Master of Commerce

M. Com.

SECOND YEAR

201 – FINANCIAL MANAGEMENT

SCHOOL OF DISTANCE EDUCATION

ANDHRA UNIVERSITY
VISAKHAPATNAM - 530 003
All copyrights and privileges reserved by the School of Distance
Education. No part of the publication may be reproduced in any
form without the prior permission of the copyright owner.
Information relating to various courses may be obtained from the
office of the School of Distance Education, Andhra university,
Visakhapatnam - 530 003.

DIRECTOR
SCHOOL OF DISTANCE EDUCATION
ANDHRA UNIVERSITY, VISAKHAPATNAM - 3

SCHOOL OF DISTANCE EDUCATION

ANDHRA UNIVERSITY
VISAKHAPATNAM
 COURSE MATERIAL PREPARATION TEAM

 Prof. G. Tulasi Rao

HOD UNIT - I
Dept. of Commerce & Mgt. Studies
A.U. Campus, Etcherla.

 R. Srinivasa Rao
Asst. Professor
UNIT - II
Dept. of Mgt. Studies
CRR College, Eluru.

 Prof. B. Parvathiswara Rao

Dept. of Commerce and Mgt. Studies UNIT - III
Andhra University, Visakhapatnam.

 R. Raghu
Asst. Professor
UNIT - IV
Dept. of Commerce
CRR College, Eluru.

 Prof. P. Veni
Dept. of Commerce and Mgt. Studies UNIT - V
Andhra University, Visakhapatnam.

EDITOR

Prof. B. Parvathiswara Rao

Dean Faculty of Commerce and Management Studies
Andhra University,
Visakhapatnam
 CONTENTS
Guideline. No Particulars Page.No.

Syllabus

UNIT- I .................................................................................................................. 01
1. Nature and Scope of Financial Management .............................................................. 01
2. Finance function ........................................................................................................ 08
3. Objectives of Financial Management ......................................................................... 19
4. Statement of Changes in Financial Position (Funds Flow Statement) ................................28
5. Ratio Analysis............................................................................................................ 51
6. Role of Financial Manager in Modern Environment ...........................................................86

UNIT- II Investment Decisions .......................................................................... 89

7. Time Value of Money ................................................................................................ 90
8. Capital Budgeting Meaning, Significance and Process .......................................................97
9. Technique of Capital Budgeting ............................................................................... 105
10. Modern Techniques of Capital Budgeting ................................................................ 113
11. Risk Analysis in Capital Budgeting .......................................................................... 130
12. DCF Techniques and Their Comparison .................................................................. 140

UNIT- III Financing Decision ............................................................................ 147

13. Optimum Capital Structure - A Theoretical Perspective ..................................................148
14. Modigliani and Miller Approach .............................................................................. 158
15. Determinants of Optimum Capital Structure ............................................................ 164
16. Cost of Capital ......................................................................................................... 172
17. Weighted Average Cost of Capital ........................................................................... 182
18. Leverage and its Applications .................................................................................. 188

UNIT- IV Dividend Policy.................................................................................. 203

19. A Theoretical Perspective ....................................................................................... 204
20. Modigliani - Miller Dividend Irrelevance Model ...................................................... 209
Guideline. No Particulars Page.No.

21. Determinants of Dividend Policy ............................................................................. 214

22. Corporate Dividend Behaviour ................................................................................ 220
23. Bonus Shares and Stock Splits Policies and Practices ................................................ 226
24. Retained Earnings – Policies and Practices...................................................................... 223

UNIT- V ............................................................................................................... 238

25. Working Capital Management ................................................................................. 239
26. Planning of Working Capital .................................................................................... 246
27. Management of Cash and Marketable Securities ....................................................... 260
28. Inventory Management ............................................................................................ 275
29. Management of Receivables .................................................................................... 285
30. Financing of working capital .................................................................................... 296
 SYLLABUS
M. Com. Paper- 201 FINANCIAL MANAGEMENT

Objective:
To develop an understanding of the Finance functions and relevant techniques of financial
administration.
UNIT-I :
Introduction: Nature, Scope and Objectives of Financial Management: Finance Function -
Profit Goal Vs. Wealth Maximization Goal Techniques of Financial Analysis: Funds Flow Analysis
and Ratio Analysis - Role of Financial Manager in Modem Environment.
UNIT-II :
INVESTMENT DECISION: Techniques of Appraisal: Process of Capital Budgeting -
Risk Vs. Return - Traditional and Modem Techniques (including problems).
UNIT - III :
FINANCING DECISIONS : Capital Structure - Determinants : Leverages - Financial,
Operating and Combined: Cost of Capital (including problems).
UNIT-IV :
DIVIDEND AND RETAINED EARNINGS : Dividend Policy Decisions; Parameters,
Dividend Models; Policies Regarding Retained Earnings.
UNIT-V :
WORKING CAPITAL MANAGEMENT : Concept, Need and Determinants of Work-
ing Capital - Working Capital Cycle - Working Capital Policy.

Suggested Books :
1. Brearley, Richard and Myers, Steward : Principles of Corporate Finance, New York,
McGrawHill.
2. Soloman, Ezra, Theory of Financial Management, Columbia Press.
3. James C. Van Home. Financial Management and Policy. Prentice Hall of India.
4. Weston J. Fred and Brigham, Eugne F., Managerial Finance, Dryden Press.
5. Prasanna Chandra, Financial Management, Tata McGraw Hill.
6. Khan. M.Y. and Jain, Financial Management, Tata McGraw Hill.
7. Pandey, I.M, Financial Management, Delhi, Vikas Publishing House
8. Ravi M. Kishore; Financial Management, Taxmann.

*** ***
UNIT– I
GUIDE LINE 1 : NATURE AND SCOPE OF FINANCIAL
MANAGEMENT

Finance may be defined as the provision of money at the time when it is required.
Finance refers to the management of lows of money through an organization. It concerns with
the application of skills in the manipulation, use and control of money. Different authorities
have interpreted the term ‘finance’ differently. However, there are three main approaches to
finance:
1) The first approach views finance as to providing of funds needed by a business on
most suitable terms. This approach confines finance to the raising of funds and to the
study of financial institutions and instruments from where funds can be procured.
2) The second approach relates finance to cash.
3) The third approach views finance as being concerned with raising of funds and their
effective utilization.
Having studied the meaning of the two terms business and finance; we can develop the
meaning of the term ‘business finance’ as an activity or a process which is concerned with
acquisition of funds , use of funds and distribution of profits by a business firm. Thus,
business finance usually deals with financial planning, acquisition of funds, use and
allocation of funds and financial controls.
Financial management refers to that part of the management activity which is
concerned with the planning and controlling of firm’s financial resources. It deals with
finding out various sources for raising funds for the firm. The sources must be suitable and
economical for the needs of the business. The most appropriate use of such funds also forms
a part of financial management. As a separate managerial activity, it has a recent origin.
This draws heavily on the Economics for its theoretical concepts.
DEFINITION OF CORPORATION FINANCE/FINANCIAL MANAGEMENT
Corporation finance of broadly speaking business finance can be defined as the
process of rising, providing and administering of all money/funds to be used in a corporate
(business) enterprise.

Wheeler defines business finance as “that business activity which is concerned with
the acquision and conservation of capital funds in meeting the financial needs and
overall objectives of business enterprise.”

According to Guthmann and Dougall Business finance can be broadly defined as the
activity concerned with the planning, raising, controlling and administering the funds
used in the business.

In the words of Prather and Wert, “Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating in
non-financial fields of industry”.

According to the Encyclopedia of Social Sciences, “Corporation finance deals with
the financial problems of corporate enterprises. These problems include the financial
aspects of the promotion of new enterprises and their administration during early
development, the accounting problems connected with the distinction between capital
and income, the administrative questions created by growth and expansion and
finally, the financial adjustments required for the bolstering up or rehabilitation of a
corporation which has come into financial difficulties”

In the words of Paul G. Hasings “Financial Management” is the management of the
monetary affairs of a company. It includes determining the best terms of raise the
money and devoting available funds to the best uses.

Ezra Soloman quotes, “Financial Management is concerned with the efficient use of
an important economic resource, namely, capital funds”

According to Joseph and Massie “Financial Management is the operation activity of
a business that is responsible for obtaining and effectively utilizing the funds
necessary for efficient operations”

Weston and Brigham define, “Financial Management is an area of financial decision
making, harmonizing individual motives and enterprise goals”.

Phillippatus has given a clear and elaborate definition. According to Phillippatus,
“Financial Management is concerned with the managerial decisions that result in the
acquisition and financing of long-term and short-term credits for the firm. As such it
deals with the situations that require selection of specific assets (or combination of
assets (asset-mix), the selection of specific liability (or combination of liabilities
(liability-mix) as well as the problem of size and growth of an enterprise. The analysis
of these decisions is based on the expected inflows and outflows of funds and their
effects upon managerial objectives”
To sum up in simple words, we can say that financial management as practiced by
corporate (business) firms can be called corporation finance or business finance. Finance
function has become so important that it has given birth to Financial Management as a
separate subject.
SCOPE
An analysis of the various definitions mentioned above make it clear that financial
management is concerned with the proper management of funds keeping in view the
enterprise objectives. The financial manager should look after that the funds are procured in
a manner that the risk and cost considerations are properly balanced, and there is optimum
utilization of funds. It also includes the way in which businessmen, investors, governments,
financial institutions and individuals handle their funds.
Many people believe that financial activities can be regarded as management of
money. But in fact, finance administers economic activities. The scope of finance is vast and
determined by financial requirements of the business enterprise, which have to be identified
before any business plan is formulated. Business needs are costly and change from time to
time depending up environmental factors, since investment opportunities which give rise to
financial needs are available from environment. Hence, the financial managers must have a
through understanding over the environment and its changes. He should also possess the

2
knowledge about nature, activities, objectives and performance of all other functions like
production, marketing and personnel in order to assess their needs. Therefore, it is
appropriate to say that finance manager requires an overall knowledge of the organization
and environment. Many times the finance manger fails because of lack of understanding of
the overall environment both internal and external in which finance function operates. It
requires a good understanding of specialization coupled with sensitivity to general trends to
make an ideal combination for the success of finance function. It also includes money,
banking and credit of different types. It depends upon the co-ordination of different business
functions. That is why, financial management is often described as nervous system of the
organisation. Hence, Husbond and Dockeray describe, “IN its overall sense, finance
embraces many areas other than corporate finance, money, banking and credit of various
types and classes considered as a whole, finance may be said to be the circulatory system of
the economic body, making possible the needed co-operation between many units of activity.
The area of financial management has undergone far reaching changes over time. The
finance function assumes a lot of significance in the modern days in view of the increase size
of business operations and the growing complexities associated thereto.
EVOLUTION CHANGES IN FINANCE:
Traditionally finance function was considered only as an activity of raising of funds
from external sources, maintaining financial records, preparing the financial reports and
statements. Even these financial statements were neither exhaustive nor were dependable as
they are today. Added to this, the investigating publics were ignorant of issues relating to
industrial finance and mobilizing savings from them proved to be difficult task. But with
advancement of technological innovation, the need for more and more funds was felt by
many a firm. Consequently, the liquidity of the firm and the financing aspects became
prominent. Quite a large interest was evinced in marketing securities to raise the required
funds throughout this period.
During 1930’s the depression resulted in the failure of large number of firms. The
firms on the brink of closure intensified the efforts to survive rather than expand. Thus the
need to maintain sound financial structure was very much felt in all quarters during this
period.
During 1940’s through early 1950’s finance was viewed from outside (i.e., raising
funds from external sources) rather than from inside the firm. The internal management of
finance and making decisions were not considered paramount. Nevertheless, the aspects of
planning and control were given some consideration and the importance of long term analysis
of finance recognized.
In the later 1950’s, a number of changes were witnessed in the finance function of the
firm. As the new techniques developed, and mathematical models introduced, wise investing
decisions were made possible. Capital budgeting facilitated the efficient allocation of capital
in the firm. Accordingly, the emphasis on finance was shifted from the outsider’s point of
view to the insider’s point of view. The decision making within the firm has gained top
priority as the capital budgeting involved an accurate measurement of returns from capital.
As a result, the financial manager is required to assess the effects of his decision on the
investor’s and creditor’s valuation of the firm. Theis necessitated the development of capital
structure and formulation of dividend policy so as to increase the value of the firm.

3
 1960’s through 1970’s with the advent of computer, there was a revolutionary change
in the information system making them more and more useful to the financial manager in
discharging his functions. The use of analytical tools for solving the financial problems has
been on the increase. Apart from these things, much headway has been achieved in respect of
decision theory techniques and operation research. With the result, purposeful financial
analysis is made possible. Thus the function of finance now-a-days has broader outlook
concerning with all aspects of management assets, allocation of capital and valuation of firm
in the overall market.
OBJECTIVES OF THE FIRM
Quite obviously, the objective of the firm should be the maximization of its value of
the shareholders. The price of shares in the market indicates the value of the firm. Factors
like investment, financing and dividend exercise an influence on the market price of the
shares.
PROFIT VERSUS WEALTH
While discussing the objective of the firm, profit maximisation attracts one’s attention
as though it is the single primary objective of the firms. In fact, it is never so. There is still
more comprehensive objective i.e., maximizing the wealth of the shareholders. The concept
of profit maximisation is value in its nature. Even though the firm earns large amount of
profits, the wealth of the shareholder may not increases. Profits can be increased by raising
more capital through the issue of shares and investing it in the business. Yet what a
shareholder get may remain the same or at times, lesser because of the simultaneous increase
in the number of shares among which profits are to be distributed. As such maxmisation of
earnings per share appears to be an appropriate objective. In this case also there is not
specification of timing and duration of returns. Besides, the uncertainty involved in the future
earnings steam is not property considered. In view of these loopholes, maximising earnings
per share can not be equated with the objective of maxmising market price per share. It is to
maximise the value of the firm over a period of time. In this context wealth could be
identified with net present value of the firm. The emphasis is on the current market value of
firm’s common stock. A higher present market price of the stock will generally imply better
future earnings potentially.
The objective of wealth maximisation does aim at long range growth of the firm apart
from profits. That is, factors like the risk involved, the consistency of dividends, the
diversified and intensified value of business are taken into consideration. The objective seems
to be logical for it considers the welfare of shareholders.
CONCEPT OF SATISFICING
The concept of satisfying means accepting something less than what is possible under
a situation. The interests of the management may come contrary to those of share-holders.
Under such circumstances, the management in order to sustain their interest may adopt the
concept of satisfying instead of maxmising with a view to perpetuate them in business and
thus seek an acceptable level of growth. They do not venture to assume greater risk, which
may pose a threat to their survival, even though the possible gains to shareholders are high
enough. In practice it is very difficult to determine whether the management is trying to
maximize shareholder’s wealth or satisfies on this factor.

