph. th«' grt:ate r the Intern, ratt! lht! s•- h m can bf- •Hn from the
B . "'"IH'r L l' growth CUrvt- b; wb_ h
AISo thl' grt'alff the number of )'l!ll~ durin g whl h 'I le futu1t valut> lncrtue~
c compound lntt"re!tt can be rnrd b
tilt grt'.iter t:ht' fu ture value · ea , o Viously

7.0 Future value ctlan of Rs. 1

6.0
! 50
j 4.0
i3.0
~ --- - ____ .. - - - -·-
2 .0
, .0
---:.;:~= :-:. :-:. =--_---------------
~

0 .0 - 1- - -- -- - - - -- - - -- --
2 J 4 5 6 7 8 9 ,o
No. ofpenods

Fig. 3.1.1 : FVIF/CW- Chart at cRffw.wnt lntie....t rates

3.1.5 Future Value of Annuity (Ordinary Annuity)

Annuity as the name indicates refers to fixed amount paid or received at annual frequency.
More particularly it refers to stream of constant cash flows due every year. When the fl:xed amount
of cash fl ows is received or paid at the end of the year or a period It ls called Ordinary Annuity.
In case cash flows are received or paid at the beginning of the year or a period it is called Annuity
Due.

Illustration

In the above example, we invested Rs.5000 for 7 years In lump sum or in one go. Suppose
~ instead if investing 5000 in Lump sum, we decide to deposit Rs.1000 at the end of each year for 5
~ years we have created an annuity. Alternatively, when we take car loan or housing loan, we repay
I the loan in constant monthly installments, we have created an annuity.
I
t
To calculate future value of Rs. 1000 annuity we will need to calculate the future value for each
investment o f Rs. 1000. The first investment of 1000 made at the end of year 1, will earn invest for
•

f 4 years, while the last investment of 1000 made at the end of 5 years will not earn any interest.
This is expressed as below:
 3.7

~ .S.b owiog I 000 lnvesOMnt fr>r 5 years.

2 ..
1000 1000
L_

I
Fig. J .1.2
I
f
FVAs, = 1000 x (1 + 5%)4+ 1000 x (1 + 5%)3 + 1000 x (1 + S%)2
+ 1000 X (1 + 5%)1 + 1000 X (1 + 5%)0
I
: (1000) X (1.216) ♦ (1000) X (1.158) + (1000) X (1.103)
+ (1000) X (1.05) + 1000 I
= 1216 + 1158 + 1103 + 1050 + 1000 = 5527
The Future Value FVn at the end of n year for the annuity value of Rs. A. at the rate of I\ Ill
I
can be calculated as below:
FVA,, = Ax(l+i) ► 1 +Ax(l+i)n-2 + ... +Ax(l+i)0
(1 ♦ nn - 1
FVA,, = Ax . I ... (3.lJ.

The temi
c1. n· -1 Is cailed as Compound Value Interest Factor for Annuity (CVlFA) or F
1
Value Interest Factor for Annuity (PVIPA).

Thus a Future Value of Annuity can be expressed as below:

FVD .. AX CVJFA.,i ... (1U
Where
A • Annuity cash flow .

CVlf"-' · Compound Value Interest Factor for Annuity or Rs.I for n periods at the interest
1
per period.

Table 3.1.2 shows the table of Future value of annuity of Rs.l for different period and I
rates.
 Finance Mana ement (MU 3-8
Time Value or Mone

Tab&e J.1.2 : ~/Compound Value lntew»t Factor Table of Annuity (FVIFAJCVJfA)

fUtllrl' value Interest factor of an ordinary a.nnuJty of Rs.1 per period at 1% for n pertods,
CVJFA/FVIFA(D.1)
-Pertod 1% 2% 3% 4% So/o 6% 1% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2 .070 2.080 2.090 2.100
3 3.030 3 .060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310
4 4.060 4 .122 4.184 4.246 4.310 4.375 4 .440 4.506 4.573 4.641
s 5.101 S.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105

6 6.i52 6.308 6.468 6.633 6.802 6.975 7.15 3 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487

8 8.286 8 .583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436
9 9.369 9 .755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579
10 10.46,2 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937

11 11.56 7 12.169 U .808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950
17 18,430 20.0lZ 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41 .301 45.599
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275

llluatratton

Mr. Mukherjee decides to Invest an amount of Rs.1.00,000 each year for a period of next 20
• years to create a corpus for future. He expects t.o earn a return of 10% each year on the Invested
amount CaJculate the Lumpsum a.mount that Mr. Mukherjee will r~elve atthe end of 20 years.
 Time V alue of Mo
• Finance 1Mana1ement (MU)
3.9
~
An,wer
. . d f 20 years can be calculated using annui
Fururc value of annuity of Rs.1,00,000at tbe en o . l'}'

formula
FVAzo = Ax CVIFA20,tOCM,

= 100.ooox57.275
= 57,27,500.
have become of Rs.57.28 Lakh. This also sho,...
This means a total lnvestment of Rs· .20 Lakh q~

the Importance of early Investment and the power of compounding.

3.1.6 Sinking Fund

• Sinking Fund refers to a fund created using a constant amounts deposited at regular Intervals
to accumulate a future fund amount after a certain period. Sinking fund concept is USed at
many plaefl such as creation of repair fund for a housing society, redemption of debenture by
companies etc.
• Let's say a company has Issued debentures amounting to Rs.100 Cr to a bank, maturing arter i
period of 5 years. Company needs to create a sinking fund to meet the redemption of th~
debenture after S years. Company expects to earn annual return of 7% p.a from the amounts
keptaside. How much amount should a company set aside at the end of each year.

• In this example Future Value of Annuity or FVA Is 100 Cr and annuity needs to be calculated
We can calculate the annuity by using the formula for Future Value of Annuity.

FYn ;;: A xCVIFa. 1

FVI!
A ::
CVIFn, I
100
A =
5.751

A = 17.38Cr
1
In the above enmpJe the tenn called as Sin.Id p
CVJF., 1 iJ .......... DI und Factor.
-•
)
• 7
,· f

J-1.7 ,._. ltv Due

. . . . . . . . & ◄ ApM fll •1::mllll:::lta.
- ~ . e d at die eN of ..ci. pu1wll
•
_.~•&rd ~ lei t e l ~ a ca. - . t of~• ut • • IMt.nd of CTld o1 ~ pel1od.

• -- tr cruud bf ~pcmllit ( , ~ a1 dw st.an al l'x.h C)ff1od it call~ u

u m 01:w.,.,.,::::
Ow ts ~ W!1es ol l'heS p.ay::.a:e ~ , t ~ bqlnning of t'Ktl pa1od
t o r ~ wssbet al Pff'IO'.b.
• 11° OU 1ft bay W/,J oe loall l!"l'len0, the bank will s u n ~ ln.stalnwn ts from
die ~en: 19C ?I me loan. For ex,uai:-. If ~ bvy , mob(!~ phone In the EMI schmie of 12

zc ;t; beM SUrt to rtcwt', ~ t from ~ Ml)nntng of the month Instead of a

iat rt; D aDe,d ~ - t y 0u,e_

• Lf(1 sar ""' 11,,nst ls.1000 at the begltlntnc of year In each of the nnt S years. In this case the
• a , , E Ito/ aa dw ~ will also earo a retun, a.s It rnt1alm tnvesud for 1 year. Henc~ the
•+ I :'➔ e ol FlltWlt Vat. wtD become

FV. = A x CVTFA,,., x{l• I) --(3.15)

J,.1.1 Pl I I I It Value of MOileY

• a p1e1 a .edMN. we understoo d how to caJcu1ate fu.ture value of cash flows and compare
cala ~ ,«.eited .t di&rmt periods of time. What if~ ~ to cakulat.e the present value
c,C__,.. calll !lows to arrtw at the decision? Present value Is the value of cash flow available
~ - A rt, is equ:twal,mt to the fua&re Yalue and is denoted as PV. ~ t vaJue or PV is also
called dw dil,, 1 ed -aiue as It Is ca1adated by discounti ng the future cash 80W$. Process of
dillc:1 w •-c 1s ae ,aw of c:ompoundJng.
• ne rae wti6cta ls med to ctiscoont the future cash flows for caJodaUn g the pt Heat value Is

aled dw div1--c rare. When pnsent value l!s lDftsted at the discount rate It will match with
tmn-- .
ft 2-dll I

509µ;.e ,.,_, wen ro choose between receh11'I Rs. 10,000 today or Rs. 12,000, 2 yean down
dlr .._ mime pe cs 11 niae coelCtjA. Assume J'OUI' discount race ls ~ ~
 __ _1•1m_ e :or~ ~
al.;u;.,
c•Viii
e;:!M~a:!:n:l•fi!e:m:e:n~t(M~U~J~---.;3·~1_:.1_ _ _ _ _ _ _
~•t_~Fl~n:an:c

An 8w er
th .lO,OOO.
th e pr es en t va lue of Rs . 12,00 0 an d co m pa re It wf Rs
We wUJ calculate
~ wit~
we ha ve to dis co un t th e fu tur e value at th e disco un t rat
e,
To calculate th e pr es en t valu
Is 7% p.a. In this c.ase.

Fo rm ula for Future VaJue is

2
FV2 = P( l + 7% )
2
12 ,00 0 = P( l + 7% )
1 12 ,00 0
p : 12 00 0 X (l + 796)2 =1.1 44 9 =10,48 1
0 Is Rs.10,48 1, wh ich Is 48 1 hi gh er th an Rs .10,00 0.
The pr es en t value of Rs .12 ,00

of FV at th e en d of pe rio d n a t re qu ire d ra te of i%~

Si mi lar ly, we ca n calculate
Present Value
e PV hr
as PV. Using th e ab ov e example, we ca n calculat
Pr es en t value Is re pr es en ted
discounting Fu tu ~ Value at th e ra te of L
FVn ...(3.1.6)
PV = (1 + rJ•
1

PV = FVn X CVTF,.J
d as pr es en t vaJue In ter es t factor
w
Ju e In ter es t fac to r Is ca lle
The Inverse of compound va
ts pr es en t vaJue of Rs.1.
de no ted as PVJF. Jt re pr es en
... (3.1.1)
PV "' FV. X PVIF,u

Where

PV • Present Value
ofye ar n
FV11 • Future VaJue at the en d

are discoun ted ts caJled as discount nr e

I - br e ar which future cash :flows
d
es t Fa cto r fo r a pe rfo d n an d in te re st ra te of J pe r pe rio
PVJFn.1 · Present Value ln t«
ra tt'.
lu es of Rs .1 fo r dif fer en t co m bi na tio ns of di sc ount
t va
We can calculate th e pr es en
 3- 12 Time Value of Mont'y
a
Tel>&. 3.1.3 : Prnent V•lue lnterfl1 Fecto r T•ble

- p, eMnt value Interest factor o f Rs.1 ~r period at 1% ror n pe riods, PVTF(n.l)

~ rtod t '"- 2% 3% 4% S% 6% 7~ 8%, 9% 10%

I 0.990 0.980 o_q11 0.962 0.952 0.943 0.93S 0.926 0.91 7 0.909

2 0.980 0.96 1 0 94:i 0.925 0.907 0.890 0.873 0.857 0.842 0.826

3 0 971 0.9 4 2 0.91S 0.889 0.864 0.840 0.8 16 0,794 0 .772 0.75 1

4 0.961 0.92 4 0.888 0.8 55 0.823 0.792 0.763 0.73 5 0.708 0.683

s 0.951 0.906 0.863 0.822 0.784 0.747 0.71 3 0.681 0.650 0.621

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564

7 0.933 0.87 1 0.813 0.760 0.711 0.665 0.623 05 83 0.547 0.513

8 0.923 0.8 53 0 .789 0.731 0.677 0.627 0.582 0.S40 0.502 0.467

9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424

10 0.90S 0.820 0.744 0.676 0.6 14 O.S58 0.508 0.463 0.422 0.386

lt 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.4 29 0.388 0.350

12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319

13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290

14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263

15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239

16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198

18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180

19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
.
20 0.820 0.673 0.554 0.456 0371 0.312 0 ..258 0.215 0.178 0.149

Pl b t!nt Value Chart

The graph shows the present value of Rs.1 at different discounting rates over different periods.
As seen from the graph the present value decreases as the time period increases and
discounting rate Increases. ·
The greater the Interest rate, steeper Is the decline in present value.
 Time Value of Mo
• Finance Management (MU) 3-13 n%_

present value chart of Rs. 1

1.2
1.0
~ 0.8
----- ------- ------- -----
J
c 0.6
- "" - •• --
I
D.
0.4
02
0.0 8 9 10
1 2 3 4 5 6 7
No. of periods

Fig. 3.L3

3.1.9 Present Value of Annuity {Ordinary Annuity)

We have seen l.n previous sections that ln case of ordinary Annuity stream of fixed cash flaws
occur at the end of the period. To calculate Present Value of annuity each of cash flow Will bf
discounted separately. The present value of annuity PVA for annuity amount of A and n periods
can be calculated as below:
A A A
PVAn = (1 + 1) 8 + (1 + i).,_ 1 + ... + (1 + I)

A (
PVA,, = (l+i) 1 1 )
{l+i),...1+(1+1)•2 + ...+1

PVA,, = A x ( : - I (1 ~ I)")
PVA,, = A x PVlf.\iJ ...(3.1.8)

where
PVIFA.,r is present value factor of annuity of Rs.1 for n period for an Interest rate of I per
period.

PVA Is present value of annuity and PYAn for a period o.

• Anan«' Maruagement (MU} 3- t 4 Tlrfle Value o f Money
a
Table J.L4 ; Pte-.,t value '"'4trflt f■ctOf' Table of an (ordhuiry } annuity PVIFA

,SU Int 1.f~h• \Jrtllftillt ,__of •(. . . . ,, ■ •"""r of lta.1,- pwlod at"' for" ,..ta Ill,
PVIJA ln.l)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
l 0 .9qQ 0.980 0.971 0 .962 0.952 0.943 0.935 0.926 0.9 17 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.736
1.783 1.759
3 2.941 2.884 2.829 2,775 2.723 2.673 2.624 2.577 2.531 2.487
4 '3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.240 3.170
3.312
s 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3 .791
6 5.795 5.601 5.417 5.242 5.076 4.917 4 .767 4.623 4.486 4.355
1 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 S.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 ' 8.306 7.887 7.499 7,139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.24-4 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606

IIIU9trlltton
An Investme nt In a new business is expected to provide guarantee d return of Rs.10,000 each
year at rate of 10% p.a. for next 5 years. Calculate the Investme nt amount.

An.-
In above example, the Investme nt Is expected to provide an annuity of Rs.10,000.
Present value of 5-year annuity as represented by PVAs can be calculated as below:
A A A A A
PVAs = (l + i)s + (l + l)4 + (l + t)3 + (l + l)2 + (1 + 1)

PVAs = A x PVFAs, 10CM,

PVA5 = lOOOO x PVFAs.10%
PVAs • 10000 x 3.791=3 7,910
The amount that need to be Invested Is Rs.37,910.
Using !the above fonnula, we can also calculate the annuity for a given value of Investment.
peri.o d of Investment.
• Pln.anc.c Manaaemenl lMUJ 3- 15 Time V.aJue of ~ •
lHIMltratton
XY'Z Ltd plans to lnve$t an amount of P.s. 1 Lakh In setting up a. plant that Is expected 8tnt
t\xed return, every yea.r at ;an a nnuaJ rate of '10%. <:alculate the value of cash flo w s ~ I()~
generated every year

AMwer
Here we are provided with the present value of annuity Le. Rs.1,00,000 and we ~ tti
ca lculate the value of annuity.
• PV As = A x PVFAs. 1 °"
Now as seen tn the earl ier example. we know that the va.l ue of prewnt value factor of atlnlll!)
for 5 years at 10% Is 3.79 1. Hence
J 00000 c A>< 3.791

A = 10000
3.791 "'
26,378

Similarly, for given vaJue or annuity, Investment and period of Investment. we can calculate !ht
implied rate of return.

IHuilltaatlon

Let's calculate the lmplled rah! of Interest of an Investment plan, wbkh provides annwty at
Rs.26,378 on an Investment of Rs.1,00,000 for a period of S years.
100,000 = 26,378 x PVFAs.1
1.00.000
PVFAs.J = 26,378 =3.791

When we refer to Present VaJue Annuity Table for a period 5 years and value of 3.791. we l!t
an Interest rate of 10% p.a.

3.1.10 Pre■ent Value of Annuity Due

In case of annuity due, cash flows happen at the beginning of the year. Present value ol lie
annuity due amounting to A will be caJculated as below:
A A
PVAtl = c1 • o• ·l • c1. i)•-2• -· •A

The aboYe expnssion can be written as below:

1 1 1 ·
PVA., ::: A (1 + 1)((1 +I}'°+ (1 + f)" - 2 + ... + (1 + i)'
• Finance Man cment MU) 3-16 Time Va lue of Mooey

This effectively me.ans multiplying the present value of ordinary annuity with a factor of (1 + i).
Hence present value of annuity due can be expressed as below:
PVAn = A x PVFA.,1 (1 + I) ...(3.1.9)

3.1.11 Multl Period Compounding /Compou nding for more than 1

once• Year
• In all our pl'fvious examples, the ca sh flows are compounded annually i.e. interest is paid once
a year. However, In practice we may receive interest more frequently than once a year, say
semi-annually or quarterly. For example, corporate bonds may provide interest semi-annually
or banks may give quarterly Interest payment on savings deposits. In such cases, the Investor
Is eaming Interest twice or four times a year. 1f this amount is re-invested, total interest earned
will be higher than annual interest rate.
• The interest rate Is usually mentioned on annual basis Irrespective of the payment frequency
as a common practice and Is known as nominal Interest. The actual Interest rate for the year
may be different depending on the frequency or compounding and is called effective interest
rate (ElR).
• Let's calculate effective interest rate (EIR) on Rs.100 deposit which provides pay out, semi-
annually at an Interest at the rate of 10% p.a.
1
Amount after 6 months ,. 100 x + ~O% = 105.

1+10%
Amou:nt available after 1 year = 105 x 2 = 105 x 1.05 =110.25
• Interest Income ln 1 -year wlll 110.25 - 100 = 10.25, which Is: also the effective interest rate.
• Effective Interest rate can also be calculated by compounding 100 for 2 semi-annual periods at
rate of 5% as shown below:
2
EIR = ( 1 + 10%)
2 -1

EIR = (1.05) 2 - 1
ElR = 10.25%
• Slmllar)y, In case quarterly payment the interest would be compounded 4 times In a year. EIR
off% nominal Interest rate will be

EIR = ( 1 + } / - 1

• Based on above understanding we can calculate the future for a given a period of time for a
multi period compounding. Let's c.aJculate the Future value of P Invested for n years t hat pays
interest m times a year at the rate of 1% p.a.
• F\naJltt M::,:ff lffl\ lMU) 3-17

_L) lllll
Time Value of'
FVn • P ( l •in) ...(J.1.101

I -rau, o'f ~turn per annum

m· number of compounding per yur
n - number of years
ted by discoun ting the future value by the same cornpoundi...
• The preffflt value can be caIcuI• --,

3.1.12 COntln11oua Comp oundi ng

In the above examples, we have seen compou nding happen at discrete lnterval se.g. an-._
semi-annual. quarterly etc. Theoretically Interest can be compou nded at infinite intervals°"
continu ously. As seen In the above example

FV• • ,{1 + -!;)""'

As m the frequency of compou ndtna In a year approac hes lnftnlty ( 00) we get cont1nU011
compou nding and the term (1 + fJ..
approac bes (e)• where e ls approxi mately 2.71821,
Therefo re the future value of investm ent P where Interest is compou nded continu ously at Ille
Interest rate of I ls

... (3.1.11)
lumpl e: Let's calculate future value of Rs.100 deposit at the end of 3 years with conttn •
compowMllng at 8 percent will be
FV1 • l0O(e)(Q.Oa)(lJ
• 100(2.71828)8.2♦ = 127.12
How does this compare wtth the annual compounding?

FV, • 100 (1 + 8%) 3 = 100 (1.08)3 • 125.97

3.1.1 3 Pr rent Value Using ContlnllOUS Disco untin g
Present value of the future value with continuous compoW1dtng can be calculated using
contfnuous dilcoundna, Sucb present value is calcuJated by inverting the future value formula•
beJow.

... (3.1.ll
-
• finance Management ( MU)

n ,e "ltUle of n'" and Double the money

3-18 Time Value of Money

Aquick way to calcuJate in terest or time required to double your money Is the use of the -Rule
of' 72." This rule states that if the number of years, n, for which a n investment will be held is
divided into the value 72. we w fU get the approx:lmate interest rate, I required for the investment
to double In value.
For example, if we want to calculate the time required to double money if we Invest in fixed
de-posit tha t yields an interest rate of 8% p.a.
72
No. of years = 8 =9 years

Alternatively. If want to double our money In 6 yea rs, what should be the Interest rate.
. 72
Ra te of mterest = ~ 12

Please note Rule of 72 does not give the exact answer, but provides an easy way to calculate
approximate value.
U1fft1 Excel for Time Value of Money
Excel provides easy tools for caJculation of terms used in Time Value of money problems. We
need to know following terms used while using excel formulae for time value of money problems
FV - Future value
NPER - Number of periods (e.g. for 4 years with quarterly compounding NPER will be 16)
RATE- Interest rate per period (e.g.10% p.a. with quarterly compounding RATE will be 2.5%).
PMT - Periodic payment, used only for annuities.
PV - Present value
Functions may be entered direct1y or a function wizard may be used for input If the function!
are en~red directly. the required inputs and structure are below.
Future Value = FV(rate, nper, pmt. pv, type); type refers to the timing of payment Le. 0 fo1
beginning of the period and 1 at the end of the period
..
Present Value= PV(rate, nper. pmt.fv. type)
NPER =NPER(rate. pmt., pv, fv, type)
RATE =RATE(nper, pmt pv. fv. type. guess); here guess means estimated value of lnteresi
expressed in decimal e.g. 0.1 for 10%.
ANNUJ'IY (PMT) = PMT(rate.nper,pv,fv,type)
Excel uses a sign convention that Indicates whether an amount Is a cash inflow or cash outflow
'For t:ample. for calculation of present when we input positive future value, It wfU provid•
lleptlve prt!Sfflt value, indicating the value of upfront investment
For uample. Present Value of Rs.1000 ordinary annuity at the rate of 10% for next 20 year
wm ht calculated as• PV(rate, n r, mt, fv, type)= _PV (10%.20,1000,0.0) ~ - 8,513
 3· 19
e n l{ MUJ
• flnatle'e M a n ,: ;m
e f e r to futur e and
Exam ples ( R
3 .1 .1 4 Solved a lu e T a b l • )
Present V p e ri o d o f 5 ye a ra at ra t& c,f 1~
sted for a 111 'J
re value o f (t ) Aa. t ,000 Inve lo o f 1 0 % p a .
Ell. 3. 1.1 : C.lcu
lata th e futu n d o f each year a l
Jntereel ra
aJ ty a l th e e
100 Invested aoou
10% p.a. (2) R i.
Soln.. : 00
s tment o ( Rs. 1 0
oflumpsum Inve
(a) Future value + 10%)
5
FV ,. 1 0 0 0 (1 J
10 ,-,) c (1 0 0 0 )
(1.6 1 1 ) • 16 1
= 1000 {CV JF~.

JOO I.e. FV o f ann

uity
tment o f Rs.
e of annual Inves
{b) Future vaJu t0,96)s - 1
FVA ,. A (l +

(J + 0 .10)
5
- 1
s.1° "' os1
J = ( 10 0 ) (6.1
• 1 0 0 (CVJFA
• 100 0. J0

z 6 1 0 .5 0
. --
the e n d of 5 fet9at
Re. t ,0 0 0 ~•ble 11 Y M I& , It ln
valu e o f
3 - the pm111ri1 (requlreci ra11 ;
Ex. ., .2 : C e)bannt,ally (b) e t o f cap1ta1
portunity co
~ (a
un~ (c ) 00ntinuoualy. Op
cei,r per e r w
rt tl .m ) ii 10 ,:,e,

--- =
rn
a
Futu.re value a t d te e n d o f y e
FV ••
p e r annwn
I - ~ or retvrn
r
rri · number o f c o rn p o ~Jng p e r y e a
n . n u ~ ro fy e a rs
1OOO
(a) Prt-sent Value fo r •nnuaJ compounding PV z 5
0 •1 0 %)
1000
3
= 1.61 J = 6 2 0.7
r Q lw t. .. i. . Co 1000
fb) PV fomuda fo -•r fflJ)OUndJnl PV =
IQ,(,~ •• s
( 1..~..
J{)Oo 1000
39
(l • 2.5%)2112 1.6
'" 6 1 0 .2 7
• Finan, ~ M,1n11 eme111 ( M U Ti m« Valutt of Mone

FV
(c) pV rormu l:i for Co nt inuou) r nmpuunc.llng PV ... e-t•

PV for lutur u Vl\lue o f Rs 1000 " J 00 0/eH = : .~~~ = 606 .42

E•- 3.1.3 : Mr. Patil plen• lo invest an amount o!Rs 25.00,000 to purcha_ae an annuity lha1 will provide
him with a ateady lnoome ovor the next 10 years. He has heard tha1 an inaurance plan provides
guaranteed 8 peroent oompound Interest on an annual basis If he were to imle91 hie funds. what the
,nou11t that he would be able to withdraw annually auch that he would have a zero balance a11er his 1881
1
wfft,drawal 10 yeara trom now?
.,.,,_:
In this example, present value of the inves tment Is provided and the Investor wants to
purchase 10-year annuity offering him annual Interest rate of 8.
25,00,000 ,. (A) (PVIFA 1o.e'41)
25,00,000 • (A) (6.710)
A a 2S,OO,OOO 3 72 578
6.710 • ' ·

Ex. 3.1.4 : You have Inherited a debenture Investment having realdual maturity period of 6 years and
paya an amount Ra. 3,000 a1 the end of each year. Prevailing mari<e1 price ot debenture Is Ra.13,869.
Whet II the Implicit rate of retum?
Soln.:
PVA = (A){PVIFAn. J
13,869 = 3,000 (PVIF~.J
13869
PVIFA6, t = 3000

PVIF~. 1 = 4.623
After referring to the table Present Value of annuity, value 4.623 corresponds to interest rate of
8%p.a.

0. 1 Explain varioua motive tor time preference tor money.

0. 2 Explain why the lnter81t in multi period compounding Is higher than annual compounding?
Q. 3 What ia an AMuity? Why II present value of annuity due le higher than ordinary amulty?
 Financial Management

Ol.eNII■ of Cofpu ■19 ,._a : ObjectM:s of Corporate finance; Functions of Corporate

Financ..-lnwstment Oedsion, Financing Decision, and Oividffld Decision. financial Ratio ~
Ovetview of Financial s~-Bllance Sheet. Profit and Loss Account. and Cash Flow Sta~
Pu,pose of Finlndal Ratio Analysis; Liquidity Ratios; Efficiency or Activity Ratios; Profitability Rftiot
Capital Structure Ratios; Stock Marie.e t Ratios; Limitations of Ratio Analysis. .

Very oft'en a difference between success and faiJure of a business can be attributed to efficiency It
the ftnandal manapment A company having a highly successful product can slowly go illa
oblivion If it fails manage its finances properly. On the other hand. a company losing market Ciin
survive and make a comeback if it has strong finances. This chapter introduces the reader to WOf1d
to the corporate finance.

Le■mlng Ob,loctlv11
• Financial Management, Functions of Financtal Management
• Objectives of Finn and Corporate Finance
• Financial Statements - Balance Sheet, Profit & Loss, Cash Flow
• Financial Ratios - Liquidity Ratios; Effldency or Activity Ratios; Profitability Ratios; Capill
Structure Ratios; Stock Market Ratio
• Llmitations o(.Ratio Analysis

4.1 Introduction to Flnan.cial Management

• A successful business is built on the pillars of three critical functions Le. production, m,a,rtl'lilni
and finance.
• Production and marketing functions work towards creation and delivery of products
services desired by the customers, while the ftnance function ensures uninterrupted fundit1
support for these functions.
 • FlllilJJCe h ltllr lilt blood nf co mpany ,1nd lll'«il'd tor cffictfflt functJonlnt! of every artlv1ty of
t,usl11n~ from 1n1tl.l 1nves t mc n1 t.o i elltng ~oods and services on CTNllt tn cu sto me rs.
• Tbc fl Mnce fu nction In the buslnen Is abo called Corp-ora te Fm;a ncc and the m;anagemen t o f
th» functlon Is known as Flnanctal Management
• Tradttionally fl nanctal man.1gtment was only tasked with ra ising funds; however. It has
evolved over a period to cover functions of Investment management and profit distribution.
• According to Guthma n and Dougal, financial management means, · the actJVJty concerned with
the planning. raising. controlling and administering of fu nds used in the business."

,.1.1 Financial Management Decisions

f inance management covers three mal.n responsibilities of the business Le. arranging finan ce,
Investment of fund s Into assets and distribution of profi ts. These fu nctions Involve three decisions
mentioned as below
1. Investment Decisions
2. Financing Decisions
3. Dividend Decision
In addition to the above functions, Finance Is also responsible for managling liquidity position
for the company to ensure uninterrupted funding for day to day operations.