4
ESTABLISHING A STANDARD GOAL
The important question that deserves to be answered is whether the business should
operate invariably in the best interest of shareholders or does it have to work for the welfare
of the society also? Before answering it, let us know what social responsibility the firm is
concerned with is. It means protecting consumer from exploitation, ensuring fair wages to
workers, providing them with better working conditions, solving the environmental problem
as pollution of water, air, etc. It is felt in many quarters that a firm must be socially
responsible in carrying out its objectives. However, it should be recognized that discharging
of the social responsibility stands in the way of accomplishing wealth maximising objective.
The pronouncement of optimization concept requires the financial manager to meet the
demands from employee unions, consumer organizations, Government and the public at
large. As a manager of a typical firm, he must acts as a liaison, agent, expected to satisfy all
these demands in a balanced way. Besides, he must consider the costs involved in meeting
these internal and external demands in relation to the assets to be build-up to maintain or
increase the present or future earning capacity of the firm which is real wealth to
shareholders.
EVOLUTION OF CORPORATION FINANCE/FINANCIAL MANAGEMENT
Corporation finance emerged as a distinct field of study only in the early part of this
century as a result of consolidation movement and formation of large sized business
undertakings. In the initial stages of the evolution of corporation finance, emphasis was
placed on the study of sources and forms of financing the large sized business enterprises.
The grave economic recession of 1930’s rendered difficulties in raising finance from banks
and other financial institutions. Thus, emphasis was laid upon improved methods of planning
and control, sound financial structure of the firm and more concern for liquidity. The ways
and means of evaluating the credit worthiness of firms were developed.’
The past World War II era necessitated reorganization of industries and the need for
selecting sound financial structure. In the early 50’s the emphasis shifted from the
profitability to liquidity and from institutional finance to day to day operations of the firm.
The techniques of analyzing capital investment in the form of ‘capital budgeting’ were also
developed. Thus, the scope of financial management widened to include the process of
decision-making within the firm.
The modern phase began in mid-fifties and the discipline of corporation finance or
financial management has now become more analytical and quantitative. 1960’s witnessed
phenomenal advances in the theory of ‘portfolio analysis’ by Microwitz, Sharpe, Lintner etc.
Capital Asset Pricing Model (CAPM) was developed in 1970’s. The CAPM suggested that
some of the risks in investments can be neutralized by holding of diversified portfolio of
securities. The ‘Option Pricing Theory’ was also developed in the form of the Binomial
Model and the Black-Schools Model during this period. The role of taxation of personal and
corporate finance was emphasized in 80’s. Further, newer avenues of raising finance with the
introduction of new capital market instruments such as PCD’s, FCD’s, PSB’s and CPP’s etc.
were also introduced. Globalisation of markets has witnessed the emergence of “Financial
Engineering’ which involves the design, development and implementation of innovative
financial instruments and the formulation of creative optimal solutions to problems in
finance. The techniques of models, mathematical programming and simulations are presently
being used in corporation finance and it ha achieved the prime place of importance. We may

5
conclude that financial management has evolved from a branch of economics to a distinct
subject of detailed study of its own.
IMPORTANCE OF CORPORATION FINANCE/FINANCIAL MANAGEMENT
Finance is the life blood and nerve centre of a business, just as circulation of blood is
essential in the human body for maintaining life, finance is a very essential to smooth running
of the business. It has been rightly termed as universal lubricant which keeps the enterprise
dynamic. No business, whether big, medium or small can be started without an adequate
amount of finance. Right from the very beginning, i.e conceiving an to business, finance is
need to promote or establish the business, acquire field assets, make investigations such as
market surveys, etc., develop product, keep men and machine at work, encourage
management to make progress and create values. Even an existing concern may require
further finance for making improvements or expanding the business. Thus, the importance of
finance cannot be over-emphasised and the subject of business finance has become utmost
important both to the academicians and practicing managers. The academicians find interest
in the subject because the subject is still in its developing stage and the practicing managers
are interested in the subject because among he most crucial decisions of a firm are those
related to finance.
The importance of corporation finance (which is a constituent of business finance) has
arisen because of the fact that present day business activities are predominantly carried on
company or corporate form of organisation. The advent of corporate enterprises has resulted
into:
(I) The increase in size and influence of the business enterprises,
(II) Wide distribution of corporate ownership, and
(III) Separation of ownership and management.
The above three factors have further increased the importance of corporation finance.
As the owners (shareholders) in a corporate enterprise are widely scattered and the
management is separated from the ownership, the management has to ensure the
maximization of owner’s economic welfare. The success and growth of a firm depends upon
adequate return on its investment. The investors or shareholders can be attracted by a firm
only by maximization of their wealth through the application of principles and procedures as
laid down by Corporation Finance.
The knowledge of the discipline of Corporation Finance is important not only to the
practicing managers, but also to other who deal with a corporate enterprise, such as investors,
lenders, bankers, creditors, etc., as there is always a scope for the management to manipulate
and ‘window dress’ the financial statements.
In the present day capitalistic regime, the size of the business enterprise is increasing
resulting into corporate empires empowered with a lot of social and political influence. This
makes corporation finance all he more important.
Further, if we refer to corporation finance as the financial management practiced by
business firms, the importance of financial management can well be described as the
importance of corporation finance.
Financial management is applicable to every type of organisation, irrespective of its
size, kind or nature. It is as useful to a small concern as to a big unit. A trading concern gets
6
the same utility from its application as a manufacturing unit may expect. This subject is
important and useful or all types of ownership organizations. Where there is a use of finance,
financial management is helpful. Every management aims to utilize its funds in best possible
and profitable way. So this subject is acquiring a universal applicability.
It is indispensable in any organisation as it help in:
(i) Financial planning and successful promotion of an enterprise;
(ii) Acquisition of funds as and when required at the minimum possible cost;
(iii) Proper use and allocation of funds;
(iv) Taking sound financial decisions;
(v) Improving the profitability through financial controls;
(vi) Increasing the wealth of the investors and the nation; and
(vii) Promoting and mobilizing individual and corporate savings.
Review Questions
1) Give a brief note of the evolutionary changes that have taken place in finance
function.
2) “Profit maximisation should be the objective of the firm”. Give your views?
3) Explain the concept of satisfying as against the maxmisation concept.
4) What are the functions of finance? Discuss them in detail.
5) Why a firm should be socially responsible? What are the hurdles in it?

BOOKS SUGGESTED
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

7
GUIDELINE 2 : FINANCE FUNCTION

FINANCE FUNCTION
Finance function is the most important of all business function. It remains a focus of
all activities. It is not possible to substitute or eliminate this function because the business
will close down in the absence of finance. The need for money is continuous. It starts with
the setting up of an enterprise and remains at all times. The development and expansion of
business rather needs more commitment for funds. The funds will have to be raised from
various sources. The sources will be selected in relation to the implication attached with
them. The receiving of money is not enough, its utilization is more important. The money
once received will have to be returned also. If its use is proper then its return will be easy
otherwise it will create difficulties for repayment. The management should have an idea of
using the money profitably. It may be easy to raise funds but it may b difficult to repay them.
The inflows and outflows of funds should be properly matched.
APPROACHES TO FINANCE FUNCTION
A number of approaches are associated with finance function but for the sake of
convenience, various approaches are divided into two broad categories:
1. The Traditional Approach
2. The Modern Approach.
1. THE TRADITIONAL APPROACH
The traditional approach to the finance function relates to the initial stages of its
evolution during 1920s and 1930s when the term ‘corporation finance’ was used to describe
what is known in the academic world today as the ‘financial management’. According to this
approach, the scope of finance function was confined to only procurement of funds needed by
a business on most suitable terms. The utilization of funds was considered beyond the
purview of finance function. It was felt that decision regarding the application of funds is
taken somewhere else in the organization. However, institutions and instruments for raising
funds were considered to be a part of finance function. The scope of the finance function.
Thus, evolved around the study of rapidly growing capital market institutions, instruments
and practices involved in raising of external funds. The traditional approach to the scope and
functions of finance has now been discarded as it suffers from any serious limitations:
i) It is outsider-looking in approach that completely ignores internal decision making
as to the proper utilization of funds.
ii) The focus of traditional approach was on procurement of long-term funds. Thus, it
ignored the important issue of working capital finance and management.
iii) This issue of allocation of funds, which is so important today is completely
ignored.
iv) It does not lay focus on day to day financial problems of an organization.

8
2. THE MODERN APPROACH
The modern approach views finance function in broader sense. It includes both rising
of funds as well as their effective utilization under the purview of finance. The finance
function does not stop only by finding out sources of raising funds and the returns from heir
use should be compared. The funds raised should be able to give more returns than the costs
involved in procuring them. The utilization of funds requires decision making. Finance has to
be considered an integral part of overall management. So finance function, according to this
approach, covers financial planning, raising of funds, allocation of funds, financial control
etc. The new approach is an analytical way of dealing with financial problems of a firm. The
techniques of models, mathematical programming, simulations and financial engineering are
used in financial management to solve complex problems of present day finance. The modern
approach considers the three basic management decisions, i.e., investment decisions,
financing decisions and dividend decisions with the scope of finance functions.
AIMS OF FINANCE FUNCTION
The primary aim of finance function is to arrange as much funds for the business as
are required from time to time. This function has the following aims:
1) Acquiring sufficient Funds. The main aim of finance function is to assess the financial
needs of an enterprise and then finding out suitable sources for raising them. The
sources should be commensurate with the needs of the business. If funds are needed for
longer periods then long-term sources like share capital, debentures, term loans may be
explored. A concern with longer gestation period should rely more on owner’s funds
instead of interest-bearing securities because profits may not be here for some years.
2) Proper Utilization of Funds. Though raising of funds is important but their effective
utilization is more important. The funds should be used in such a way that maximum
benefit derived from them. The returns from their use should be more than heir cost. It
should be ensured that funds do not remain idle at any point of time. The funds
committed to various operations should be effectively utilized. Those projects should
be preferred which are beneficial to the business.
3) Increasing Profitability. The planning and control of finance function aims at
increasing profitability of the concern. It is true that money generate money. To
increase profitability, sufficient funds will have to be invested. Finance function should
be so planned that the concern neither suffers from inadequacy of funds frittered away
on uneconomical operations. The cost of acquiring funds also influences profitability of
the business. If the cost of raising funds is more, then profitability will godown.
Finance function also requires matching of cost and returns from funds.
4) Maximising Firm’s Value: Finance function also aims at maximizing the value of the
firm. It is generally said that a concern’s value is linked with its profitability. Even
though profitability influence firm’s value but it is not all. Beside profits, the type of
sources used for raising funds, the cost of funds, the condition of money market, the
demand for product are some other consideration which also influence a firm’s value.
SCOPE OR CONTENT OF FINANCE FUNCTION/FINANCIAL MANAGEMENT
The main objective of financial management is to arrange sufficient finances for
meeting short-terms and long-term needs. These funds are procured at minimum costs so that

9
profitability of the business is maximized. With these things in mind, a Financial Manger will
have to concentrate on the following areas of finance function.
1. Estimating Financial Requirements
The first task of a financial manager is to estimate short-term and long-term financial
requirements of his business. For this purpose, he will prepare a financial plan for present as
well as for future. The amount required for purchasing fixed assets as well as needs funds for
working capital will have to be ascertained. The estimations should be based on sound
financial principles so that neither there are inadequate nor excess funds with the concern.
The inadequacy of funds will adversely affect the day-to-day working of the concern whereas
excess funds may tempt a management to indulge in extravagant spending or speculative
activities.
2. Deciding Capital Structure
The capital structure refers to the kind and proportion of different securities for
raising funds. After deciding about the quantum of funds required is should be decided
which type of securities should be raised. It may be wise to finance filed assets through long-
term debts. Even here f gestation period is longer, then share capital may be most suitable.
Long-term funds should be employed to finance working capital also, if not wholly then
partially. Entirely depending upon overdrafts and cash credits for meeting working capital
needs may not be suitable. A decision about various sources for funds should be linked to the
cost of raising funds. If cost of raising funds is very high then such sources may not be useful
for long. A decision about the kind of securities to be employed and the proportion in which
these should be used is an important decision which influences the short-term and long-term
financial planning of an enterprise.
3. Selecting a Source of Finance
After preparing a capital structure, an appropriate source of finance is selected.
Various sources from which finance may be raised, include: share capital, debentures,
financial institutions, commercial banks, public deposit, etc. It finances are needed for short
periods then banks, public deposits and financial institutions may be appropriate ; on the
other hand, if long-term finances are required then share capital and debentures may be
useful. If the concern does not want to tie down assets as securities then public deposits may
be a suitable source. If management does not want to dilute ownership then debentures
should be issued in preference to shares. The need, purpose, object and cost involved may be
the factors influencing the selection of a suitable source of financing.
4. Selecting a Pattern of Investment.
When funds have been procured then a decision about investment pattern is to be
taken. The selection of an investment pattern is related to the use of funds. A decision will
have to be taken as to which assets are to be purchased? The funds will have to be spent first
on fixed assets and then an appropriate portion will be retained for working capital. Even in
various categories of assets, a decision about the type of fixed or other assets will be
essential. While selecting a plant and machinery, even different categories of them may be
available. The decision-making techniques such as Capital Budgeting, Opportunity Cost
Analysis etc. may be applied in making decisions about capital expenditures. While spending
on various assets, the principles of safety, profitability and liquidity should not be ignored. A