4.1.l(A) Investment Decisions

• On an ongoing basis. ftnance manager needs to take decisions on creation or acquisition of long
tenn and sbort•tenn assets. These decisions Include selection of projects/assets for
Investment, period of investments, period for Investment etc.
• The decisions of Investment In long term assets Involve large sums of money and are expected
to provide returns over a longer period. These decisions are also called capital budgeting
decisions.
• Every long-term Investment decision wm Involve an element of risk. Risk and returns from
Investments are Interrelated and the financial manager need to strike an optimal balance
keeping overall objective of the firm in mind.
• This balance of rtsk and reward ls called as the r1sk reward trade-off.
• A finance manager needs to evaluate multiple Investment options before finalizing the
l optimum investment for the company.
• Capacity expansion, purchase of equipments, land and bulldlng. mergers and acquisitions are
f examples of capital budgeting decisions. Divestment or sale of assets also fall In the domain of
, capital budgeting decision.
 Financial Ma~
~3
• Finance Manq•m~l (MU) ~
decisions that will maxJmlze the value of
• Finance manapr l·s e,cpectrd to take Investment Ult
company. . nt In current assets such as stock. d~~
• Short term lnvHtment decisions Involve lnvtstJne . .->vi\
kl
., __,. de sits etc. and are calIed wor n g capl~I dfC'lslons.
iuun,1 po fo th level of stoek to be maintained, credit JleT1od
• A nnance mana1er needs to create policies r r1el on cash or credit. Investme nt of sbo" t-..
t.o be granted to b\lyers, pu rchase of raw mate a · - ·~
funds Into mutual funds, ftxed deposit etc.
k I In mind Impact on profitability and requl~
• Wori<lng capital decisions are taken e: og ncertalnty In business In the backdrop of short.t
of liquidity for the buslness.d Duehto
economic cydes and rapt tee no "Ii'
~:cal
°'c:ange s, 1 large business prefers higher levei C(

liquidity.
4.1.1(8 ) Plnand ng Decl•lo ns
e funds to meet the Investment requirements of the fina
• Finance manager nee ds to rais
Pundlna can be raised by taking on debt (loan funds) or equity or combination of both. 1'he 1111t
between equity and debt Is called as the capital stn1cture.
• Use of more debt will mean that the number of shareholders wUI remain same and may
tncreaae proftt available for shareholders. However, It also leads to hiper risk as debt lnvo!vts
ftxed upenaes towards Interest and repayment of debt Irrespective of the performance of tbt
ftrm.
• Use of equity provides flexlblllty; however it comes at higher cost as the shareholders demand
higher return compared to debt holders.
.
• Finance manager needs to maintain optimum capital structure that helps to maximize value r
the firm for acceptable level of risk. A finance manager wtll look at multiple factors befon
choosln& • fundtna such u rate of Interest. availability of memal funding, rtsk profDe Ii~
project. estimated timeframe or returns from the project etc.
4.1,1(C ) Dividend Dedalo M
• Third Important dectston for a ftnan~ manager is dlstrtbution of profits, known as ~
deds1on. Tbts dectslon Involves decision on bow much profit to be retained In the busineSS ff
a vis dlstrtbutlon to shareholden.
• Dependtn1 on II owth opportunities available for the company. cash balance of the comP-.
and requirement of funds, finance manapr wtll take decis1on on retention of the profits.
• Shareholden of the company havtnc good opportunities for growth, wUI prefer to retain ~
share of profits In the company, which It can reinvest the profits In the b inesa to ,en,nt
higher returns. us
 4-4

Thu will Increase the ~1u,. of the Arm d ._ _

• an sruoreholder an , .am returns 1n future lrom op1tal
apprtdaU on P,rcentage of profit retained In the business Is called as the r,1rnllon ratio. while
perrentage 0 1 profit.s dl st n buted lo sharehold ers Is c:alled a s d ividend p ayuul ratio. f ir ms
havlna limited lnveumen t opporTunlli
e es or investmen t requirements wlll prefer to have high
payout ~do
• Dividends are generally taxed at higher rate in most o f the countries. hence companie s choose
to buy back shares to reward shareholders Instead of declaring large dividends .
4.1.2 Object ive of Corpor ate Financ e

• Effectiveness of financial managem ent decisions can be gauged from Its success to achieve the
objective.
• It may seem that maximiza tion of profit and dividends are natural objectlvn of the eorporate
finance. Every business Is set up to make money or eam proflt from sale of Its products and
services. Hence, one may argue that profit maximization Is the most obvious objective of the
company.
• Profit maximization can be defined as the management of financial resources aimed at
Increasing the profit of the firm. Profit maximization can be achieved through range of actions
such as raising the prices of product and/or producing more for same cost by cost reduction or
more efficient production If a firm goes on to Increase prices to take advantages of high
demand, market will attract more sellers and once demand supply are In equilibrium, price
will stabilize.
• These actions wUI provide short term profits for the company. Company can also achieve
higher profits In short tenn by avoiding Investments and saving on interest costs. However, It
may Impact future prospect of the company. On the contrary what If It makes large
Investments that has provides returns after a very long period?
• The goal of profit maximlzatlon mainly suffers from following shortcomlngs:
1. Short term or loq-term profit : Profit maximization objective does not specify short- or
long-tenn profit maximization, hence Is ambiguous In guiding actions of the firm.
2. nme of Value of money : Profit maximization objective falls to consider the time value of
money.
3. Rl•Jr manai11tment : Profit maximization objective does not con5ider the risk and uncertainty
In the business.
• Maximization of profit was considered main objective of the firm till the concept of
sharehold ers wealth maximization came Into being overcome the shortcomings of profit
maximization.
 5 Financial Ma~ ""
•. Financt Management (MU) 4· ~
_._ lders and the objective of corpora te R.. .
• Finance managers are the agenl:ll of the sha,~110 "'Ii"<.
function is to maximize sh1ttholders wealth. Shareholders are ~e owners of the ft.rm h~
us with max1mizatlon of owners' ·
the maximization of shareholders wealth ls synonymo ~~

4.1.2(A) Shareholders' Wealth Maximization

• Shareholders of the firm are interested in maximization of returns on th eir inv ~ nt "1ilQ
ts maximized when the value of the firm is maximiud.
• Value of the firm is sum.of net present value (NPV) of all the cash flows of the firm.
• NPV considers actual cash flows overcoming flaws of accounting treatment. time valUt r.c
money. uncertainty or risk profile of future cash Oows by considering an appropriate ratt O!
discounting.
• All those projects with positive net present value (NPV) ~re considered ror Investment Fina~
manager will prioritize projects that offer the best returns for the acceptable level of risk.
• Objective of shareholders wealth maximization provides a framework for taking decision~
investment. financing or profit dlstrlbutions as finance will choose decisions that ~
the NPV of the finn.
• Most of the large compan.ies are publicly listed and their shares are traded on stock exchl111ts
Hence. for listed companies, shareholders' wealth maximization also means maximi2ationri.
market price of Its shares.

4.1.3 Agency Problems

• In large companies. generally the ownership and management of the company is divorr~
Shareholders own the company and proress1ona1 managers are responsible for running ltf
business and take decisions for the company. .
• Relationship between sbareholdttS and the mangers is that of Agency In which managers a.1
as agents for shareholders with objective or maximizing shareholders' wealth.
• The separation or ownership from management may give rise to situatlonswhere managmef
may act In Its own best lnte1 ests rather than those of the shareholders.
• Managers may prtoritfu to maxtmi-ze their wealth In the form salaries and perks. tat
declsl0t1S that may subonilnat2 shareholders' Interests ln favor of other stakeholders or tl111
altogether avoid every risky project to safeguard their position ~ the company. leading to klll
of potent1al opporwnlaes for th.e company.

• 11iis conflict between the Interests of shareholders and managers ls called as ~1

Pro~ The agency Problem leads to agency costs, which Includes the cost incurred ~
1
monJtonng and controlling actions or managers and possibility of less d'wl optimum shJl'!
price oTthe company.
 4-6 Pln1nctal M.a , emr:nt

• Many «"nr,,.n1e• actve 110 <'1t opUons to the managers to ensure that 1he Interests of
1ha11,holdili'i il\d fl\illait:"5 are aligned, However, rt111 there ~y be l lWatlonr. of ronfllct ln the
1n1,,rewt or nunaawrs and ~ 11rehold•n.

• Shareholder. • 11po lnl dlrtttors o n 1'111, Board of the company. The company's board has a
prllftlll'}' rr11ponsl blllty to keep an ovr n.lghr on the managers' actions, performance,
"'munen111on ere. and guide the management. 54.TUtlny of out.11de analysts or corporate
11ovemanc:e advisory nnnll also help r,dudn,11 lhe r1sk of conftld of Interest betw~n
,h1reh11lden1 • nd managers.

4,1,4 Organization of Plnance Punctlon

• Finance function la vuy cr1tlc.al function for the orpnlz.atlon; In efficient ft1111nclal managem,nt
can abo lead Ill failure o r the companies; Hence, lh, flnance fu nctton directly rt'ports to the
m1Matn1 dlTeCtor or head or the company.
• The eJCecutlve headlr• the nnance function In an orpnlzatlon la known as Chief Finance Officer
,
(CfO) or sometl.mes dlmctor of nnance.
• In larae companies, -CFO wtll delep~ th11 responsibilities to the Finance Controller and
TrM,uN!r. Followlng chart explains the funct1on.s and responslbllltie, of these officers.

aoeNlofDlleotor.

1
Chle!Extcutlve
Ollk:er(CEO)

1
P•n lllolnt
MafM41ng
•
Chi.tFNIIOe
Offlcaf
'
Pr 11:llITTI
o,p..ai:a..
I
1 . 1
Flnaia •
r,__
I
Col•• In

I lllljor
'"' 1111 •
L lllalor Fin aa •
lnlilmalC..tlluls Capil,,! Buctga •.g

, p....,.,_bon of Flnanclal Stalii,....

Prepa,allon dO..-lnclFOl-.1
Tuallon
Caah ~
Blnklng R II I; ahlp
1n-R 1 1,.
AoDounanQ Rllk. Manege,ne,11
Mergers end Acqulalllona

.--..
, ,.........
I
 4. 7
fl nt nc e M111,:;1Mnt (M
U)
•

4 .2 flnanclaf S ta te
m e n ts
l pe rf or m an ce an d fin
--
an ci al positio n of th
f
nt ia l st t~ m t'n ts ar e tJlt' rt t0 rd s o f Rnancla
• Flna
r1od, e de cision maktrs
co mpany In , spedtlc pt In fo rm at io n fo r all th
Y the main soul"t%
of financial , tir
• FtnJnc la l sO ltr mt'n ts ,H
or s, sh ar eh ol de rs . cr ed itors. regulators
r ma11.1Btment ln vtst
anrl art' us td by th
i't lt
d4!p,rtmt'nts etc.
ro tlt & Lo ss ac co un t an d Cash Fl ow ~t t'n
clude Bala nc t Sh te t P
• F1n.1nd al m tr m t'n ts In
a r.
.1nd art' prepartd t'a ch ye st ar ts fr om A pr il OJ to March
31.
an d In In d la
llt>d as fiscal ye ar
• Financial ye ar Is also a fo r th is pe ri od. In In dia.
compan1es
st.at tm en t
to pr tp ar e tlnancial ts every qu a" er.
• Co mpa_nft'S are requ lr td e tln an da J st at em en
angH ar t required to fll
listed on main stock exch
flnenclal St el e ••11•

Profit & Loss CashF1ow

Ballnce St at em en t
St lM t Account

Turnover C uh A ow fr om
>s te ts
~ li n g AciMtles
Lilbil1ties Groaa Profit
C at i Row from
C) pe ,a lln gP ,c fif lnYMting Activities
C ae tlF lo w fro m
Profit Alter Tax Financing Activities

et
4 .2 .1 B a la n ce S h e
rs' eq ui ty at a po int
of
f
B al an ~ sh ee t is a summary st atem en t o as se ts, llabUitles and ow ne
•
time.
.
~ w fth econom k value . _.., an d controlled by th e in d JV . . 'd•· -' or an enorr
• Asset is a re so u owEtn".a"'m . J ... ..,
- to provide fu tu re be ftts
- -pe-..t ed f se ts ar e plm _t an d machinery. ca . sb
a
th t Is ex ne · · pies o as
fixed de po si ts "-Co

J obUption ow ed b th e lndlvfduaJ or an en tit y to external parties su

cb as
• Lu bU tty ls a ftnanda Y
m ts etc.
lo ,n s, credit, ta x pa ym
N a picture of th e fl in t of dm e fo r exam
pk
• BaJan~ sheet provfd ncfal po si tio n at th at po
arch 31 20 20 Will na I st at em en t of asse ts an d llabf
lides on rJiJl
ba la n~ sh ee t as on M provid e
•
day.
 eaiance sbftt of die company provides rollowtng Important t nformallon
L HoW n,udl asMU are owned by the company?
z. HoW ts company nnandng the ass,ru7
Hott ts tM company's liquidity poslllon7
3.
4, w,iac ts die owners' equity In the company?

t.(1 ~Ile 1n !Umpie of baWICf sheet and understand lmporttnt Items of the bat.nu i'heet
,_.., h?t'Ama. wtbtllaLlldl) 31-.....JO It H11 19
Eqalty and UablllUes
Sblrebolcien' Funds
Shan! C.pltal 6,000 6,000
Reserves and Surolus S,875 2.SOO
Total Shareholders' Fullda 11.875 8,500
Nell-Current U.abWISes
Long Tenn Borrowings 2,000 2,000
LonR Tenn Provisions 1.250 1250
Total Noa CUJTe11t llabWdes 3,250 3,250
Cunut Uablltlies
Short Tenn Borrowings ,3,200 3,000
Trade Payables · 2,700 2,500
Shon Term Provisions 1,500 1,250
Total Current IJabUltlel 7,400 6,750
TOTAL 22,SZS 18,500
A 111
NOII-Cu.rTent Assets
Fixed AsSl!U
Tangible Assets 11.000 10,000
lntanmble Assets - -
TotalFIHdA UII 11,000 10,000
Non-Curnnt Investments - -
CauaeatAssell
Inventories 3,000 2,250
T~de R«dv.ables 3,950 3,000
Cash and cash equivalents 4,375 3,000
Odler Current AsSffl 250 250

Total Clarrot As.et1 11.575 8.SOO

TOTAL 22,575 18,500

 r ,nanaatMar,

ft ta -current asse(S, Current assets i1' 11,.

_ ,..,._1 ,,MU and non ~
.Ulft\ l ff c1.uiiAN1 btt<;.ffD .,., . -- nod or I year. NoO-CVJTelltl asseg ~
uwu that an Ille conttr\cd Into c:a1h within • pe \i
conv,rrtl'd IMtl> caJb tu11y.

Cunent 11 I bi kldu•e
• Cuh and cast! """Jvah!nts such a.s fixed deposits. ueasury bills etc.
• Marimal>lt M(llri!les such as ll1ted equity and debt securUles.
• lnwntory wti lch Include raw materual. llnlslled goods etc.
• Debtors which fndude receivables due to sale on credit to customers.
• Other curn,u assets such as tall claims etc.

Non-cu11•1t - - . lndud•
• Fixed assets whkh lndude plant and machinery, building. land. furniture, rT assets etc. f1:ud
asuu haw finite meful life and undergo wear and tear. Hence, the value or fixed asseis b
amortized ower die period or useful llfe of asset by allocating expense each year. Th•• "1P"llfl
Is called as depred.ltlon.
• lnvesonents that cannot be easily liquidated In 1 year or not Intended to be liquidated wtdlbi t
year such as !nvestments in other companies, securities etc.
• Intangible assets such patents, brand, goodwill These typically arise In case or acqtll$ltlons.

Ll ■ HlttJ•

Liabilities are categorized Into current. non-current liabilities and shareholders' funds. Cwffll
liabilities Include the obligations that are due and payable within 1 year. Non-current llabllltie'
lndude obllptlons are payable after 1 year.

itu Mt llabHltlel lndude

• Trade payabtes artstng due to purchases on credit
• Short term borrowl1111$ such as cash credit, overdraft loans repayable In one year etc.
• Other current liabUlties such as provisions for taxes, d!Vidend,s etc.
Non a.r ant llabllltl• Include
• Long term boM"Owtng repayable aftB 1 year.
• Tax llablUtles payable over long tenn also called as det:.........t
IQ I ed tax llabillti
Shareholders• Funds Is owners' capital and i'l!Sen, 1 es.
d
company's operadons. es " surplus ac.cumuJ.atact aw1 • ~ •
 ~ n,,... itqc 31£nt lMV) ♦• l O
F'i!Ulndal M:e:cnt

:i-1 ,,ont • LGII ACCCNnt

,,,..,tll $ Lou a«UUnt t, a n atr:men1 or company's "nandal J)ttfonNnct for a given period.
•
rn,11 , a !Ms account Is .ilso al~ n P & L account a.nd prvvlde,s a summary of the wes.
• ~ ind pro"ta/loss In ach J)'riod of time.

• ™ ptt1od fo r wh1ch P & L 1ta1:e~n1 Is p'"'pared ls ca lled as aa:ounttng perfod. Accounlin1

~ Is ,enenlly a paiod of I year and In India sp,.ins between April 01 to Marth 31.
• Llst'd companies art! requlrt!d to report P & L account '1/ery quarter md file the same with
su,dcexchangell,

• pa L accoont Is prt!pal't!d using 'matchln1 concept'. Matching concept refers t.o the principle of
acrount1ng exJ)enttS against the r'1/enueseamed during that period.
• for eumplr:, eXptenses Incurred for purchase of stoc.ks to be sold next year wlll not be
accounk<l this year but will be accounted In next year's P & L statement.
Ids take an eumple of P & L statement of ABC Pvt. Ltd.
ParUatlan (Amnuut la IL Lakia) 2020 2019

Net Revenue 34,000 29,000

Other Income 2.000 1,800
Total Rnenues 36,000 30,800
Oper.adq Cost
Cost of Materials Consumed 24,500 21,000

Employee Benefit Expense 3,000 2,500

Other Expenses 2,500 2,000

Depreciation and Amorti2atlon Expense 500 450

Profit Before Interest and Tu 5,500 4.850

Finance Costs . 1,000 850

Proftt Before Tu 4,500 4,000 •

Income Tax 1.125 1.000

Proftt After Tu. 3.37S 3.000

Main categories of p & L statement of a company indude :

• Revenues from sale of goods/services also referl't!d to as operating reftllUes.

.r.
. ,.
•
r

.... ,., .. r,offtd frocn ln(l'f"ftl. rent.

~ pie Of ~-.
flnanaaJ

-uipments etc. also called as

~ m-ua. f
--"'"" cost of ,oods sold.
~s~ as
0
• E.cpeiwe 1ncurnd oo consu,np00" ma
• en,p1oytt ..,q,ea.sa fflllftl and actm1 nfstrldon etc..._ value of ftxed assets. ""IPll!III
I
n,orttzadon In u.,e -
• 0 e p ~n on find assetS l"!ftectiDII nd administration and depredation are
lncludtnc wtt of pd, sold. tmploy!ll, IJdlinl a

as Oj>ei allllfl ~ e s .
• lnt:ettsi openn on the borrowlrtp-
• Profit Wore tu.
• Tu npemes.
• Profit after tax.

P1uflt hM following main categorl•

• Grw Pl oftt (GP) : This Is the dlffereno. between sales and cost of goods sold. Cost of
sold Is the material consumed for the goods sold during the period. Material consumed
unsold goods becom<P.S part of Inventory reported In the balance sb~
• Prollt before depredation, Interest ud taxes (PBDIT) : This refers to the
equivalent to mrenues minus all operating expenses after exdudlng de•preclad
Depredation Is excluded as It Is only an allocation of fixed asset cost.
• OperatlDg prollt (PBIT/EBIT) : '"!15 refers to profit/earnings before interest and tax
the difference between revenues and all operating expenses.
• Profit before tu (PBI) : This refers to difference between operating profit and In
expenses and also Includes non-operating Incomes. PBT means the difference between 1
and expenses exdudi.n& taxes. -

• Proftt after tax (PAT): This re~rs to the difference between PBT and taxes.
4.2,3 C■•h Flow Statement

Cash flow statement Is a statement of chaqe In cash

balance sheet date& It summanus th position of the companJ bet\llrlll
e sources and uses of cash I tO th
acdvllles, Investing ac:ttvttles and llnanct . D ree categories Le. ~rll
ng acthotties. Swn of th th dl&ilf
cash position of thr company. Arwysis of • · ree catqories l.s the
cash flow lblt.en,
Importance Insights about the quality of the ent of the compAl!f
a,..pany-, earntnp.
 ..
Le(5 iakr an eumple of cash flow sutemfflt of ABC Pvt Ltd.

tf I 1(Allr llall'Wdi)
c.ti nows from Openid. . ActMttes
zozo 2019

Net Profit before tax 3.375 3,000

Adf"2b&✓at ror
Depredation 500 450

Interest expenses 1,000 850

non-operating Income - -
Operating profit before working capital wnges 4,875 4,300

changes In woddng capital -1.500 -1,300

Net cub flow from operadna lldlvldes 3,3'75 3,000

CUil Flows from IJnestlD&AcdYttles

Pun:base of Pixed Assets -1,000 500
Sale of Filled Assets - -
Non-operating Income - -
Net Cub Flow lllffS1ln& Activities -1,000 500

Cub Flows from Plaanc:1111 Ac:ttvldel

Interest Paid -1,000 -850
Dividend Paid - -
Repa,-nt from Lona Tenn Bom,wing - -
Net cab low from Flulld91A£d,llles -1.000 -850
Net lncrNN/dea NM In c.alll IJld c:asb equJftlentl 1.375 2,650

C... flow h'Offl op arattng actlvttt.

Tbls refers to the sources and uses of cash from operations of the bmlness. In simple words It
Is the difference between cash realved during the period from sales and the cash paymnt made
~ Offfattnc apensa..
 ._ tJ rm;1no 1 1 Ma":f:"'·11i I

• Fl • Me f ,ot lMU) fl after taJ u startl ng point and adjllst!ric

'
1
<>p,rnon, 0t>h now Is calrulaUnl by usln& pro assets and curnnt llabillttes. !Qi
~ IDC\l~n1
noo-opN lflflC tftCOffltft and ~
tc ,, "low,, ... ,w,utt... •cthlltll
m company's Investments. This 1....,
and ~ of cash fro · '"''Udts
Thb ~f,n to th, 50Urttl b lldlnt. equipments, purchu. and ••'- ..
purch&H mcl Ak of llttd ~ JUch as land. u ._ 04
lnvnunenu. lntrtt-SI and dividend income etc-

Ctlh flow fl"Offl "-'"-.dntl -ctlvltlll

h banks financial Institutions, Investors etc. .....
l'l!fers to the sources and um or cas 10
Tbls • , ~Q
t f Interest. payment of dividend, Issuance of new s"•-
lnd ude5 ~ e n t or Ioans, paymen o ·- <1,

Mklluonal borrowing, etc:.

4.3 Flnandal Ratio Analysis

-
• Financial statemmlS of a flnn are analysed by the Internal and external stakeholders Le.
management. lnvestDrs. bankers, suppliers and customers for taking Important decisions. Fer
example, suppliers use them to decide whether to give more credit or reduce the credit to die
company.
• lnves10n may use It to decide on holding on to shares, sell or purchase the shares. Bankers wit
like to decide whether to extend new loans or cap the exposure to the company. Customers wit
like to see If company is capable of lnvestlna required resource to fu1filJ a large project
Management will like to analyse the financial statements to benchmark against com. ·
mcl Identify al'l!as of Improvement. •
• Financial Ratio analysis ls_the study of ratios of the llnanclal parameters of the company. h I
used to understand financials of the company on many parameters as mentioned below
•
1. Uquidity
2. Efficiency
3. Profitability
4. capltal Stru~
5. Valuation or stock market ratios

4.3.1 Uquldlty Ratios

• As the name suggests liquidity ratios are used
Uquldlty ratios helps to undem:a d th to study liquidity position of the ,
n e conipany's abfllty ...,.
obllptlons that are payable within 1 to Ille-et tu CUl'Tfflt Uabllt.....
ynr.
-
• flOID'W 14 f •o.nt (MV) 4- 14 l'ln&ncl.il Managmegt

• L,Cl of adt-qUaU liquidity may '"d to company def:iultlng on Its ~yment obligations.
~ I and trade cndltors can l!>ecome Jittery, stop extending fresh CT'l!dlt or may start
defflladllll e,rfy ~yments of eldst!ng credit. If llquldlty doesn't Improve In time, ll can
_,- In loo or business and can also lead to b.ankruptcy situations In the worst case.

• ExaSS liquidity may not have such negative Impact but can have less than optimum returns.
1'1le n,ost common llquldlty ratios are CWTent ratio and quick ratio.

4 ,3,l(A) current Ratio

• current ratio Is the ratio of t:Wffnt assets to the current llabilltles of the company and
represents company's ability to repay au-rent llabUttles using current assets. Current liabilities
1 re the financial

~= •
obligations that are repayable within one year.

~
•
~• fol de Cumlnt ratio •

• CUITellt assets Include those assets that can be converted Into cash within one year without
•
adversely Impacting value of the assets and lndude stock or raw materials, finished goods,
work in progress. debtors, cash and marketable securities.
• Cumnt ratio of less than 1 Is considered unsatisfactory and Indicate that current assets don't
flllJy cover current liabilities. Current ratio between 1 to z Is considered satlsfaaory, while
more than 2 Indicate company's funds may be locked In unproductive assets. In addition to the
ratio, It Is Important to understand the composition of current assets as It will affect the
company's ability to liquidate them and convert to cash.
• For example, non-moving stocks or debtors appearing In current assets may be very difficult to
convert to cash.

4.3.l(B) Quick Ratio

QuJck ratio also called as add test ratio Is the ratio of liquid assets to the current liabilities
111d used to measure company's ability to service current llabl11tles using liquid assets. While
cakulaunc quick ratio Inventories are subtracted from current assets as early dearance of
lavtntory may lead to loss of value.

I
-----
....
l'.Nu 1 :atl Dfl

fta SI I ■t of A8C Ltd-

. . . . . .(A l
,,. . . 1 , ..,
,1. ....-20 !t•Mar-t;
-
Equity ud UabllldeS
6,000
SllaffllOlder■' Puodt 6,000
Sharr C.pltal S,875 2,500
8,500
-
Reserves and Surplus 11,875
Tolal 511ardlolden' Funds
Noia-Cwrellt uabl)ldes 2,000 2,000
Long Tenn BolT1)WiDgS 1,250 1,.250
Long Term ProYlslons 3,250
3,250
Total Noll eunut llabWdet
Cum!llt IJabllttles 3,000
3,200
Shon Term Borrowtn&S
2,700 2,500
Trade Payables
1,500 1,250
Shon Tenn ProvisiOns
7,400 6,750
Total cun-eat Uabllldes
22,52S 18,500
TOTAL
!trltl
Non-C1u1eut :\■sc'tl
FtxedAssets
Tangible Assets 11,000 10,000
lntan~ble Asseu - -
Tolal F'lxe,l /i• r >s 11,000 10,000
Non-Current Investments
Cl.lftl'f 41 Hts
- -
.
lnv,ntorles
3.000 2,250
Trade Receivables
3,950 3.000
Cash and cash eqw~Jena
4.375 3.000
Other CUTTfflt Assets
250 250 -

....-_
Total Curnat AIIIII
11.575 8,.500 -
TOTAL
22.575
-
 - C11rl'ent ratio ,.
4-16

Cun-em Assets
Current Uabllities
Flnandjl Manqemtnt

11,575
= 7.400 = 1.S&.
Quick ratio ,. Current Assets - Inventory
Current Liabilities
; 11,s1s - 3 1000
7,400 " 1· 16
4,3.2 Efficiency or Activity Ratio•
company Invests funds In creation of Rxed and current assets In th.e normal course of business.
Efficiency or actlvtty ratios are used to study how efficiently a company Is using its assets.
4.3.l(A) Inventory Tumover

lnvmtory turn,;,ver r.ttlo Indicates number times company turns over the Inventory eath yeat
and provides information on how qU'lckly company Is able to sell Its Inventory. For example.
Inventory turnover ratio of 9 Indicates-that the company is able to sell Its Inventory nine times a
year.
Colt of googa sold
I
i,. r:-ula : Inventory tumovet ratio ,. AY9fllge Inventory

The average inventory Is the average of opening and closing Inventory.

We can calculate lnvenrory holding period o( Inventory days by dividing no of days of the y11ar
by Inventory turnover ratio. For example. if a firm has an Inventory turnover ratio of 9, lnven.tory
365
days will be
9 = 40.5 days.

I> Fomiulll : lnvenlOry days• lnwuto,3:!.mover

Average inventory
= 365 " Cost of goods sold
For tht external stakeholders. such as a nalysts cost of goods may not M IVlllable. In :$Uth
cases. they can use sales In place of cost o.f goods sold to c-alrulatl' Inventory turnover ra!lo.

t Fonnuia : Inventory tumOVer ratio • ,.....,.;::.ntory

•=- mtll.me.s an pl:ln- of avt'r.oj,'C. tnv~-ory
... they use closing lnvrntory In lhe d~no minator
Saln
ln11entory rumo11Pr !'ltfo O Inventory
••
• ,..... "' ...= I Ir< rM\IJ u~ 0 rinven
t ory Nmover ratio Is of<:ost """"
a""" "'1e
it., nw>" •Pl" 119,u
. er rJ'f';af d inventory are mentio ned on the rosi hh.
IClndly -.. d.-1 f _.....f,, sold. an • · 1tt
t,odJ dw ('Ol1 0 ~
m ., ,., • ""'"'ttlf'Y ., cu mover ra no 7
f 11,vrrtio ry
Wlut b tbr , ppnlilf'laU vatue o . ( op,eratlons .ind Inventory rurnm-er
O
n tt,e lnduslt}' 0
. r-.u.
, ......, w m<J\·t·r nttlo d#pends d other nrms In the Industry. Fun~ L
Iftft D-·, tiOS ID past an '~
"' campmy nnds 10 M compMNI wltb ra . Is calculated as .iverage o( monthly dn... .
...... ltl'YenlOl'Y ·~
Rrm• bavin( hlidi s:nsooallty, 1<tt• -,,-
_.- -• seasonalll!)',
lnwntoiy 10 - ' > oul the ..,, .,..."'

Cost of g~ sold
l~ntory tufflOffl' nl'lo • Average Inventory
24,SOO • 9 .3 3
" ( (3000 ; 2250} )

365 =1.§. = 39.12 days

ln'l'l!ntory days = Inventory trunover ratio 9.33

~ cost of sales Is not available, sales can be used In place of cost of sales.

4.3.2(■) Debtors Turnover

• Ddlton represent the amount receivables by flnn from Its customers. A firm sells Its goods•
cash or credit Debtors turnover ntlo provides a measure of number of times debton •
tumover rach yrar and Is used to calculate efficiency of the collectlon of receivables. It is
calculated as follows:

]
where

Average debtors Is the average of opening and dosing debtnrs.

• Debtor Days or Collection period lndJ t
remain outstanding or th · ca es •n average number of days for which dtt,rlid
10 o eT words ave~r numbe of d cfll/J
I
_>
cash from thr debtors. Debtor days
.
FGl'IMII :Dlbtor dly.(c:F
r
Or average collect10

•••petlod)• . 366
n pe
ays
riod
·
taken by the company to
Is calculated iS belo'llo~
J
Debbi lumowr .
• Effecttvmcss or com~ny s tftcllt policy ind
comparing debtor days With com ti . ffllclenl-y or collections can be as:sesstd tf
pr ton and wilt, .
t'XlmpIt. If a company has policy to the compa.ny's own credit pallet
I 30 rxtrlld lO da .J
c - to • thrn the collection OJ)entl ys Ctedit and the ave.-. col}erUoel prnc>"
ons art said to be d!lcifl!t
 -
Jilt ~ Ml":'£fflfflt (MU)
., - • •
4• 18
Flr>ondal Ma::r::n,1

• If Ille eo/ltctlan ~Mod much hlglwu romp.,rtd to JO. It!'< say 45 cl.a}'$, then company's
ron,ctton ellk1ency Is low. It • lso means company's custo!IK'rs orr not very credit worthy and
~ needed to !Mo watdltd ca rdldly,

Sales 34,000 34,000

l)d)b>"' wmover nallo • Awra1e Debtors =
( (3950; 3000)) = 3475 • 9.7s

360
l)eb1Drclays" Debtors turnover ratio =m
365
•37.32 days
4,3.2(C) Ageing Schedule
This rtfBS 10 the analysis of debtors based on number of days for which they are outstanding.
In this. ou1;Standl111 debtors are cate1orlzed as per the ageing of receivables I.e. number of days
,tntt when they are outstanding. Ageing analysis provides a picture of slow•movl"ll debton.