10
balance should be struck even in these principles. One may not like to invest on a project
which may be risky even through there may be more profits.
5. Proper Cash Management
Cash management is also an important task of finance manager. He has to assess
various cash needs at different time and then make arrangements for arranging cash. Cash
may be required for
(a) Purchase raw material
(b) Make payment to creditors
(c) Meet wage bills
(d) Meet day to day expenses.
The usual sources of cash may
(a) Cash sales
(b) Collection of debts
(c) Short-term arrangements with banks etc.
The cash management should be such that neither there is a shortage of it and nor it is
idle. Any shortage of cash will damage the creditworthiness of the enterprise. The idle cash
with the business will means that it is not properly used. It will be better if Cash Flow
Statement is regularly prepared so that one is able to find out various sources and
applications. If cash is spent on avoidable expense then such spending may be curtailed. A
proper idea on sources of cash inflow may also enable to assess the utility of various sources.
Some sources may not be providing that much cash which we should have thought. All this
information will help in efficient management of cash.
6. Implementing Financial Controls
An efficient system of financial management necessitates the use of various control
devices. Financial control devices generally used are:
(a) Return on investment
(b) Budgetary Control
(c) Break Even Analysis
(d) Const Control
(e) Ratio Analysis
(f) Cost and Internal Audit,
Return on investment is the best control device to evaluate the performance of various
financial policies. The higher this percentage, better may be the financial performance. The
use of various control techniques by the finance manager will help him in evaluating the
performance in various are and take corrective measure whenever needed.
7. Proper Use of Surplus
The utilisation of profits or surpluses is also an important factor in financial
management. A judicious use of surpluses is essential for expansion and diversification plans
11
and also in protecting the interests of shareholders. The ploughing back of profit is the best
policy of further financing but it clashes with the interest of shareholders. A balance should
be struck in using funds for paying dividend by the declaration of dividend and expected
profitability in future. A finance manager should consider the influence of various factors,
such as:
(a) Trend of earnings of the enterprises
(b) Expected earnings in future
(c) Market value of shares
(d) Need for funds for financing expansion, etc.
A judicious policy for distributing surpluses will be essential for maintaining proper
growth of the unit.
RELATIONSHIP OF FINANCE WITH OTHER BUSINESS FUNCTIONS
Any business enterprise basically performs found function, viz,.production marketing,
personnel and finance. There is inseparable relationship between finance and other functions.
All the business functions directly or indirectly involve the mobilization and use of funds.
For example, purchasing machine for production operation require funds from finance
department. Similarly, in order to recruit and train people, the personnel department needs
monetary resources to pay for their salaries and training cos. In the same way, advertising and
sale promotion activities are concerned with marketing function. But their performance needs
the support of the finance for the allocation of adequate resources. Thus, all the functions of
the organization affect the finance resources. The Finance Department acquires the necessary
resources for the organization and allocates them vigilantly keeping in view their priorities
and importance, because requirements for resources are unlimited and their availability is
always limited. As such, the finance function is critically related with other function of the
enterprise. The financial polices and strategies are designed to suit the production and market
decisions. They are so integrated and work together to achieve the overall objective of the
enterprise. Hence John Hampton states that finance is a specialized function, more
particularly, a service function to other departments.
Business function means functional activities that an enterprise undertakes in
achieving its desired objectives. These functions may be classified on the basis of its
operational activities.

Business Functions of a Manufacturing Undertaking

Purchase Production Distribution Accounting Personnel Research and

Function Function Function Development
Function Function
Function

Finance function of a business is closely related to its other functional areas. Funds
will be wasted in the absence of efficient production and in the absence of proper marketing,

12
the firm will not be able to engage funds judiciously in the business. Most of the important
decisions of a business enterprise are taken on the basis of availability of funds. However,
finance function in practice should not limit the general running of the business. Financial
policies of a firm should be devised in such a manner so as to match the requirements of other
functional area. The relationship between finance function and other business function of an
enterprise is discussed below:
1. Purchase Function
Materials required for production of commodities should be procured on economic
terms and should be utilised in efficient manner to achieve maximum productivity. In this
function the finance manager plays a key role in providing finance. In order to minimize cost
and exercise maximum control, various material management techniques such as economic
order quantity(EOQ), determination of stock level, perpetual inventory system etc. are
applied. The task of finance manager is to arrange the availability of cash when the bills for
purchase become due.
2. Productivity Function
Production function occupies the dominant position in business activities and it is a
continuous process. The production cycle depends largely on the marketing function because
production is justified when they are resulted in revenues through sales. Production function
involves heavy investment in fixed assets and in working capital. Naturally, atighter control
by the finance manager on the investment in productive assets becomes necessary. It must be
seen that there is neither over-capitalisation nor under-capitalisation. Cost-benefit criteria
should be prime guide in allocating funds and therefore finance and production manager
should work in union.
3. Distribution Function
As goods produced are meant for sale, distribution function is an important business
activity. It is more important because it provides continuous inflow of cash to meet the out
flow thereof. So while choosing different distributing channels, media of advertisement and
sales promotion devices, the cost benefit criterion should be the guiding factor. If cost
reduction in distribution function is effected without compromising efficiency, it will lead to
increased benefit to the enterprise in the form of higher profit and to the consumers in the
form of lower cost. As every aspect of distributor function involves cash outflow and ever
distributing activity is aimed at bringing about inflow of cash both the function are closely
inter-related and hence should be carried out in close unison.
4. Accounting Function
Chales Gastenberg visualizes the influence of scientific arrangement of records, with
the help of which inflow and outflow of funds can be efficiently managed and stocks and
bonds an be efficiently marketed. Moreover, the efficiency of the whole organization can be
greatly improved with correct recording of financial data. All the accounting tools and control
devices, necessary for appraisal of finance policy can be correctly formulated if the
accounting data are properly recorded. For example, the cost of raising funds, expected
returns on the investment of such funds, liquidity position forecasting of sales etc. can be
effectively carried out if the financial data so recorded are reliable. Hence, the relationship
between accounting and finance I intimate and the finance manager has to depend heavily on
the accuracy of the accounting data.
13
 Financial Provides
Accounting Raw Data

Provides To
Decisions
Management Financial
Accounting information Management Take 1.Financing

2. Investment
Cost
Accounting Provides 3. Dividend
Raw Data
Process and
Analyses Data
Received

Data Generation
(Accounting and Financial Management Relationship)

5. Personnel Function
Personnel Function has assumed a prominent place in the domain of business
management. No business function can be carried out efficiently unless there is a sound
personnel policy includes backed up by efficient management of personnel. Success or failure
of every business activity boils down to the efficiency of otherwise of the en entrusted with
the respective function. A sound personnel policy includes proper wage structure, incentives
schemes, promotional opportunity, human resource development and other fringe benefits
provided to the employees. All these matters affect finance. But the finance manager should
know that organization can afford to pay only what it can bear. It means that expenditure
incurred on personnel management and the expected return on such investment through
labour productivity should be considered in framing a sound personnel policy. Therefore, the
relation between the finance and personnel department should be intimate.
6. Research and Development
In the world of innovations and competitiveness, expenditure on research and
development is a productive investment and R and D it self an aid to survival and growth of
the introduction of newer varieties, the firm is bound to be gradually out marketed and out of
existence. However, sometimes expenditure on R and D involves a heavier amount,
disproportionate to the financial capacity of the firm. In such a case, it financially cripples
the enterprise and the expenditure ultimately ends in a fiasco. On the other hand, heavily
cutting down expenditure of R and D blocks the scope of improvement and diversification of
the product. So, there must be a balance between the amount necessary for continuing R and
D work and the funds available for such purpose. Usually, this balance is truck out by joining
efforts of finance managers and the person at the helm of R & D.
7. Financial Management and Marketing
Marketing on the most vital areas on which the success or failure of the firm depends.
The methodology to the pricing policy is vital in the marketing effor, image and sales level.
Determination of the appropriate price for the firm’s image and sales level. Determination of
the appropriate price for the firm’s product is of importance both of the marketing and
financial managers and, therefore, should be a combined decision. The marketing manager
provides information as to how different price will affect the demand for the company’s

14
products in the market and firm’s competitive position whereas the financial manager can
supply information about costs, change in costs a different levels of production and the profit
margins required to carry on the business. So, the financial manager contributes highly
towards formulation of the pricing policies pertaining to marketing.
8. Finance Management and Strategic Management
According to Holfer and Schendel, “Strategy means fundamental pattern of present
and planned resource deployments and environmental interaction and indicates how the
organization will achieve its objects”. Finical concepts are not complete and effective unless
they are linked with strategic management considers the markets, whether relating to capital,
product or labour, as imperfect and changing. So strategies are developed to manage the
business firms in uncertain and imperfect market conditions and environment. Proper
corporate strategies have to be devised for proper implementation of corporate policies.
Hence, the corporate strategy and financial polices are closely interlinked as stated below.
a) Finance policies involve proper deployment of resources such as materials, labour
and capital. Strategic management involves development of strategies to
effectively manage the business firm in imperfect market conditions and
environment. So formulation of appropriate financial policies is possible only
when the finance manager keeps in mind the changing market conditions and
environment.
b) Corporate strategies involve development of appropriate methods and technique to
compete in a particular product segment or industry. Shareholders are considered
not only the group interested in the firm. They are other also such as creditors,
employees, customers, suppliers, etc., equally interested in the welfare of the firm.
Financial policy should be devised in a manner, which can take care of the interest
of all these groups.
c) Strategic management is a multi-dimensional activity. It lays emphasis on growth
profitability and flow of funds besides on the maxmisation of the market value of
the equity shares. The financial policies are to be devised in a manner which
create not only enough corporate wealth for achieving market dominance but also
help in successful long term survival of the firm.
So, it will be seen that the financial management is closely linked with all other areas
of management. As a matter of fact, the financial manager ha a grasp overall areas of the
firm because of his key position. Moreover, the attitude of the firm towards other
management areas is largely governed by its financial position. A firm facing a critical
financial position will devise its recruitment, production and marketing strategies keeping the
overall financial position in the view. While a firm having good financial position may give
flexibility to the other management functions, such as, personnel, production and marketing.
FINANCIAL FUNCTIONS
The functions of finance may be categorized into three major decisions areas:
1) Investment Decisions
2) Financial Decisions
3) Dividend Decisions

15
 Through three areas of decisions are identified, none of them is independent. They
exercise a combined influence on the market price of the company’s share and hence on the
maximisation of the value of the firm to shareholders. Let us discuss each of them in detail.
INVESTMENT DECISIONS
Capital budgeting is the main aspects of investment decision. Capital budgeting
means the long range planning of allocation of funds among the various investment
proposals. The returns on those proposals can be derived for a fairly longer time in the
future. As it is budgeting made into the future, risk is associated with the capital projects as
well as with the expected returns. It must be noted that the efficient management of existing
assets also forms part and parcel of investment decisions. The financial manager is equally
responsible for the efficient management of current asset also. He must determine the degree
of liquidity the firm should possess. A conflict exists between profitability and liquidity.
Insufficiency of funds in current assets results in inadequate liquidity. In order to ensure that
neither insufficient nor-excessive funds are invested in current assets, the financial manager
must equip himself with sound techniques of managing the current assets like cash,
receivables, inventories etc.
FINANCING DECISION
The second import decision area is financing. The principal aspects of financing
decision is determination of capital structure. The financial manager has to decide which
finance mix provides the best. This must be decided taking into consideration the market
price per share. That is, the financing mix should be such that the market price per share
would be maximum. Employment of debt capital affects the return and risk of shareholders.
Having decided the optimum combination, the next step would be raising the finance though
the sources available on favourable terms.
DIVIDEND DECISION
The third important decision is the one relating to dividend policy. How much of the
earnings should be paid to shareholders as dividend must be decided. This decision must be
made with a consideration to the future expansion of the firm. Apart from this, the dividend
decision include the stability of dividends over a period of time, the stock dividends etc. The
dividend pay out ratio is to be determined in the light of the objective of maxmising the
market value of the share. The dividend decision is to determine the portion of retained
earnings as a means of financing the expansion of the firm.
As it has already been pointed out about, the three decision areas are interrelated and
hence an optimal combination must be achieved, so that the value of the firm to the
shareholders would be maximum. The financial manager would be able to make optimal
decision when he makes use to the tools of financial analysis. Further, since management is a
complex system consisting of interrelated systems, the subject of finance cannot be studied in
isolation. An interdisciplinary approach is all the more essential to comprehend the relation
of firm’s finance with other branches of management. The financial decision must be geared
to other functional requirements like marketing, production, personnel, research and
development etc.

16
ORGANISATION OF THE FINANCE FUNCTION
Financial management is in many ways an integral part of the jobs of managers who
are involved in planning, allocation or resources, and control. The responsibilities for
financial management are dispersed throughout the organization. For example.

The engineer who proposes a new plant shapes the investment policy of the firm.

The marketing analyst provides inputs in the process of forecasting and planning.

The purchase manager influences the level of investment in inventories.

The sales manager has a say in the determination of the receivables policy.

Departmental managers, in general, are important links in the financial control
system of the firm.
There are, however, many task of financial management and allies areas (like
accounting) which are specialized in nature and which are attended to by specialists. These
task and their typical distribution between the two key financial officers of the firm, the
treasure and the controller, are shown. Note that the treasure is responsible mainly for
financing and investment activities and the controller is concerned primarily with accounting
control.
Functions of the Treasurer and the Controller

Treasurer Controller

Obtaining finance Financial accounting

Banking relationship Internal auditing
Cash management Taxation
Credit administration Management accounting
Capital budgeting and control

Typically, the chief finance offer who may be designated as Director (Finance) or Vice
President (Finance) supervises he work of the treasurer and the controller. In turn, these
officers are assisted by several specialist managers working under them. The finance function
in a large organization may be organized as shown in.