..... (ao. of days) OubtandlJla Amoullt (II.) PeruatapofTotal Debbi.a

0-30 S0,00,000 50.0%

31-60 22,50,000 22.5%

61-90 22,S0,000 22.S%

More than 90 days 5,00,000 5.0%

TOllll 100,00,000 100.~

4.3,2(D) Asset Turnover Ratio

It Ille measure used to calculate the effldency of total assets of the company. It is the ratio of
Jiles ro total assets. Higher the ratio better Is the efficiency of the assets.

f ForaM.- '. AIMIi IUfflCW8I' rallo • Ave,aoe ~ 111• 1

OR
I
Soml'flmes. analysts use SalesfTo!lll Assets to calculate anet t11movfl' rado

EFOffllull : Flud 111111 lumo..., tS11o • A - . ,:Z:, .♦ 11

I
01!
SomttJmes. analysts USf Sales/Flud AsSt1S to e2tcubt.f ftud Wft tumaVf'J' ratio
 Fl nandal Ma
4-19
Flmtntt Jib 1 MV

l!hmntklft 340000 - 34000 - 1 66

~ N rnover ratio s ( fZZ57S ; t8S00}) - 20S37 - .

4.3.3 Pt ontabtllty Ratio

In th!l' profit me:! IOS5 siatement, we have seen different types of profit me.asures such ~
profit. PBDIT. o~n tlng profit. PDT etc. While these profit measur es provide absolute ~ ut
profits. ·t hey don't provide us the Information about the efficiency of company's opera~
Profttablliry ratios help in measurement of the efficiency.

4.3.3( A) Gross Profit Margin

It Is t:he ratio of gross profit to the sales of the company and is expressed i.n percentage~
It is the amount or gross profit earned by the company for each. Rs.100 sales .
Ciross Profit Margin = Sales - Cost of goods sold
Sales
Ciross Profit
" Sales

4.3.3(B) Operating Pruftt Margin

It is the ratio of operating profit to the sales of the company. It Is the amou.n t of operating pnft
earned by the company for each Rs.JOO sales..

Operating Profit Margin = Sales - Operating expenses

Sales
= Operating Profit
Sales
4.3..3 (C) PBDIT/EBITOA Margin

It Is the rat!~ or profit before intenst d .

ep!"fflatlon and tax th
~ u n i o( operarlng profit earned b th to e sales of th e comp,ny. It IS
Y e com;pany for each Rs. I 00 sales.
OJ>f rating Profit Margin ,, PBDIT
Sales
c Sales - OperatJ
ng ,x-~nses • DeprKtatloll
Sa les
 I

.,. J(
O) Net P10AI Matgin

··-
-,-6
..... n tllll ,al pn>ftl af\ff tanO im gift
II ...,_ rhc ln.foffll.ltlon

...,oo ~
1H
ot \tx comj),lnJ ,nd 11 nprcstcd In ~
th~ amount of ~ pn,Ac nl'Md by the oomp;lny for each
tage

Profit a~r aa
Nl!'I Profit Ma~n • Sain

pa,tkWk~ (A._mt la lb. Laldt) zoie

Nl!'I R.-venur 34.000
Other income 2.000
Total Revenues (,\) 36,000
Operadq Cost
Cost of goodssold (B) 24.500
Gross prvftt (q • (A-B) 11,SOO
Gl"OI$ prvftt margin (q/(A) . 31.94,.
Employee Benefit Expense(D) 3.000
Other Expenses (E) 2,500
PBDIT/EBITDA (G) • C-D•E 6.000
EBITDA IDlll'pD (G)/(A) 16.67'Mi
Depreciation and Amortization Expense (F} S00
EBIT (H) • (C· D•E·F) s.soo
EBIT Ma.rgt• (H)/(A) 15.28%
Finance Costs (I) 1,000
Proftt Before Tax O) 4,500
Income Tax 1,125
Profit After Tu (K) 3.37S
Net profit maf'lln (K)/(A) 9.38%
4.l.4 Capital Structure Ratios

tile!Capit:;iJ Sfructure of a company Is the composldon of total c.apltal of lht comr,;,r,y oet\\-eef'I dl'c:
prov:lllty. lkbt to equlry ratio and total debt ratios are commonly u~Ml '"•' r r ,, •!:1tct<~-~ .l r
~ Ill the ln fonnatlon h.ow ls company flnandng the u ~.
 ♦-21
• "In _,1 (MU)

4.J.4(A) D•bt 1111ultY RatfO

Total dl'bt
• Tota! l'qulty

4.3.4(9) Total Debt Ratio

Toal debt Total Debt
= Total C.ipital = Total Debt+ Total Equity
Low debt to equJty rado or lower debt ratl.o means that the company Is financing Its bus1.._
u.slr11 own source.. As company doeS not have to make any ftXed payments to equity slureholdtri.
It Is less rlsky s,oura or runding. Hence. companies with low levels of assets and operad~ It
competitive or unce11ain business environment will choose to llnance their assets using ~
than debt Companies having large asset base and having predictable cash Oows will choose hJllilr
levl'I or drbt l\na,ncing. Ulitlty companies, power generation companies, raw material etc. Ille dil.
as nwn source or f'undlng: Debt 1s called leverage and companle$ having higher debt are lel'ffilll•
leveraged com_P&Dles.

4.3.5 Retum Ratloa

Return r.atio are used ta calculate the efficiency of the company's investments. Analysa
compan! the return ratios of dlffen!nt companies to compare efficiencies and company', haNt
higher retum ratios generally command higher market value.

4.3.S(A) Return on Equity (ROE)

It ls the ratio, of profit after taxto the average equity and Is expressed In percentage teia t
shows bow much return company Is earning on the shareb.olders equity.
Return 00 equity (ROE} • Pro~t after tax
Average equity 0 R

Someomes. Return 00 equity • Profit after tax

Shareholders' equity

4.3.S(B) Retum on lnve ·cni.6nt (ROI)

It Is the ratio of earnings before Interest and taxes and average of total assets. It snows.-
m.u ch mum company can generate on total assets.

Return on Investment (ROI) = £BIT

Average total useu
where. EBIT Is earnings before lntenst and tu
OR

Sometlrnfl. Return on Investment (ROI) • £BIT

Tot.ii U1«1
 4-22

--~btlo
..-.■IM'I

u1fr lO Baunc.r sti~ of ABC Ltd for 2020.

Total Debt • Short term debt• Long term debt

• 2.000 • a.200.. s.200
Total liqulty ., t 1.875.

1~~5., o.s4.
Debt to equity ratio ,. 5
1

,.s.6 Stuck Market Ratfoa (Valuation Ratios)

Stock market ratios are used to calculate the valuation of the company's shares ustng certain
l,eftellmar1c ftnancial parameter. Analysts, Investors use these ratios to compare with other
companies in the Industry or With the historical valuation of the company.
,.J.6(A) Price to Eamlngs Ratio (P/E Ratio)
lbls is the ratio of rnarlcet, price of share to the urnings per share of the company. Earnings
Jiff share Is the net profit of the company divided by total number of shares.
P " Share prtce
E Earnings per share

4.3.6(8) Price to Book Ratio (P/B Ratio)

lbls Is the ratio of market prtce of share to the book value per share of the company. Boole
value per share Is shareholders' equity of the company divided by the total number of shares.
P Share price
e ratio := Book value per share

4.3.6(C) Price to Sales (P/5 Ratio)

• This Is the ratio of market price of share to the sales per share of the company. Book value per
sbre is total sales of the company dlYided by the total number of shares.
p Share price
Srado = Sales per share
• Lower lhe value of these ratios msns that the share P~ Is trading comparatively dleaper
COtnPiffi! to the denominator value, which may ..i-lfy
a'6'•
that the share pricn may be .tbactl..e
II> buy.

' S10cJc lllarke{ ratios QJI be calculated bodl on historical and foreasted bub. In C3W o( die
ha . martcet price wt.di dlf hi.stortcal ftnandab of the
lor1c.a! basis, analysts com~ a1ffl!l'lt
Qlia,Jlitny.
 A B
Car; •Y 250 350
Shat~ prk e ( P) 150
100
Sales per shart' (S)
(ToUI s,les(No. of share-s l
2s 40
E&mlngs per share (E)
(Net Profit/No. of sh~)
125 200
Book value per sha!1! (B)
(Shareholders· equity/No. of shares)
10 8.75
P/E
2 1.75
P/B
2.5 2.33
P/S

4.3.7 use of Ratio Analysis

Ratio anatYf!s is very useful tool for investors, management. lenders etc. It h.elp$" In followbl
manners.
L Tl"endi ualysls : Financial ratio analysis h~lps to compare current performance of comp,DY
with past petforman~ and helps In study of different trends. For example, a company seUin11 5
different producU. compare gross profit margins of these product with each other and alSO
with their historical performance and form opinion on trends on d emand. cornped1i"
scenario etc.
z. Beadlmarldns wttb competition : Performance of one company can be benchmarked ~
other companies In Industry by comparing the ratios• However, t ls Important to con#
I
companies of similar size for more useful comparison.
3. Areu of lmproweweat : SW<!y of Hna.nct;g ratios . h . . f'f» ,I
Improvement tin elp 11\ana.g emenl Identify •

4. Dedsloll making : Study of lln.mdal ratios ca h ~

on fuwre expansion contraction sal n e1P manag~me nt to take 1mport:.1n1 dfC1 .,
· , e or pu rch.ue of ~"
llnandal ratio analysis, to decide on invesnn . unlts etc. lnvt-.st.ors a 111 use
er:n or sale of stcuritles of a comJ)atlY•
 ••• nn.ano.., Ma..-,;:Jteiil

.a.J.I Umftations of Riiltlo A_natyals

~ o .,._.,~u• ' ''l,(-01 an tmpor\.llnt 1'>nl for atulyn, • romp;tnJI'• p.-rfonnanc, HOWf'YC'r. It
.-,id n<>C b<' u,.-d '" t1'r only •o•ir~, lot 1tulyn1. at n biH llmiUtlOIU and that M<ed 10
,r,id-.~nc1 l>t'fnr~ lwl«I~ compitny·, l>t"rfonnan~ bu1'd on t~ nttlo atulysb . lmpon..int
i.,,,..ut\O'I' uf nuo an.aly.o a~ .u b<!lnw

1. 1t11tor1c•I lnfonnaUon : luuo ilnalysh. I~ bilsl!d on hbtnriClll Onancul lnfomutlon. For ma1or
,w, ho lden such as lnYfi"ton. lenders rt<.- future ~ formancr o( the company Is more
r\'ltrvant perfn rman«. Company·s fut un, Onancial results may not be 1n line With the past
performance

z. Ed--1 facton : Comp.iny's Onand;il perform,, nu dep~nd on t~ external ~nvironment

such as competition. regulatory changes. global recession etc. Rado analysis does not consider
the Impact.of th61!' f.tctors.

3. 0pendonal changes : R.ltlo analysis does: not l'actor lmpaci or Internal changes or the
company. For example. new product launch, a ppolnonent of new managem1mt etc.
♦• Oianges In accounting policy : Companies can change accounting policy and procedures. In
such caRs, reported financial n umbers for that pet1od may not be comparable with financial
results of the past. Hence, comparison of financial ratios for two pet1ods will become d lffenmt.
Further. a_ccounting policies of two companies may be different. making the comparison
between the two difficult. Analysts are expected to adjust the reported numbers while
calculating the ratios and comparing the ratios.
S. N•n!pu.Jadon of ftnaudaJ statements : Financial statements or companies are required to be
audltitd by the chartered accountants. However, chartered accountants rt'ly on the financial
infonnation provided to them by the management. In fact, preparation of financial statements
many times Involve Interpretation of accounting standards and an element or judgment.
Management can interpret such policies as per their convenience. For eumple. In some cases,
large number of debtors may be not being recoverable and need to be accounted as loss, but
management may certify that these amounts are recoverable. In such cases. llnancul
statements a nd the ratio analysis may not provide true and fair picture or the com~ny's

~rformance.
6. Season.allty : Large number oJ businesses are dependent of seasonal changes In demand and
supply. In such cases ~rformance o r company In accounting period can be subnanmlly
d.l fft~nt 'rrom performance ,n other l!Ccounting period. AnaJys.u nttd to c.oMld er me clfect of
k.so!Wlty whale using ratio analysts.
 ..
,a
. . fU IJl l#I ,.. .,• .., ,,
, .
..,.,.o,,, ,al o..

..... :
erou profit IMl'Jin •
(Salt'.S _~ of mods sold)
Sales
(SS,00,000 - ♦0,00,000) • 27 .2 "
• 55,00,000
Sales ,. 55.00.000 • 11 tim es
s .oo.000
lllffnll)f}' lllm oY ~ • 1nvento1Y
Setr ss,00,000 • •.22
AsMt tum ov ~ • Totll assets• 40,00,000

Ra .55 ,00 ,00 0, t o t a l ~ • equity of Ra.20,00,00 0•

la ."' -2 ; A .:0 1.- ,Y Im l0lal .
. . of
_
Th . oo,11p1 11y Ill a 50 .00 0 lh lrN outltandlng and h'l8lket price pe r.,
p,t1ftt _, ., IIJ I d Ra.5.00,0 00.
am in gl ratio, price ID book rat
io.
• Al,7', CIiio I 11 IW lffl on 9CPIY , pri ct ID

Soln. :
Rf fllm OD eq uit y • Ne t pront
Shareholders' eq uit y
5100.000 25"
= 20,00.000 •
t pr oft t
£amine per stwe • No. of shNe
ares ou tst an din g
s.00.000 ·
.. 50,000 • 10
! nU o " Price per sh are
E EamJncs Pf f sh are
75
= io•1.S
D-. .1. __ ,
Net __ _,_
... ,,w or ~ e n• !9!!!
tr
v ...11e p« sb ar e •
No. of Ibara outmndlna
-

= 20.00,000
so.ooo • 40.
p Price per share 75
•
8raao Book Y.lllue ~ ~ • 40 • t.87
 f_ ,-,,,• M•"'"c nr ( MUJ 4 Z!> Pl.r,.v,naJ Manarrmo,nt

- ..,., , Fd/04- '9 a N e "1110CS 01 - 1>$11 10e . , _ s..,,..,,,., El9e,nc ■rd Samara E:lll<)v,cC IIIO M"'
f$.
~
rrr'.
~s--
,_,. io, t,oe, oo,1 c,e: s M e n d ~ wt-=t,
OJ"""' ta,DO
.... ~
.. •
....... , . . , , l..lfl iOwlllf' ,.ti()

75.00.000
na5 -

e.c E1 bk. I
ne1 pro1.1 m■,,;,rw return on equity.

t••ElacA:llc
90,00,000
WlloLl Mr

'~Net ""oil 7,50,000 0,90.000

~ - 75 ,00.000 1,00.00.000

-°"""'..-,,
, 0.00.000
20,00,000
40 ,00,000
28 .00.000
o,,t,40'1 15,00,000 15,00,000
; Cd/I ond marl<elable MCUrities 15,00,000 7,00.000
eu,,ent lla'Jllil• 30.00.000 -40.00.000
cu,,.,,. ralio 1-33 LOO SumilOmO

I ,.-,.tlo 4.50 3 .57 Swuitomo

Net ma.min 10% 11% Samara
ROE 10% 9.9% SumllomO

Current assets
L Curttnt rad0 c Current liabilities
= 40.00.000 _ 133
Sumitomo Electnc current r atio 30.00,000 - .
_ 40.00.000 00
Samara Electtic current ratio - · 40,00,000 " 1•
Sales
2. ln'ttntory rumover ratio " Inventories
90.00,000
Sumitomo Inventory turnover ratio " 20,00,000 "' 4.50
-- 1,00,00,000 _ 3 57
Samara Inventory turnover ratio 28,00,000 - '

3. Net prollt ..
_,....i N'et proOt
,_ a-n '" Sales
7
,so,ooo • 10%
Sunutomo Electric net profit margin • 75,00.000
9 901000
Senara Electric net profit margin " 90,00,000
' = 11'1&

4. Rtnirn Net pr9flt

• on equity " Shareholders equity
71SO,oOO ., !0%
Sumitomo Electric ROE c 75,00,000

9.90,000 ,. 9.904141
.. Sa1N111 Electr1c ROE " 1.00.00.000
 Whll are ll'le main fun.liCl,nslllllllml of a finance ,nanaget?
Why • ahlllhofdera' _ , . m■Jlimldlk>n objd'l8 being beHBr than profit ~
otjlCINe?
0.3 wt1at 11 , . ager,er PftJblern and wtar do8S is 1nse?
Whal .,. lhe rrillgllf'D 1D IIIIOlvei agency Prot,1ems·?,
a. e
Q. 5 How don,ratio ltlaly8ls ,help ii filanciaJ anal,ail?
1

CJ.I Whit ara lhl, ratlol ·to measure riquklly of the firm?
Whit ara Iha KtMIY radoe~ how doN current 81981B, IUmovet' ratio. fixed ·•1881 1umove, _
Q.1 ~? . ~

Whit are lhB .limilaliona of rdo analysis?

..
 ~

• •

Capital Budgeting
- . -it
!
-
,-J_:: M . nd - - - - - - - - - - - - - · - - -
/ c,pltll 9...,,..•.ng : eantng a Importance of Capital Budgeting, Inputs for Capi'tal Budgeting
oecisions; investment Appraisal Critenon-Accounting Rate of Return. Payback Period, Discounted
I p-ayt,,ck Period. Net Present Value (NPV), Profitabilrty Index, lnte~I Rate of Return (IRR), ,and
r.40difif<l Internal Rate of Return (MlRR.)

Long term investment decisions are probably the most critical of the corporate finance decisions
as tbtY have the potential to shape the future of the business. Investment in new technology at the
right rtme or a wrong acquisition can make or break a company's fortunes. In this chapter we
understand how to evaluate the long· term capital decisions.

L,elffllnt Objecth,. .

1
Capitil Budgeting- Meaning, Importance, type of projects
,
• lnvestml!Dt Decision criteria - capital budgeting appraisal tech niques

s.1 capital Budgeting Decisions

• The investment decision Involves decision to invest funds in creation of long term and short-
term assets (current assets). Among the two type of assets decisions on investment in long
term assets are more critical a~ they typically involve large sums of money and provide retu rns
over a longer period. Examples of long-term investments a re purchase of equipment. land.
building. acquisition, joint venture. divestment etc. The lon g-term investment decisions are
called as capital budgeting decisions. The investment decision In short term assets Is called as
working ,capital decisions.
• The primary objective of any flnn is to maximize shareholders' wealth. Hence. finance manager
nttds to assess multiple proposals before finalizing projects for investment Capital budgeting
LS the process of capital allocation and refers to the decisions on the investment In long term

usets and proje<.."t.S of the company.

 1
~•!~~~~~:.l::::!:::!~~l...---..i
,ii Flnanot Management (MU) s~z------------•ea
· - p.,.1:a..,elld
; ,::&ttt...
~

• Cat>ltal budgeting process Involves

1. ldcntlflcatlon oflnvestn1ent projects.

2. Evaluation o( Invescment proposal

3. Selection of Investment proposals
4. Preparation of capital budget and implementation
S. Performance review of the Investment projects.
s requirement of Investment. es timated cash flaws ...
• Capital budgeting uses Inputs su ch a , "-'ti!
period of cash flows, projected financia ls, e,cpected rate of return etc. to evaluate va~
Investment proposals.

s.1.1 Importance of Capital Budgeting

Capital budgeting differs from current eKpendJture and has following characteristics winQ
make them most Important Investment decisions for a company.
1. Capital budgeting decisions involve outlay oflarge Investment amounts.
2. It helps to control costs of the projects by optimizing expenses.
3. Capital budgeting decisions ha·ve long term impact on the performance of the company.
4. Capital budgeting decisions are generally irreversible in nature.
5. Capital budgeting decision Involve an element of uncertainty or risk.
6. Capital budgeting decisions are critical for shareholder wealth maximization.
7. It involves reVlew of the performance of projects and feedback.

s.1.2 Types of Investrnent Projects

Investment projects can be classified into following 3 types based on their dependence on ead
other.
Independent Projects
These projects are not related to each other and decision of selection of tile projects can bl
done independent of another. A firm if deems fit can choose or reject all the independent pro;era
based on the investment appraisal.
Mutually exd...,ve projects

Thtse are mutually exclusive projects, which means that when a company chooses one proit'!I
other projects automatlcaUy get rejected. Examples of mutually exclusive projeru ar,e selecrior. C:
semi-automatic or fuJty automatic manufacturin,g set up, in house manufacturing or ou tsoumns-
 -
c o,ttP s,r1o bl"Y proj ects
~-.-.n mt'5 cwo proJects unde r tvalu a on ar, co mp1ementary to t-ach other. meant ng srlec tion
:,on, .-
ol ~ project reqlli res selection of anot her prote ct

Appraisal - Capital Budgeting Techniques

--
5.2 inv est

fnVP~"
me nt

e =
·s d L-fore finallzat1on using capital budge ting
.......,..ent proposals are carefully appra 1
tt(bo\ques. Most comm only used capital budg eting techniques are
as mentioned below .

,\cC'Ounting Rate of Retur n (ARR )

t.
Z. payback Period (PB)
3. t,iet Present Value Method ( NPV)
al Rate of Return (IRR)
4_ Intern
s. Modified lnternaJ Rate of Return (MI RR)
6. Profit1biUty Index (PB)
n (ARR ). cash fl ows and not
In all the above methodologies. except for Acco unting Rate of Retur
tilt accounting profi ts/los ses are coraJdered as basis to calcu
late retur ns and inves tmen t in the

proj«tS-
s.2.1 Accounting Rat e of Ret urn (ARR)
Accounting Rate of Return (ARR) is also called as Average rate of
return measures prolitabiJlty
of the Investment using financial accounting informatio n. Accou
nting rate of retur n Is the ratio of
ge investment The average
average annual profit after tax for the projected period to the avera
t a nd vaJue at the end of the life
ID¥eStmellt Is calculated by taking an average of in.ltial Investmen
of the project. At the end of project life. the value of investmen
t may be fulfy depreciated. or it may
SOlff salvage val~.
Average net profit
ARR = Average investtnent
T otal net profit for the life of the proje ct
.. Avenge net proftt = No. of years
1
Av ~ lnv~ ent = 2 (lnJd .l lnvestrMnt + Salvage value)
Is also added,
Some times in the calcufadon of a~ra ge Investment working capital

Ar CIp la.te e Rule

um hurdJe rate decided
• In this method. all protects having an ARR higher than minim
r n ~ l ' l l t are accepted.
acceptNi.
• In case of mutually exclusive projects, one haVI ng highest ARR is
 • ht 1d fl ( 1• "111n14r ;m
rn1 \M IIJ

X
1 y
7
Nf'I P ro ft t J ,5 0 0
4,00 0
\'e .1r I 4,5 0 0
r; 0 0 0
YeJr Z 5,5 0 0
6. 0 0 0 .__,
Y r; ir 3 6, 5 00

__ _'._: _ ____,r
I _
"" Jr "
- 0 00 - - - , - -
l.!1.. 000
20000
--i
Toud
S a w q e Va fof'

• · ., 5 ,5 00
• (4
00t1 • 5 011() ◄• 6 0 0 0
fu r
A v e ~ ,. Ner pr of it
bSOO) • S.OOO
{JSOO • 4500 4.. 5 5 0 0 •
fo r ' "
A v r~ e N tr profit
0 • 5000 ) • l i ·~
ID \lt•. st ~ n l fo r
K • ( 5000 z
" "'"l"llRf'
2 soo
rn r fo r l . r ( 400(,0z• 50 0 0 ) • 1
AVf'r.JRe fn vu rm

S, 50() l~
ARR fa t >. • l: '.S OO •

AAR fur so0o • ," •"?.,.

r ~z.5,:.00
e.t

t
er IRR ro m ~ t o pr oj t'C
P ro 1 «1 Y h .u h igh
a
N ., ft a e n d Danea, tt
M .. fb
Uy • \ 'a .ll Jb lt '
ll<X'Oununa , ~ l..D )t j, l) M t rn d
~ b y .i.n.tl ~
hod ai. It
J Ir I) V f'f )• u m ~ mrt
r. , p ro fl ,~ tJlfV 1h 41 u
)O ra tt , ar ro u n n
l AR R l nt "O IJ
 -
-

2.
finance Management (MU)

It does not consider time value of money.

S-S

J. It doesn't provide the value added to the shareholders.

Capital Budgeting

oes not take into account the risk profiles of di"

~. It d uerent projects.
_ • payback Period
522
payback period Is th e amount of time taken by the firm to recover the investment in the
proleet It is generally expressed in number of years. In other words, it is the time taken by the
firm to achieve breakeven.
Methodology for using payback period as mentioned below

1. Calculate the cash inflows and outflows for each period

z. Calculate cumulative cash flow at the end of each period
3, calculate the point of time In year at which the cumulative cash flows equal zero.

1uuttratlon
Afinn decides to invest Rs.5 Cr In setting up of garment manufacturing plant. It Is expected to
take 1 year to set up the plant and st.lrt the production. Cash flows after the start of production
are as mentioned in the below table. What is the payback period?
Cfo =- 500 Lakh ; CF1 = 100 Laich, CF2 =175 Lakh, CF 3 =225 Lakh, CF 4= 225 Lakh,
CF5 = 1SO Lakh
Cumulative cash flows at the end of each year.

Table 5.2.2

Year Cash Flow CWRulatlve cash Flow

0 - 500 - 500
1 100 -400
2 175 -225
f
•
3 225 0
From the Table 5.2.2. we understand that cumulative cash flows become zero at the end of
year 3. Hence, payback period is 3 years.

Ar-eepta,.ce Rule for Payback Period

f • Management can decide on maximum payback penod for accepting any investment projects..
f All projects having paybac k period less than the threshold payback period are accepted.
• In cue of mutually exclusive projects, project.S with lowest payback period Is chosen.
.,t
 vestment proJectS·
I
l. It 15 very simple technique to select n ·d ncertainty associated with proj
2. Ir focuses on near term returns, thus avo• u ects With , •
payt,,<k .,rt..,_ th
I
3. It may be easter to obtain funding for proJectS wi lower payback period.

Demerits
1. It ignores cash flows after the payback•period,
2. It Ignores the time value of money.
3. It igno~s the risk element In the proJectS,
4. It Is not consistent with the shareholder value maximization, as projects baVing
paybad< period .,. n,j,ct,d dosplte higher cash tlowS over longer period. ..

5.2.3 Dlsc:Ounted Payback Period ~

In the discounted payback period method, simple cash flows are substituted by d'ISC~
cash flows to account for time value of money. lo this method all the cash flows Involving . 11
projo<t .,. dis<owltod "'"" an appropriate discount rate. which Is typically the • - '
of aipflal or rat,of""""' expect,d m>m a project havfnf equivalent risk. ~•

JUU9tntion
In the above example, let's assume the firm has required rate of return of 10%.
T.W.5.2.J

·tear
'
1,-~,_., ,~,:.rc+tiow
•.

;, ..
. '
0
(1+08
Oai+■lfl:idW «QVNIIIN
. CllllaRow
-500 - 500 -500
0
'1 100 91 -409
2 175 145 -264
3 225 169 -95
4 22S 154
From the Table 5.2.3, we understand
year 3 and 4. The payback period for die that cumulative cash Bows become ffl'O ~1
cumulattvecasb flows equal-CJS Laich. project falls between year 3 and 4. At the end of)d

No. of years requJred for ~overy of Rs. 95 Lakh -- 154

95 .. 0.62.

"""'baCk period : 3 + 0.62 : 3.62 yean.

Discounted .-~
 .,,.t
Capital Budptlng
,C ..., end Duff"ii• lta of ualng ~ Paybed( Pertucs
L

..... ...,.,,.es on near term returns. thus avoid un

1. If ""'--- ceruJnty associated with projects with longer
p,yt,ack period.
Z. [)iscounted payback period takes Into consideration time value of money.

.,.... ~
I ,. It ianores cash flows after the payback period.

Z. It Involves estimation of additional variable I.e. discounting rate.

1 It Is not consistent with the shareholder valu_e maximization, as projects having longer
payback period are rejected despite higher cash flows over longer period.
S,2.4 Net Pruent Value Method {NPV)
I'

Net present value or NPV ls the sum or present value of all current and future cash flows. In
this method, NPV for each investment project is calculated. Projects having positive NPV are
·apectec1 to enhance shareholders value and can be selected for Investment. If the Hrm must
dM)OSe between mutually exclusive projects, then the project having a maximum NPV is selected.

1111111 to calculata NPV

L Calculate the opportunity cost of capital depending on the risk of the project.
z. Calculate net cash flows ln each period. All cash outflows carry negative sign.· while cash
Inflows have positive sign.
3. Calculate present value by discounting the cash flows.
4. Calculate sum of present values of cash flows.

Whe~.
CF • Net Indicates cash flows In each period
I • Discounting rate
n- No or years
PVJF • Prnent value Interest factor
JU, lbatto..
In the abow example lnvolvtna Rs.5 Cr investment let's calculate the NPV of project.
 11
'ln:!;"!!;n~ce~M'll~.:na:l§l:Ct!:;m:!c:nt~(~~~•u~)~---.;5~-~8- - - - - - - - - - - -•Ca•1•';:a~I8~u~dlt~11e
!•t.~f~
100 175 225 225 ISO ~
NPV = -soo •uo• c1.1012 • c1.1op . . c1.1 01◄ • ~
= -500+91 + 145+ 169 +154+ 93
: 152
The NPV of the above project Is Rs. l 52 Lakh and can be considered for Investment

Acceptance Rule

1. Projects having positive NPV are acce.pted for investment.

2. In ca.~t of mutually exclusive projects, the project with highest NPV is chosen.

Mertta and Demerits of using NPV method

Merits
1. NPV method provides the absolute value added to the firm by choosing an investment projen
2. NPV method considers time value of money and risk of investment.
3_ NPV method considers the cash flows over tile complete life of the project
4. NPV method provides unambiguous method.ology for selection of projects.

Deme.lta

1. NPV cakulatlon can vary subst.intially depending on the assumption of discount rate.
2. NPV method considers same discount rate for cash flows In near and longer future of th,
pro1ect. which may have different levels of risk.
3. NPV method Is n ot very useful for selKtlng among projects having materially d!IIerem
lnvestmt-nt rt'Q\)lrement.

5.2.5 Internal Rate of Return (IRR)

Internal ratt' of return Is th, rate of return received by the company by Investing in the project
It is the discount rate fur which NPV of the project becomes zero. Internal rate of return Is alsc
termed as IRR. for decision mak:lng purpose. IRR of the project is cakulated and compared with
the required rate of mum. AJI projects having an IRR more than the requl.red rate of return are
consldt>red for investment If a fl.rm has to choose between mutually exclusive projects, proJta
ha\'ing the highest !RR ls selected.

5tepa to c:ak:ut■t. IRR

1. Calculate me Initiate Investment outflow.
2. Calculate net rash flows In eacb ~riod. Cash outflows carry negative sign, wh'lle cash lnOoWS
ha\•e positive sl.gn
3 Calcu~lt' the discountf'd cash nows using IRR as discounting as rate.
4. Solve the equation for IRR fo r which NPV Is :zero
 - 0 ..

CFn ::

" CF 1
forffiUla : CFo • ;, (1 + IAR)1

111.,_,,.tton
In the above example Involving Rs.S Cr Investment

S00 = t OO 175 225 225 150

(l+IRR ) + (l+ IRR)i + ( l +IRR) 1 +- (l+I RR) 4 • (1 +1RR) 5

Solving above example using e.xcel form ula provides us the value of IRR as 20.3%.

~ n e e Rule
• Management will decide a cut-off or hurdle ra te for acceptance of projects. All projects having
IRRgreater than the hu rdle rate are accepted.
• In case of mutually exduslve projects. investment p roject having highest !RR ls chosen.
MerltS and Demerits of using IRR method

Meritl
\ 1. Investors can compare IRR with the required rate of return and take decision on the selection
of projects.
z. IRR measure can be used to compare projects having different Investment requirements.
oemertts
1. Selection of projects based on IRR method does not consider the overall vaJue added to the
firm.
2. !RR assumes that all future cash flows are reinvested at the IRR.
1 3. IRR can be used only when there is requirement of initial Investment involving cash outflow at
initial period. For the projects involving multiple net cash outflows. the IRR formula can
provide more than one value. In such cases, use of IRR b!comes confusing.

5.2.6 NPV Profile

• NP.V method and IRR method generally provides same results while selecting conventional
projects having Initial outflows followed by net positive cash flows in subsequent periods. In
the above project involving Rs.S00 Lakh investment. NPV was positive and the IRR of 20.3%
was higher than discounting rate of 10%. Both the methods concluded acceptanC'e of the
project.
• KPV ls inversely related to the required rate of return. For a given set of cash flows, NPV is
maximum when the required rate of return or discounting rate is zero, as it v.111 be simply sum
total of all positive and negative cash flows.
 5 10
. . f lnan~ t,b .nagemenl MU)
V go on reduci ng and will becorne Zerr . ,
tncreases, ~ P w 111 ~ ¥r.
• A& the rtqulred rate of rtturn h ·gher than IRR NPV will become n "f:
dlscoundng rates I ega~
required rate ls equal to !RR. For ·

35

30
25
20
15

' 10
5

0
s
5
25

o ~ ra1er-.)
10
- 15

Fig. 5.2.1 : Example of an NPV profile

5.2.7 Modified Internal Rate of Return (MIRR)

Modified Internal Rate of Return ( MIRR) is the modification of internal rate of return ~
overcome two shortcomlngs of the !RR methodology.
(a) One shortcoming of the IRR methodology is the as~umption that the positive cash flows an
invested at the rate of IRR which may not be practical. MIRR assumes that the positive~
Oows are reinvested at reinvestment rate, which is taken at the company's cost of cap!a
Present value of cash flows is calculated using financing.

(b) IRR formula provides multiple values of IRR Ln projects involving investment outflows in man
than period

Fonnula : MIRA a -"~

VPVCi=- 1
where

FVCF · Future value of positive cash flows.

PVCF . Present value of negative cash ftows.

n · No. of ~rlods.
 C...pl131 Budgeti ng
~ of u.tng MIRR method
~·rtd

l ~
1
d-«es the shortcommgs of I RR, by d istlngulshtnR between IRR d
It ad ,._.
It uses ra .
an reinvestment rate.
te of financing for discounting the negative cash fl 0 w hl h fl
s w c re e cts the actual cost
nd and may vary for different companies dependi ng on rnod f fi .
1)1 tu s . e o nanctng. For example,
c:enipanY using debt fun ding for p ro1ect will use interest rate as fin ancing rate

J
°" co111P3ring MIRR
DJ
and c ul•off o r hurdle rate management can take decisions on project
stleetiOll-
t
I ~
I H is
, more complicated method a nd d ifficult to understand for persons without financial
. 1,ackgrOund.
, Ukt IRR it also doesn 't provide the value added to the s hareholders.
~ 8 p,ofttablllty Index (PI)
5,2.
Profitability lnde.x (Pl) Is the ra tio of present value of future cash fl ows a nd In itial cos t o f the
. profitability index or more than 1 indicates that company is making money from the
pro,'fCl after considering time val ue m oney and the project viable. All proJects having Pl of more
~ can be selected. In case of mutually exclusive projects. projects having maxi m um Pl are
~ td-
PV
Pl =
CFo
CF1 CF 2 CF3 CFn
Pl - (l+i) t + (l+i)2 + (l+l)l +...+ (1 + IJ"
CF0

[am,..
In die above aample Involving Rs. 5 Cr investment. Profitability Index will be calculated as
below:
100 175 225 225 150
Pl = - +
1.10 (1.10) 2 + 3+
(1.10) (1.10 )4+( l·lO)s
500
652
::
500
:: 1.30
 5 12
W Finance Mam l'menl (MU)
. h Pl 1
Acceptance Rul e . t the prorecL" w ere <
Pl - J an d re1cc d
I
• Acce pt the projects where Pl > or - Ith the h ighest Pl •~ acce ptc
• In ca'ie of mut u.illy exclusive profects. one w
Mer tts and Dem erit s of using MIR R rnet tiod

Mer lb
I. Pl cons ider s d me val ue of mon ey.
2. Pl conslde rs nsk asso etated with d1e proj ects.
I• d ;idd to s hJre hold ers· value
an
3. Projects w ith Pl > 1 also me..in that NPY Is pos ave
1
Pl meth od can br used for eva luati on of pn,j ects requ iri ng ,nte nnit cnt ca,h mvt stm ent\
4.

Dem erit
ders .
I. It ~oestt1't prov ide the valu e adde d lO lhe shar ehol

5.2 .9 Cap ital Rat ion ing

dme If a firm has acce ss to unltmt(!d
A finn keep s on eval uaong mul uple pro1eru all lhl'
crt>d to enh ance "ha reho lde~ value w,U "
capi tal all the 1nv~ onen 1 proposal,; that are ex-pe
tl'd How ever . In prae1 1ce d firm w tll have only limited cap1t.1I for m,•e stme nt, fun:he-
selec
effic ient mo nito ring and ma nag eme nt In t.i
unched<ed capt ta l inve~tment may pose prob lem of
-stmt'nt with in over all ln\'e<.t.mem Qj>
casts. proJect:5 lha1 dre providin g high est rerum ove r 1nvt
retu rn ove r lnv1;>stm ent and can be U\ed lo
are chosen The profitabillty Index Is a proxy for the
deode on pro; ects In case of cap1t.1I r.itfo ning.

Iflu trat lun

ap1t .a l bud get of Rs. J 0,00 .000 ~nd ll lw
!.,tot's tllke an example, whe re ma ~ge mt-n t only ha.,
t'stment requ 1n:m ents , bJse d o n I RR. NPV mi
t'Val~fe'd muJ nplr pro, ecu with d1ff ert'n t LnV
profirabillty mdex (Pl} as t>clow

I Protect lnves~ en~ RR (~ ) NPV Pl

A ' 6.00 .000 16 2.40 .000 1.40

l s.00.000
I

I
I
B 18 2.00.000 I 1 2s
'
! C ! 4,00,000 18 ).80.000 1.4 5
I D 2.00.000 21 1.20 .000 . I 70
f
F. I 2.00.000 17
I I
1.00.000 ~ 1 SO
Man :.gff flrnt a.n mak e mul tiplt comb1naao1u ba,
to Rs. I 0.00.000 u t,,,Jo w
td on e;,ch cr1tt:rion for proJN.ts 1m01,:no:~
 'i I I
=
------
Project~
~ - -- IRR
. r---
lnves1.nu~nt
Cap11..aJ Budgeung

n 21 1-
i--:rno.ooQ
NPV l
B - I 20 (JIJO
lf3 ' IHl(),OfJO
- 200.000
A
TOTAL
I 1.000,000 320,000
Project PT Investment NPV
D 1.70 200,000 120,000
E 1.50 200.000 100,000
A 1.40 600,000 240.000
1,000.000 460,000
Project Pl Investment
A 240,000 600,000
•
C 180,000 400,000
TOTAL 420,000 1.000.000

Profitability index provides combination of projects that maximize returns for given
mvrstment aod management will choose projects o. E and A.
;ie: use present Value Interest Factor (PV IF) for discounting the future cash flows and use
eompound Value Interest Factor also called Future Interest Factor (CVIF/CVF/FVTF) for
caicUlatTng future cash Hows.

s.2.10 project Mo1n itoring and Audit

s.2.10(A} Solved Example
El. S.2.1 : Management is evaluating options of buying a new welding machine. A new
machine of Schumak Machines company has total investment requirement of Rs. 2,50,000 and
rias net cash flow of Rs. 250,000 tor 9 years. An alternative to Schumak is another machine of
Hootto International costing Rs. 15,00,000 and has cash flows of Rs. 250,000 for 11 years.
The required rate of return is 12 percent. Calculate the IRA, NPV and Pl of bo!h projects.
Sain. :

(A) Sdlumak Machines

• NPVofSchumak = - 12,50,000 + 250,000 x PVAf<J.0.12

:: -12,50,000 + 250,000 x 5.328
= - 12,50,000 + 13,32,000 = 82,000
 :::nC"t'::,!M~a:n,e:S:m:e:n~t(~M~U
•t~FlN
! - 2)---~S
~•:I
d'scount at w
•=~:::,-------.. .-,~
hich Nl'V Is nl
• IRR of Schumak Is equivalent I
- 0
- t 2,S0,000 • 250000 x PVAF,1u - 12.50,000
PVAF9JBJ1 = - 250.000

= 5
= 4.946
Referring to PVAf table, PVAF,.0.1•
and PVAF,.o 1• = 5.132
Hence, IRR corresponding to
(5 - 4.946} = 14%- 0.29% = 13.71%
S = 14%- (S.132 - 4.946}

PV 13.32,000 = J.06
• Pl for Schumak = Investment = 12.50,000

(B) Honil'O l.ntematfonal

. = - 15•00•000 + 250'000 x PVAF11.o.12
• NPV of Hontto
= - l 5,00,000 + 250,000 X 5.938

= _ lS,00,000 + 14,84,500

= - 14,500
• lRR of HonitD Is equivalent discount at which NPV is nil
-15,00,00 • 250000 x PVAF I uu = 0
15,0 0,00
PVAF,uu = 250.000

PVAf1uu = 6
Referring to PVAf table,

PVAF11_o_u = 5.938

and PVAfn.Dtt = 6.207

(6 - S.938) _
Hmce. lRR comspuodlng to 5 = 12% - (6. 207 _ 5_9JB) = 12% - 0.23% - 11.77%
14.84 S00
1
• Pl for Honito = 15,00,00 "'0.98

From die comparison of the two proposals, we understand that Honito's NPV is oep!ll't
henu IRR less that cost of capl~I and Pl Is less than 1. Hence, Hortito is relKted,
 n t( M U )

\ R vtew Question,]

. rtance ot capita• budget

. th• iffll)O in g decisions.
, difference between intern
al rate ,of retum en d acco
in ' " ' untmg rate ratumi.
~ _....._ and demerits o f
01
~ ~-~~ pa yb ac k period melhoda
logy fol C8llilal budgeting?
f;pl . rtcomlngs o t IRR methodo
-

0.' " ' tne shO logy?

wN' dill•f1 I ....ap
,. ,1,
~
1

\J(Sl ~
4,5 , . I~
Q 'tin~
81"'" . ·t. ta.I
~

- g~t:ech
· n:-
budgeting- a n d e,cplain
- wily NPV methodolagy i!I

==iq=u~-•' - - - - - - - - - - - - - - - - - - - -
the ffl08' ~ ·I
~
~o oliii
. QCl
 Working
capital Management

'
an ing W oncin g Ca pit al; Importance of Wort,
, _nt : Co ncepts of Me of w~
W ald..g Capltaf . . . . . ,g Ca pit al N ~ s; Estimation
g an En t ity 's W or tm
rs Affectin
Capi'tal M a ~ t : Facto em en t of Recetvables; an d Man
agefnent
Inv en tor ies ; M anag
c ~ R eq u ~ ts: M an ag em en t of
ur itie s.
of Cast! .,,c f M a ri t~ s«

cash are the

se s lik e 'C as h is ki ng ' m ea ni ng th os e wh o ha ve
es th e ph ra
We ha ~ ha rd m an y tim cr ed it Th es e ph ra ses sig
nify th,
we do n't se ll on
har' m ea ni ng
kings or 'Aaj Nag.ad Kai Ud rk in g ca pi ta l m a.n ag em en t of finns. We WllJ
t an d sty le of m an ag in g wo
Im po rta nc e of cu rre nt as se em en t.
th e va rio us co m po ne nt s of wo rk in g ca pi tal m an ag
stu dy

LM m lftt Obje ct lv•

g. im po rta nt of wo rk in g ca pi ta l m an ag em en t
me..1nin
• Working Capital - concept,
ca pi ta l I'
of wo rk in g ca pi tal, fa cto rs af fe cti ng w or ki ng I
• ()p en ting cy de, typ es
I
• M ~ o f lov en to ry
Management of rec.elvable
s
•
ar ke ta bl e se cu rit ie s.
• Management of cash an d m

o rk in g Cap it a l M a n a gement
6 .1 Int1oduct1on to W
lo the normal co ur se of
bu s' R ho ld a sto ck of good s to fulfil sale!
• . mess, a rm ne ed
pe
to
rio d to cu sto ~~: cash.balaacr
m er s and m . .....
e cr ed it am ,n
in tu ne ly ma nn er ; pr ov id
~l re m en ts en
to me et pa ym ts.
Investment • la rg e po rti on of a firm 's
asseG
• This requtrement to ho ld H . . m cu rre nt as se ts le ad s to
locked l.n eu.rrent assets. ence, it's Im po rta nt to st ud y th capia!
e m an ag em en t o f working
f .
There are tw o m ajo r concePts O JiVorldng ca pi ta l
1. Gross working capital
2. Net working capttaL
 rn~nl MU) 6-2
......,.ncr
f r""'.:..i Wo11un Ca Ital M111na ~m~,
cofl(:ept of Gross Working Capital a
._1.1 nd Net Working Capital
..-rldtll capital refe.r s to lhe total of curre t
~ ..-v n as:s-ets invol v!~ inv
, debtors (also known a s account receivables)
b entory (also known as
~ ). . cas and marketa ble secun ties
- ~... eaptul refers to the difference between ·
lit' .,,o,._..., current ass,ets and .
, . ft~ the amount o f funding needed to finance w k. . current llab11Jties
a,.d iS re ,..,,hleS to the suppliers. . or mg capital. Current lia bilities here
~ ude pa,-
...,.uifement of working capital depends on the operating cycle 0 f th
1bt , .., . . . e company He.nee. to
• -~nd wortcing capital better, we need to first understand the . f
llll""' _ · concept o operating cycle.
operating Cycle
6,1•2
aperating cycle refers to ~e period elapsed between the time of purchase of raw materials to
I • ~tlOII of cash from seUmg the goods or services by the firm.
f j'lting cycle consists of ma.ny activities such as purchase of raw materials. conversion of
I • :: material Into WlP or work in progress, conversion to WlP to finished goods. s.aJe of
I fiDSShed goods and collection of cash from customers. post-sale.
t , nae dntf period from purcbue of raw matetial to sale of goods is the inventory conversion
pertod fortM company.
, T'llt tilJle period from sale of goods to collectio.n of cash is the debtor conversion period. The
,..enge inventOry conversion period of the company is also called inventory days and the
~ col)tctian period as debtor days, as calculated in fi nancial ratio analysis.

Sale of inventory
•

- Inventory penod Account receivable penod---1

~payable Cash cycle
period (Net operating cyde )
•
Castl paid for inventory Cash received from sale

OperatJng c:yde ·I
Fig. 6-1..1

Operating Cycle = tnvent.ory Conversion Period + !Debtor Conversion Period

fmffltury amvffSion perio:d consists of raw material conversion period
OR

OJ)e"r.rting Cycle = Inventory Days • Debtor Days

 t\ ~l"llting ycle • Cost of goodssold • Credit Sales
Aver:tge lnvC'nto ry Avemge Debtors

. raw materials on credit and get time for payrneot

~"' nllll\) nnns pure hase , ~,..
• h 1 pr.t,1 · h h blocked In current assets will not be blocked t ~,
refi-~I m tndll pertod lienre. t e cas or tbt
. r .• -1. __.e or n.t operattn1 cycle refers to the tfme Pt!rtoct ,.__
te,t\rf (\r-"NOf\l CY\:lll, \,AMI "T~ f __.. ,_ ··11111
· _.__ f-w ma~rlals to tbe realisation o c - uvm s.tlt
~ _ . .1 of ('Uh for pu.tt.-se o , • ·

• l'be c.ad1 <'\!\.'If Is .~culated u~lng followtng formula :

C.UI •de • ln,·entory Conversion Period .. Debtor Conversion Period

- Cl'Nlitors Def'e.rnl Period .

C.sh (;yt'~ • lnYttntt,ry Days • Dtbtor Days - Account Receivables Days.

t.l.3 Importance of Working Capital Management

• C\ln-.nt Msets form a st,nlfk-ant portion of the total assets of a firm. In case of trading flllnJ.
workh~ capita.I contnllution ls very high and may contribute to even S0-9 0% to total assets.
• Cun-ent ass I ts 5Uch u short mrm lnwstments provide lower returns compared to fixed asStt3. 1

tnwntories and debton do_n't provide any d ll'KI returns. Hence large Investment In current 1

ass rs can rnult In sub-standard return on invt'stment

• ~ aCNmulat1on of Inventory can ~ult In problem of non-movl.n g Inventory aod may
lose value In tuna.re. ~ account receivables may pose problems of collection and In SOl!lE
ca,a mull itl Joss dllt' to non-ron«tfon.
• Ota the octt.. hand. IOw Jffti of curffnt assets can lead to deJay in fulfilment of orders and 1113'/ ,
IHd to lelllponJl' loss of busint's$. This may also result poor utilization of fixed assets.
• IMct.quate atrffllt asseits can lead to ineffldendes In day to day o perations and can lead ro
..,.._.,. cost and affect profttabiUty and competitfvmess of the company.

• She-Up ol liquid cwnnt assets can lead to de.lay in repayment to operational and flnanml
cnodltors and loss of reput.ation. Continued sbortage of currfflt assets can exacerbate thtsf
pn>Nffla.s and may e\'ffl also lead to bankruptcy lf co.m pany ca.n not arrange fina ncing in Umr ~
~oblipdon:5.

• Effldtent wortm& capftal nwnagement is requittd to mainr.ain balance between return oo

in-.~w..t and opdmum liquidity for s.moorh operations of the compa ny. Working capital
I M ~ n l requirco,s day to day monitoring of current assets to e nsure smooth bustness
ope-rations &!Id oco,pies larp portion of fl.nan~ manager's mindshare.
 ~ • •::: ttt""'nl {MU) fl 4
1 Wor ldef Capi ta.I MIJ'\l&lm\ent

._ •·• ,..- ma n•n t and Var tab te Wortttng C.p tt.f

•Miro' r..-d• tu m,.lntaln adeq uate levf'I 0 f curr ent a~sets f
A , ,m,, or rmooth running or th,
• ~ HoW11'Y"'• ch• amo unt 1,( curr ent ~ffLi Is not constant and k
~ ts f t com .. ttps chancing.
dlna on the, •l'aa onal fa ctor , Curr ent 1isse
· o t 11, pany hav, tw0
,t,ptn components I e.
nfnl or tb.-J work ing capll.<II and V.1na ble (~ mpo r.uy or fluctuating) work.mg capital
l'fl1'1A ·
I
••" "• or fl•INI wor k1q capi tal rrler s to the mln mum amount of current assets
• ,...
.......,r-.d by t:he com pany . Permanen t wor king capital Is akin t fl· asse t Investment. as It
ed
.,....-
°"
I l'fffl'lln ftirl!d for 1on, term. Furt her as In caH of flJCed asse ts company may need to
wi I .
th In sales.
~ pttrm tnen t work Jn1 capital arad ually With grow
ftuctuattna wor klnt capi tal refer s to the addlt:fona
l curren t assets required
~-- _,. . or •
• 1 _,,_ .. -
s to stockpile large finis hed good s
#

d\11 to s•so nal requ irem ents. For exam ple. a company need
to n,tel d,m and In peak seas on and will have
curr ent asse ts. The temp orar y worktng capit.al
requ irem ent In the peak season.
..,,ount keeps ftuc tuat hll depe ndln 1 on the seas onal
1tffipG1"1!1 wortdn1 capltaJ will be high whil e In slack
seas on It will be non-existent.
temporary WOfillng capital

) la = > ~ ~ ~
llme·
t Fig .LU

t.1,5 Pac.ton Affec:ti11g Wo rki

ng C.p ltal Nee ds
ificant lnOuence on the work ing capital
• Nllln• ol .... .... : Nature of busi ness has mos t sign
to carry Inve ntor y of varie ty of
rtq11lmnent or the company. TradIna or retai l com panies need
com pani es hold majority of asse ts
product.I and has subs tant ial inve stme nt In Inve ntor y. Such
truc tion com pani es need to carry
Ill lit form of Inventory Le. curn nt asse ts. Similarly, cons
lnftn tory and alto have to deal with high rece-lvables
especially In gove rnm ent sect or, In tum
o1he r hand, utilities such as telecom
dNI wtdl hlah worklna QpU al requ irem ent On the
and low requirem ent of
cocapanJea . tlec trtdt y have very larg e Inve stme nt In fixed asse ts
worth• capital.
In dete rmin ing curr ent asse ts that
• S 1tn1I Fed 8n : Seasonality plays a vitry Impo rtan t role
to main tain large Inve ntor y
company nted to ·maintain. Our1"8 the peak peri od. firm will need
be lowe r. For a man ufac twin g
hip demand and duri n1 the slac k seas on Inve ntor y will
to lltttf
at a shor t notic e due to
company It maynot be feas ible to Incr ease prod uctio n subs tant
ially
to avoi d loss of busi ness ,
constraints of capacity. Impact o n qual ity and pric e. llcn ce
uctio n th roug hout the year
lbanuf,1rturin1 companies choo se to main tain Ieve I prod
.....
 Working Capital Manage
•
-
Finance Management (MU) 6•5

, . cyclical industries respond to the demand situation a

• CyclkaUty : Companies operating in b . . lld
.. llltlll.
~
· h lical upturn when us1ness rs Witnessing h
adjust current assets accordingly. In t e eye • . . 1gi.1
demand, companies wi.11 like to maintain high current assets to cap1tahze_on the opporttin1ty,
. will li'·ke to work with minimum Investment m current assets ,.
In downturn, companies ..,
o~rhead and financing costs.
• Credit Policy : Debtor days of the company is largely driven by the credit policy adopted by
the company. Large established companies need not extend credit to ~elr customers, Whi!,
companies looking to penetrate lnto market may choose ~o extend credit as a tool to ~tablish
themselves. Credit policies of the companies are largely mfluenced by the prevalent mdustry
practices. For example, retail shops need not extend credit to the customers, however
wholesalers and dlstt1butors may have to extend credit to achieve the saJes targets.
• Manufacturln& cydejTecbnology : Manufacturing process used by company impacts the
manufacturing cycle and in rum r'equlrement of current assets. Use of less automation rnay
help company to save on fixed asset investments, but will require large Inventories due !-0
longer manufacturing cycle. Further, flexibility of manufacturing technology also plays an
Important role. Companies having flexible manufacturing operations can use their capacity ror
manufacturing different products during slack period. Companies with inflexible
manufacturing technique may choose to maintain steady level of production to avoid
underutilization despite lower demand and can add to inventory levels.
• Avallablltty of Credit: Finns that are able to procure input materials on credit from suppliers
can ~uce theJr net working capital requirement and cash cycle by utilizing such credit
Uberal credit terms from suppliers can even allow some firms to op~rate with negative
working capital. For example. some large retailers can easily a credit period of 60-90 days from
their suppliers, maintain inventory of 30 days or less and sell in cash to retail customers and
thus operating With D'!gative working capital.
• Operating Effldeney : Firms running operations In efficient manner can reduce the
requirement of current assets. Operating efficiency has many facets. The factors such as easy
avaOablHty of input materials, accurate sales forecasting and planning, utlll~tion of resources
etc. can substantially reduce need to carry lnvento·ry at aJJ levels and reduce working capital
requirements. Inefficient operations will require higher investment in current assets.
• Sale of opendons : Requirement of worldng capital generally reduces wtth increased scale
of operations, as company bas more flexibility. Sub-optimaJ operatlons require a flnn to
maintain higher of current assets. SmaUer firms also find It easier to obtain working c:aplcal
ftnandng (:Olftpared to long term loans.
• Plucn11aoa
. hi •
~ ·- - ~- --. ·• 1m1-- · t sn
· · ..,....,,en · current assets are higher when the firm is
~ to ftuctuabOn tn input prices. In such cases, cost of raw material prices fl ucruaong.
bowwer firm has only limited flexibility to pass on p.rice Increases to end cus tome rs. In ~-ud'
caRS, flrm may need to Invest la~ amoqnt in current assets tn take advantage of favorablt
Input pn~s.
 ,-nnagrment (MU) 6-6
f f i~ cr Wr,rtoog Capita l M
'allli ~ t
da,es In Working Capital M
l anagement
6-j,6
. capital management involves declslo
.,orkJf\S n on following two areas-
\• level of current assets and .
opn11111lll
. g mix between short term and long t e ,,
• fl11ane1n rm "nancl ng

, .."'
"

fnvtstJTI
-,ortdng capital - Trade off

ent in current capital generally provi des 1

ow return on tnvestme
• s rninlmUDl amount of current asset.~ sho ld b nt. hence to marjm1z~
ret'1 111 u e maintained On th
fflcletJt current as:se t.s can lead to risks of default · .e other hand.
1
nSll on payment obl1ganons · nd
ID determining appropriate level of cu rrent a ts " loss of sales.
Hence, sse • a trade-off bet
, ust be considered. w een pro fltth11ity vs
Hquld1!) m
_ lllustr.lte th.ls trade-off let's consider 3 alternative work! .
, 10 ng capital pohcles presmbmg use
-'different levels of current a s sets for achievtng same ou tput• Th e re1au.o nsh1p between output
111

!ad Cllrrent assets is as d epicted in the below r han.

,
...._t
1"
requtrement of current asset mcreases with Increase In Ou tp ut h av..ever the relanonship
.
.......-.en
v,:•~·- rurrent assets and o utput i s n ot linear. Current assets incr ease at s 1ower pace at
nigher level of output. This is due to Improve d operating efficie ncy at h igher level of outpuL
, Policy A has the highest lnve stml'n t In current assets for a given outpuL As current assets are
;;lso proxy for the llquidjty, policy A can be considered a s lhe most conservative Policy c has
the 10-.-er level of current assets. mea n ing lowest liqu idity and can be co ns idered a s lhe most
aggrrssi\le, while policy B is average How do the policie s compare In term of p rofitab1hty
Q!r'.datl'd using return on Investme n t (RO I)?
Net Profit
ROI = To ta l assets
Nel Profit
= Cu rren t a ssets + No n -current assec;

• Ucompany can maint.ii n level o f sale s while redu cmg the level o f current assets the pohcy C
~..\'ing lowest level of current ass ets w i ll have the h1ghes1 ROI or pro fit.1 b1hry. \\ hale
C01lSffi.itlve policy A having h ighest le vel of cu rre nt assets, wlll have lowe st prufi1abtlt1)
HIYWtver. with Incr ease In p rofl ta b ihty com pany a lso face<; highe r nsks t e clel.iy 111 PJ} ment
obligations d ue to lower cash. lo s t sales due to lo we r stock and d ls sarbfl ed customerr, dut' tu

kYil'tl' crt'dtt period etc.

' 1iu& wt can conclude tha t profitabiliry a nd llquldrcy .ire 1n"ersely rdatl'd to ~ach othl :

~ u profit.1bHl ty or r-etum Is iUSOCU1ted W1 th htjthe r nsk.

 Wo r king Capital Man.
b1 •~
• Mm.-~mt-'f\l (MU) ""
f lfl.,1.1\("t ; de-o ff b etween pro tltabilJty alld
full manag<• thl.s tra 1'Gil¼
• H nee-, milnagemenl need to 1..al't! y .o mum lt-vel of current assets . ."",
rbk and return. whUP deciding on the op
♦

A
Coo$fflYc11/ve policy

I 8

! A"9f8g9!lolk:)'

a
'll
C
~ Aggrosswel)ollcy

0Ulj)IJI

Fig. 6.1.3 : Chart

Mix of short t.-m and long term financing

Generally, Interest rates on short term funding are lower than long funding. Further. shon
tenn debt can be repald back during the times of lower requirement Hence higher the proportioJ
of short term debt. lower the interest cost and higher the profitability.

6.1.7 Estimation of Working capital Requirement

Operating cycle of a company provides most appropriate methodology to calculate the worku!g
capital requirement However, In .practice other methods are also be used. Three importa:.:
methodologies to estimate working capital requirements are as follows :
t. Cw amt 11nts bold&,.1 period : This method ls derived from operating cyde concept n>i
lnvolv6$ calculation of working capital based on holding period of individual current assets.
Z. Ratto of sales : ln this method current assets as a percentage of sales is estimat ed based !O
assumptions and past experience and accordingly current assets are calculated. Th is is mOSl
· commonJy used method in practice as ft assumes rhe requirement of higher worlang capl!i
with inc~ase in sales and Is easier to use.
3
· Ratio of ftud lnvesbinrat : In this method current assets as a percentage of fixed as5tti !
estimated and accordJngly curr t •'
en asset amount ls calcuJated. This method is not use.! oitr-
practlce.
 Mat erta J C.Ost
I
lbw Mat. enals Con sumed
36.0 00
Manllfactur1n1 Cos t

Labo ur
12.000
I
Pow er and Fuel
10,0 00
Factory Ove rhea ds
7,50 0
Oth er Exp ense s
1.500
Dep recu tion
5.00 0
Annual Sales
108.000
Fixed Asse ts Inve stme nt 75,0 00
Fina nce Costs 1,00 0
Profit Before Tax 4,50 0
Tota l Fixed Asse ts 25,0 00
Profit After Tu 3,37 5
AssUmptions for calculating wor king capi tal und er
each met hod Is as follows :
Melbod 1 : Inventor y : 1 mon th supply raw mat eria
ls and 15 days supp ly of finished good s.
Debtors : 1 mon th, Ope ratin g Cash: 1 mon th of tota
l cos t
Metlllod 2 : 20% of annu al sale s.
Nelllod 3 : 40% of fixed asse t Inve stm ent

N llbc d 1 C.lc ulat lon :

Raw mat eria ls inve ntor y = 36i~OO = Rs. 3,000 Lakh

Finished Goods Inve ntor y = Tota l cost

24
36,0 00 + 12,000 + 10,000 + 7,500 + 1,500 + 5,000
=
24
72,0 00
= 24
= Rs. 3,00 0 Lakh
• Finance Manarment ( MU) 6 _9 \'Vorklng Capital Man~t~

Debtors =

Cash l}alance =
Annual Sales_ 108,000 = Rs. 9,000 Lakh
l2 -

Total Cost _ 72,000

12 - 12
12

= Rs. 3,000 Lakh

'
. mventory
Total Current Assets = Raw material . + Finished goods inventory + Debtors

+ Cash balance
= 3000 + 3000 + 9000 + 3 000
= Rs. 18,000 Lakh
. •
Note : h, cases where semt-flmshed goods or WIP inventory also need to be c alculated,
. add Ql!,;::
~
labOr. power and fuel expenses a nd maintenance ii provided to ra.w material consumpt10 ., for,
estimating cost of semi.finished goods.