17
 Organisation of Finance Function

Chief Finance
Officer

Treasurer Controller

Cash Credit Financial Cost

Manager Manager accounting Accounting
manager manager

Capital Fund raising Tax Data

budgeting manager manager Processing
manger manager

Portfolio Internal
manager Auditor

The Finance officer, in addition to their specialized responsibility, has significant

involvement in injecting financial discipline in corporate management process. They are
responsible for emphasizing the need for rationality in the use of funds and the need for
monitoring the operations of the firm to achieve desired financial results. In this respect the
tasks of financial officers have assumed new dimensions. Instead of just looking after routine
financing and accounting activities, they guide and participate in the task of planning, funds
allocation, and control so that the financial point of view is sufficiently emphasized in the
process of corporate management.
BOOKS SUGGESTED
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

18
GUIDELINE 3 : OBJECTIVES OF FINANCIAL
MANAGMENT

OBJECTIVES OF FINANCIAL MANAGEMENT

Financial Management is concerned with procurement and use of funds. Its main aim
to use business funds in such away is that the firm’s value / earnings are maximized. There
are various alternatives available for using business funds. Each alternative course has be
evaluated in detail. The pros and cons of various decisions have to look into before making a
final selection. The decision will have to take into consideration the commercial strategy of
the business. Financial Management provides a framework for selecting a proper course of
action and deciding a viable commercial strategy. The main objective of a business is to
maximize the owner’s economic welfare. This objective can be achieved by:
1. Profit Maximisation
2. Wealth Maximisation
The firm’s investment and financing decisions are unavoidable and continuous. In
order to make them rationally, the firm must have a goal. It is general agreed in theory that
the financial goal of the firm should be shareholder’s wealth maximisation (SWM)m, as
reflected in the market value of the firm’s shares.In this section, we show that the
shareholder’s wealth maximisation is theoretically logical and operationally feasible
normative goal for guiding the financial decision making.
Definition of Profit
The precise meaning of the profit maximisation objective is unclear. The definition of
the term profit is ambiguous. Does it mean short – or long-term profit? Does it refer to
profit before or after tax? Total profits or profit per share? Does it mean total operating
profit or profit accruing to shareholders?
Time value of Money
The profit maximization objective does not make an explicit distinction between
returns received in different time periods. It given no consideration to the time value of
money, and it values benefits received in different period of time as the same.
Uncertainty of returns
The system of benefits may possess different degree of certainty. Two firms may
have same total expected earnings, but if the earnings of one firm fluctuate considerably as
compared to the other, it will be more risky. Possibly, owners of the firm would prefer
smaller but surer profits to a potentially larget but less certain stream of benefits.
1) Profit Maximisation
Profit earning is the main aim of every economic activity. A business being an
economic institution must earn profit to cover its costs and provide funds for growth. No
business can survive without earning profit. Profit is a measure of efficiency of a business
enterprise. Profit also serve as a protection against risks which cannot be ensured. The
accumulated profits enable a business to face risks like fall in prices, competition from other
19
units, adverse government policies etc. Thus, profit maximisation is considered as the main
objective of business. The following arguments are advanced in favour of profit
maximisation as the objective of business.
In the economic theory, the behaviour of a firm is analyzed in terms of profit
maximisation. Profit Maximisation implies that a firm either produces a maximum output
for a given amount of input, or uses minimum input for producing a given output. The
underlying logic of profit maximisation is efficiency.
i) When profit-earning is the aim of business then profit maximisation should be the
obvious objective.
ii) Profitability is a barometer for measuring efficiency and economic prosperity of a
business enterprise, thus, profit maximisation is justified on the grounds of rationality.
i) Economic and business conditions do not remain same at all the times. There may
be adverse business conditions like recession, depression, severe competition etc.
A business will be able to survive under unfavourable situation, only if it has
some past earnings to rely upon. Therefore, a business should try to earn more
and more when situation is favourable.
ii) Profits are the main sources of finance for the growth of a business. So, a
business should aim at maximisation of profits for enabling its growth and
development.
iii) Profitability is essential for fulfilling social goals also. A firm by pursuing the
objective of profit maximisation also maximizes socio-economic welfare.
However, profit maximisation objective has been criticized on many ground. A firm
pursuing he objective of profit maximisation starts exploiting workers and the consumers.
Hence, it is immoral and leads to a number of corrupt practices. Further, it leads to colossal
inequalities and lower human values which are as essential part of an ideal social system. It is
also argued that profit maximisation should be the objective in the conditions of perfect
competition and in the wake of imperfect competition today, it cannot be the legitimate
objective of a firm. The concept of limited liability in the present day business has separated
ownership and management. A company is financed by shareholders, creditors and financial
institutions and is controlled by professional managers. Workers, customers, government and
society are also concerned with it. So, one has to reconcile the conflicting interests of all
these parties connected with the firm. Thus, profit maximisation as an objective of financial
management has been considered inadequate. Even as an operational criterion for
maximizing owner’s economic welfare, Profit maximisation has been rejected because of the
following drawbacks:
i) The term ‘profit’ is vague and it cannot be precisely defined. It means different
things for different people. Should we consider short-term profits or long-term
profits? Does it mean total profits or earnings per share? Should we take profits
before tax or after tax? Does it mean operating profit or profit available for a
company has presently 10,00,000 the earnings per share are Rs. 10. Now, if the
company further issues 5,000 share and makes a total profit of Rs. 1,20,000 the
total profit have increased by Rs. 20,000, but the earning per share will decline to
Rs. 8.

20
 Even. If we take the meaning of profits as earnings per share and maximize the
earnings per share, it does not necessarily mean increase in the market value of shares and the
owner’s economic welfare.
ii) Profit maximisation objective ignore the time value of money and does not
consider the magnitude and timing of earnings. It treats all earnings as equal
though they occur in different periods. It ignore the fact that cash received today is
more important than the same amount of cash received after, say, three years. The
stockholders may prefer a regular return from investment even if it is smaller than
the expected higher returns after a long period.
iii) It does not take into consideration the risk of the prospective earnings stream.
Some projects are more risky than others. The earning streams ill also be risky in
the former than the latter. Two firms may have same expected earnings per share,
but if the earning stream of one is more risky then the market value of its shares
will be comparatively less.
iv) The effect of dividend policy on the market price of share is also not considered in
the object of profit maximisation. In case, earning per share is the only objective
then an enterprise may not think of paying dividend at all because retaining profits
in the business or investing them in the market may satisfy this aim.
Maximizing Profit after Taxes
Let us put aside the first problem mentioned above, and assume that maximizing
profit means maximizing profits after taxes, in the sense of net profit as reported in the profit
and loss account (income statement) of the firm. It can easily be realized that maximizing this
figure will not maximize the economic welfare of the owners. It is possible for a firm to
increase profit after taxes by selling additional equity shares and investing the proceeds in
low-yielding assets, such as the government bonds. Profit after taxes would increase but
Earnings per Share (EPS) would decrease. To illustrate let us assume that a company has
10,000 shares outstanding, profit after taxes of Rs. 50,000 and earning per share of Rs.5. If
the company sells 10,000 additional shares at Rs. 50 per share and invests the proceeds (Rs.
5,00,000) at 5 percent after taxes, then the total profits after taxes will increase to Rs. 75,000.
How ever , the earnings per share will fall to Rs. 3.75 (i.e.,Rs. 75,000/20,000). This example
clearly indicates that maximizing profits after taxes do not necessarily serve the best interest
of owners.
Maximizing EPS
Let us put maximizing EPS as the financial objective of the firm, this will also not
ensure the maximisation of owner’s economic welfare. It also suffers from the flaws already
mentioned, i.e. it ignores timing and risk of the expected benefits. Apart from these problems,
maximisation of EPS has certain deficiencies as a financial objective. For example, note the
following observation.
For one thing, it implies that the market value of the company’s shares is a function of
earnings per share, which may not be true in many instances. If the market value is not a
function of earnings per share, then maximisation of the latter will not necessarily result price
for the company’s shares. Maximisation of earning per share further implies that the firm
should make no dividend payments so long as funds can be invested internally at any positive

21
rate of return, however small. Such a dividend policy may not always be to the shareholder’s
advantage.
It is, thus, clear that maximizing profits after taxes or EPS as the financial objective
fails to maximize the economic welfare of owners. Both methods do not take account of the
timing and uncertainty of the benefits. An alternative to profit maximisation, which solves
these problems, is the objective of Wealth maximisation. This objective is also considered
consistent with the survival goal and with the personal objectives of managers such as
recognition, power, status and personal wealth.
2. Wealth Maximisation
Wealth maximisation is the appropriate objective of an enterprise. Financial theory
assets that wealth maximisation is the single substitute for a stockholder’s utility. When the
firm maximizes the stockholder’s wealth, the individual stockholder can use this wealth to
maximize his individual utility. It means that by maximizing stock holder’s wealth the firm
is operating consistency towards maximizing stock holder’s utility.
A stock holder’s current wealth in the firm is the product of the number of shares
owned, multiplied with the current stock price per share.
Stockholder’s current wealth in a firm = (number of shares owned) x (current stock
per share)
Symbolically, W0 = NP0
Given the number of shares that the stockholder owns, the higher the stock price per
share the greater will be the stockholder’s wealth. Thus, a firm should aim at maximizing its
current stock price. This objective helps in increasing the value of shares in the market. The
share‘s market price serves as a performance index or report card of its progress. It also
indicates how well management is doing on behalf of the shareholder.
However, the maximisation of the market price of the shares should be in the long
run. The long run implies a period which is long enough to reflect the normal market value
of the shares irrespective of short term fluctuations.
While pursuing the objective of wealth maximisation, all efforts must be put in for
maximizing the current present value of any particular course of action. Every financial
decision should be based on cost-benefit analysis. If the benefit is more than the cost, the
decision will help in maximizing the wealth. On the other hand, if cost is more than the
benefit the decision will not be serving the purpose of maximizing wealth.
Shareholder’s Wealth Maximisation (SWM)
What is meant by shareholder’s wealth maximisation (SWM)? SWM means
maximsing the net present value of a course of action to shareholders. Net Present Value
(NPV) or wealth of course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has positive NPV creates wealth for
shareholders and therefore, is desirable. A financial action resulting in negative NPV should
be rejected since it would destroy shareholder’s wealth. Between Mutually exclusive
Projects are additive in nature. That is
NVP(A)+NPV(B)=NPV(A+B)
22
 This is referred to as the Principle of Value-additive. Therefore, the wealth will be
maximized if NPV criterion is followed in making financial decisions.
The objective takes care of the questions of the timing and risk of the expected
benefits. These problems are handled by selecting an appropriate rate (the shareholder’s
opportunity cost of capital) for discounting the expected flow of future benefits. It is
important to emphasise that benefits are measured in terms of cash flows. In investment and
financing decisions, it is flow of cash that is important, into the accounting profits.
The objective of SWM is an appropriate and operationally feasible criterion to choose
among the alternative financial actions. It provides an unambiguous measure of what
financial management should seek to maximise in making investment and financing decisions
on behalf of shareholders.
Maximising the shareholder’s economic welfare is equivalent to maximising the
utility of their consumption over time. With their wealth maximized, shareholder can adjust
their cash flows in such a way as to optimize their consumption. From the shareholder’s point
of view, the wealth created by a company through its actions is reflected in the market value
of the company’s shares. Therefore, the wealth maximsation principle implies that the
fundamental objective of a firm is to maximise the market value of its shares. The value of
the company’s shares is represented by their market price that, in turn, is a reflection of
shareholder’s perception about quality of the firm’s financial decisions. The market price
serves as the firm’s performance indicator. How is the market price of a firm’s share
determined?
Need for a Valuation Approach
SWM requires a valuation model. The financial manager must know or at least
assume the factors that influence the market price of shares, otherwise he or she would find
himself or herself unable to maximise the market value of the company’s shares. What is
appropriate share valuation model? In practice, innumerable factors influence the price of a
share, and also, these factors change very frequently. Moreover, these factors vary across
shares of different companies. For the purpose of the financial management problem, we can
phrase the crucial questions normatively; How much should a particular share be worth?
Upon what factor or factors should its value depend? Although there is no simple answer to
these questions, it is generally agreed that the value of an asset depends on its risk and return.
Risk –return Trade-off
Financial decisions incur different degree of risk. Your decision to invest your money
in government bonds has less risk as interest rate is known and the risk of default is very
less. On the other hand, you would incur more risk if you decide to invest your money in
shares, a return is not certain. However, you can expect a lower return from government bond
and higher from shares. Risk and expected return move in tandem; the greater the risk, the
greater the expected return. Figure shows this risk-return relationship.

23
 The Risk-return relationship

sExpected Return

Risk Return

Risk-free return

Financial decisions of the firm are guided by the risk-return trade-off. These decisions
are interrelated and jointly affect he market value of its shares by influencing return and risk
of firm. There relationship between return and risk can be simply expressed as follows:
Return = Risk-free rate + Risk premium.
Risk-free rate is rate obtainable from a default-risk free government security. An investor
assuming risk form her investment requires a risk Premium above the risk free rate us a
compensation for time and risk premium for risk. Higher the risk of an action, higher will be
the risk premium leading to higher required return on that action. A proper balancebetween
return and risk should be maintained to maximise the market value of a firm’s shares. Such
balance is called risk-return trade-off, and every financial decision involves this trade-off ,
and every financial decision involves this trade-off. The interrelation between market value,
financial decisions and risk-return trade-off is depicted in figure. It also gives an overview of
the functions of financial management.