Method 2:
30
Current Assets at 30% annual sales = 108,000 x 1 oo

= Rs. 32,400 Lakh

Method 3:
40
Current Assets at 40% of total fixed asset investment = 75.000 x 100

= Rs. 30,000 Lakh

Jn the previous secnons, we d iscussed the importance o f working and process for esnmatJonaf
cumnt assets. Now let's understand r.he t«hniques to manage currcm assets i.e. management of
inventories, management o f receivables, managt-ment of cash and marke table s ccurilles.

6.2 Management of Inventories

Inventory fonns probably tbe largHc portion of current assets of monufa rtunng and tradu!f
companies. Trading companies need to hold fin ished goods inventory fo r tlrnt>ly f\Jlflllmt'!lt ti
customer requirements and los~ of ru stomers. ManulactuMng com panies a lso need to hold nw
materials and Work th Pr.ogress (WIP) inventory ln add ition lO finished good , . Y.'h!lc mi'
matertaJs Inventory- Is requJrtd to ensure smooth proJuction. WIP mv«'ntory ansl'5 Clll! r~
productio11 cycle.

The main objl'!C'Uves of ~kllng inventory can be c.tegori2ed as below ·

l. TraasacUoa moth,• 1 Transacnon motive Is the main o bjective of holding invenwry 11

lnvolves hold.Ing inventory to ensure s mooth produc-tfon and su p plies tor \illi's .i<~
fnventory ls held dep.e nds on many facton such as the producnon capacity , clnn,1nc:l f"'.!
 ,, . I IJ
• f1n:a.n« M• Workln u l.ap1t.aJ 11,fana c menl

,
-..raut Jonar y motJve : Accord ing to thl!> rno,lvr
1. ,,. ~- , busine ssn hold mve-ntory to guard against
nfo(C)e cn .and unpred lc-tabl,. l!Vents lead1ou l d
ll < " o 1:srupU t>n m pniduct1on o r supply o(
ro,Jltria l:..
nd
3,. mottve : U er th is motive, btislnesses hold inventory or reduce to take
specul•tlff
,antage the price movem ent· For ex:amp Ie, retaile rs may stock up certain goods In
ad~
dcipation of p rice increas es· while ma nu facture rs may stock up raw materi als if the prices
an
have fallen.
er motives : These Include motive s sueh as ava1hn . • g discou nts assooa ted with bulk
4- Oth
i purchases, reduce orderi ng cost etc.

,.2.1 Inve ntor y Mana gem ent Tech nique s

• Tbere are many motive s and advant ages or holding Inventory viz. fl ex:lbility in production. take
price advantage that comes with bulk purchase. smoot h fulfilment of custom er demand etc.
• TIie disadvantages of holding excess inventory are cost: of storage, cost of funds on the
capital
btodced In inventory, dange rs of obsolescence etc.
• As long as the benefi ts of holding invent ory outweigh the cost of invent ory,
manag ement will
prefer to bold Invent ory.
, • L,«s srudy the prindp les of invent ory control that help in taking Import ant
decisions in
is
Inventory management s uch as how much to order? when to order? what to control? What
wetrstock?
•
~ 6.2.l( A) Econ omic Orde r Quan tity (ECQ ) (How much to Orde r?)
much
• One of the impor tant consid eration s in invent ory manag ement is to determ ine how
inventory should be ordere d.
rder or in
• la case of raw materials. It is the quanti ty of raw materi als to be ordere d in each o
use of produc tion of finishe d goods It's the decision on how much to manufacture in a
tion run. Whenever a firm buys and stores inventory it has to bear two ma jor type
of
f produc
r, oosts namely ordering costs a.nd invent ory carrying costs.
• • Onlerla, Colts are the costs associa ted with placing the order and Include
1 costs to prepare a
issuing
J purchase order, cost of transp ortation. inspecting, movement of order. stonng . cost of
order
s.1 payments etc. These costs are fixed per order and increa se with Increase in numbe r of
~ reduce with Increa se Is size per order
include
• Carryiq Costs are the costs associa ted with !holding and storing unsold goods. These
Ct>sts of wareh ousing , salvie s, transp ortatio n and handli ng. taxes, and Insuran
ce, de precia tion,
ry
shrfnkage etc. The Invent ory carrying cost Increases wtth the Increase In the levtl of invento
 Worklng Capital Managetllen_t
• Plnanre M1tn,:ment (MIJ)
6· I 1 ...
• Ec:onomlc l)rder .quantity Is a scientific method to calculate mos t economic quantity 0, ,
lnvento1y that minimize the total of ordering and carrying costs. There are 3 variables Involve~

tn c.ilculatlon or ECQ.. These are the :

t. Dem.and or product : The number of units of the product forecasted to be sold over a given

time period (usually a year), expressed as A

2. Ordertq cost: Ordering (;()St per purchase order expressed as 0 .
3. carrytng cost: Carrying cost per unit assuming the item is in stock for entire period.
expressed as c.
If Q is the order quantil;y per purchase oni·e r or, then the total ordering cost for a year wi.JI be

TOC = A~O

lf the usage of Inventory is constant for each period. then

average lnventnry tan be expressed as¥

Total carrying cost (TCC) = Canying cost per unit x Average Inventory

TCC = ~
2
,,, total Inventory Cost (TC) ls the sum of total oryiering cost and total carrying cost.
TC = TOC+ TCC

TC
= A(Ol .2W
Q + 2
A5 discussed above, EOQ refers to the quantity Q, where TC Is minimized. We can use calculus
to ftnd the lowest po,lnt on the total Inventory cost curve. The resulting EOQ is.

t~. ·.~
lllutn.tion
·=.o-~ I
.
l.et's·ta.ke an example on use of EOQ method. S·u
l.n •. year and ordering costs and rryt ppose that usage of an inventory item Is 2000
ca ng costs are Rs 100 rd
~specttvely. The EOQ expressed as n ls cal-·'• · · per O e;r and are Rs. 10 per unit
"' \.\Dated as below :
Q ,. ✓2 (2000} (100)
10
,. ✓2 {2000) {100)
10
.. aoounJt:s.
 6 11
W orll11
'I
I

I
\ ,.,
..,,..,-
_..
IYVKl,\J

..-/"

£00
F'9. 6.2.1
• In the Flf(. 6 ·2·1 • we have plotted total ordering costs: total n1rrytn g costs: and total inventory
C1>stS (which ls sum of the first two costs).

• w~ see that whereas total canying costs vary directly w1th the size of the order. total ordering
costs vary inversely with order site. The total inventory costs sum total of ordering and
c;arrytng costs decline at first as the fixed costs of ordering are reduced with larger orders.
However, the total inventory costs start rising when the additional carrying cost5 start
otfstttin& decrease In total ordering costs due to a larger average inventory.
.
• The point EOQ. represents the economic order quantity. which minimizes the total cost of
ln\'lt\Otory.

6~2.1(8) Reorder Point {When to Order?)

• In addition to knowing how much to order, when to order or reorder point is' another
Important dedslon ln inventory management function. To calculate the reorder poin:t. we need
to consider the ttme elapsed between placement of order of an item to receipt in the inventory.
also called as Lead time. Reorder point can be calculated as below
Reorder point = Lead time x Average usage
• Suppose It takes 5 days between the placement and receipt of an order. The EOQ order size
was 200 units and a dally usqe of 20 u,n1ts. resulting in an order being placed (and filled)
every 10 days. The reorder point for the flnn will be expressed as;
Reorder point = S x 20· =100 units.
• So the firm needs to p.lace a.n order when the inventory falls to 100 units, as it will take 5 days
to receive Inventory by which time the existing stock will be exhausted.

t• 1.2.1{C) S.fety Stock

• TM caJculali<m of reorder point assumes that the lead time and average usage are always
known with certainty.
 6- 13
• 1-ln.an« ~ anagemen t (MU)
d •. ·rt bed hy 11sag r t1nd the. lo.id time ar(• 1101
• In pr:ir uce , how ever the dem and for pro uct .il 1::sc • l d or if t he lead n me io; higher th
d S
•n
, nurrl\• cert.un. 1f thr act-ual usagl' Is nigh er t .in esuma c
h

"'l >«·ted. a fim1mJy f.lce a situation of stoclt out

.-.;n safe ty stock to ;"Jllow for uncertain ty In dc-n, dttd
3
10
• Th.-reforc. it beco mes impe rativc l o ma "" to acco unt for
·-~•1 . I d time. Henc e, reor der poin t need to recalC'ula tcd J
for m,·e nn>ry as ..,.,. a s m ea
the s.11ery stock.
l
Reorder Point : Lead time x Average usage + Safety .S lCX:k
th
.1bov e exam plt', If the exp e~ stoc k out qua ntity is 5 un its per day. Then e reord er
• In the
un its.
pc,lnt will be 100 u_nits plus safety stocks of 25 (S x S) i.e. 12S

6.2 .2 Inv ent ory Control Systems

tas k, hence 3 firm need to have formally
Cont rol and man agem ent of Inve ntory Is a com plica ted
Its scale of oper ation s. The mos t popu lar
mon itore d 10-.•e ntor y cont rol systt-m suitable with
inve ntor y cont rol syst em s a_re as men tione d belo w:

6.2.2(A ) ABC Method ,of Inv ent ory Control

or a variety of Item ~ depe ndin g nn the
• A man ufac turin g firm need s to main tain Inventor y
num ber of items can be an thou ~and , of
prod uct. In s:om t' case s, like auto mob ile firm s. t.he
pvts depe nding on mod els. However. mos t of the
total inve ntor y valu e Is typic ally accounted
for the firm to focu s mor e arten11on in
bv rela th·tl y smal l prop ortio n of Items.. It a.dvisable
cont rolhn-g the more valu.1ble Item s.

This is acro mpl1she-d by ustng ABC method of inve

ntor y cont rol. In th is met hod inventory
•
Items are d uslf lcd In A. 8 and C categ orit>s.
for majo rity of Inve ntory valu e. Thes e items
• A _ateg ory ltem.s a.re most vahu ble and ac-co unt
a~ mon itore d str1cdy and more freq utntJ y.
Catqory B lte-m s accou.nt for I ~ port ion of tot.1.1
Inve ntor y valu e and Invo lved modrrate
•
e:ont ml and monitorin g.

• Ca ~ry C cont ains large num ber of Item s, even smal

ler port ion of Inve ntor y va lue and henr t
belo w Fig. 6.2.2 , • A" 11em s reflect tht
ln,"OI~ ml ~I monitortng. For the 6nn described by
perc ent of 1nven10!)'
fact
th bly 15 perce.nt of the lt:~ms In lnve ntDr y acco unt for 70
at roug
\>'ilZue,

•
,
~ neit 30 ~ • u of the IU!,ms• group -s ·· acco unt 1 or 2 0 perc tnt o f inve ntor)' vah.1t' Aod
....i I I
12\o're tha:u bl( or 55 pert tnt. of thr itens ..
-..-.a n on Y 10 perc ent of t tlW) lnve nlor y v,1lut
 14
II
Wm I.J n t Al>il.ll M11n .111t' mrn l

-
fo I

t 1W

':
i '" Ill

'-' k) ◄ • f'III ; fl t
•
tl t11

""" _.,,,..i,- "' 1ot• rn1

lyslt
fl,e I 2 :t Gra phic pre Nntatlo n ot A8C ena

• .) ,1( 1) J" lt In Tin,• (l tT)

W,1<: p1o nM• red by Toy ota
J11•t h l 11111 un j ttl bll ' "'"~ " ll d\ I "''11 lJ I" ,i.h, .r 11111 ) \ , lt' fll
1
ugh lnv ento rv nee ded at
1•J7rl 1h •h~ 11,, 111,, l111p ltl', ll'I "'" " 111111.u11t,1i11111,1 t.lllo
1,.q1t1 fu li••11 111
ih• 11,ll l' 111 1il1t1III ft1 1 t II I IIIIJ

t 111.rn.111t111wnt ,111,: n, r ,1w m.it eri.JI

ord e rs wit h lhe ir
, 111 JI I o•l 4'HI ,11 11111r 1ll1111 n 1.t t1 .1~r111.-n
l" :).t.11110 11 it! fli.,1hl ll'a.
I l'Ju n• hwt· ntt111, r o st b · rec el\, ng
, J1 11,,1t1, l h i,111 11, 11111,,,., ,, ,,m , lt•n, , .. ,lt•11 u," 1' wi\. ;t(' ,i ml
l'h l\y '" .., 11 h ,•n1 lot lht• JU t\4 h td(O tl
pm , ')\ , \\ ht,· h l't•du, l'S lll\' ento ry c osts.
i:••1111, ,,1th• ,ii
1

,HI' J'l"l hhll 111111 .111,J lt1Vtl1110 1

llllom1<1llun (\'S tl'm Jll d Vt'I")' l'ffi aen t
I jl't t 1Jl1h ,, . ,1 ~•t' I \' Ill\ Ill

'• •IHI"'"''''" .-1,.. 111 ,... •II•• i'C'll

,•:.l th at JIT wtll suff er
, II\Q •1'hl t1l11 11•, 111, 1 ,1:. nc,>tll'll , wht< h ,<'t'm.$ l o ~uu
• 111 j1T11.-, 111t11 01 ,lc!1

l1,1m ,•oq• Iii.il l ,111l e 111 \i; , , 1:,,U

• 111 ,-..I wrn hl. JI I I• a t.. , , 1,1m 1,,u11

t.J with \ lC"lh l.l k t'n I., reu11,~ 1, nlt>nng ,·ust,; by red uon g
11ng htichl\ .-Ilk 11·111 ""l' l'lit• 1 b,1,
r Otht'n-V1.st> it ran c:ausl'
t 11111-0. tttm .,._, ., .. , , ... ,,. hy , lr 1 C'h11
•.it thl'
wllh l,1:>l mtn uh· .1m111gvm rnts :ind df'ft
•IU4 • 11,1h u,ut Ith , ,•,nr tl , ' " ' ) "'" l, lllt r.l
~"II "' f111 0~ u,.- h l.;hl · H•p h1,t t,,1tt"d
Supph Ch ..il n M.1nag.-m t>nt
1~1 1"'" ' . , , JI I In I''-" 111 , ,
,luh ns r,u m,u e r1"\tutt em.-nt ,,f t'dc h tt t m
.and
t>I MJ '•\ ,1nina whi. h 11.-1 11 u, 1•rtll lU11100 ..d,c-
lt1 l1-,, tu,; •r•••m
U'l.i n,1)-'t'm c-11 l o t tn\'t 'n tun e fl ue- to
• A n11,.1111ial 11\t11 \1tjt ir I N 11,11 ,h" '' ct,• m vu.l vr,I In tht'
f\n.111.c• m.i n~'\'r mu. t ht> A~ .ll"l" -,( Ul\' elllO ry
h Ill 111\'1'1\lO I
.~ iOll,111" l11t p OIY-l t'llll lOll l 111 fUlh

, n.11 1~1111.11,1 .u,,1, 1111tr"I 1, h11h11u1\

-- -- -- -- -~-- ----
 Workln Capital Ma11.1
6• I S
• fl'l\!lrtee Mana me11t (MU
d in inventory. the lower the OPtirna.1 I
f funds 1nveste ev,1
• The greater the opportunity cost o rd quantity, all other things held consta Ill
er the optimal o er llt
averag~ Inventory and ttie low th fetY stock needed, and the lower th
the tower e sa . e lo~
• The lower the average lead time. Id nstant. To reflect change in cost of
things he co capft;i
Investment in tnventory, all other I er Accordingly, EOQ value W1U aJso b I,
. ed h1·gber or ow · · ecoll\.,
can-ying cost need to be ad1ust ·

lower.

t or current assets and arise due to Sal

• Receivables Is set."Ond major c00st1 tuen . . e of
These are aJso caUed as account receivables or ..,_,,
product/service on credit to customers. " <UJe
reei!lvables or trade debtors.
. · . f goGds/servlces as soon as It raises Invoice for sale on custollte,.
• A company 1-ecord s th. e sa1e o . ..,
• ot complete till the time It realises conslderatton for the sarne
however th e transaction IS n · .
• One may argue that unlike Inventory it ls entirely the choice of the company to sell products on
credit and in fact there are many businesses like retail who need not sell any product on c~it
• The amount of trade receivables for a com.pany will depend on percentage of credit sales by
the company and credit period For example, if a company has an average daily sales ol
Rs. 50,000 and sells 50% of products on credit at an average credit perlod of 45 days. Tot
account receivables will be 50000 x 50% x 45 = 11,25,000.
• Tbere are ~ny reasons for a business to sen products on credit like prevaJ.ent indusoy
practice, mMt short sales tllrgt'.t. expansion in new area of business/geography etc.. cleal"ince
of non-moving stock etc. Tbe funds blocked in receivables n.e ed to be financed which Implies a
cost f'or .tbe company. Further, company need to incur additional costs like collection and
_potential badiiebts due non-repaym.ent Hence, receivables need to be managed carefully.
• There are three major aspects r.o management of receivables :
1, Credit Polley
2. Credit Evaluation and Decision
3. Jlecetvables Mooitoring
 'f fltJaore Man~ emenl (MU) 6 -1b Wo r kin Caplual Maru ement

_ .1 credit Policy
63
nie amou nt of t rad e receivables. period of tr.1de re-ceivablc$ and terms rd:ttt-d to cr~dlt are
go"~rned by the credit policy of the firm. The credit policy of a company Is ba-.ed on following
\r;al'1ables
c~dlt standa rds
1.
_ credit tenns
2
3. collection policy.
Credit policy are expected lo have bearing on sales of the company, bad debt, discounts etc.
L,et's exami ne these variable independently. The goal of the credit policy is to enhance
s11archolders· wealth by striking a balance between higher sales a nd risk.
rds
6.J.1{A) Cndlt Standa
• credit standiards define tb.e mlnlmum criteria for extending the credit to customel"'S. Based
. 0 0 credit standards company will decide which custome rs can avail credit from the company.
•r:
ngbt credit standard s will limit the number of customer s eligible for credit sales. but will also
reduce the probability of bad debt and collection costs. Lenient credit standard s will Increase
number of customer s and sales but will also increase risk of bad uebt and collection costs.
"" • finance manager plays a role in credit analysis to determin e credit worthine ss of a customer .
Creditworthiness depends on 3Cs i.e. Characte r. Capacity and Collateral . Collateral or security
for granting the credit is generally provided by cus tomers to banks for avaihng loans and may
not be rieltvant for granting trade credit In most cases.
• Qaarac:ller' refers to willingn ~s of custom er to pay and is moral factor responsib le for
'• repayment Capacity refers to the ability of the customer to pay and is dete rmined by the
lin.tndal stren,th of the custome r. Company can use tools such as credit references, credit
rllbal, auulyds of ftaandal statrmen ts. put repayme nt track record etc. for
.. Niu &Nini the creclltwv■ 1htaess of a custome r. This as explained In mor e details In later
part of the dlapter.

e.3.1(8 ) Credit Terms

• Credit ~ refer to the terms on whl.c'.h trade credit provided by the company to Its
customers. These lnclude crecllt period. cash discount, penal charges or delayed paymen t
dlarges.
• Oedlt period refers to the length of nme period for which credit Is provided. Longer credit
~od means higher flexibDity for customer s and hence c.an lead to hlgher sale-. for the
company. Hip.er sales and longer credit will also lead to increase In ln\•estme nt in n..-ce1vable<i

•mount
 Work.I n Capital M.inageinellt
6 -17
• fln.1nce \farugl'ment ( '-IUJ
can offset increased cost due to higher
fi from higher sa Ie5
• If the! tncn.• J~ In operating pro it d will have a favoLLrabl,e impact on profit of the
tm'"l?stml!nl tn r~t'iv.ibles. higher rred1t perlo
(omiuny

• Credi! period I:. mentioned JS 'net date'. i um credit period of 30 days for paYTllent
• tom<'r has a max m
• For e;1..1mple. ·nel 30 me;ins Cl.IS th pany to customers for early paYTllent
. . Offered by e com
Cash discount ts. the discounl as per the industry policy, however by
d vid credit to customers
Company may nee to pro e . ages customers to pay early and reduce in
d i t ustomers it encour
providing c.ish scount o c . h discount and credit period will be state the
· bl s Credit terms having cas
investment in rece,va e..· 'Z/5 net 60' refers to the credit term
rl d of cash discount for examp1e. ,
cash discount rate, pe o d within 5 days and credit period of 60 days.
offering a cash discount of 2% for payment ma e
• Credit terms somedmes also mention • d eIayed payment charges to avoid delay in repayment by
customers. Pen.11 rate or delaye d paymen t charges referred to rate of Interest charged by
companies to customers for any delay in payment

6.3.1(C) Collection Policy and Efforts

• CoUection policy refers to the set ·of collection procedures to ensure collection of trade
receivables on due date. Having provided credit to customers, company can't simply expect all
customers to pay o·n due date.
• Some customers delay the payments due to genuine or may be habitual late payers.
• The policy should be explicitly fix the responsibility of coUection and follow up. Collection can
be handed as a part of accounts or sales team.

• In any case efficient coUection requires coordination between saJes and accounts department
Sales department should use inputs from accounts department while granting credit to
customers.

• Accounts department should coordinate with sales for recovering de.l ayed payments. Some
companies offer cash discounts to encourage customer to make payments before due date and
also charge penal Interest charges in case of delay in payment
• The policy shouJd ~respibe set of actions for reminding customers to make regular payments,
follow up for delayed payments and separate process to collect old and delinquent dues. Some
customers have the habit of delaying the payments, regu.lar follow up can d iscipline such
customers to pay on time.

• Some customers may have genuine issues due to business downturn etc. .and had to be hand)ed
carefully. An email should be promptly sent to customers In case of delay requesting to ruke
the payment Immediately.
 6-Jij

en
~mt' c:an t' o owin~ bv email rrom i.,nior
'fl1<'
, pc"~1111nl \ ' l<I~ 11nd leg.ii notice If requ ired. Direct le m<'mb
er!> of colle-cuon lt-Jm, lt"ttt'rs and
.-..,r the real purpnlie of collectton· t.ttL gal act,on is gener.,lly costly and m~y .. not
~ •· .. nen paym ents
canno t be collec ted, a comp romis e
trttt'rne nl can be made lo collec t a perce nt.i nt
i ge of total due amou
... 2 Trad e-of f ·
6,,.
c;oa1 of any credit policy is maxim lzat1o n of shareholders· w I h by
, . ea t maximizing operating
rofits from increa se in sales. Any change . in credi t policy n d be decided after weighing In
p ee to
,"()st-benefit analysis.

Managem ent need to consi der a trade-off bet w een the returns f ddl I
, cost or savings du t . rom a tlona sales or lost
Jes vs addio on.il
e O increa se or decreas ·
sa e '" receivables. Impact on bad
debts etc. The below chart expla ins the trade •0 ff be ·
tween tight and loose credit policy.
Cost of adl1Wllstrat10n and
ba<1-oeb1l loss
II)
~
~
i
g
ta
or,
iii
0
u

Tight - Credit policy - Loose

Fig. 6.3.2

Let's take an exam ple.

fflUltrltlon - Change In cred it stan dard s

sents varia ble costs befor e
Afi nn is selling produ ct for Rs. 100 per unit, of which Rs. 80 repre
tales.. Currently, annu al credit sales to selec t custo mers are
at a level of Rs. 240 Lakh and credi t
ards is expec ted to Incre ase
terms include credit perio d of 1 mont h. The relax ation in cr edit stand
-is expec ted to incre ase to 3%.
saJes to Rs. 300 Lakh annu ally. Curre nt bad dt>bt ratio Is 2%, which
Is 20%.
Rate of tax is 25% and post-tax oppo rtunit y cost of carry ing additional receiv ables
due to the addjt ional
let us evaluate the trade-off betw een the expected additional profitability
ables.
sales and the oppo rtunity cost of the Incre ased inves tmen t in receiv
ional sales
' Contri bution fro m additfo naJ sales = Cono ibuti on margin x Addit
_100 ~ 80
- JOO x 60 =02 0x60 = Rs. 12La kh.
debt loss on existi ng sales •
' AddJoonaJ cost due to incre ase bad debt losses = Increase In bad
42
bad debt on addit ional ~ale s = 3% - 2% >< 240 • 3% "'60 = 2.4 • 1.8 = · Lakh.
..,,,. ,, ..
 6·I9 Work1n Capita] t.1
• fin.arn.r ~!.m~cn1 ( Ml/) -ln. t~

CoJtlr tl:t ut1on - Addidonal Cost= 1 2 _ 4 2 •

• = lfi£ht'r ·
rt l·h.rngt> In ope111 ttng prcifl t · - 7..S4~h
• After t,u chilnge 1n 1,peraung proflt = 7 R ( 1 - 0· 25 ) = Rs. S.BS Lakh

• Atldl11onal rKf'l\able<i = 60"' l = R-. 5 1...;ikh.

12
• lnvt>sLment in = Pense raoo x Addjoonal receivables
addltlona l rece1\·ables = C'u
= o.8 ,c S = 4 Lakh.
• Req uired Rel urn o n Inves tment = Cost of capital x Additional investment = 0.2 x 4::: o.aI.a
Profi ta bility fro m addit io nal sales is su bstantially higher than the required return on addJtildi.
Investme nt, hence it Is advised to provide to addltlo nal cus to mers. ~

Illustration 2 - Change In credit te rms

· Let's ass ume In tht> above fimi has an option to increas e credit period for existing cost
60 days, which is expected to res ult an increase fn sales from Rs. 2 40 Lakh to Rs.
Ollltrs ·
360
1..i:
Current bad debt ratio is 2%. which is expected to Increase to 4%. Rate of tax Is 25% and
. . P0st-tc.i
o pport11nity cost of carrying addit ional receivables 1s 20%.
Let's evaluate the trade•ofT based on proposed change in credit terms
• Contribution from additional sales= Contribution margin x Additional sales
20
= lOO X 360.00 - 240,00 = 0.20 X 120,000 = Rs. 24 Lakh.

• Additional cost due to Increase bad debt losses= 1 % x 240 + 4% x 120 = 7.2 Lakh.
• Increase In operating profit= 24 - 7.2 = 16.8 Lakh.
• After tax change In operating profit= 16.8 x 1 - 0.25 = Rs. 12.6 Lakh.

• Investment in addftionaJ receivables associated with new sales= ~~-able c?st

· rng pnce
Credit period In months 80 2 z
x Additional sales i< 12 = 100 x 120 x 12 = 0.80 x 120 Xu= 16 Lakh.
Investment in additional receivables associated with change in credit period on existing Hlei
_ Variable cost E . Additional credit period in months
- Selling price x xlsttng sales x
12
1
l2
=0.80 x 240 x =16 Lakh.
• Total Increase in receivables = Rs. 32 Lakh.

• Expected return at 20% = 0.20 x 32 = Rs. 6.4 Laich.

After tax change in operating profit is higher than the ex pected return. hence, the tradt-ollb
favo ura ble.
 f ~ :!:J!C6
~"':':,:1,;;r
1J1 iiim •U._____6•·1112°
•e•n•r•(•M ..._______,:w~or~lo~n!g,;u:,p~l~t.a.l~M~a~n:ag£·e~m::;e;:n~l
.,,., f"aluatlon of lndlvldual Account for Credit

Stfort offen ng credit terms to any cust omer. compan y should perform cred it evaluation of
_,,ual customer. The credit evaluation involves following steps :
_,JJ•=
c,-td11Information
1 cf't'(ilt An.11lysls
Cft'(lit oec.1sion and Credit Lim.it
)

6,3,l(A} credit Information

lbC? first step for credit evaluation i.s to obtain credit information. Commonly used sources of
c¢1it information in India are as follows :
flnandal statement : Financial statements are ,one •if the most sources of financial position of
tbt .compallY· In India ~ubllc limi~ed companies and pr .,,ate lim.i ted companies are required to file
t fin.tncial statements with the registrar of companie5. These can be accessed by the firm planning
~ to grant credit for payment of certain fees. In addition, there are some third party providers that
~ pro\llde the financ~al info~mation ln m~re user friendly format. Company can use this Information.
t In case of propnetorshtp, pa~~h•p ft~s financial information is not publicly available,
~ company need t.o seek the finanaal information from the customer willing to avail the credit.
Trade references : Company can ask customers to provide reference of other parties having

l
'
I
lr1(!e ulationsh1ps. Company can check from these references track record of the customers. This
is an easy and free resource for checking credit worthiness.

CredJt rating : Companies can check the credit rating of the customers if available. Credit
, rating are the ratings on the credit worthiness provided by third party credit rating agencies such
, as Dun & Bradstreet, CRlSL, ICRA etc. These are used by companies to avail financing, but may not
l be available for all customers.
Past trac:ik record : Company can check the record of past dealings for existing or old
f
i customer.
! 6.3.3(1) Credit Analysis

Havlng collected credit information, the firm must make a credit analysis of the applicant Ratio
Wlysis of financial statements, credit rating etc. are used to understand repayment capacity.
Information ,o n management of the customer and trade reference can be used understand
: "'Plltltion of the customer. Some companies have developed internal credit scorin.g system based
I Oil 6nancial ratio analysis, management analysis, past payment track et~ to decide on credit
WOfthiness.
 t> ,' I

6 ,3 ,J(C ) Cre dit Dec isio n and Cre dit Lim it

m ~ t t,e re• aL h e c1 abou t the gran t of cre d it Th e d eci•..ion to &ta
lint r In '(ltt m ,, ty,.I \ a dl-0 ,10 11
Ill
J nv <an S<"I a cred it limi t for .i cu1,
10rner , 11,-+,;_,
nh t cJn h.. lnr a ,mi; le tr.in H-o on llr J t o mp ,
thr l,
d a t any one li me ''ICII
c n ts ., rn.l \l mum limit on !ht• amll unr t h e fi mi will perm it t CI be owe
n i,r'°'

6.3 .4 Mo nito ring of Rec eiv abl es

J\ l\n n lll't'd Ill !"1'.iul.irly mo111to1 thl' recc l\:oh

le,; to e ns u rt' th t1 t the re ce ivab les are getting

collN: tt>d •" pt"r tht> ln>dl t li'rm aml rnlnl ml'Z e the bad debt losses. Follo wing methods Of
mon lt11ri1~ r,r t l'fl'•lvatlle,; :11e commonIv us ed.

Rec elvable1 Mon itor ing

Rece lvebles Monitoring

'
A~ age Collect10n
P N lOO
l
Aging Schedule<
l
Co flectJo n
Exponence
Matnx
Credrt
'
Ullhzatton
Report

6.3 .4( A) Ave rag e Col lec tion Per iod (AC P)
peri od of cred it sale s and compares the
• In this mrth od. fl nn com putes the aver age collection
s ame w ith the l"t-edit polic y.
Deb tors x 360
Averagt> Collection peno d (ACP) = Cred it Sales
it peri od as per the polic y to judge the
• Ave rage- roll,~cuon peno d Is com pare d with the cred
0n peri od is mor e tha n the cred it period as
effic ienc y o f collcccio n policy. If the aver age co llect1
s to impr oved .
per the pohc y. then tht> colle ctio n polic y a nd effor ts need
effica cy of colle ction effor ts. However,
• Thr abovt> meth od prov ides an over all pictu re of the
ic deta ils on am o unts that are due fo1
.wer age collection perio d s uffers from lark of s pecif
long er th:111 av<'rage pen od to take acno n.

The early payi ng a ccou nts can mask perf orm a nce of
slow payi ng acco unts . Impa ct of seasonal
•
red in.
vana non s in sales on the colle a1on peri od ts not facto

6.3 .4( 8) Agi ng Sch edu le

ent band s o f agin g or aging bucktts. ~
• In tlus mr!h od. recoavable s are dilSs ified into d iffer
outs tand ing.
n:-fr rs to the length ol time for whic h rece iva bles I
 t,1.i nagement (M UJ 6 -22 Working Capita l Management
f ~111.anc«'
' g3 naly is provides 3
cleare r pictu re of the s low moving accou nts and provide early
'fht a~1n . d of
• n risk of defau lt. Following is the aging sched ule of receivables having credi t perio
0
3(31'11lS

30 days.
I• n,e ~verage collection perio d may be close 35 days. Howe ver, the table
show s 6% amou nt
th311 45 days a nd 3% of the amou nt is outst andin g for more than 60 days.
utsranding for more
0
t the amou nt at risk of
hich n,ay pose risk for collec tion. Aging sched ule provi des an idea abou
;efault and help take remedial actions.
• Aging schedule does not comp are the receiv ables with the sales.
Aging (Day s) Outs tandi ng Percentaae

0-30 s.00.000 61
31 -45 2.so.000 30
46-60 50,000 6

61 and above 25,000 3

Total 8,2S, 000

6,3.4(C) Collection Exp erie nce Mat rix

Jo this technique, recei vable s arisin g from the saJes are plotte
d again st the sales of perio d. This
of the same perio d. In the
helps to comp are collec tion exper ience of receivables with the sales
ables are show n horiz ontall y.
collection exper ience matri x sales are plotte d horiz ontally and receiv
following table show s an exam ple of collection exper ience matri x

Amount ln Rs. Lakhs Months January February March Aprll

6000 6000 7500 5000
Sales
Recei vable s
Janua ry 3500

Febru ary 2000 3500

March 1000 2500 5000

500 1500 3000 4000

April
200 500 2000 2500
May
200 0 1000 2000
June
 WorkJn Cap ital Man•
f.r l. J

Thr r l'(""l'IVahlC', .irr ,i"" t•xpn,!it' d

--
[l .~ ..

-- Moath• January f d>ruary March Aprtl

- -,\mount In h Lakh•

~a l1"1
'

6000 f,000 7500 sooo

Receivables%
January 58%

Februa ry 33% 58%

17% 4 2% 67% 0%
Ma rch

April U% 25% 40% 80%

May 3% 8% 27% 50%

June 3% 0% 13% 40%

6 .3.4(D) Credit Uti lization Report

In this report, details of the total llmlt of credit offered to each customer and the extent to
which II Is utlllzed ls plotted and reviewed on periodical basis. This provides the Information on
the extent to which to tal limits being utilized.

Customer Credit Umlt (Ra. L•kh) Limit UtlJJzed (Rs. Lakh) % UtUlt.atlon

A 2000 1500 75

B 1500 1400 93

C 1000 800 80

Total 4500 3700

6.3.5 Sale of Receivables/Factoring

• Assignment or sale of receivables Is one or the most commonly used methods for realls.atlon or
early payment an d reduce receivables. In this transaction, company sells Its receivables to
banks or specialised flna·nclal Institutions.
• This transaction ls called Factoring or assignment of receivables. There are speclalistd
flna:ncial Institutions who engaged In pur chase of receivables called as Factors.
• A Factor or bank deducts d iscount and factoring charges from the r eceivables amount and pays
the balance amount to the com psany.
• On the d ue date Factor collects.th@money directly from the cus tomers. In a typical factoriiil
trans action, to mltlg.ite risk of defauJt or delay, factors require com panies to compensate diem
up to a Rxed pt>rce ntage o f rl"C'elvables.
 ,, 14
w ,11 1t11, r, ,. Hl.,t l Man.i mt'nt

..,.,..pi, I ,,,mJ1lll'Y I, t \rlllk ,orn .. flUl',l.l•1th nc lt'f l"lv .. bl.- C>f lh '.iOO l..ikh d11I' .ch.er 6-0

.)I'
.'
,. ~ ",ntt• .,,, .. .Ir.. , tl'rllll' '"'"

IIJO"'"'111
L
~tl htl l W1l h • 1-ar '"' .,,
drdtlf t ,11-.,1111111, h-1, ,.,., 111 uy Ra I J. l..akh ( 1o1,...
..,u1
Ii h ,111\,

J. .., d
4 -,,, Ji.n p.tyRs 48Rl..akh to
1'1" on Ju" ,J.,1,. t h .. hank 1,r I 1 II
' ,,11•Jl-'nY •H or w l 'ollf'CI th t• p.iymcnt dlrt'Ctly from th e
~
r,,tTtd
111'
_s_ _ __ _
l t_le
, .,_!'~ emen t of Cash •n~ Marke table S~u~_
.,, · . .. 1~ prohahlyth11 li•.i•,I prod uc tlve llSNnt am o nl( r urre nr :t"l5f't.s, ,. ~ ldlt cash dOt'S not
(.>"'
r('turn F.v1•n In r ,,i.e, wlwr,, rnsh I\ I nv t-,tt>d l11 thr h,m lr dt'pn\ lt \ o r s hort te rm
1c any
~ibl,r scoiri t lr\ rrtu rn, ,1r,, Kl:'ncr •.•llv mu, h low•r tha u u>'it u f <.tplt.11 However, lt ls
St' crltir ·11 In rnnny .,,.r,cr 111 ~ 11 111d
' · · " u • lo rn"ct J>dym ..nt 11blt1t:1 lions We have seen
i,,hlY most
th
I"°nd> of growing u\h balt1n(r\ on e hdl,mce "herts This can be attributed to many reasons
:~ is 1ncreaslng untc rt.1irit1,,, . , hortcnt-cl bwil nes!i cycle'i, niptd disru ption In busi ness and black
f"'il"c\lollts llkc glohal flnanclal rr1sls or 21108, dcrnon.,ttzatlon, pandemic like COVI D 19 etc .
,.,.l Motives for Holdln g Caah

companies hold sumclent tai.h balance for various reasons. Then: are three maJor motives for
t,oldlllj! cash
, Transaction Motive : In the normal course of hu1.lness. compa ny need to make various such
as purchase or goods. salarte~ to employee s, utility payments, Instalmen t of loans. Interest
expenses, dividend ~tc. Co mpany also receive c:.sh from sale of good, how ever the need to hold
cash arise!> because thl! timing mismatch es between cash recelpt.'i from sale and expenses . This
.s motive for holding the cash In transact ion motive. Company can choose to maintain ca sh for
Immediate payments and balance In the marketable securities and time the conversio n of
securities to cash with the payments.
, ~utton ary Mottve : A finn may hold Caih to meet contingen cies of the future. These
amounts to gu ard off against unexpect ed fund requirem ents. These may artse due t o sudden
shilrp fall In sale~ or higher than expected payments etc. As these fund s may not be required tn
normal course company can Invest such funds In liquid marketab le securitles such as short
term fi xed deposits, money market mutual funds. If the company has an access to s hort term
funds or unutlllzed cred it lines etc. It can choose to borrow the funds Instead of holding the
c,uh
• Specujadve MotJve : So metimes companie s h old cash to take advantage of Investme nt
opportunitle!> such a s advance mitcrial purchase In anticipation of fall In Input price s, holding
hind, to Invest In marketab le securities or borrowing and holding cash In anticipatio n of rise In
Interes t rates In near futu re Speculati ve motives are generally not common.
 6 .4 .2 Cash Management Process
anagement of ca sh a nd cash equlvaJents, th
s tnvolves t h e m · ~
The , a,;h managt>meni proces .d t d into cas h quickly. Cash managern
. thd t ran be lfqu, a e . eni ,,
includes marketable sccunne-s · f ·h fina ncing s hort term defici ts and inves.._
conr cm ed w 1th collection f cas 1• • °
I pavmcnt o ca s •
. the cash manage
ment process .
""~nt
of c.1Sh surplus Following p1ctUre captures.
,__
- ' cas1,
I
cofleotlOn

Business
ope rat,ons Deflcrt Borrow
' .

•
.
r

. Surplus lnves1
l nforma11o n .

and control
,

"
'-- Cash payment ,--

Fig. 6 _4 _1 : Cash management cycle

Cash management process consists of following steps

1. Forecasting cash flows
2. Managing cash collections and disbursements
3. Investment in marketable securities

6.4.2(A) Forecasting Cash Flows

• This is the starting point of the cash management process. Cash forecasting is done for various
periods. Companies prepare cash forecast for daily, weekly, monthly, quarterly and annual
period and these are considered short term forecasts also called as cash budget.
• Cash budget helps company
1. To determine requi.rement of operati.ng cash
2. Plan and negotiate short term borrowings
3. Invest surplus cash
• Accurate cash forecasting can help company to prioritize payments, borrowings, minimize id.It
cash and borrowings.

• Long term ca.sh flow forecasting of 3 to 5 years helps in final izing financing a nd investment
strategies.

• DaJJy, weekJy and monthly cash budget are prepared by forecasting a ll the receipts and
disbu rsements (payments). The receipts consis t of cash lntlows from operating and non-
operating activities.
 r,tan.agl'ment ( MUJ 6 -l 6
f f',nlnct Worltlngu gttal M11.1t11gem~IJl
/ ., .,, .,, nes consl~t ol collecllon~ frt, m t,~tne~ activt 11 -h
"-..?1,ann,.. 11 1 . l'S 1>uc as ~les and service,
1
, 1,;,.-
. . t:OO'> ISt of other t:<Jllu-tion· s sue t1 as rental income. fn tere,;t
.,-illlr non•oP'•r,1t1ng l d ~h tnf ow!>
~e. income fro m ,alt: of asset such as land · building ttr · Disbursa 1~ consist . of all the
' such as parments to be made for
,'Al tfl O\II~
i) operating act1 V1ties such as purchase of mate rial. taxes, salaries. overheads etc.
1
Non-oper,iti ng activities s u, h as capita l ~nd iture, interest payment. prino pal re pavment
IJI1 •
oflong term loans etc.
-rM difference between receipts and dis bursals is the net cash shortfall or s urplus Following is
' example of month ly cash budget of company having 9QOA, sales on credit and 10% on cash.
10
company collects 80% of credit sales in next month and 20% in the month after. Further.
,ornpany also buys raw materials on credit w ith credit period of 30 days. So the purchase of
·tie current month is paid in next month.
l
-
i;;,..nt I.II Rs. Thousands Februal') March April May June July AU.RU
...... 375 525 450 525 375 300 375 450
~oia1Sa1es
~redit sales @90% 338 473 405 473 338 270 338 405
Cash sales 38 53 45 S3 38 30 38 45
llt(elpts/ collectlons
Cash sales, current month 45 52.S 37.S 30 37.5 45
80% of last month's credit sales 378 324 378 270 216 270
~O'lb ofrmonth old credit sales 67.S 94.5 81 94.5 67.S 54
Ifoul sales receipts 491 471 497 395 321 369
Purchases 22.S 315 270 315 225 180 225 270

Disbursement for purchases and other

~rating expenses
100% last month purchases 315 270 315 225 180 225
Salaries and Wages 45 52.S37.5 30 37.5 45
Other expenses 45 52.S37.5 30 37.5 45
Total Operating disbursals 40S 375 390 28S 255 315
Capital expenditure so 75
Advance tax 45 37
405 425 510 28S 255 352
Total Cash disbursal
Net cash now 86 46 -14 110 66 l'Z
150 236 282 268 378 444
Beginning cash balance
rrOQJ cash 236 282 268 378 444 461
BorroWing - - - - - -
Interest on borrowings - - - - - -
Repayment of borrowing - - - - - -
236 282 268 378 444 461
~slni cash balance
- ...., I I C.
 Worlon f Capital Manag, ,Tlt
() l.i 111
• flln.irK" Man.tf ~mrnt (MU}
~
tlon of ca h now stalem ents using adlusted
c;U)I forrca-'1in1 lnvulve , prepar a
• LA>tlC ttt'lft lltt
d h now statem ent prepar ed us ing toreca sted .profit illld
IJIC'Offll" method. It h a proJect e ca~

d from the project ed profit and loss st:atemcn

• Nel profit. dt pren nuo n Interest etc are ust>
l
h . 'tal budge t The workin g capital changes art
C..p1tal expend iture is taken from t e cap1 . .
tal to sales in the past and the same lS extrapolate(! for
csurnat ed uslnl{ ra tio of working capl
- . . made for 2 to 5 years. Long term cash forecast Is
fururt> periods Long tenn cash forecast is
. ts •n the future and finalize financi ng strateg ies.
usc>d fo r estimat ing financing require men 1

6.4.2 (8 ) Managing cash Collection• and Disb urse ment s

. fully manag e cash t1ows In accord ance with the cash budget
Finance manag er need to care
Finance Manager need to prioriti ze or acceler ate the collect ions a nd delay or postpo
ne tasb
disburs als wherever feasible.

l . Accelerate Cash Collec tion

• The firm will like to s peed up collection of accoun ts r-ece1vab le so that It can u se
the cash
earlier to make payme nt or conser ve for future payme nts. Some of the method s to
speed up
the colJecti ons are
1. Expedite prepar ing and mailing of the invoice.

2. Reduce time for collection of payme nt instrum ents from custom ers - This helps to reduce
mail ftoat i.e. the time taken by the custom er cheque s to reach the firm.

3. Reduce the time for processing the payme nt - The time requir ed for processing
the
payme nts Interna lly as well as with the bank Is called as proces sing float Compa ny needs
fD
expedi te the proces sing of collect ed cheque s or payme nt Instrum ents to reduce
the
process ing float The mail float and proces sing float are togeth er known as collecti
on or
deposi t float

Compa ny can use decent ralized collect ion system, lockbo x system to reduce the deposi
t floats.
• Decen tnllud collect ions : Company can have decent ralized collect ion centres that collecis
the payme nt instrum ents such as cheque s or drafts from the nearby custom ers and
deposit tbe
same In the local bank accoun ts.

• This helps to reduce malling and proces sing time for realisa tion ( payme nts. Funds
0 from local
bank accoun ts to central ized or concen tration bank accoun t using electro nic fund transfe
r.
 6· 28
Working Ypital Mana ement
. _,...hol system : This ls a very popular . .
, ~ S}'S\em sn Umted States, where f\rm establishes
__, 00 cenrres near customers and place b
"°11~- t payment In struments In post box which
po5t ox at the collection centres. Customers
d~ a.re directly collected and deposite<I to the
ny's bank accou nt by local ban~rs of th
(lJITIP3 e company. This helps to substantially reduce
[ht processing time as bank directly collects and deposit cheques.

die advent of electronic fu nd transfers d . .

WIth an onJine bank.1ng the use of cheques etc. for the
pa)'11'ent Is coming down drastically.
z. contr0l Disbursements
• control of disbursem ents Is essential for success of efficient cash management. This involyes in
so ..nng
I .• , down payments to conserve cash and r·ed · uce borrowlng requ1rements.
. The company
th d
should utilize e tra e credit available for purchase and delay the payments to the due date.
• company should make the payments early only where it earns the cash discounts. Unlike
collection which involves decentralized collections for accelerate collections, the disbursement
I Is centralized from one bank account.

f • This helps the company to effectively control payments. The disburseme.n t bank account is also
j CM concentration bank account where all the balances are transferred from the local bank
I accounts. Sometimes the companies have issued cheques and the books of the company shows
the payment. however due to mailing and processing time the cheque may not pro.c essed. In
f such cases company's bank balance will be higher than the book balance, because as per
l accounting books entry is passed when cheque issued. This difference is called as payment
f ftoat ordisbursementfloa~

I 6.4.2(C) Investment in Marketable Securities

!
r Generally, firms ti)' to maintain target level of cash or optimum level of cash. Excess cash over

1 and above optimum level is invested in short-term marketable securities. ln this section we will
Wldemand the firm's use of marketable securities. Investment in marketable securities held for
cash needs for precautionary motive, controllable outflows such as dividend, tax payments etc. ln
I choosing the marketable securities the firm should examine basic features of security such as

: The fiTTn Is investing cash in marketable securities for use at a later date on short
f . Safety
notice. Hence th.e firm will invest funds only in very short term securities offering high degree
I

!.
of safety and very low default risk.
Marketability : Marketability refers to the liquidity of the marketable security; it indicates the
•na.A d . b h "ch r..,.,•rity or investment i.s converted Into cas h. The securities
s~ an convenie nce y w 1 ""'" '"
for investment s hould be highly marke table.
t
 6-29

r1 d for repaym ent of principal and interesL A

M tur11ty • Manin ty rders to th e time pt.' o . s tht
• a· · . d lh II uldlty reduces. The price of long terrn se
mo1turit)' lncn:•ase:; IJW risk Increases an e q t th f'i CIJr1t1
latiJlru In price and ensure sa l!ty, ~ rms lnven b
v.ines wi th lntcrosl rates. To a vo1d vo ~J t ~
c.u1h s urplus Into short 111.nn securities.

Types of Short term Instruments

overnment securities and regarded
• Treasury BIiis (T·blJI) : These are short term g as tJie
safest and one of the most liquid security. Treasury bills Issued by central government and
have original maturity of 91 days. 182 days. 364 days.
• CommerctaJ papers (CP) : These are short term unsecured debt Instruments g;enerally Issued
by large companies. These instrument have high liquidity. In line wi th Treasury bills these are
also Issued at a discount and redeemed at par.
• Bank deposits: These are fixed deposits held with the bank and varies between 7 days to 365
days or more.
• Certlflc.ate or deposits (CD) : These are unsecured debt Instruments Issued by the banks 10
raise short term funds. These are issued at discount and redeemed at par. They are highly
liquid Instruments.

• Inter-corporate deposits (ICD) : This is short deposit parked by one corporate entity with
another. GemeraUy, companies Invest the ICDs with their sister concerns or subsidiaries. On the
due dat,e company receives principal and lnt,erest.

• Money Mark.et Mutual Funds : This is one of the most popular instruments for parking short
term fu10ds. Money market mutual funds Invest funds in the money market instruments such a.~
treasury bUls, commercial papers, certificate of deposits. Companies can invest funds In money
market mutual funds and redeem the units ais a.nd when required.
6.4.3 Cash Balances to Maintain
• Most companies establish an optimum target of cash balances to maintain. Excess cash can be
Invested in mark.etable securities and interest can be earned. Idle cash means loss of
opportunity to earn interest from invesllllent Higher the interest rate, larger will be
opportunity cost of maintaining Idle cash. At the same time the company needs sufficient cash
to meet day to day requirements.

• The optimal balance should balance the twin objectives th·e abllity to Invest the excess cash for
a return and ensure sufficient liquidity for future needs. How much cash is optlmum cash?
There are tw,o methods for estimating optimum cash.
 f f\11.anee M3nngen\ent (MU) 6- 30
W or km g Cap
ital M ;& ~g em en t
/ a ) oeterm . in ln g O!>timal C
•.,.3(,. c e rt a in ty - W il h a m B a u ash B a la n c e u n d e r
m o l' s Cash Model
C o n d it io n s o f
jhe S.tU!ll0l 's m od el is ba sed on
th e as su m pu·
• ccuratel)' an d th e on s ...
u, at all lh e o sh ne
pa ym en ts ar e m ad e ed s .tr e fo re ca sted
a un if or m ly ov er a pe no d of
ca mpanY in cu rs tr an . ti m e.
sa ct io n co 5t w he ne
• jhe . u"" holding ve r it conv er ts m ar ke
co st fo r ke epin g th e ta bl e se ru nti es to ca
~~••
Id le cash bal"'nN• sh and
• 'fhe obiective of th n•~
is mo~el is to m in im
iz e th e su m of th e
rrunit)' co st of ho ld in fixed co st s of tr an sa ct
g ca sh balances. T he io ns an d th e
opPo es.. T co st of ho ld in g cash
ln cn-.ases as th e id le ca
hi s Is s1m1·1ar to E · Ord er
111creas co no m 1c Q ua nt ity of EOQ
sh
managemen t. co nc ep t of in ve nt
or y
• Total cost is th e su m
to ta l of ho ld in g co
\ cash, Holding co st st an d tr an sa ct io n co
is eq ui va le nt to th e st of co nv er si on of
op po rt un it y co st of m se cu ri ti es to
:u nt ai ni ng average ca
~ where 1s C is the rt"Q sh ba la nc e Le
~ uired cash bi.lance.
•·
• ib e com pa ny 's ho ld
in g c.ost is in te re st
fo rg on e on th e av er
ag e cash ba la nc e i.e
me in te re st ra te fo r . k ( ~) . w he re k
15
th e pe no d. l.e r's as su m e th at the co
mpany In cu rs a transa
per transaction. ctio n co st of c
• Then cost fo r m ak m
g to ta l pa ym en t of T 1s c 'l<

Usmg calcul us . thtt C

T ot al Co sl = k )( ( ~
. C )( m
1s m in i m um w he n

Where
C· Opomal Cash ba la nc
e
T· Total cash ntteded du
nn g th e pe no d
c· Cost pe r tr an sa ct io
n
k· Opportunity co st ho ld
in g ca sb fo r th e pe rt
od
l'-tratio.1
f Rs.
.t
A fin n m at ed a ca h re qu 1~
m ~n \ 40 00 0 over a month. w tl tt e disb ur se m en t ar
0 e m ad e
· tlns un t ~ te Oppor • 8 n, ,rc cn t pe r annu Th tn n ~ cn o n co st 1s R
tunat)' L"l lt !i "~ ra tr IS m. e s. \00
y-
 6 0
Working Cap1t1aM '
z (JOO } (40001 ,_, aooooon "' Rs. 3265_
0,75
Optimum t.a,h 8dlance C • 8
JZ
40000 = 13.
No. of transacdons In a mont h = 3265

Holding
costs

Minrmum
Cash balance

Transacik>n costs

c· Cash balance

Fig. 6.4.2 : Optimal cash balance

6.4.3(8) Determining Optimal Cash Balance Under Conditions Of

Uncertainty - MIHer-Orr's Cash Model
• Baumol's model is based on the assumption that payments can be accurately predictfd,
However. in practice cash inflows and outflows are uncertain. The model assumes:cash inflows i

and cash outflows are stochastic i.e. each day a business may have both different cash
payments and different cash receipts and the daily cash balance ls normally distributed.
• The MIiier-Orr model places an upper and lower Umit for cas h balances. When the upper llmlt
is reached, a transfer of cash to marketable securities is made. When the lower limit is reached,
a transfer from securities to cash occurs. A transaction will not occur as long as the cash
baJance faUs within the limits. Securities are sold for the value such so that the cash baJance
rises to the Return Point
1
1
Return Point = Lower Limit + x Spread
3
Upper Limit = Lower Limit+ Spread
The equation for calculation spread is as follows :

Spread = 3 x
f<r} fc}
~(3)4xk

Where
c - cost per transaction cost
k - opportunity cost of holding cash
a2 · variance of a daUy cash balance.
 Uppef hmil

- Purchase of securitkls

~ell1mPo1re
- Sale of SGCurrties

Lower Omit

Fig. 6.4.3 : Chart

• wt,en the actual cash balance drop s to the lowe r limit, cash balan
ce Is increased upto the
return point. which can be done by selling Investments in marketable securities.
• wt,en the actual cash balan ce touch es the uppe r limit. In such cases
, It is necessary to buy
marketable secur ides and resto re the cash balance down to the return
point The amount to be
Invested Is the diffe rence betw een the uppe r limit and retur n point.

~o n
The management of a comp any has set a. safety cash balance of Rs.
750,000. The standard
(ie¥ialion (a) of the dally cash balan ce durin g the last year was 375,000,
and the transaction cost
was Rs. 1000. The comp any also has the oppo rtuni ty to Invest Idle cash
In marketable securities at
an annual Interest rate of8% .

DaUy Inter est rate = ~Ps : 0.022%

¾£3) (375000) (375000) (1000)

Sprea d = 3x (8)
(4) 365

Sprea d ,. 5064 81
1
Retu rn Point : Lower Limit+ 3 x Spread
506481
= 750,0 00 ♦ 3 =918827
Uppe r limit = Lower Limit + Spread
= 750,000 ♦ 506481 :: 1.256,481
 i
• - •Fl•n•an. ~~M;.;,;a~
• . na~~e~n~
,e~n~t~lM•~'-- - - •6•·•33• - - - - - - - - W •o•r•kl•n Ital Ma~ el'llelit II

I Review Queatlon• I
0.1 Explain ihe concept of wori<lng capital. groaa working capital and net working Capital.

Q, 2 Explain the conoept of aperaling cycle end cash cycle.

Q. 3 Explain the Importance of working capital management.

0.4 List the factors affecting working capital and explain In b rief.

0.5 Explain the trade-offs in optimum working capital management. inventory man4 119men
I, C1911
management, receivables management.
Q. 6 What is economic order quantity and what Is ltle trade-oft for deciding economic Older
~ ~? ~
0.7 What are the motiVes for holding cash ba'lance?

Q. 8 What are the three elements of credit polloy In receivables management?

Q. 9 What are the different types of short•tenn Investments ava.llable for finance manage, k:r
investment of excess cash?

oao
 Sources of Finance
and Capital Structure

s,,td'of Anand: Long Temi_Sources ~ Equity, Debt. and Hybrids; Mezzanine Finance; Sources of
si,of1 Ttf'T' Finance - Trade Credit Bank Finance, Commercial Paper; Project Finance.
o,1111 §trUdUN : Factors Affecting an Entity's Capital Structure; Overview of Capital Structure
n,eorifS and App~~s _- ~et Income Approac~ Net Operating Income Approach; Traditional
~ h. and Modi_ghani-Millef Approach. Relation between Capital Structure and Corporate
. concept of Optimal Capital Structure.
v,ue;

Acompany needs to sutvive the down cycle and be agile enough to seize growth opportunities
an upcyde. Debt capital can be easier and faster to arrange than equity, however long-term
pact on the flexibility and su.rvlval needs to be well understood. This chapter provides
dtrstandlng about the concept of capita) structure and different sources of financing.

Long Term Sources of finance -Equity, Debt, and Hybrid, Mezzanine financing
Sources of Short-term finance • Trade Credit, Bank Finance, Commercial Paper
Project Finance

.1 Introduction to Sources of Finance

In the previous chapter we discussed in detail the long term and short-term investment
decision considerations for canying out the investment function of finance manager. In this
sect1011, we will discuss the various sources of financing and financing considerations to carry
out thl! financing function.
Sources of financing can be classified into two broad categories i.e.
I. Short term financing

2. Long term financing.

 Sources of Ftna111I' lii L.1 rn.11~lructu~
7 -2

h t re repayab le within a period or

• hon tern, flnancinti Includes the source• of nnan«- I a a
nee that have maturity of more lha n
I year. Lonll te nn fl m111cln11 Includes the :sources o f nna
t )'t!ar and Include sou"'e that have no nxed matu r1 ty sue
h as """Ulty
-, • perpetu al debt t tc.

• F11, 7.1 I 11hows the typl's of nnanclnt1,

,
SowoN of '1nencln g
I
l 1
ShOfti.rm Longlem l
Financing Flnanc:ing
I
! l l l l
Trade ea,• ComrntHcial
Paper
Equfty Debt Hybrid
Cledll Finance
I
I l l . l
ConYer1ible Warrants
Term Loan Debentures Debenturea

,... 7.1.1 : Typa, of flnwlng

7 .2 Long Term Sources of Financing

• Long term sources of financing are used by the compan ies to fund their long term or
permane nt fund requirem ents. These are the most crltlcal source of ftnandn g for business as
these provide the nettssar y capital for Investm ent required for sustaine d growth of the
company.
• Long term sources of ftnances are typically cosdler than the short-te rm ftnandng, howtver
provides more flexibility to the company.
• These are used for funding long term outlays such as purchas e of plant and machinery, land.
bulldlng. Investm ent ln permane nt working capital, expansion, acquisit ion of companies,
assets. provide risk capital for new venture s etc.
• The most commonly used sources for long term financing are as below.
7.2.1 Equity

• Equity capital is also called as the ownersh ip capital or shareho lders capital. It consists of
fu nds raised from exi~tlng and new shareho lders of the compan y and earning s retained in the
company.
 IIUIOI MIi
~01111. t,s nl 1r1n•nu, & Ca 1111 Stnn turti
il".rfl .,.. al ,, known ordln.-ry sharT,/
~ t o mnion rrl0t-k \ t
• - ""• share premium and rl'lalu-·• u,r,.holdrni' rapltal 111 um or
~up,..... ru l'Arnln1111
C11pltal "'pre e nt1 tht' mruchnu
• _......,d
Allffl"' '~- m rapltnl th1A1 , r ,
• ....a..nld,n and C'lln be a ltt-red by the, c . · ' l mpany nrn raise from ltt
~~- orni.).lnv ai r111r lhl' "" I
shl~n. Authorited ca pital Is dlv1d d <1u rcnwn1 oftc,r t.nklnit approval
rrot" . . ha h «' Into equity sha n•s •lsu c.illcd as ordinary
s)llrtS- £1(:h equity s re a a face, value or p11r vo1lur An
tro"' llS- I. Rs. S. Rs. .IO or Rs. I 00. d (lcnor11lly in lhl' denomination of

~ company raJse funds and Issue shares. equity h

• c-.ip1ta 1 t At has beon subscribed and paid
or
..., the shareholders the company Is called as Issued and pa Id capital. It Is equal to number or
.,,
rqul'Y sham mat have been Issued and the foce value or shores.