24
 Organisation of Finance Function

Chief Finance
Officer

Treasurer Controller

Cash Credit Financial Cost

Manager Manager accounting Accounting
manager manager

Capital Fund raising Tax Data

budgeting manager manager Processing
manger manager

Portfolio Internal
manager Auditor

The financial manger, in a bid to maximize shareholder’s wealth, should strive to

maximize returns in relation to the given risk; he or show should seek course of actions that
avoid unnecessary risk. To ensure maximum return, funds flowing in and out of the firm
should be constantly monitored to assure that they are safeguarded and properly utilised. The
financial reporting system must be designed to provide timely and accurate picture of the
firm’s activities.
Implications of Wealth Maximisation
There is a rationale in applying wealth maximizing policy as an operating financial
management policy. It serves the interest of suppliers of loaned capital, employees,
management and society. Besides shareholders, there are short-term suppliers of funds who
have financial inertest in the concern. Short-term lenders are primarily interest in liquidity
position so that they get their payments in time. The long-term lenders get a fixed rate of
interest from the earnings and also have a priority over shareholders in return of their funds.
Wealth maximisation objective not only serves shareholder’s interests by increasing the value
of holding of holding but ensures security to lenders are primarily interest in liquidity
position so that they get their payments in time. The long-term lenders get a fixed rate of
interest from the earnings and also have a priority over shareholder in return of their funds.
Wealth maximisation objective not only serves shareholder’s interest by increasing the value
of holding but ensures security to lenders also. The employees may also try to acquire share
of company’s wealth through bargaining etc. Their productivity and efficiency is the primary
consideration in raising company’s wealth. The survival of management for a longer period
will be served if the interest of various groups are served properly. Management is the elected
25
body of shareholders. The shareholders may not like to change a management if it is able to
increase the value of their holdings. The efficient allocation of productive resources will be
essential for raising the wealth of the company. The economic interest of society are served
if various resources are put to economical and efficient use.
Criticism of Wealth Maxmisation
The wealth maximisation objective has been criticised by certain financial theorists
mainly on following accounts:
i) It is perspective idea. The objective is not descriptive of what the firms actually
do.
ii) The objective of wealth maximisation is not necessarily socially desirable.
iii) There is some controversy as to whether the objective is to maximize the
stockholders wealth or the wealth of the firm which includes other financial
claimholders such as debenture holders, preferred stockholders, etc.
iv) The objective of wealth maximisation may also face difficulties when ownership
and management are separated as is the case in most of the large corporate from of
organizations. When managers act as agents of the real owners (equality
shareholders), there is a possibility for a conflict of interest between the
stockholders or the firm.
In spite of all the criticism, we are of the opinion that wealth maximisation is the most
appropriate objective of a firm and the side costs in the firm of conflicts between the
stockholders and debenture holders, firm and society and stockholders and managers can be
minimized.
Financial Management and Profit Maximisation
The primary aim of a business is to maximize share holder’s wealth. This can be
done by increasing the quantum of profits. Financial management helps in devising ways and
exercising appropriate cost controls which ultimately help in increasing profitability. The
following elements are involved in maximising profits.
I) Increase in Revenues
For maximising its profits, a firm will have to increase revenue receipts. Revenues
will go up only when sales increase. There should be all out efforts to increase the sales. All
possible markets should be exploited so that demands for products increases. This should be
followed by increasing production for meeting increased demand. In a competitive economy,
profits can be increased either by raising the price of products or by increasing the volume of
sales. The second alternative will be more appropriate.
II) Controlling Costs
Another way of increasing profits is to control or reduce costs. This will increase the
margin of profit per unit. The costs may be controlled by controlling material wastages,
increasing labour efficiency, reducing overhead cost by increasing production etc.

26
III) Minimising Risks
A business operates under a number of uncertainties. Business is done with an eye on
future which itself is uncertain and difficult to predict. There are may risks, both business
and financial.
It is generally said more the risk and more the gain. In spite of this, that financial
decision should be taken which will not involve more risks but at the same time may help in
increasing profitability. A financial manager will have to balance the pros and cons of various
decisions so that risk element is keep under control.
Questions
1. ‘Financial management is the appendage of the finance function.’ Comment.
2. State the objectives of financial management.
3. Indicate the possible areas of conflict between management and stockholders.
4. Explain the six famous ‘A’s of financial management.
5. Discuss briefly the scope and functions of financial management.
6. State the role of the financial management and explain his functions in an
organization.
7. Describe the evolution of financial management.
8. Discuss briefly different functional areas of financial management.
9. Distinguish between:
(a) Financial management and economics;
(b) Financial management and accounting.
10. Discuss briefly the problems of International financial management.

BOOKS SUGGESTED
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

27
GUIDELINE 4 : STATEMENT OF CHANGES IN FINANCIAL
POSITION (FUNDS FLOW STAEMENT)

INTRODUCTION
The basic financial statements, i.e., the balance sheet and profit and loss account or
income statement of business reveal the net effect of the various transactions on the
operational and financial position of the company. The balance sheet gives a summary of the
assets and liabilities of an undertaking at a particular point of time. It reveals the financial
status of the company. The asset side of a balance sheet shows the deployment resource of an
under taking while the liabilities side indicates its obligations, i.e., the manner in which these
resources were obtained. The profit and loss account reflects the results of the business
operations for a period of time. It contains a summary of expenses incurred and the revenue
realized in an accounting period. Both these statements provide the essential basic
information on the financial activities of a business, but their usefulness is limited for
analysis and planning purposes. The balance sheet gives a static view of the resources
(liabilities) of a business and the uses (assets) to which these resources have been put at a
certain point of time. It does not disclose the causes for change in the assets and liabilities
between two different points of time. The profit and loss account, in a general way, indicates
the resources provided by operations. But there are many transactions that take place in an
undertaking and which do not operate through profit and loss account. Thus, another
statement has to be prepared to show the change in the assets and liabilities from the end of
one period of time to the end of another period of time. The statement is called a Statement of
changes in Financial Position or a Funds Flow Statement.
The funds Flow Statement is a statement which shows the movement of funds and is a
report of the financial operations of the business undertaking. It indicates various means by
which funds were obtained during a particular period and the way in which these funds were
employed. In simple words, it is a statement of sources and application of funds.
TOTAL RESOURCES CONCEPT OF ‘FUNDS’
The total resources concept states that the term ‘funds’ represents total assets or total
resources of the firm. All he changes that result in increase in assets and liabilities or decrease
in assets and liabilities are described in Funds Flow Statement.
To prepare the funds flow statement on the basis of total resources, it is necessary to
compare the balance sheets of the business at the beginning and at the end of the relevant
period under consideration and the differences in the individual accounts of the two balance
sheets are noted separately. Then they are recorded in funds statement as inflow and outflow
of funds. The following method is used to determine what changes would constitute the
inflow of funds and what change would constitute the outflow of funds as pictured below.
INFLOWS OF FUNDS
According to this concept, all the changes which result in an increase in funds of the
enterprise constitute sources of the funds. Usually funds flows in a business firm from the
following sources.

28
 SOURCES

OPERATIONAL ISSUE OF SALE OF BORROWINGS

PROFITS SHARES FIXED ASSES

FUNDS

PURCHASE OF PAYMENT OF LOSSES PAYMENT OF

FIXED ASSETS LOANS TAXES,
DIVIDENDS

1) The earnings (operational profits) of the firm.

2) Increase in liabilities through increased use of borrowed funds or increased trade credit.
3) Decrease in assets such liquidation of current assets, the sale of fixed intangible assets and
earned depreciation on such assets.
4) Contribution of additional funds by owners of the company likes issue of shares.
B. OUTFLOWS OF FUNDS
All the changes that cause decrease in total funds of the firm are regarded as use of
funds indicating outflow. The following items are states as uses of funds:
1) Net Losses and Payment of Dividend: When losses are incurred operations funs go out
of the business, likewise payment of dividends and taxes.
2) Increase in Assets: With increase in fixed assets, inventory, receivable investment
orother assets, amount of funds decrease showing application of funds.
3) Decrease in Capital Funds: Retirement of bonds brings about decrease in owner’s
capital.
4) Decrease in Liabilities: Funds go out of the business by the amount of decrease in
liabilities like current liabilities or debt.
While preparing funds statement on total resources basis, source of funds must equate
their uses because the balance sheet, both assets and liabilities column of which are equal to
each other is the fundamental principles.
Working Capital Concept of ‘Funds’
According to the concept of working capital, the term ‘funds’ refers to net working
capital (current assets minus current liabilities). In other words, the funds flow statement and
statement of source and application of net working capital describe change net working
capital and reasons of such variance between two financial periods. In order to have proper
comprehension of this concept, it is necessary to spilt balance sheet in fixed and floating
aspects. The fixed part incorporates all the fixed and long-term liabilities and the floating
part consists of current assets and current liabilities. The internal movement of funds usually
29
takes place between those two area rather than between the company and the outside world.
An analyst must observe these internal movement of funds as between the fixed and current
parts can be picturised by the following figure.

LONG-TERM FIXED ASSETS

(FIXED)
LIABILITIES

CURRENT CURRENT ASSETS

LIABILITIES

Funds Flow Line

The major objective of the Funds Flow Statement is to show the flow of funs through
working capital. So two statements are prepared under this concept. In the first statement it
changes in net working capital are recorded. This statement is called “Schedule of Changes
in working capital”. The second statement called “Funds Flow Statement” is prepared to
focus light on factors contributing to variance in working capital as displayed by the above
schedule.
Rule
The flow of funds occurs when a transaction changes on the one hand a non-current
account and on the other a current account and vice-versa.
When a change in a non-current account, e.g., fixed assets, long-term liabilities,
reserves and surplus, fictions is because of the fact that in such case neither the working
capital increase nor decrease. Similarly, when a change in one current account results in a
change in another current account, it does not affect funds. Funds move from non-current to
current transactions or vice-versa only. In simple language funds move when a transaction
affects
(i) A current asset and a fixed asset
(ii) A fixed and a current liability
(iii) A current asset and a fixed liability
(iv) A fixed liability and current liability

30
And funds do not move when the transaction affects fixed assets and fixed liability or current
assets and current liabilities.
CURRENT AND NON-CURRENT ACCOUNTS
To understand flow of funds, it is essential to classify various accounts and balance
sheet items into current and non-current categories.
Current accounts can either be current assets or current liabilities. Current assets are
those assets which in the ordinary course of business can be or will be converted into cash
within a short period of normally one accounting year.
Current liabilities are those liabilities which are intended to be paid in the ordinary
course of business within a short period of normally one accounting year out of the current
assets or the income of the business. The following is the list of current or working capital
accounts.:
LIST OF CURRENT OR WORKING CAPITAL ACCOUNTS
Current Liabilities Current Assets
1. Bills payable 1. Cash in hand
2. Sundry creditors or Account payable 2. Cash at bank
3. Accrued or Outstanding Expense 3. Bills Receivable
4. Dividends payable 4. Sundry Debtors or Accounts Receivable
5. Bank Overdraft 5. Short-term loan & advances
6. Short-term loan advances & deposits 6. Temporary or marketable investment
7. Provisions Against Current Assets 7. Inventories or stock such as
a) Raw materials
b) Work-in-process
c) Store and spares
d) Finished Goods
8. Provisions for taxation, if it does not 8. Prepaid Expenses
amount to appropriation of profits
9. Proposed Dividend (May be a current
9. Accured incomes
or Non-Current liability)

31
 LIST OF CURRENT OR WORKING CAPITAL ACCOUNTS
Non-Current or Permanent Liabilities Non-Current or Permanent Assets
1. Equity Share Capital 1. Good will
2. Preference share capital 2. Land
3. Redeemable preference Share Capita 3. Building
4. Debentures 4. Plant and Machinery
5. Long-term Loans 5. Furniture and Fittings
6. Share Premium Account 6. Trade Marks
7. Share Forfeited Account 7. Patent Rights
8. Profit and Loss Account (balance of 8. Long-term investment
profit, i.e, credit balance)
9. capital Reserve 9. Debit Balance of Profit and Loss Account
10. capital Redemption Reserve 10. Discount of Issue of shares
11. Provision for depreciation against 11. Discount on Issue of Debentures
fixed assets. 12. Preliminary Expenses
12. Appropriation of profits: 13. Other Deferred Expenses.
a) General Reserves
b) Dividend Equalisation Fund
c) Insurance Fund
d) Compensation Fund
e) Sinking Fund
f) Investment Fluctuation Fund
g) Provision for Taxation.
h) Proposed Dividend

PROCEDURE FOR KNOWING WHETHER A TRANSACTION RESULTS IN THE

FLOW OF FUNDS OR NOT
1) Analyse the traction and find out the two accounts involved.
2) Make Journal Entry of the transaction.
3) Determine whether the accounts involved in the transaction are current or non-
current.
4) If both the accounts involved are current i.e., either current assets or current
liabilities, it does not result in the flow of funds.
5) If both the account involved are non-current, i.e., either permanent assets or
permanent liabilities, it still does not result in the flow of funds.
6) If the accounts involved are such that one is current account while the other is non-
current account, i.e, current assets and permanent liability, or current assets and

32
 fixed assets, or current liability and fixed asset, or current liability and permanent
liability then it results in the flow of funds?
Examples
(A) Transactions which involved only the current accounts and hence do not result in
the flow of funds:
1) Cash collected from debtors.
2) Bills receivables realized.
3) Cash paid to creditors.
4) Payment or discharge of bills payable.
5) Issued bills payable to trade creditors.
6) Received acceptance from customers.
7) Raising of short-term loans.
8) Sales of temporary or marketable investments.
9) Goods purchased for cash or credit.

DIAGRAMS DEPICTING FLOW OF FUNDS

FLOW OF FUNDS

NO YES

WHEN WHEN
BOTH CURRENT ONE CURRENT
OR AND
NON-CURRENT OTHER NONCURRENT
ACCOUNTS ARE ACCOUNTS ARE
INVOLVED INVOLVED

(B) Transactions which involved only non-current accounts and hence do not result in
the flow of funds:
1) Purchase of one new machine in exchange of two old machines.
2) Purchase of Buildings of Furniture in exchange of land.
3) Conversion of debentures into shares.

33
 4) Redemption of Preference shares in exchange of Debentures.
5) Transfers to General Reserves, etc.
6) Payment of bonus in the form of shares.
7) Purchase of fixed assets in exchange of shares, debentures, bonds or long-term loans.
8) Writing off of fictitious assets.
9) Writing off of accumulated losses or discount on issue of shares, etc.
(C) Transactions which involve both current and non-current accounts and hence do
not result in the flow of funds:
1) Issue of shares for cash.
2) Issue of debentures for cash.
3) Raising of long-term loans.
4) Sale of fixed assets on cash or credit.
5) sale of trade investments.
6) Redemption of Preference shares.
7) Redemption of debentures.
8) Purchase of fixed assets on cash or credit.
9) Purchase of long-term/trade investments.
10) Payment of bonus in cash.
11) Payment of bonus in cash.
12) Issue of shares against purchase of stock-in-trade.
MEANING AND DEFINITION OF FUNDS FLOW STATEMENT
Funds Flow Statement is a method by which we study changes in the financial
position of a business enterprise between beginning and ending financial statements dates. It
is a statement showing sources and uses of funds for a period of time.
Foulke defines this statement as:
“A statement of sources and application of funds is a technical device designed to
analyse the change in the financial condition of a business enterprise between two dates.”
In the words of Anthony, “The funds flow statement describes the sources from which
additional funds were derived and the use to which these sources were put.”
I.C.W.A. in Glossary of Management Accounting terms defines Funds flow Statement
as “ a statement either prospective or setting out the sources and applications of the funds of
an enterprise. The purpose of the statement is to indicate clearly the requirement of funds
and how they are proposed to be raised and the efficient utilization and application of the
same.
Thus, funds flow statement is a statement which indicates various means by which the
funds have been obtained during a certain period and the ways to which these funds have

34
been used during that period. The term ‘funds’ used here means working capital, i.e., the
excess of current assets over current liabilities.
Funds flow statement is called by various names such as Sources and Application of
Funds; Statement of Changes in Financial Position; Sources and uses of Funds; Summary of
Financial Operations; Where came in and where gone out Statement’ where got, Where gone
Statement; Movement of Working Capital statement; Movement of Funds Statement; Funds
Received and Disbursed statement; Funds Generated and Expended Statements; Sources of
Increase and Application of Decrease; Funds statement, etc.
USE, SIGNIFICANCE AND IMPORTANCE OF FUNDS FLOW STATEMENT
A funds flow statement is an essential tool for the financial analysis and is of primary
importance to the financial management. Now-a-days, it is being widely used by the financial
analysts, credit granting institutions and financial managers. The basic purpose of a funds
flow statement is to reveal the change in the working capital on the two balance sheet dates.
It also describes the sources from which additional working capital has been financed and the
uses to which working capital has been applied. Such a statement is particularly useful in
assessing the growth of the firm, its resulting financial needs and in determining the best way
of financing these needs. By making use of projected funs flow statements, the management
can come to know the adequacy or inadequacy of working capital even in advance. One can
plant the intermediate and long-term financing of the firm, repayment of long-term debts,
expansion of the business, allocation of resources, etc. The significance or importance of
funds flow statement can be well followed from its various uses given below:
1. It helps in the analysis of financial operations
The financial statements reveal the net effect of various transactions on the
operational and financial position of a concern. The balance sheet gives a static view of the
resources of a business and the use to which these resources have been put at a certain point
of time. The funds flow statement explains causes for such changes and also the effect of
these changes on the liquidity position of the company. Sometimes a concern may operate
profitably and yet its cash position may become more and more worse. The funds flow
statement gives a clear answer to such a situation explaining what has happened to the profit
of the firm.
2. It throws light on many perplexing questions of general interest
Which otherwise may be difficult to be answered, such as
a) Why were the net current assets lesser in spite of higher profits and vice-versa?
b) Why more dividends could not be declared in spite of available profits?
c) How was it possible to distribute more dividends than the present earnings?
d) What happened to the net profit? Where did they go?
e) What happened to the proceeds of sale of fixed assets or issue of shares, debentures,
etc.?
f) What are the sources of the repayment of debt?
g) How was the increase in working capital financed and how will it be financed in
future?

35
3) It helps in the formation of a realistic dividend policy
Sometimes a firm has sufficient profits available for distribution as dividend but yet it
may not be advisable to distribute dividend for lack of liquid or cash resources. In such
cases, a funds flow statement helps in the formation of a realistic dividend policy.
4) It helps in the proper allocation of resources
The resources of a concern are always limited and it wants to make the best use of
these resources. A projected funds flow statement constructed for the future helps in making
managerial decisions. The firm can plan the deployment of its resources and allocate them
among various applications.
5) It acts as a figure guide
A projected funds flow statement also acts as a guide for future to the management.
The management can come to know the various problems it is going to face in near future for
want of funds. The firm’s future needs of funds can be projected well in advance and also the
timing of these needs. The firm can arrange to finance these needs more effective and avoid
future problems.

1
Helps in analysis
of financial
statements

2
6 Throws light on
Helps knowing perplexing
the credit questions
worthiness
USES OF
FUNDS FLOW
STATEMENT
3
5 Helps in the
Acts as a future formulation of
dividend policy
guide

4
Helps in the proper
allocation of
resources

6. It helps in appraising the use of working capital

A funds flow statement helps in explaining how efficiently the management has used
its working capital and also suggests way to improve working capital position of the firm.
7. It helps knowing the overall creditworthiness of a firm
The financial institutions and banks such as State Financial Institutions, Industrial
Development Corporation, Industrial Finance Corporation of India, Industrial Development
Bank of India, etc. all ask for funds flow statement constructed for a number of years before
36
granting loans to know the creditworthiness and paying capacity of the firm. Hence, a firm
seeking financial assistance from these institutions has no alternative but to prepare funds
flow statements.
SOURCES OF FUNDS
The following are the sources from which funds generally flow (come), into the
business:
(1) Funds from Operations or Trading Profits
Trading profits or the profits from operations of the business are the most important
and major source of funds. Sales are the main source of inflow of funds into the business as
they increase current assets (cash, debtors or bills receivable) but at the same time funds flow
out of business for expenses and cost of goods sold. Thus, the net effect of operations will be
a source of funds if inflow from sales exceeds the outflow for expenses and cost of goods
sold and vice-versa. But it must be remembered that funds from operations do not necessarily
mean the profit as shown by the profit and loss account of a firm, because there are many
non-fund or non-operating items, which may have been either debited or credited to profit
and loss account. The examples of such items on the debit side of a profit and loss account
are: Amortization of fictitious and intangible asset such as goodwill, Preliminary expense and
Discount on issue of shares and debentures written off; Appropriation of Retained Earnings,
such as Transfers to Reserves, etc., Depreciation and depletion; Loss on sale of fixed assets;
Payment of dividend, etc. The non-fund items are those which may be operational expenses
but they do not affect funds of the business, e.g., for depreciation charged to profit and loss
account, funds really do not move out of business. Non-operating items are those which
although may result in the outflow of funds but are not related to the trading operations of the
business, such as loss on sale of machinery or payment of dividends. The methods of
calculating funds from operations have been discussed in the following pages.
2. Basically, there are two methods of calculating funds from operations:
a) The first method is to prepare the profit and loss account afresh by taking into
consideration only fund and operational items which involve funds and are related to
the normal operations of the business. The balancing figure in this case will be either
funds generated from operations or funds loss in operations depending upon whether
the income or credit side of profit and loss account exceeds the expense or debit side of
profit and loss account or vice-versa.
b) The second method (which is generally used) is to proceed from the figure of net profit
or net loss is arrived at from the profit and loss account already prepared. Fund from
operations by this method can be calculated as under:

37
 (a) Calculation of Funds From Operation
Closing Balance of P & L A/c or Retained Earnings (as given in the
balance sheet)
Add : Non-fund and Non-operating items which have been already
debited to P & L A/c:
(i) Depreciation and Depletion
(ii) Amortization of factious and Intangible Assets such as
(a) Goodwill
(b) Patents
(c) Trade Marks
(d) Preliminary Expenses
(e) Discount on Issue of Shares, etc
(iii) Appropriation of Retained Earnings, Such as:
(a) Transfer to General Reserve
(b) Dividend Equalization Fund
(c) Transfer to Sinking Fund
(d) Contingency Reserve, etc.
(iv) Loss on Sale of any non-current (fixed) assets such as:
(a) Loss on sale of land and building
(b) Loss on sale of machinery
(c) Loss on sale of furniture
(d) Loss on sale of long-term investments, etc.
(v) Dividends including:
(a) Interim Dividend
(b) Proposed Dividend (if it is an appropriation of profits and
not taken as current liability)
(vi) Provision for Taxation (if it is not taken as current liability)
(vii) Any other non-fund/non-operating items which have been
debited to P/L A/c
Total (A)

Less: Non-fund or Non-operating items which have already been

credited to P & L A/c
(i) Profit or Gain from the sale of non-current (fixed) assets
such as:
(a) Profit on sale of land and building
(b) Profit on sale of plant & machinery
(c) Profit on sale of long-term investment, etc.
(ii) Appreciation in the value of fixed assets, such as increase in
the value of land if it has been credited to P/L A/c
(iii) Dividends Received
(iv) Excess Provision retransferred to P/L A/c or written off
(v) Any other non-operating item which has been credited to P/l
A/c
(vi) Opening balance of P & L A/c or Retained Earnings (as
given in the balance sheet)
Total (B)
Total (A)-Total(B) = Funds generated by operations

38
 (b) Funds from operations can also calculated by preparing Adjusted Profit and
Loss Account as follows:
Adjusted Profit and Loss Account
Rs. Rs.
To Depreciation & Depletion or By Opening Balance (of P
amortization of fictitious and & L A/c)
intangible assets, such as: By Transfers from excess
Goodwill, patents, Trade Marks, provisions
Preliminary Expenses etc. By Appreciation in the
To Appropriation of Retained value of fixed assets
Earnings, such as: By Dividends received
Transfers to General Reserve, By Profit on sale of fixed
Dividend Equalization Fund, or non-current
Sinking Fund, etc. assets
To Loss on sales of any non- By Funds from
current or fixed asset operations (balancing
To Dividends (including interim figure in case debit
divided) side exceeds credit
To Proposed Dividend (if not taken side)
as a current liability)
To Provision for taxation (if not
taken as a current liability)
To Closing balance (of P & L A/c)
To Funds lost in operations
(Balancing figure, in case
credit side exceeds the debit
side)

3) Issue of Share Capital

If during the year there is any increase in the share capita, whether preference or
equity, it means capital has been raised during the year. Issue of shares is a source of funds
as it constitutes inflow of funds. Even the calls received from partly paid shares constitutes
an inflow of funds. It should also be remembered that it is the net proceeds from the issue of
share capital which amount to a source of funds and hence in case shares are issued at
premium, even the amount of premium collects shall become a source of funds. The same is
true when shares are issued at a premium, even the amount of premium collects shall become
a source of funds. The same is true when shares are issued at discount ; it will not be nominal
value of shares but the actual realization after deducting discount that shall amount to inflow
of funds. But sometimes share are issued otherwise than in cash, the following rules must be
followed:
1) Issue of shares of making of partly paid shares as fully paid out of
accumulated profits in the form of bonus shares is not a source of fund.
2) Issue of shares for consideration other than current assets such as against
purchase of land, machine, etc. does not amount to inflow of funds.

39
 3) Conversion of debentures or loans into shares also does not amount to
inflowof funds. In all the three cases mentioned above, both the amounts
involved are non-current and do not involve any current assets or funds.
4) Issue of Debentures and Raising of Loans, etc.
Issue of debentures or raising of loans (long-term), whether secured or unsecured
results in the flow of funds into the business. The inflow of funds is the actual proceeds from
the issue of such debentures or raising of loans, i.e., including the amount of premium or
excluding discount if any. However, loans raised for consideration other than a current asset,
such as for purchase of building, will not constitute inflow of funds because in that case the
accounts involved are only fixed or non-current.
5) Sale of Fixed (non-current) Assets and Long-term or Trade Investments
When any fixed or non-current assets like land, building, plant and machinery,
furniture, long-term investments, etc. are sold it generates funs and becomes a source of
funds. However, it must be remembered that if one fixed asset is exchanged for another fixed
asset, it does not constitute an inflow of funds because no current assets are involved.
6) Non-Trading Receipts
Any non-trading receipt like dividend received, refund of tax, rent received, etc. also
increase funds and is treated as a sources of funds because such an income is into included in
the funds from operations.
7) Decrease in Working Capital
If the working capital decrease during the current period as compared to the previous
period, it means that there has been a release of funds from working capital and it constitutes
a sources of funds.
APPLICATION OR USES OF FUNDS
1) Funds lost in operations
Some times the result of trading in a certain year is a loss and some funds are lost
during that period in trading operations. Such loss of funds in trading amounts to an outflow
of funds and is treated as an application of fund.
2) Redemption of Preference Share Capital
If during the year any preference shares are redeemed, it will result in the outflow of
funds and is taken as an application of funds. When the shares are redeemed at premium or
discount, it is the net amount paid (including premium or excluding discount, as the case may
be). However, if shares are redeemed in exchanges of some other type of shares or
debentures, it does not constitute an outflow of funds as no current account is involved in that
case.
3) Repayment of loans or redemption of debentures, etc.
In the same way as redemption of preference share capital, redemption of preference
share capital, redemption of debentures or repayment of loans also constitute an application
of funds.

40
4) Purchase of any non-current fixed asset
When any fixed or non-current asset like land, building, plant and machinery,
furniture, long-term investments, etc. are purchased, funds outflow from the business.
However, if fixed assets are purchased for a consideration of issue of shares or debentures or
if some fixed asset is exchanged for another, it does not involve any funds and hence not an
application of funds.
5) Payment of dividends and tax
Payments of dividends and tax are also applications of funds. It is the actual payment
of dividend (may be interim dividend) and tax which should be taken as an outflow of funds
and not the mere declaration of dividend or creating of a provision for taxation.
6) Any other non-trading payment
Any payment or expense not related to the trading operations of the business amounts
to outflow of funds and is taken as an application of funds. The examples could be drawings
in case of sole trade or partnership firms, loss of cash, etc.
LIMITATIONS OF FUNDS FLOW STATEMENT
The funds flow statement has a number of uses, however, it has certain limitation
also, which are listen below:
1. It should be remembered that a funds flow statement is not a substitute of an income
statement or a balance sheet. It provides only some additional information as regards
changes in working capital.
2. It cannot reveal continuous changes.
3. It is not an original statement but simply are-arrangement of data given in the
financial statements.
4. It is essentially historic in nature and projected funds flow statement cannot be
prepared with much accuracy.
5. Changes in cash are more important and relevant for financial management than the
working capital.