• ~ l y . company Issues new shan:s to Investors It Issues ot ll premium to the face value to
rdlfCt the ptrcefVed market value of th e company. Share premium n!presents the difference
!ht Issue price and the face wlue of 5hares. For example. Issue price of IRCTC share was
Rs. 320 per share vs face value of Rs. 10.

• AJ,oCher lmporunt component o( share capital Is retained earnings. It represents the total
profits retained by the company In the business after paying out the dividend to shareholden
ol the company. Retained earnings are not a source of new capital; however, It forms part of
ownership capital. As company has retained the earnjngs Instead of distributing It to
shal"l'holders it is considered as a part of shareholders' capl tal.

7.2.l(A) Salient Featu .... of l!qulty Shara

• Ownenblp and votln1 rl&bts : Each equity share represents proportionate ownership of the
company. Equity shareholders have voting rights In proportion to their shareholding.
Shartholders are expected to vote on multiple matters such as appointment of directors on the
board of the company, new fund raising, acquisition or mergef etc. In modem times,
shareholders can also vote using e-votlng option. A company needs to conduct annual general
llleeting of shareholders once a year, where directors elected based on majority votes.
ln'lfflors can vote In person or appoint another person to vote called as proxy voting. To
~fexuard rights of minority shareholders. there are registered Investment management
co111pan1es that cast proxy votes on behalf or mutual fund shareholders or high net worth

investors.
 Sources of Finance & Capital Stru
• Finance Mana. ement ( MU) 7-4

• Control over management : Shareholders can exercise control over the management 6-~,
board of directors. voting on managerial compensation etc.
• Claim on assets : Equity shareholders have a resldaaJ claim on the assets of the cot11paqy Ii
the case of liquidation.
• At the time of liquidation of company, claims of debt holders, fina nciers, gove~
employees. trade creditors are first paid off. The shareholders are paid off only the r-esld-.t
amount.
• Limited UabUlty : As a company is separate legal person, shareholders of the company are IIOt
required to share any liabilities of the company. So in case of failllll'e of the company dt,
financial distress; etc. shareholders are not required to contribute any shortfall etc. Eq~
shareholder is holding the risk only to the amount that they have invested in the shares of-tWe
company.
• Dividend : Whenever a company declares a dividend, all shareholders have the right to rectlw!
dividends In proportion to their shareholding.
• Freely transferable : Generally, there are no restriction on sale of equity share of publiclJ
listed companies, hence shareholders can easily sell equity shares and convert to cash.

Adv■nbltg• of Equity Fundlnt

1. It is a source of permanent capital for the company. It provides company flexibility to take -
riskier and long gestation projects.
2. Equity shares do not carry any fixed payment such as interest t>r coupon. Payment of dlvid
is entirely at the discretion of the company.
3. EquJty share capital provides leverage to raise...:1dditional debt at more attractive terms;
well capitalized companies are considered less risky by the financiers.
4. Equity funding allows the company to increase shareholder base and brand name of th
company.

o,a-tv■nt'ae• of Equity Funding

1. Fund raising through equJty can lead to dilution of the ownership and
promoters.
2. Fund raising through equity is costlier due to compliance cost associated with fund raising
from public.
3. Dividend paid out to the shareholders are not tax deductible, hence vis-a-vis debt it a less taX
efficient source of financing.
4. Cost of equJty is generally higher than debt, as investor expects higher returns for the risk.
f flnln cr Mana e ment (MU 7.5
Sources of f11nan ce & Ca ital Structure

l(I) Mea n• of Raising Equity

7.2.
pub llCl N,,..
1-
this method, the comp any ls raising equity· capital by Issuing shares to general public.
Under ·
purpose for which funds are
company prep ares ~ prosp ectus containing details such as the
t,elng ra
ised• past financial perfo nnance of th e company, background and future pros pects of
t or not in this
company. This Information helps the general public to decide whet her to inves
on stock exchanges and
compaDY· Securities Issued by this method are gene rally listed
types of funding through public
available for sale and purc hase on exch ange s. There are two
issuance.
ted company for the fi rst time
a. (DJtial PublJc Offering (IPO) : This is an offering by an unlis
shares.
in its life to the gene ral public. It conta ins eithe r a fresh issue of
alrea dy listed
b. Follow-on PublJc Offe rlq (FPO) : This is an offer of sale of share s by an
company throu gh an offer document to the general public.

2. Rights Iau e

This is a method of raisi ng of funds through issuance of new

shllre s by the company to existing
share s in prop ortio n to the
shareholders. The share hold ers are offered the 'right ' to buy new
rs may accept or reject the
number of share s they alrea dy poss ess. The existing shareholde
right Shareholders who do not wish to take up the right share
s can sell their rights to anot her
trans fer their rights, then the
person. If the share hold ers neith er subscribe the shares nor
company can offer the shar es to public.

3. Private Plac eme nt

and some selected individuals.
In this method, comp any allot s share s to Institutional investors
ves issuance of securities to
It helps to raise capital more quickly than a public issue. This invol
out seeking perm issio n
less than SO persons with out issuing prospectus lette r of offer and with
companies or pnva te limited
for listing for the share s. The issue rs could be public limit
companies. These secu rities may be listed or unlisted.

4. Offer for Sele

rles like issui ng hous es or
Under this method. shar es are offered for sale through ·lnten nedla
l the securities to the uJtimate
st.ock brokers at pre agree d price. These lnter m~a ries resel
r and the difference between
investors at a market relat ed price. This price is generally highe
Intermediaries. This method is
the purchase price and the Issue price repre sents profit for the
not common in India.
 Sources of Fina.nee & Caplt;1I ~, rt,1 tu
• Flnana M ment (MU

7.2.2 Debt
r long-term finance and consists of deht ntu
04!bt C3pltaJ rrprMents most common source 0
and term loans.

7 .2.2(A) Debentures
...., e of long-term financing for high rated cr
Debentures or bonds .are an attra1.uve sourc . . .
worthy companies. These are generaIIy Issued by the companies to banks . or
. inst,tutio
Investors such as mutual funds. Insurance com panl·es etc· Debentures are classtfled mto two hr
types N 1n-convertibl e De be ntu res (NCD)
and Convertible Debentures. Non-convertj
debentures fonn part of debt financing while convertible debenture are considered hybrid sou
of finance.
Non-convertible debentures (NCDs)
• NCOs are long term debt Instruments and are repayable on maturity.
• Interest on the debentures is paid by the issuing company on monthly, quarterly, se
annualJy or annually at fixed or a variable rate as agreed at the time of issuance of
company.
• NCOs are either secured by the assets of the company or unsecured.
• In some cases, Instead of lnterest_payment, the NCOs are Issued at a discount to the face val
of the debenture and are redeemed at par or face value. The differ~nce between issue price
face value represents the Income for the investors.
• NCDs are freely transferable and traded on stock exchange or over the counter market
Advantagea of NCDs

• Cost effective source of financing as NCOs typically lower interest rates due to liquidity.
• NCOs can be structured to suJt cash flows of the company such as zero coupon bonds, mon
or annual interest payment, full repayment on maturity and intennediate period etc.
• Ownership Is not diluted In NCO Issuance.
• Interest paid on NCOs Is: not tax deductible.
Dluctvantaga

• NCO is attractive source of finance .only for highly rated ·compani·es.

• · NCO has fixed interest and repayment obligations. Delay in servicing of NCO interest C31'
impact reputation of company as Information on listed NCDs is freely available.
• Many NCOs ,have terms and conditions th t
. a may Impact company's flexibility In undertaking
critical decisions.
 uan mcnl ( MU 7.7 Sourcu of tlnance & ea tat
f ~""""
I) rerm Loan•
7.J. J(
r,rfll 1oaru are one of the most popular sources or long•term nnanclng for medium and s mall
• cQIIIP'nleS and •~ u5ed for purpoSl'S such as for business expansion. purchMe equipment,
building. managtn11 cash n ow etc.
latfl'II•
ferfll tnans have fixed maturity and repayable over the maturity period In regular payments.
• renn loan havl' maturity of more than 1 year and depends on the purpose of flnanclng,
, For example, term loans for capital projects are for a period of more than 5 years. whlle
worldnK capita I term are generally for a period of J years.
, Tenn loans can be secured or unsecured In nature. Secured tenn loans are the ones where the
loan Is secured by nxed asset security such as land, buUdlng. plant and machinery et,c. and
thtSe are most common.

, In India. term loans are provided by banks and Non-Banking Finance Companies (NBPCs).
, unsecured term loans are provided for a smaller amounts and shorter tenor.
, nie company taking a loan Is called as borrower and bank or NBFC providing the l.oan Is called
as lender. In some cases. lenders provide time of 6 .months to 2 years, before recovering
regular repayments called moratorium period, to provide time for construction and
commencement of production.

Advlntatea
• Term loans are dlrecdy hegotiated between borrower and lender and are processed faster
compared to other long term source of ftnandng.
• 801TOwer need not require credit rating etc. for availing term loan.
• l~rmatlon regarding delay' on term loan servicing Is confldentlal between lender and
borrown.
• Own~rshlp Is not diluted.
• Interest paid on tenn loans Is ·tax deductible,

Dllldvantage

• Teran loans generally carry higher cost of borrowing compared to NCDs.

• Term loans require regular repayment. hence less flexible.
• Lending tern;,s may Include restrictive covenants that company may find difficult to comply.
7.2.3 Hybrid flnandng

Hybrid financing refers to the financing Instrument that has some properties of debt as well
equity. These are tailor made to balance flexiblUty for the company and risk protection for the
Investors.
 Sou~e1 of FJnance & Cap,wi •r,

nd FinaJldDI are .
TM Im porunt forms of hyb
I Pre-fere:nce shares.
2 Convertible debentures.

3. Warrants~
7 2.3(A) Preference Shares
• . te of dividend, payable from the profits
d
rlty and flxe
ra
Preference shares carry fixed rnatu J r1..+.ts on dlvfdends and ass ets of the comPiny
Th rry preferent1a IIY' •
made by tM company. e.se ca . does not make profits, 1t can skfp !ht
I the year compa ny i
hence ca,led as preference shares. " ..... unt ls added to d ividend payable for tht
.__ hOId rs however u,e amo
dlVidend to preference s,...re e · rth of the company.
next year. The preference shares fonn part of the net wo

Adire..taa•
rth of the company, hence help Improve the leverage
• Preference shares form part of the net wo '
position.
_,
• Company can skip d tvldend to pnaerence s
hareholders tn the event of loss, hence Is more
flalble compared to other $9Urce5 of debt.
• Th.ere Is no dilution of ownersbJp or voting rights.
D9an Mi'll»I•
• Preference shares generally carry higher rate than traditional debt Instruments such as NCDs,
term loans etc.
• Dtvldend paid on preference shares is not tax-deductible.
• In some cases. preference shareholders may have right to convert to equity shares If company
skips dividend payment for some period
7 .2.3(B) Convertible Debentures •

• Convertible Debentures are a type of debenrures that can be converted Into the equity sbanll
of the company after a stipulated time period at the option of the debenture holder. In s
cases, Issuer can also have opdon to convert del,entures Into equity shares.
• During the tenor of the debentures, Issuer company pays Interest or coupon at the pre-a
rate of Interest.

• The terms of issuance such as conversion price Into equity share, tenor, interest pa
frequency etc. are fixed at the time of Issuance. Convertible debentures are mainly of 3 types.
(a) Compulsorily convertible debentures (CCD): These debentures are compulsorily conve
into equity shares at the end of tenor (maturity) of the debenture. Por listed companies sudl
maximum conversion tenor ls fixed at 18 months. For private limited the tenor of converti ·
debentures can be higher.
~ _--,o ,c r y
• ,--::;_.,. _ n ◄ at •( MUJ• 7-9 Sou rcn of ~·1nan~ & Capital Sln.lcture

rtfbl~
""" sr ,._.~ ckbenta:res (OCD) ·. Th ese dJ!,.,..nlures
L-
can be co nvert ed into equity
~ at - ~ ol lftlOr ( ~tw1ty) of the de~on.ire at the opUon of de~nn.ire holde rs. For a
~ ~~"l'J cbe !N!rlmum ~ r for OCOs Is 36 months.

,rtd'r ~ ddaentutts : In ~ of partly convert1ble debentures, some portion of

I"' ~ can be converted mto equJty shares. These are not very popular.

,., 2 rs
• ~ ~ help attract funding duri ng uncertain times. It Is a popular source of
==-::g
Ear start-ups.
• ~ con-.tttible debentures help In red ucing fi nancial leverage of the company .

... ·•-·,111•
case ol c:,pdDnally convertible: debentures, conversion to equity depends at the option of
• ~ ~ and compa ny may have to plan for redemption.
• ca,:, a sioCJ to equity can result in dilution of ownership.
• IJ:ill',e equity. company bas to pay coupon on the debentures d~ng the tenor.

7..2.l(C) Wan-ants
• A wa ,ant is a derivative instrument which provides the bolder of warrants right to buy the
saar-es ci ~ issuing r.ompany at a fixed price called exercise price until the expiry date.
• Wan aw (all be traded in the secondary market by the Investors.
, nxn tw0 mam types of warrants known as calJ and put warrants. Callable warrants entitle
IWl cstXA s with the right to buy shares of a company from that company at a pre agreed price at
a future date prior to expiration. When a warrant holder decides to exercise the right, company
is.sues the shares to the warrant bolder.
• APuuaWe warrants offer investors the right to sell shares of a company back to that company
~ a spedfic price at a future date prior to expiration.
• Watt auts are sometimes ~ued with the preference shares or bonds to make the issue
anaafft: for investors and reduce the rate of dividend or Interest rate·as applicable. These
wa.uams an detachable meaning they can be separated from preference shares or bonds can
sdd separately.

\tnq 1 111

• A - . , :aat does not offer any voting lights to investor. .

• itb an instrument to attract Investors during uncertain times.

 Sor,ta:t ol Anaott .Ir up'..4
7- llt
r
• r
DI t.rt 1•
• Warra::ts.1rt~~!f!Ji,.postcuau usialL
- • t ua new equitJ lo{usion.
• ~ CO ~ CID CJnJ:V dliOO may DO( nr::>U.t

7.2.4 Mannine nnr.ce

_ _,f _,.,rifv wbidi provides the fi112 nci ..,- n
• Maza:-.t.- w fir-.anong is ~ bybc'id 1:,aweeo debt~ POf-•J •·

CGUYe, t CY · ta DIM deb( to equilY ID ~ o f ~

Ides _ ......, to ~_ .. _ . _ ...~ nrniects and ts typicaJly used in f na
• tt IA iri cocnpany .....,....
1 WJUel ,._, r u -• I"'"-,

nsky acquis1tiam b)- g, oup al in. clb>n on the b a ~ sheet of the company.

Ptulw• of• a,w..._ ftw•.dlll

• in t1!nm of smlority of I epajmeGt a,; panine loanS att subordinate to seniOT debt. but

m priority Oft!' equity shareholdeB-

• MerzaaiM loam an ansecured in lli!ibltt and any lriper ratt of inw-est than debt.
• Mez:uninr lenden generzJJy I eeeiwe wamnt to convert iDtO equity at pre agreed price, iD ~
mez zauine loans an oot repaid at the time of maturity.
• 14ez:unfnr loans cm be resu uaw ed intD senior debt by the company.

• Interest paid on mezzanine debt is tax dednmole

• It is an unsecured source of funding for the bom>wff and help obtain funding in
piojeLU

• Me zzani;,e financing offer flaibillty of strucblriog repayment as per cash flows.

• Ownen may not lose control or chl•dion if the company meets obligations.
• Many times me z1aoine 6naociers also bring ezpertise to m,a;; G bo,stoess

DS1nftw1ta1•
• Lender may.put restrictive~ on the company.
• Interest rates on mezzanine debt are typically ve,y high.

• Short term sources of· finance are ....,.....1.1- ......._,

· -,--r--. .,,,uun a period of 1 year and are used for
day
__to day or worting cap1t31 requirem~nts such as ...
,.,..., .-..,_
..,.... ~
~ p
of Inputs ,vr
-..,_."' credit to customers, payment of salaries. OVN heads etc.
f F1nan~ Management MU) 7 -11
Sour ces of Fina nce & Ca Ital Strucrure
, 1be most commonly used sources of short term 11nana
.. .ng are :

1_ Trade credit
z. Bank finance
3, Commercial paper.

'
Short term sources of financing are generally cheaper and easil Y avai.1able. hence there Is a
. egy or fl nancing
tendency to use. short term sources wherever possible. However, this strat . .1s
fraught with nsk. Use of short term sources for funding long term resources can lead to
shortage of funds at the time of repayment
, This leads to mismatch in payment obligations of facilities and cash lntlows from long term
investments. If the same is not refinanced in time can lead to financial distress, default and
bankruptcy l~ some cases.
• Use of short term sources to provide long term loans have been identified as one of the reasons
for some recent failures of the companies. Board of directions and management should avoid
such temptation.

7,3.1 Trade Credit

• Trade credit is an important source of short-term funding and arises due to the credit period
availed by the company from their suppliers for payment.
• Credit period depends upon the industry norms, credit policy of the suppliers and credit
worthiness of the company. Sometimes suppliers offer cash discount for early payment of
trade credit to expedite the collection.
• Depending on the amount of cash discount and availability of funding. ~ company can decide
whether to avail trade credit or pay in cash. Credit terms include cash discount rate, discount
period and credit period. For example, •2/5, net 45' means credit period of 45 days and cash
discount of 2 percent for payment within 5 days. Some companies purchase goods on credit
and sell on cash to end customers, thus operating without any investment in working capital.

Advantages
• Companies need not enter into any formal agreement or provide any security for availing trade
credit
• It is can be availed quickly, hence fastest way to grow sales.
• It helps company to reduce financial leverage or external debt

Disadvantages
5
• Suppliers may increase price to account for credit period intere t
 7-12 Sources of f inance & Capi tal Slruct
• Finance Man,:menl (MU) ure
......
• New rom1>anles Ond It difficult to get credit
• Credit period offered In trade credit Is generally short

7 .3.2 Bank Finance

on source of short-tenn finance. Many lar
• 8 an k ft nance Is th e secon d most Comm · ge
.:-r bank ftnance over utilizing credit due to cheaper rates.
ere ditwo rth. y companIes pre,c
• In this mode of ftnandng. banks assess the credit requirement of cuS tomers after anal}"Ling
sales, current assets and trade credit position and provide a credit limit to the customer
against the security of accounts receivables or Inventory as collateral security.
• Credit llmlt Is generally set for a period of 1 year and renewed each year. Following are the
most used short facilities provided by the banks.

7.3.2(A) cash Credit

Cash credit or CC Is a working capital facility offered by the banks. In this, banks sanction a
credit limit to the business depending on the credit worthiness and position of current assets.
Following are the features of cash credit facility.

Featu,_ of cuh credit fadllty

• Cash credit or CC limit Is the credit limit granted by banks to business for meeting their
working capital needs.
• Cash credit limit is sanctioned for a year of up to 1 year and must be renewed every year by the
borrower.
• Generally, banks require collateral In the form of land, building, fixed deposits etc. for granting
CC fadllty.
• Borrower can withdraw funds upto the credit limit and repay as per their requirement There
are no restrictions on the number of withdrawals or repayments, as this Is a revolving limit
• Interest Is charged on the dally outstanding balance and not on total limit

Advantages

• CC limit offers high degree of ftexlbllity as business can borrow and repay any time during the
year.
• Interest ts payable on the outstanding amount and not on the credit limit.
• No principal repayment required and only Interest is charged at the end of every on the
average outstanding balance.
 nt MU 7 - J3 Sources ol Ptnancf' & C..a It.al !>tructure

~--gea
• e.ash {ffdlt llmJt need to be renewed every y~ r.
, Banks generally restrict th e limits only upto lhe extent or net current assets with a margi n or
2S%. In case of shortfaJI in th e amoun t of underlying current assets. banks may require
companies to r epay the shortfall amount and reduce the limit
• Banks may charge a minimum fees or co mmitment charges to ensure utilization of CC limit

7,3,2(1) Overdraft
Under this faclltty banks allow the customer to draw funds ov·er and above the balance In the
current account upto a certain fixed limit, called an overdraft limit This limit operates similar to
cc facility and need to be renewed every year. The limits granted under this facility are smaller in
size and carry higher rate of interest
7,3.2(C) BIii Discounting
• Under this facility a company can discount the Invoice or bills for the goods or services billed to
its customers. Company approaches bank with the bills accepted by Its customers a~d banks
makes.the payment to the company after deducti.ng applicable discount charges.
• On the due datt!. bank collects the payments from the customer of the company. Before
discounting t:be bills or Invoices bank checks the creditworthiness of the customer to which the
amount is billed. The bank requires th~ bills to be duly accepted by the customer.
• With large scale of implementation of enterprise resource planning or supply chain
management solutions, the bill discounting has moved to electronic platform and acceptance of
this product has increased.
7.3.3 Commercial Paper (CPs)
• Commercial paper is a short-term unsecured money market Instrument with a maturity
ranging from 7 days to 364 days.
• Companies having a good credit rating can raise working capital funds by lssulng commercial
papers.
• A company issuing commercial paper need to obtain credit rating of the proposed Issuance
from the credit rating agencies. Commercial papers are subscribed by banks, mutual funds,
Insurance companies etc.
Featuru of commerdal paper
• Commercial papers are Issued at a dls<:_ount and redeemed at face value. The difference
between the Issue price and face value represent the Interest Income for Investor.
 7-14
• Finance Man.a ement (MU) I th reof
0 f Rs. S lakh or multip es
• Commercial papers are 1.ssued In d enomlnatlons
·
• Commercial papers are freely transferable.

Advantages -• finance for large companies.

. e of working capil.AJ
• Commercial paper Is cost effecttve sourc

• It is unsecured In nature. ding on the requirement

rlti s upto 1 year depen
• It can be issued for different matu e till th maturity.
• Commercial papers do not require any interest outflow .e

DIAdvantat• · ·· d
. _._ 5 tamping charges, issuing an
· I . r involves rating ,,,.,arges,
• Issuance of commercta pape · ct fi r smaller companies.
agent ,charges and is not viable source offtnan ng o rted widely and can de nt repu
· I paper can be repo
• Any delay in repayment of commeroa
1

of the company.

7 .4 Project Finance

• •
Project finance refers to long term finanang t,or infrastrucrure• Industrial
. proje-crs · · ·
funding is mainly provided on the strength of the project cash flows and ts secured by all
assets of the project, including any long-term revenue agreements. Lenders have no reco
or limited recourse to the sponsors (investors) of the project. which means that in case de
lenders cannot ask the sponsors to make payment. Typical examples of project finance
aill)Orts, roads, mines, oil blocks, power plants etc.
• In the project finance, a separate legal entity called as Special Purpose Vehicle (SPV) is crea
by investors (or sponsors). The SPV owns the project and funding is raised by the SPV.
mitigate the risk associated with the projects lWd ensure viability, the SPV generally enter i
long term sale agreements with customers or take or pay agreements. Long term purch
agreements are common in setting up new power plants, where the SPV enters into long te
contract wtth electricity distributions to purchase electricity at pre agreed price. In ind us ·
projects, it is common practice to enter into take or pay anangements wtth the customers.
• This involves customer agreeing to buy off take from the project or pay some fixed penalty fi
any shonfall. In off take or purchase from the project. As the financing amount i.nvolved
very large and repayment tenor is long. project finance is provided by a syndicate
consortium of banks or financial institutions.
• As the repayment of project finance depends on the su,.,.__f to·pte
·
parties are Involved In the project financing. . . _ o projects, there are mu
 7 I~
t,1,urr,:s <Jf Fm~na & ~ptt:al.struaure
"'tilt o( tht Important Jnrtlc,; inv,,lved rn th,.. .
• ;,,,, , Jr,:e:.~ <1( pr<,J'!rt ar,:
,.__,.. : There are the prr.r,ld,-r1 r 1t11
t, ~ - · · r, i:.-.p,uJ for the pro)er:t In the form of equi ty
~ 1n11141
.--4/or subordinated loan , . The \p-On
P ., 'IOr " 1111 rwrmally h,Ne 1?xpenem::.e In me relevant .sector
ind will support the projea u,mpany lr1 prrn,dlng ~kllled peo,,nnel
z.. s,rcf?J hrpote VebJde (SPV) : nu~ 1•, aho knr,wn as project vehide and ts set up by the
s"""SOf
r·· sspedflcally for the pu~,..· ,>f Ulf· prr,1·,..e1
. ,,~nd rr11ni th e prr,.,iect.1

J. (otlU'adOn : These are the entltl~ that th,: SPY appoinu rn build and maintain the project:.
Somedmes SPV also appoints contractor~ for operating the project.~.
4, Off-taken : Off-take rs arc the parties that purc.ha'II! output from rhe project In most of the
projects. the SJ'Vs enter into long term arrangements w1th the off takers w sale the output to
tn511re viability and reduce the ri!lk. Many a times such long term contracts are executed wfth
the govemmmt a.geodes.
s. Ballks/Flnaacul lutltut:lons : These are the lenders u, tile project and generally form a
consortium of bankers. The cash flows and asseu of the project are secured to them.
6. Spedlll« Advlton : These are the !l'J)eciallst5 haYlng domain knowledge of the Industry and
provide Inputs regarding the planning. v1ablllty and executfon of the project.

llllb lnvotved In IN oject flnandng and management of mks

Project financing Involves multiple risk.1 such as completion risk, cost overruns, market 11sk.
tnYfronmentaJ risk. foreign exchange risk, pollrfcal risk et.c. Spons51rs and lenders need to assess
diese risks and built suitable mltlgants to manage the risks.
• Coapletlon ruk : Completion risk can be mitigated by awarding turnkey contracts, taJcfng
performance bonds from contractors.
• Cost OYernan : fn case of cost overruns a standby credit, fadllty can be used, or lende.rs may
require the sponsors to guarantee to fund cost overruns.
• Martcet rbkl : Market risk refers to the risks associated with the shortfall In demand or off
tab when production commences. To mitigate these, SPVs are required to enter long term
contracts with the off takers or take or pay agreements. Long term purchase agreements
ensure vlslbOlty of revenues. In case take or pay arrangement off takers need to pay penaJty in
cue they don't Ifft. or off take contacted quantity.
• !aYlroameataJ/Govenuneat rtllo : Many dmes, the projects are envlronme!)tally sensitive
and need approval from the relevant environmental agencies and regulators. Hence, the
finance documents Include necessary representation a.nd warranties regarding the necessary
approvals for the project and In case of misrepresentation the same ls treated as default
Sometimes change In government policy can affect the viability of the project. Jn such cases,
JpOnsor, D'lllf ~ek Government guarantees,
 Sour~ of Finance & C

where projectS are fund

• ,.,,r<ril" ndu,np r1slu : 1-ori•I~ .ix.chvige risk arises d .
I domestic currency. Sharp epre
, u,,,.n, y •ntl r..v1>nuf!1 o f pro/tt:U are n .
ch roject and In s uch cases foreign
,1om,..u, , urrflflry ' "'" 4/lf'ct rrpaymtent of . e p . D
from the governm ent. Fo .
" " ' t,,i rovPrNJ thr11ugh t onvertlbflfry guarantee

~-
rs.lfplaln, lh«i wQneJng of prr,Ject flnance transaction.
------, F',nancial
)(}(llOO by C3Nr§·hOIC"'II! rnslJtutions/BankS
of Pa,en1 (..o(r\1>6/lY)

Equity Debt

f.Jl,a.nta, Subt.1'11(/G &oeciAI Purpose Veh'IIIW Purchasers

~ <',ov.,,nffl4111t 1111 001'\l'.o~ /SPV) of Produce

Contractors,

"9. 7.A.1 : Working of praj1ct flnMm

Aftanta9N of Project f'lnance

• I.A:ndvs• have llmfted or no recourse on the sponsor.

• Abflfty to undertake proJecu: with long gestation periods.
• f'rojea nn.ance ls an of't-balanc:e treatment for financing for sponsors: so does no~
•pon,ofs ftnanclal lwerage.
• Allow• beuer ta• treatment tor the project.
• More than one 1pon,ors can be Inducted to mitigate the risk of the project

antae- of ftrllUKt l'lnance

• Du., w complex nature of projects project finance Involves higher cost of due dill
analy1l1, legal documenul:lon.
• ft 11 very time con.fuming process to de up funding under the project finance.

• C.,,tnilJy, the rate of lnt.ere1t Is higher compared to financing with no recourse.

• Lender, wtll generally Incorporate number of restrictive covenants that
op.r!Donal ftnlblllty of the profect vehicles.
f f!nanceM 7-17 Sources or finance & Ca Ital Structure

7.s Caplt81 Structure

Capital structure denotes th e way of company finances Itself. Capital structure of the company
is the combination of debt and equity In the total capital of the company. Co:mpositl.on debt
t,etween long term a nd short tenn debt Is also considered In the capital structure. The use of debt
aod preference shares Is described as financial leverage or trading on equity, as they are raised on
the baSis of equity position.

• The ratio debt to total capital ls called as leverage. Debt capital and preference shares need to
be serviced with periodic Interest and dividend payments. The use of financial leverage Is
double edged sword. lf a finn can earn higher returns that cost of debt, shareholders' earnings
will Increase and If the rate of return Is lower than the cost of debt, it will erode shareholders'
earnings.
• Popular measures to calculate capital structure ·are Debt ratio and debt to equity ratio and are
calculated as below:

Debt ratio Debt D

= Total ,capital = D + E

Debt to equity ratio Debt D

= Equity =E
• Capital structure has an Impact on the shareholders' earnings and risk and the value of the
company. Hence it is Important to have optimum capital structure.

7.5.1 fac:tors Affecting Capital Structure of the Company

Whenever a finance manager needs to decide on the financing for the Investment, they
evaluate multiple financing · options and are expected to _choose one that enhances the
shareholders' value. There many factors that affect the capital $tructure of the company. These are
internal t.o the company as well as external to the co.mpany. Important factors affecting the capital
structure are listed below :
• Cydlcallty/Stability of ~uslnes:s : Cyclical business are expected to have large and frequent
fluctuations In sales, such firms may find It difficult to have stable earnings to meet fixed
expefises. On the hand, stable businesses with large base of fixed assets can have steady stream
of revenues and profits. Such firms can choose to have more leverage. Examples of such
businesses are utilities as electricity companies, telecom operators etc.
• Cost : Cost of flnanctng is i.lll Important consideration for deciding on Hnandal leverage. The
costs of raising funds through different sources of finance are considered and cheaper source
of finance Is chosen.
 Sources of Finance & Lapna 1:itru
• Finance Mana em ent (MU 7. 18

th
• Floatation Costs : Floatation costs refer to the costs associated wi raising of furicJ!. su
th
processi ng fees. broker's commission, underwriting fees, expenses on e prospectus
Higher the noat,H1on cost of a source. the less attractiv e.
• Control Considerations : If the issuance of more shares may lead to substa ntial dilution
promote r shareho lding or loss of control, company may not conside r t he equity issuan
fund raising and will prefer debt funding. .