Procedure for preparing a fund flow statement

Funds Flow statement is a method by which we study changes in the financial
position of a business enterprise between beginning and ending financial statement dates.
Hence, the funds flow statement is prepared by comparing two balance sheets and with the
help of such other information derived from the accounts as may bee needed. Broadly
speaking, the preparation of a funds flow statement consists of two parts.
1. Statement of Schedule of Changes in Working Capital.
2. Statement of Sources and Application of Funds.
1. Statement or Schedule of Changes in Working Capital
Working capital means the excess of current assets over current liabilities. Statement
of changes in working capital is prepared to show the changes in the working capital between

41
the two balance sheet dates. This statement is prepared with the help of current asset and
current liabilities derived from the two balance sheet.
As, Working Capital = Current Asset – Current Liability
(a) An increase in current assets increases working capital
(b) A decrease in current assets decreases, working capital.
(c) An increase in current liabilities decreases working capital; and
(d) A decrease in current liabilities increase working capital.
The change in the amount of any current asset or current liability in the current
balance sheet as compared to that of the previous balance sheet either results in increases or
decreases in working capital. The difference is re order for each individual current asset and
current liability. In case a current asset in the current period is more than in the previous
period, the effect is an increase in working capital and it is recorded in the crease column.
But if a current liability in the current period is more than in the previous period, the effect is
decrease in working capital and it is recorded in the decrease column or vice versa. The total
increase and total decrease are compared and the difference show the net increase of net
decrease in working capital. It is worth nothing that schedule of changes in working capital
is prepared only form current assets and current liabilities and the other information is not of
any use of preparing this statement.
2. Statement of Sources and Application of Funds
Funds flow statement is a statement which indicates various sources from which funds
(working capital) have been obtained during a certain period and the uses or applications to
which these funds have been put during that period. Generally, this statement is prepare in
two formats:
a) Report Form
b) T form or an Account form or self-Balancing Type.

42
 PROBLEMS
1) B.M. Company presents the following information and you are required to
calculate funds from operations:
Profit and Loss Account
Rs. Rs.
To Expenses: By Gross Profit 2,00,00
Operation 1,00,000 By Gain on Sale of
Depreciation 40,000 Plant 20,000
To Loss on Sale of building 10,000
To Advertisement Suspense A/C 5,000
To Discount (Allowed to customers) 500
To Discount on issue of shares written off 500
To Good will 12,000
To Net Profit 52,000
2,20,000 2,20,000

Solution:
Calculation of Funds from Operations
Rs.
Net Profit (as Given) 52,000
Add: Non-funds or non-operating items which have been
debited to P&L A/c: Rs.
Depreciation 40,000
Loss on sale of building 10,000
Advertisement written off 5,000
Discount on issue of shares written off 500
Good will writer off 12,000 67,500
Less : Non fund or non-operating items which have 1,19,500
been credit to P.L A/C gain on sale of plant 20,000
20,000
Funds from operations

99,500

Alternatively:
Adjusted Profit and Loss Account
Rs. Rs.
To Depreciation 40,000 By Opening balance -
To Loss on sale of building 10,000 By Gain on sale of plant 20,000
To Advertisement Suspense A/c 5,000 By Funds from
To Discount on issue of share 500 Operations 99,500
To Good will 12,000 (balancing figure)
To Closing balance 52,000

1,19,500 1,19,500

43
2) The following are the Balance Sheet of Y Company for the year ending
31st December, 2002 and 2003. Prepare a Statement showing sources and
application of funds for 2003.

Assets 2003 2002

Rs. Rs.
Working Capital 28,550 26,100
Furniture 8,750 8,000
Leasehold Improvement 4,500 5,000
Less: Accumulated
Depreciation 2,400 2,100 1,600 3,400
39,400 37,500
Liabilities & Share holder
Equity
Debenture payable 15,000 15,000
Premium on Debentures 900 1,000
payable
Capital 17,000 15,000
Retained Earning 6,500 6,500
39400 37,500

The net income for the year 2003 was Rs. 2,800 and dividends of Rs. 3,000
were paid.
The items affecting net income but not affecting working capital were:
Depreciation of Furniture Rs. 800, Amortisation of premiums on Debentures
Payable Rs. 100, Amortisation of leaseholder improvement Rs. 500.
Solution:
Funds Flow Statement of Y Company for the year ended 31st December, 2003.
Sources:

Funds from Operations 4,200

Issue of shares 2000
Total sources Rs. 6,200
Application:

Purchase of Furniture 750

Payment of dividends 3,000
Total Application Rs. 3,750
Increase in Net Working Capital Rs. 2,450

44
2) The following are the Balance Sheet of Y Company for the year ending
31st December, 2002 and 2003. Prepare a Statement showing sources and
application of funds for 2003.

Assets 2003 2002

Rs. Rs.
Working Capital 28,550 26,100
Furniture 8,750 8,000
Leasehold Improvement 4,500 5,000
Less: Accumulated
Depreciation 2,400 2,100 1,600 3,400
39,400 37,500
Liabilities & Share holder
Equity
Debenture payable 15,000 15,000
Premium on Debentures 900 1,000
payable
Capital 17,000 15,000
Retained Earning 6,500 6,500
39400 37,500

The net income for the year 2003 was Rs. 2,800 and dividends of Rs. 3,000
were paid.
The items affecting net income but not affecting working capital were:
Depreciation of Furniture Rs. 800, Amortisation of premiums on Debentures
Payable Rs. 100, Amortisation of leaseholder improvement Rs. 500.
Solution:
Funds Flow Statement of Y Company for the year ended 31st December, 2003.
Sources:

Funds from Operations 4,200

Issue of shares 2000
Total sources Rs. 6,200
Application:

Purchase of Furniture 750

Payment of dividends 3,000
Total Application Rs. 3,750
Increase in Net Working Capital Rs. 2,450

45
3) From the following balance sheet and additional information given, you
are required to calculate funds from operations for the year ended 1999.

Liabilities 1998 1999 Assets 1998 1999

Rs. Rs. Rs. Rs.
Share Capital 1,00,000 1,50,000 Land & Buildings 1,00,000 95,000
General Reserve 30,000 30,000 Plant & Machinery 80,000 90,000
Profit & Loss A/c 20,000 22,000 Stocks 70,000 1,10,000
6% Debentures 80,000 80,000 Debtors 20,000 25,000
Creditors 65,000 58,000 Investment - 10,000
Provision for tax 5,000 10,000 Cash 10,000 10,000
Goodwill 20,000 10,000
3,00,000 3,50,000 3,00,000 3,50,000

Additional Information’s:
1) During 1999, Dividends of Rs. 15,000 were paid.
2) Depreciation written off plant and machinery amounted to Rs. 6,000 and
no depreciation has been charged on land buildings.
3) Provision for tax made during the year Rs. 5,000
4) Profit on sale of machinery Rs. 2,000

Solution:

Calculation of Funds from Operations

Rs.
Closing balance of P/L A/C given in the B/S 22,000
Add: Non-fund or non-operating items
already debited to P/L A/c: Rs.
Depreciation 6,000
Dividends 15,000
Provision for Tax 5,000
Goodwill 10,000 36,000
58,000
Less : Non-fund or non-operating items
already credited to P/L A/c:
Profit on sale of machinery 2,000
Opening balance of P/L A/C (given in B/S) 20,000 22,000
Funds from Operations 36,000

1. Provision for tax has been treated as a non –current liability

2. Goodwill written off during the year is : Rs. 20,000-Rs.10,000

46
4) From the following Balance Sheet as on 31st December, 200 and 31st
December, 2001. you are required to prepare a schedule of changes in
he working capital and Funds Flow Statement taking:

a) The provision for tax and proposed dividends as non-current liabilities

b) The provision for tax and proposed dividends as current liabilities.

As on 31st Dec As on 31st Dec

Liabilities 2000 2001 Assets 2000 2001
Rs. Rs. Rs. Rs.
Share Capital 10,000 15,000 Fixed assets 10,000 20,000
Profit & Loss A/C 4,000 6,000 Current assets 13,000 14,500
Provision for tax 2,000 3,000
Proposed dividend 1,000 1,500
Sundry creditors 4,000 6,000
Outstanding
expenses 2,000 3,000
23,000 34,500 23,000 34,500

Additional Information:
1. Tax paid during 2001 Rs. 2,500
2. Dividends paid during 2001 Rs. 1,000
Solution:
a) When provision for tax and proposed dividends are taken as non-current
liabilities:
Schedule of Changes in Working Capital
Particulars Increase (+) Decrease (-)
Rs. Rs.
Sundry Creditors 2,000
Outstanding expenses 1,000
Current Assets 1,500
Decrease in working capital 1,500
3,000 3,000

47
 Dr Provision for tax A/c Cr.
Rs. Rs.
To Cash-tax paid 2,500 By Balance B/d 2,000
To Balance C/d 3,000 By Profit & Loss A/c 3,500
5,500 5,500

Dr Proposed Dividend A/c Cr.

Rs. Rs.
To Cash- dividend paid 1,000 By Balance B/d 1,000
To Balance C/d 1,500 By Profit & Loss A/c 1,500
2,500 2,500

B) When Provision for Tax and Proposed Dividends are taken as current
liabilities:
Schedule of change in Working Capital
Particulars Increase (+) Decrease (-)
Rs. Rs.
Sundry Creditors 2,000
Outstanding expenses 1,000
Current Assets 1,500
Provision for tax 1,000
Proposed dividend 500
Decrease in working capital 3,000
4,500 4,500

Calculation of Funds Flow Statement

Sources: Rs.
Increase in share capital 5,000
Funds from operations 2,000
Total sources 7,000
Applications:
Purchase of fixed assets 10,000
Decrease in working capital 3,000

Note: In case the Balance Sheet contains the amount of “Proposed dividends”
as well as the amount of “Provision for Tax”, it can be presumed that the
“Proposed dividends” and provision for taxation appearing in the last year’s
Balance Sheet must have been paid during the absence of any other
information. This presumption should generally be made at least for “Proposed
dividends”

48
5) The following are the balance sheets of Raghava Industrial Corporation
Ltd., as on 1st January and 31st December, 2003.

Liabilities & Capital Jan. 1 Dec 31 Assets Jan. 1 Dec.31

Rs. Rs. Rs. Rs.
Current Liabilities 60,000 64,000 Cash 80,000 88,800
Loans 44,000 44,000 Debtors 20,000 41,400
Accumulated Depreciation Stock 30,000 30,000
Of land & Buildings 10,000 5,600 Land 8,000 8,000
Retain Earnings 30,000 39,000 Buildings 40,000 32,000
Capital 70,000 87,000 Equipment 30,000 34,000
Brokerage on
Loans 4,000 3,600
Patents 2,000 1,800

2,14,000 2,39,600 2,14,000 2,39,600

The income for the period is Rs. 20,000. A part of the building was sold for Rs.
2,800. The depreciation charge for the period was Rs. 1600. Additional capital
of Rs. 10,000 was raised during the year. Out of the profits, Rs. 7,700 was
transferred to capital account.
Your are required to prepare (a) statement showing changes in working capital
and (b) Funds Flow Statement

Solution:
Statement of changes in Working Capital
Jan.1 Dec.31 Increase Decrease
2003 2003 Rs. (+) Rs. (-)
Cash 80,000 88,800 8,800
Debtors 20,000 41,400 21,400
Stock 30,000 ‘ 30,000 ‘
Total Current Assets 1,30,000 1,60,200
Current Liabilities 60,000 . 64,000 . 4000 .
Networking Capital
(Current Assets-Current 70,000 96,200
Liabilities)
Increase in Working Capital 26,200 26,200
Total 96,200 96,200 30,200 30,200

49
 B) Funds Flow Statement of Raghava Industrial Corporation Limited for
the year ended 31st December, 2003.
Sources: Rs. Rs.
Funds from Operations 21,400
Sale of Building 2,800
Issue of Shares 10,000 34,200
Total sources
Applications:
Purchase of equipment 4,000
Payment of dividend 4,000 8,000
Increase in Net Working Capital
26,200

Working Notes:
1. Calculation of Profit/loss on sale of part of the Building:
Rs.
Balance of accumulated depreciation (Jan.1)
10,000
Add: Depreciation charged during 2003
1,600
11,600
5,600
Less: Balance of accumulated depreciation (Dec. 31)
6,000
Accumulated depreciation on part of the building that is sold
40,000
Opening balance of buildings
32,000
Total original cost of the building sold
8,000
Net Book value of building = Rs. 8,000-Rs.6,000
= Rs. 2,000
Sales value of building = Rs. 2,800

Hence, there is a profit of Rs. 800 (Rs. 2,800-Rs. 2,000) on the sale of part the building.