• Tax Rate : Interest is tax deductible expense, higher the taX rate large is the value
savings on interest expense and lower Is the after taX cost of debt Hence a higher tax ra
make debt relatively cheaper and more attractive.
• Capital market condition : When the capital markets are booming, firms can fi nd it
raise funds through equity and command higher valuation. Hence, In boomin g marke
firms make a beeltne to raise funds through IPO or private placement.
• Competition : Firms operating In industries with Intense competi tion are likely
pressure on earnings, hence are expected to ltmit the financial leverage to avoid the ris

7 .5.2 Capita l Struc ture Theor ies

Capital structur e theories aim to establish relationship between capital structure-
market value of the flrm. Importa nt capital structur e theories have been discusse d as belo

7 .S.2(A ) Net Incom e Approach

• Net Income approac h propose d by Durand In 1952, suggests that value of the fi
Increased by Increasing the financial leverage.

A.Num ptlona
• Cost of debt Is generally lower than the cost of equity as the weightage of debt in to
increases, WACC goes dow~.
• Net income approac h assumes that the cost of equity and cost debt remains con
Increase In financial leverage.
• According to this approach, cost of capital of the firm changes with the chang1: in the
leverage. Company's capital structur e has two elements I.e. debt and equity.
• Weighted average cost of capital also known as WACC Is the cost of capital for the firm
sum of the weighte d average cost of equity and debt.
WACC = Cost of Equity x Equity weight + Cost of Debt x Debt weight
In this approac h,
Value of the firm = Value of equity+ Value of debt
= Net income Interest
Cost of equity + Cost of debt
 / - )9
Sources of Finance & Capital Structure
NI I
= - ♦-
kc k.i
Value of the firm = Net operating income
Weighted average cost of capltaJ
NOi
= WACC

Where
k.. cost of Equity
kd. Cost of Debt
WACC. Weighted average cost of capital.

111ustr•tion
ABC Ltd has EBIT (i.e., Net Operating income) is Rs. 50,000; cost of equity~) at 15% and cost
of debt (k.s) at 8%. Total capital is Rs. 400,000. Calculate cost of capltaJ and value of the firm under
different combinations of capital structure I.e. using leverage (debt to total capital) of 20%, 50%,
80% and 100%.

AJiSW8f

Investment 400,000 400,000 400,000

Debt ratio 20% 50% 80%
Debt Amount 80,000 2,00,000 3,20,000
Interest rate 8% 8% 8%
Net Operating Income (EBIT) 50,000 50,000 50,000
Less:lnterest 6,400 16,000 25,600

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

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

Market Value of Equity (NI/Ke) 2,90,667 2,26,667 1,62.667

Market Value of Debt (Debt

amount) 80,000 2,00,000 3,20,000

Total value of the ftrm (Debt +

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

From th e above exampIe. it is clear that the value of firm increases at the proportion of low .
cost capital i.e. with increase in debt cap,a..t
.... · Net income approach assumes that the cost of equity
remains the constant with the change in leverage.
 sources of Finance & Capital St
7-20
• f inance Management (MU)

7.5.2(8) Net Operating Income (NOi)

Net operating income theory states that the value of the finn depends on net operating I
and risk of the business and is independent of the capital structure of the firm. This theory

developed by Durand.

Assumptions
• Value of the firm is dependent on the operating income and the associated business ri sk
finn and both these factors not affeeted by the financial leverage.
• The weighted average cost of capital and the value of firm are Independent of the fl
leverage. '
• It assumes that the equity investors will demand higher returns to compensate ris:k
increase i.n proportion ofleverage.
As per this approach,

Total Market Value of the firm M= E:~T

V = D+E
E = V-D
As cost of debt is constant
NOi-i
. E =
k.i
kw - Overall cost of firm
D - Market value of debt
E - Market value of equity
NOi - Net operating income

Dlldbatlon
Debt ratio 20% SO% 80%
Debt Amount 80,000 2,00,000 3,20,000
Net Operating Income (EBIT) 50,000 50,000 50,000
Less: Interest 6,400 16,000 25,600
Earnings for sbareholden (NJ) 43,600 34,000 24,400
WACC(kw) 11.5% 11.5% 11.5%
Value of the firm M 4,34,783 4,34,783 4,34,783
Market Value of Debt (D) 80,000 2,00,000 3,20,000
Market value of equity E = (V _ D) 3,54,783 2,34,783 1,14,783
Cost of equity (NI/E) 12.3% 14.S% 21.3%
f f inance Management (MU) 7-21
Sources of Finance & Capital Structure
-- lo
the above example, under the NOi appro h
. ac value of the firm remains constant with change
rage as t.he higher proportion of low co t d b - . .
111 lf"e s e t is offset by increase m cost of equity.
!Cost of Equity (Ke)I

]l
a.
c'.3 · Weighted Average
0 r------------ Cost of Capita l
~
()
(WACC)

! Degree of Levera~~ I
F'ag. 7.5.1 : Diagrammatic representation of NOi approach

1.S.2{C) Traditional Approach

Traditional approach is intermediate between the net income and net operating income
approach. As per this approach, it is possible to reduce cost of capital by using optimum mix of
debt and equity. Cost of capital for the firm will reduce and market value will increase as the share
of debt in th~ total capital reaches optimum level, after which cost of capital will increase and
marl<et will decline as equity shareholders more returns for the increased risk. Traditional
approach is based on foDowing assumptions :
(a) The cost of debt capital remains constant up to a certain level and thereafter rises.
(b) The cost of equity Capital remains constant more or less up to a certain level and thereafter
in.creases rapidly.
Traditional approach can be illustrated in Fig. 7.5.2.

Cost of
Capital I

X Level o1 Leverage

Fig. 7.5.2: Traditional approach

• Finance Mana ement MUJ 7-22 Sources of Finance & Capital S

7.5.2(0 ) Modlgllanl - Miller Approach to Capita l Struct ure

.
Modiglian i a nd Miller approach advocates that t h e change In capital structure does not
Impact on overall cost of capital and value of the firm. This approach Is similar to net op
Income approach and recognizes only the net operating Income and risk of inveS t ment as
Impacting cost of capital and value of the flrm.
Modigliani • Miller approach Is based on following assumptio ns :
• There are no taxes I.e. income tax or tax on dividend.
• There no transactio n cost for buying and selling securities.
• There Is no bankruptcy cost
• There Is a symmetry of Information between the Investors and company.
• Investors will behave rationally.

Modigliani - MIiier approach In rul world

In practice however corporations have to pay taxes on income and dividend may also be
Further, there are transaction costs Involved and Information asymmet ry also prevails. Hen
the extent of these factors. financial leverage reduces WACC and Increases the value of the fl

7 .5.3 !lemen ta of Capltal Structu re

While planning capital structure of a company, the finance manager needs to consider va
elements of the capital structure. Some of the Important elements are as follows :
• Capital mix : This represent s mix between sources of finance i.e. debt and equity. Com
should decide a target capital mix suitable for Its business and try to achieve the same
deciding In financing new investme nt With .additional debt cost of financial distress will
higher and company will need to Incur floatation cost For Issuance of new shares Com
will need to Incur ftoatation costs and may also lead to dilution of control of exi
shareholders. Hence, In terms of preference, companies will first use retalnetl earn
followed by debt and fresh equJty.
• Matw1ty aad priority : This refer to the maturity of debt obligations and priority
repayment of debt holders. Longer maturity debt provides Oexlbillty to the company. Sho
maturity debt Is cheaper but restrict the Oexlblllty. Companies prefer to match the maturl
of the debt with the cash flows, by ftnandng short term assets using short term debt and lo
term assets using long term debt However, there Is not always 100% matching and sometim
companies use short term debt to finance long term assets for a temporar y period a
graduaJly refinance using long term debt
• Terms and conditions : This refer to the terms and conditions prescribed by lenders or
providers when a company avails financing.
f flll'nce Man ement MU) 7-23
Sources of Finance & Capital Structure
ese may include restrictions on capital ex nd
• 1b dividends et d ~ pe iture, meeting certain fi na ncial targets,
restflctlon on th c. an orm part of the agreements. Companies need to carefully
odate and ensure at the operational fl •b·i·
neg . eXJ I tty and strategic objectives of the company
and tnterests of shareholders are not compromised.
,...-acy : Companies need not depend on s ingIe currency for its financing needs. Large
• """'·-
cornpanles can raise funds in foreign currencies
· such as Dollar, Japanese Yen, Euro etc. to take
advantage of favourable Interest rates and depth of the markets. However, currency ns
. k. needs
to be kept In mi nd a nd need to be managed by hedging the repayment obligations. Companies
having large foreign currency income need not actively hedge repayment, others need to hedge
the exposure in currency market using appropriate financial instruments.
• flnalldal market segments : This refers to the various market segments which a company
can tap for raising finance to suit Its requirements. For example, company use domestic or
foreign market for a long-term financing. Company can raise flnanclng using bilateral
arrangements or consortium of banks. It can choose flnance from banks or raise funds by
issuing debentures In the capital market. Companies having large fund.Ing requirements prefer
to diversify the sources of funding to avoid dependence on single flnancter or market.

7,5,4 Optimum Capital Structure

The optimum capital structure Is that capital structure that leads to the maximization of the
value of the firm and minimizing cost of capital. The use of debt capital in capital structure
increases the earnings per share as the interest on debt is tax deductible. However, higher levels
of debt In capital structure leads to increase in cost of. financial distress and cost of equity, thus
adversely affecting the market value of shares. Optimum capital structure balance trade-off
between higher earnings per share and cost of financial distress to maximize the market value of
the flnn.
Following theories provide different approaches for deciding an C?Ptlmum capital structure :
(a) EBIT-EPS analysis : EBIT-EPS analysis Is an Important tool for designing the t>ptlmal capital
structure framework of the firm. EPS I.e. earnings per share denotes the earnings available to
shareholders. As per this approach, optimum capital alms to maximize the EPS for a range of
EBIT I.e. earnings before Interest and taXes. EBIT of the companies fluctuate with change In
sales and profit margins. If the Interest costs: are high for companies having large fluctuations
In EBIT, the EPS can tum negative when EBIT fat! substantially. Hence, companies having large
fluctuations In EBl1' should use less le.verage.. Companies having stable EBIT can use relatively
higher leverage or debt. Financial break-even point and financial Indifference points help ln
dectdtng the leverage.
 Sour ces of Finan ce & laptl.11 \tru
7- 24
• I- inane r M.in,1 emen t ( MU

EBIT for which the firm 's EPS •~ abou t

(b) Financial Break-even : It deno tes tne level of
th e estim ated level of EBIT Is subs tantially highe r
than the brea k-even poi nt, company

debt to the l aplt.al

t whe re two diffe rent capital stru
(c) Flna nc lal Indi ffere nce Poin t : This refers to a poin
the EBIT exceeds over the
prod uce same EPS for different levels of EBIT. When
llnan d al indifferen ce. company can fund using more debt
pany will study cash flow s ava ila
(d)C ash Row anal ysis : In the cash flow analysis, com
flow s repr esen t the oper ating
servicing of debt and acco rdingly plan the fu nding. Cash
bala nce shee t item s. Debt se
flow s I.e. post -tax EBIT after making adju stme nt for
debt as per the repa yme nt sc
lndu de interest on the debt and contracte d repa yme nt of
repa yme nt capa city.
Cash fl ow analy sis Is a very impo rtant tool to meas ure the
perio d or decl ine in profit
Net profit may not always trans late Into cash durin g that
may be plan ning high er saJ,
nece ssari ly impact cash gene ratio n. For example, com pany
k funds In high er cred it and
profi ts In comi ng perio ds, how ever it may have to bloc
late into high er cash gene rati
Inve ntori es. In such cases, high er profit may not trans
com pany may not be able service larger debt paym ents.
tile forecast perio d and debt
Cash n ows and debt obligations are plotted for each of
: Debt service coverage i.e.
cove rage and debt capacity of the company Is calculated
ratio indicates the capability
cash fl ows to the debt obligations. Debt service coverage
debt that a com pany can se
comp any to service debt Debt capacity repre sents total
the period. Difference betw een debt capacity and debt
position repre sents room avail
com pany to raise debt in the case of requ irem ent

I Aevtaw Qu1.uons .I
Sou rces of fln■ nce9
s and prefe rence share s.
Q. 1 Com pare the features of equit y share s, debenture
Wha t are the characteristics and advantages of equit
y finan cing?
Q. 2

Q. 3 Discuss various mean s of raising equit y financing.

Explain the features of debe nture s. Wha t are the types
of debe nture s?
Q. 4

Q. 5 Expla in the pros and oons of debe nture s.

rence share s?
Q. 6 Explain the adva ntage s and disadvantages of prefe

Q. 7 Wha t is the difference betw een term loan and debe nture s?
Q. 8 Wha t is wa"a nt?
Enlist differ ent sources of short term financing for a
firm.
Q. I

Q , 10 Com pare commercial pape r with cash credit facility.

 f Flnanct Mana emen t MU) 7-25 Sourc es of Finan ce & Ca Ital Struc ture

Why Is commercial pape r not suitable for small companies?

Q. 11
Why is project finan cing suitable for financing infrastructure
projects?
Q. 12
How is the risk in project finance is managed?
Q. 13
capt tatst n,dU N
Q, t
Whal Is capital structure?

Why the value of levered firm (having leverage) is always

greater than the value of unlevered
Q. 2
firm when corporate profits are taxed ?
capital structure.
Q, 3 Discuss advantages and disadvantages of using equity and debt In the
l is Rs. 60 Lakh . Cost of equity of
Q.4 Tolal equity capita l of ABC ltd is Rs. 40 lakh and Debt capita
ABC Lid Is 14%. cost of Debt is 10% and tax rate Is 30%.
Calculate weighted average cost of
capital.
Q. 5 Di9cuss factors affecting the capital structure of the firm.
a.1 What are the elements of capital structure of the firm?

Q. 7 What are the approaches to decide capital structure of the firm?

capital structure.
' Q. I What Is the optimum capital structure? Discuss the elements of
□□□
 Dividend Policy

Dlvtdlftd l'olcy : ~ anlng and lmportancf! of Dividend Policy: Factors AffKtlng an Entity's
Dividend Decision; Owrvif!w of Dividend Policy T h ~ and App,oachf!s-Gordon's -'PPfoach.
Watm's Approach. and Modigliani-Millf!r Approaeh.

Leaming Objectlvea
• Meaning and Importance of Dividend Policy
• Factors Affecting an Entity's Dividend Decision
• Overview of Dividend Policy Theories and Approaches · Gordon's Approach, Walter's
Approach, and Modigliani-Muter Approach

8.1 Introduction to Dividend Policy

• Dividends are payments made by a company to the shareholders of the company. Most
dividends are paid In the form of cash. Dividends ts the most common approach for
distribution of profits to the shareholders, other being buyback of shares or bonus shares. Part
of the profit gets distributed to the shareholders.
• Companies can choose to distribute part of the earnings to shareholders and reinvest the
balance in the company. The ratio of the dividend and the total profits is called dividend
payout ratio and the ratio of reinvested amount to total profits is called as retention ratio.
• Board of directors of a company formulate a dividend policy outlining guidelines of dividend

.
distribution. Dividend policy has the parameters for payment of dividends to shareholders
such as frequency, amount, timing of dividend and depends on the financial position of the
company.
• It determines the dividend income that equity shareholders will earn, amount of own equity
available for business requirements. Dividend policy also shapes role in attaining desired
capital structure for the company.·
 8 2
Dl vldend Po112
1... vtanc:. of dividend pollcy
1. Build ■hareholden tna,t : A well comm un 1rated dllvld d
bulld shareholders trust, as th e policy h en policy or the company helps to
e1ps to establu h co I
expectations and actual payout ns .slency betw~n shareholders'

z. Future profits : Dividend policy signal 5 •·L

uie expee1.it1on or fu t
example, company making stable dividend ure pronts or the company. For
payments, raises divide d •
company expects growth In profits In future. n payout it signals that

3. Dttdpllne manaaement : Sound dividend policy . d

provl es guldellnes for dividend payout and
restrict management from taking reckless outJandl h 1
· s nvestment decisions.
4, Influences stock price and value : Dividend payout Is f h
one o t e 1mportant consideration for
valuation of companies. hence a change In dlvtdend policy Infl uences th e share price.
5, Influence ln1tltuttonal Investors : Balanced divided dividend. pollcy sends strong signals
about the company's capital allocation policy and help attract Institutional Investors.
a.1.1 Types of Dividend Polley
• Constant dJvldend policy : In this policy, the company decides a ftxed amount of dividend for
the shareholders. In this policy dividend amount does. not change periodically.
• Constant payout pollcy : In this policy, the company pays a fixed percentage of profit as
dividends. The dividend amount grows or declines with change In profits.
• Residual payout policy : In this policy, the company pays residual amount from profits alter
accounting for planned capital expenditures.
• ln-egular dividend policy : In this policy, the company does not have fixed amount or
schedule for dividend payout and It Is at the discretion of the management
• No dJvldend policy : In this policy, company has policy to retain all the profits for
relnvestme·nt and does not pay any dividends.

8.1.2 Factors Affecting Dividend Decision

• Lep) rules : Compaft¥ needs follow the rules and guidelines per the local government In
India. Companies Act. 2013 lays rules for distribution of dividends.
• FundJng requtre'ments : The firm should consider the funding requirements and cash flow
position of the company to decide the dividend decision. For this purpose, projected cash flows
are of particular ·i mportance.
• Investment opportunities : One of the significant factors of affecting di~idend decision Is
availability or lack of Investment opportunities,
 • Flnance Mii::gmt>nt ('MUJ

• Firm h av1ng :.ttnc.-tfve lnvN tment opportu~nltles are likely to postpOne dividend payments It
futurt- period and reinvest earnings in 't he business. while firms lacking good lnvestrn'll
opportunitlM will like to have higher payouts.
• Contractual rHtrictJons : Many times lo:an agreements with lenders restrict the divldelllf
payment to shareholders, companies need to comply with such restrictions Whit
announcement of di vidends.
• Liquidity posltlon : Liquidity of a company is an important consideration in many divldeail
decisions. Greater the cash position and overall liquidity of a company, the greater its ability 11D
pay a dividend. In the low Interest rate environment firms may prefer to borrow funds and be
more liberal In dividend payout
• Access to capita) market : Finns having easier access to long term capital markets are lf!II
dependent on internal funds and are more tlexlble in dividend decisions.
• stage of the business: In the growth stage, business needs funds for investment and Will Illa
to reinvest more profits for growth and limit the dividend payout In th1! mature sta11,
company's Investment requirement Is limited and they are likely to pay :higher dividelld
payout
• Stability of earnings : Companies having stable earnings profile are likely to have larpr
dividend payout. compared to companies having large fluctuations in earnings. Henc,.
companies in the industries such as utllttles e.g. NTPC Ltd or fast moving consumer goods
companies e.g. Hindustan Unilever Ltd are likely to have larger dividend payout compared to
cyclical companies like Tata Motors Ltd.
• Type of Industry : Some industries are highly cyclical and show large fluctuations in demand,
while some industries have periodic Investment requirements due to technological changes.
Companies operating in such industries are likely to have low dividend payout to safeguard
ag!llnst uncertainty.

8.1.3 Dividend Polley Theories

• We had studied In earlier chapters that equity Investors earns returns in the form of divideltd
income and capital gain.
• When a company declares the dividend, equity sharehoJders receive the income In cumiit
period. When a company chooses to reinvest the eamtngs·, equity investors expect to earn froll
capital gains In future.
• Some theories propose that the company's dividend policy has an Impact on share price ofdle
compa11y, while Miller-Modigliani propose the irrelevance of dividend income and share priete.
Let's study.
,.1.• Dividend Dlacount Models (DDM)
DMdend PoUcy

w, undttStood from the concept or pr~ nt value that valu r

,_J cash nows generated from the usei. Dlvtd . e O any asset Is the present of value
..,.. end discou nt mod I h
-«nt value all of Its future divtdend paym e 5 are price ls worth the sum of
r -- ent:s. It can be shared u follows :
Po "' D1 t • D2 • 01 D,
(1 + k) (1 + k)2 (1 • k)l • ... • (1 + k)•
Where
p0 • Pr1et per share
o1, D1,--D-· Dividend per share per year
r . cost of capital

Dividend discount model has two popular variations I.e. Gordon's model and Walter's model.
1.1.s Walter's Model
Walter's model of dividend policy proposes that the dividend policy of the company has an
Impact on the share price of the company. According to the model proposed by James Walter,
market value of company's shares depend on div:ldend payout ratio, Internal rate of return and
cost of capital for the company.

ANUffiptlon•
Walter's model Is based on following assumptions.
• laterpal flnandna : All
investments of the firm are financed from retaln~d earnings of the
company. New equity financing Is not available.
• Constant return and cost of capital : Company's internal rate of return and .cost of capital are
constant.
• Constant earnings and dividend per share (EPS) and (DIV) : Earning per share and
dtvtdend per share of the company are constant
• laftnlte life : Company has infinite life.
• l ~ payout or 100% retention : Company either distributes 100% of profit or reinvests
100% profit amount
According to Walter's model market value per share is sum of present value of all future
dividend per share and present value of gains on investments from retained earnings.
r
. (E-D) xk
0
► Formula : Market price pctr share (Po) • i + k

...... 2 ,,·
 t F'IJM-. e = rmell tMUJ

Wh•,-..
P • Maricctt pr1C't' ~r share
D · Dividend ~r share
k · Cost of capital of the firm
E • Eamlnas per share
r · Internal rate of rrtum of the fJnn.
lflu81ntton

The earnings per share of company are and the rate of capltalJzation applicable to the comp;iny
Is JO and 12% respectively. The company Is evaluating an option to adopt a payout ratio ofSOCW, or
75%. Using Walter's formula of dividend payout, calculate the market value of the company's:
share If the lntemar rate of return Is 15%
Answer

Using Walter's formula

• For payout ratio 50% and RoE of 15%
Dividend per share = 10 x 0.5 = 5
0.15 x (10 - 5))
5 :) ( 0.12
Price per share P = ( 0.ll) + 0. l 2

= 42 + 52 = 94
• For payout ratio of 75% and RoE of 15%
Dividend per share 10 x 0.75 = 7.5
0.15x (10- 75))
(
7.5 ) 0.12
Price per share P = ( 0.l 2; + 0 _12
=62+ 26= 88
As the internal rate of return is higher, higher Is the retentio{l ratio, higher the retention higher
wm be the share price. In fact share price will be maximized when the retention ratio is 100%.
lmpllcatlons of Walter's model

• For growth firms : In case of growth flnns Internal rate of return (r)> cost of capital (k).
shareholders of such firms wilJ maximize value by reinvesting all the earnings. The optimum
payout ratio for such firms fs zero.
• For normal ftrms : In case of normal firms, Internal rate of return (r} Is equal to cost of capital
(k). For such firms dividend policy bas no Impact on share policy ~nd dividend payout ratio Is
optimum.
• fot dedlninl ftnns: In case of decllnJn fl Dtvldinicl 'ez
....nttal (k). Shareholders of suet, ftnn 1 '1nl lntff~I ra_i. of ,_,,_
..-- s will pref · n . .. ., (r ) ls l1Ss than
.a.. dividends elsewhere for better r-· e-r to have l 00% payout Uo eost of
un ,.,,...rn,. ra as they can lnvu t
~ - - of Walter'• mod..

No ,sternal ftnandna: Walter's assumo,H

• .,...on of no externaJ
world. companies have access to external fl flnanct~ Is not practical In real
nandng.
eoostant nte of retum and cost of capital . w
• • alters assumpao f
and Internal rate of return for the entire Iii ·f °
· n constant cost ,of capital
e o company Is unr llstt Co
cost of capita) or rate of return are subject t.o ch · ea c. mpany's rnargtnaJ
ange with more compettt1on in real world
l,1,6 Gordon's Model ·
Myron Gordon's model proposes that the market Yalu O·r th h
e e s ares ls sum of present value of
all future stream o f dlvid end s.
Gordon's model ls based on the assumption that the stream of fu.. ,_ di·"d els
..... e n en • will grow at
some constant rate In the future for an infinite time. The model Is helpful in assessing the value of
stable businesses with strong cash flow and steady levels of dividend growth.
Gordon's model Is based on followl.n g assumptions:
• l~rnal flnandng : All investments of the finn are financed from retained earnings of the
company. New equity financing is not available.
• Constant return and cost of capital : Company's Internal rate of return and cost of capital are
constant
• Constant retention : Company's retention ratio I.e. ratio of retained earnings to profits Is
constant
• Constant rate of growth : Company's earnings are growing at constant rate of growth.
• Infinite life: Company bas infinite life.
• Cost of capital Is pter than rate of p-owth : Cost of capital of the firm Is greater than i:ate
of growth.
• No taxes : There are no taxes on earnings.
D1 D2 D3 Doo
3
Po = (l + k)1 + (1 + k)2 + (1 + k) + ... + (1 + k)'"'
0(1 + g] D (1 + g)2 + Dfl + g)3 + ... + D(1 + g):
Po = (1 + k) + (1 + k)2 (1 + k)3 (1 + k)

where,
P - Price per share
D - Dividend per share
 8•7
DIVl dtnd P.
• Finan ce Mana gmen l (MlTJ

g • Rate of grow th In dividend

k • Cost of capita l

I► ]
Dividend = Earnings per share x Payout ratio
Payout ratio Is 1- reten tion ratio i.e. 1- b, wher e b Is the reten tion ratio.
(1 - bl
Formula : Po• e, (k _ g)

tion ratio
J
Growth rate g can be estim ated using retur n on equit y and reten
g = ROE x Retention ratio .. ROE x b
of retur n (r) or
Earnings per share can be expre ssed as Assets per share (A) x Rate
E1 = r x A

Illuatratlon
s with face value of Rs.11
A Company bas total asset s of Rs.500,000 divided Into 10,00 0 share
on rate of 12% and retu rn•
per share . Company bas policy of 50% payout ratio and capltaUzati
the comp any's share.
asset s of 15%. Using Gordon's method, calculate the mark et value of

D1
As per Gordon's model, share price P = (k-g )
E1 fl- bl
= (k - g)
= A- (0.15 ) x (500, 000) _ 7 5
El rx - 10.00 0 - ·

=
g = bx r 0.50 x 0.15 =00.75 or 7.5%
7.5 (1- 0.5)
p s •
(0.12 - 0.075 )
3.75
= 0.045

P = 83
Price per share is Rs. 83.

Impl lattlo na of Gon ion'• mod el

n (r) > cost of capital 00,
• For IJ'OWtb ftrms : In ~ of grow th firms Intern al rate of retur
(b).
mark et price of share (P0) will lncn .ue with Incre ase In ttten tion ratio
 Dlv'ld tnd Polic y

,or nonnal ftnna: In case of norm al ftrm 5• 1ntem aJ rate of ret ( )

• um r Is 'QUal to cost of capl ~I
(k)- for such ffnn s, divi dend poli cy has n 0 l mpa ct on shar e policy.

•
,or ded lnlq ftnn s : In ca54! of ded fntn g n
·
Wfth Inc
mu Inte rnal rate O-f retu m (r ) Is less than cost of
capital (k), valu e of Hrm WIii decl ine rea ~ In rete ntio n ratio (b).
LJHtltadoM of Gordon•• mo del
No external ftaa ncl q : Wal ter's assu mpt i on o f no exte rnal ftna ndng Is not prictlcal In real
• . ·
world, com pani es hav e acce ss to exte rnal ftna ndng
con stan t rate of retu rn and cost of capital .· wa Ite s assu mpt ion of cons tant cost of capital
r'
•
com pany Is unre alist ic. Company's marginal
and Inter nal rate of retu rn for tbe enti re life of
mor e com peti tion In real wor ld.
cost of <:apltal or rate of retu rn are subj ect to cha nje Wfth
.1.7 Div ide nd Irre lev an ce - Modlgllanl - MIi ier Approach (M M)
8
Modigliani and Mer ton MIiler In 196 1 state s
Modigliani Mlller app roac h put forth by Fran co
com pany. According to this theo ry prtc e
dlat dividend deci sion s are Irre leva nt for the shar e of the
of share Is only influ ence d by earn ings per shar e.

Alll, lfflp tiofW of the mo del

fed cap ital mar kets : Thls mod el assu mes that the capi tal mar kets are perf ect Le. aJl
• ,-,.,
stor have acce ss to free info rma tion , all Inve stor s are rational, there are no flotation or
Inve
transaction cost s.
s: re are no corp orat e taxe s, alte rnat ivel y both divi dend and capi tal gain s are taxe d
• No tue The
at same rate.
me and capital pin s : It is assu med that
• lnft stor Is lnclHferent betw een cllvldend Inco d
and capi tal gain Inco me and only conc erne
lnvestor is Indi ffer ent betw een d tivtd end inco me
about tota l inco me.
forecast future mar ket prices and divi dend s
• No ruk or uncertainty : All the Investors can
with unce rtain ty and risk of unc erta inty does
not exis t This mea ns that disc oun t rate Is sam e

for all securities and for all periods.

nt poli cy
• Investment policy : The Orm has fixed inve stme
Price per shar e as per MM app roac h ls
0 1+ PI
Po = 1+k

~ Fonnula : P 1 • Po (1 + k) - D,

where,
d
p 1 = Mar ket pric e of the shar e at the end of a ~rlo
 Dividend Polla
"8ana N••t■
8·9
• <Wt (MU) ...
p • Market pr1~ of die sha.re at the beginning of a period
0

k • Cost of capital
01 • Dividends received at the ehd ofa period

UfflltattOM of Mod'9flanl - Mfflw Til ■Ow"Y

• Pfffec:t capital markets do not exist. lnfonnatton asymmetry exists. Taxes are present In die
capital markets.
• According to dlls theory, there ls no difference between lntemaJ and external finan~
However, Issuance of new securities Involves floatation costs.
• Taxes are pres.ent. further Is most of the markets capital gains and dividends are taJlli
dffferently.

I Review QUNtlon• I
Q. 1 Why la It '"1)ortant to have a dividend policy for a flnn?

Q. 2 EJaborate the fllCtofs affecting dividend policy.

Q. s A firm Is upectect to declare a dMdend of Rs.1 O next year and has a payout ratio of ~
Company lntemal rate of retum la 16% and cost of capital 12%. Calculate the market price d
shale uelng Gordon's model. ·

Q. • What are the assumptions of MM theory on dividend policy?