2. Funds from operations:

Net Income 20,000
Add: Expenses that do not effect working capital
Depreciation 1,600
Amortization
Brokerage on loans 400
Patents 200
2,200
22,200
Less: Gain on sale of a part of the building already
Include in sources 800
21,400

BOOKS SUGGESTED
1. Managerial Fiance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

50
GUIDELINE 5 : RATIO ANALYSIS

INTRODUCTION
We have already studied that there are various methods or techniques used in
analyzing financial statements, such as comparative statements, trend analysis, common-size
statements, schedule of changes in working capital, fund flow and cash flow analysis, cost-
volume-profit analysis and ratio analysis. The ratio analysis is one of the most powerful tools
of financial analysis. It is the process of establishing and interpreting various ratios
(quantitative relationship between figures and groups of figures). It is with the help of ratios
that the financial statements can be analysed more clearly and decisions made from such
analysis.
MEANING OR RATIO
A ratio is a simple arithmetical expression of the relationship of one number to
another. It may be defined as the indicated quotient of two mathematical expressions.
According to Account’s Handbook by Wixon, Kelll and Bedofrd, a ratio “is an expression of
the quantitative relationship between two numbers”. According to Kohler, a ratio is the
relation, of the amount, a, to another, b, expressed as the ratio of a to be; a:b (a is to b); or as a
simple fraction, integer, decimal, fraction or percentage.”. In simple language ratio is one
number expressed in terms of another and can be worked out by dividing one number into the
other. For example, if the current assets of a firm on a given date are 5,00,000 and the
current liabilities are Rs. 2,50,000, then the ratio of current assets to current liabilities will
work out to be
5,00,000
————
2,50,000
or 2. Such types of ratios are called simple of pure ratios. A financial ratio is the relationship
between two accounting figures expressed mathematically. A ratio can also be expressed as
percentage by simply multiplying the ratio by 100. As in that above example the ratio is 2 x
100 or 200% of current liabilities. It is also expressed as a proportion for example, ratio of
current assets to current liabilities is, say, 5,00,000; 2,50,000 or 2:1. Some analysts also
express ratio as a ‘rate’ or ‘time’. For example, the ratio of stock turnover is, say

50,000
————
10,000
or 5 times which simply conveys that stock has been turned over 5 times. In the example
given above (current assets Rs. 5,00,000 and current liabilities Rs. 2,50,000 we can say that
the ratio is 2 times.
Thus, the ratio of two figures 200 and 100 may be expressed in any of the following
ways:
(a) 2:1 (b) 2 (c) 2/1 (d) 2 to 1 (e) 200%

51
 In all these cases the inference is that the first figure is double, 200% or 2 times than
that of the second. Ratio provide clues to the financial position of a concern. These are the
pointers or indicators of financial strength, soundness, position or weakness of an enterprise.
One can draw conclusions about the exact financial positions of a concern with the help of
ratios.

NATURE OF RATIO ANALYSIS

Ratio analysis is a technique of analysis and interpretation of financial statements. It
is the process of establishing and interpreting various ratios for helping in making certain
decisions. However, ratio analysis the not an end in itself. It is only a means of better
understanding of financial strengths and weaknesses of a firm. Calculation of mere ratios
does not serve any purpose, unless several appropriate ratios are analysed and interpreted.
There are a number of ratios which can be calculated from the information given in the
financial statements, but the analyst has to select the appropriate data and calculate only a few
appropriate ratios from and pulse rate or the body temperature and their interpretation
depends upon the caliber and competence of the analyst. The following are the four steps
involved in the ratio analysis.
a) Selection of relevant data from the financial statements depending upon the
objective of the analysis.
ii) Calculation of appropriate ratios from the above data.
i) Comparison of the calculated ratios with the ratios of the same firm in the
past, or the ratios developed from projected financial statements or the ratios
of some other or the comparison with ratios of the industry to which the firm
belongs.
ii) Interpretation of the ratios.
INTERPRETATION OF THE RATIOS
The interpretation of ratios is an important factor. Though calculation of ratios is also
important but it is only a clerical task whereas interpretation needs skill, intelligence and
foresightedness. The inherent limitations of ratios analysis should be kept in mind while
interpreting them. The impact of factors such as price level changes, change in accounting
policies, window dressing etc., should also be kept in mind when attempting to interpret
ratios.
A single ratio in itself does not convey much of the sense. To make ratios useful, they
have to be further interpreted. For example, say the current ratio of 3:1 does not convey and
sense unless it is interpreted and conclusion is drawn from it regarding the financial condition
of the firm as to whether it is very strong, good questionable or poor. The interpretation of
the ratios can be made in the following ways:
1) Single Absolute Ratio: Generally speaking one cannot draw any meaningful conclusion
when a single ratio is considered in isolation. But single ratios may be studied in relation to
certain rules of thumb which are based upon well proven conventions as for example 2:1 is
considered to be good ratio for current asset to current liabilities.
2) Group of Ratios: Ratio may be interpreted by calculating a group of related ratios. A
single ratio supported by other related additional ratios becomes more understandable and
52
meaningful. For example, the ratio of current assets to current liabilities may be supported by
the ratio of liquid assets to liquid liabilities to draw more dependable conclusions.
3) Historical Comparison: One of the easiest and most popular ways of evaluating the
performance of the firm is to compare its present ratios with the past ratios called comparison
overtime. When financial ratios are compared over a period of time, it givens an indication of
the direction of change and reflects whether the firm’s performance and financial position has
improved, deteriorated or remained constant over a period of time. But while interpreting
ratios from comparison over time, one has to be careful about the changes, if any, in the
firm’s policies and accounting procedures.
4) Project Ratios: Ratios can also be calculated for future standards based upon the projected
or proforma financial statement. These future ratios may be taken as standard for comparison
and the ratios calculated on actual financial statement can be compared with the standard
ratios to find out variances, if any. Such variances help in interpreting and taking corrective
action for improvement in future.
5) Inter-firm Comparison: Ratio of one firm can also be compared with the ratios of some
other selected firms in the same point of time. This kind of comparison helps in evaluating
relative financial position and performance of the firm. But while making use of such
comparison one has to be very careful regarding the different accounting methods, policies
and procedures adopted by different firms.
Use of Financial Analysis
Financial analysis is the process of identifying the financial strengths and weaknesses
of the firm by properly establishing relationship between the item of the balance sheet and the
profit and loss account. Financial analysis can be undertaken by management of the firm, or
by parties outside the firm, viz, owners, creditors, investors and others. The nature of analysis
will differ depending on the purpose of the analyst.
Trade creditors
Trade creditors are interested in firm’s ability to meet their claims over a very short
period of time. Their analysis will, therefore, confine to the evaluation of the firm’s liquidity
position.
Suppliers of long-term debt
Suppliers of long term debt, on the other hand, are concerned with the firm’s long-
term solvency and survival. They analyse the firm’s profitability over time, its ability to
generate cash to be able to play interest and repay principal and the relationship between
various sources of funds (capital structure relationships). Long-term creditors do analyse the
historical financial statements, but they place more emphasis on the firm’s projected, or
proforma, financial statements to make analysis about its future solvency and profitability.
Investors
Investors, who have invested their money in the firm’s shares, are most concerned
about the firm’s earning. They restore more confidence in those firms that show steady
growth in earnings. As such, they concentrate on the analysis of the firm’s present and future
profitability. They are also interest in the firm’s financial structure to the extent it influences
the firm’s earnings ability and risk.
53
Management
Management of the firm would be interest in every aspect of the financial analysis. It
is their overall responsibility to see that the resources of the firm are used most effectively
and efficiently, and that the firm’s financial condition is sound.
LIMITATIONS OF RATIO ANALYSIS
The Ratio analysis is one of the most powerful tools of financial management.
Though ratios are simple to calculate and easy to understand, they suffer from some serious
limitations:
1. Limited Use of a Single Ratio
A single ratio, usually does not convey much of a sense. To make a better
interpretation a number of ratios have to be calculated which is likely to confuse the analyst
than help him in making an meaningful conclusion.
2. Lack of Adequate Standards
There are no well accepted standards or rules of thumb for all ratios which can be
accepted as norm. It renders interpretation of the ratios difficult.
3. Inherent Limitations of Accounting
Like financial statements, ratios also suffer from the inherent weakness of accounting
records such as their historical nature. Ratios of the past are not necessarily true indicators of
the future.
4. Change of Accounting Procedure
Change in accounting procedure by a firm often makes ratio analysis misleading, e.g.,
a change in valuation of methods of inventories, from FIFIO to LIFO increases the cost of
sales and reduces considerably the value of closing stocks which makes stock turnover ratio
to be lucrative and unfavourable gross profit ratio.
5. Window Dressing
Financial statements can easily be window dressed to present a better picture of its
financial and profitability position to outsiders. Hence, on ne has to be very careful in
making a decision from ratios calculated from such financial statements. But it may be very
difficult for an outsider to know about the window dressing made by a firm.

54
 o Limitations of Ratio Analysis
1. Limited use of a single ratio
2. Lack of adequate standards
3. Inherent limitations of accounting
4. Change of accounting procedure.
5. Window dressing
6. Personal bias
7. Un comparable
8. Absolute figures distortive.
9. Price level changes.
10. Ratio no substitutes.

6. Personal Bias
Ratio are only means of financial analysis and not an end in itself. Ratios have to be
interpreted and different people may interpret the same ratio in different ways.
7. Incomparable
Not only industries differ in their nature but also the firms of the similar business
widely differ in their size and accounting procedure, etc. It makes comparison of ratios
difficult and misleading. Moreover, comparisons are made difficult due to difference in
definitions of various financial terms used in the ratio analysis.
8. Absolute Figures Distractive
Ratios devoid of absolute figures may prove distractive as ratio analysis is primarily a
quantitative analysis and not a qualitative analysis.
9. Price Level Changes
While making ratio analysis, no consideration is made to change in price levels and
this make the interpretation of ratios invalid.
10. Ratios no substitutes
Ratio analysis is merely a tool of financial statements. Hence, ratios become useless
if separated from the statements from which they are computed.
Classification of Ratios
The use of ratio analysis is not confined to financial manager only. There are
different parties interests in the ratio analysis for knowing the financial position of a firm for
different purposes. In view of various users of ratios, there are many types of ratios which
can be calculated from the information given in the financial analysis. For example, a
supplier of goods a firm on credit or a banker advancing a short-term loan to a firm, is
interest primarily in the short-term paying capacity of the firm, or say in its liquidity. On the
other hand, a financial institution advancing a long term credit to a firm will be primarily
interest in the solvency or long-term financial position of the concern. Similarly, the interest
55
of the owners (shareholders) and the management also differ. The shareholders are generally
interest in the profitability or dividend position of a firm while management requires
information on almost all the financial aspects of the firm to enable it to protect the interests
of all the parties.

Various account ratios can be classified as follows:

Ratios

Traditional Classification Functional Classification Significance Ratios

or or or
Statement Ratios Classification According to Tests Ratios According to importance

1. Balance Sheet Ratios 1. Liquidity Ratios 1. Primary Ratios

or 2. Leverage Ratios 2. Secondary Ratios
Position Statement Ratios 3. Activity Ratios
2. Profit and Loss Account Ratios 4. Profitability Ratios
or
Revenue/Income Statement Ratios
3. Composite/Mixed Ratios
or
Inter Statement Ratios.

(A) Traditional Classification or Statement Ratios

Traditional classification or classification according to the statement, from

which these ratios are calculated, is as follows:
Traditional Classification or Statement Ratios

Balance Sheet Ratios Profit and Loss Account Ratios Composite/Mixed

or or or
Position Statement Ratios Revenue/Income Statement Ratios Inter-Statement Ratios

1. Current Ratio 1. Gross Profit Ratio 1. Stock Turnover Ratio

2. Liquid Ratio (Acid Test or
or Quick Ratio)
3. Absolute Liquidity Ratio
4. Debt Equity Ratio
5. Proprietary Ratio
6. Capital Gearing Ratio
7. Assets-Proprietorship Ratio
8. Capital inventory to working
9. Ratio of Current Assets to
Fixed Assets
2. Operating Ratio
3. Operating Profit Ratio
4. Net Profit Ratio
5. Expense Ratio
6. Interest Coverage Ratio
2. Debtors Turnover
3. Payable Turnover Ratio
4. Fixed Assets Turnover Ratio
5.Return on shareholder’s fund
6. Return on Equity
7. Return on Capital Employed
8. Capital Turnover Ratio
9. Working Capital Turnover
Ratio
10. Return on Total Resources
11. Total Assets Turnover.

56
(a) Balance Sheet or Position Statement Ratios
Balance sheet ratios deal with the relationship between two balance sheets items, e.g.
the ratio of current assets to current liabilities, or the ratio of proprietors funds to fixed-assets.
Both the items must, however, pertain to the same balance sheet the various balance sheet
ratio have been named in the chart classifying statement ratios.
(b) Profit and Loss Account or Revenue/Income Statements Ratios.
These ratios deal with the relationship between two profit and loss account items, e.g.,
the ratio of gross profit to sales, or the ratio of net profit to sales. Both the items must,
however, belong to the same profit and loss account. The various profit and loss account
ratios, commonly used, are named in the chart classifying statement ratios.
(c) Composite/Mixed Ratios or Inter Statement Ratio
These ratios exhibit the relation between a profit and loss account or income
statement item and a balance sheet item, e.g., stock turnover ratio, or the ratio of total assets
to sales. The most commonly used inter-statement ratios are given in the chart exhibiting
traditional classification or statement ratios.
(B) Functional Classification or Classification according to Tests
In view of the financial management or according to the test satisfied, various ratios
have been classified as below:
(a) Liquidity Ratios
These are the ratios which measure the short-term solvency or financial position of a
firm. These ratios are calculated to comment up the short-term paying capacity of a concern
or the firm’s ability to meet its current obligations. The various liquidity ratios are: Current
ratio, liquid ratio and absolute liquid ratio. Further to see the efficiency with which the liquid
resources have been employed by a firm, debtors turnover and creditors turnover ratios are
calculated.
(b) Long-term Solvency and Leverage Ratios.
Long-term solvency ratios convey a firm’s ability to meet the interest costs and
repayment schedules of its long-term obligations e.g. Debt Equity Ratio and Interest
Coverage Ratio, Leverage Ratio.

57
 Functional Classification in view of Financial Management or
Classification According to Tests.

Liquidity Ratio Long-term Solvency and Activity Ratios Profitability

Ratios

(A) 1. Current Ratio Financial Operating 1. Inventory Turn over (A) In relation to Sales
2. Liquid Ratio (Acid) Composite 2. Debtors Turnover 1. Gross Profit Ratio
Test or Quick Ratio 1. Debt Equity Ratio 3. Fixed Assets Turn 2. Operating Ratio
3. Absolute Liquid 2. Debt to total capital Ratio 3. Operating Profit Ratio
or Cash Ratio ratio 4. Total Assets Turn 4. Net Profit Ratio
4. Internal Measure 3. Interest Coverage ratio 5. Expense Ratio
(B) 1. Debtors Turn 4. Cash Flow/Debt 5. Working Capital (B) In relation to
investment
Ratio 5. Capital Gearing 6. Payables Turnover 1. Return on
Investments
2. Creditors Turn Ratio 2. Return on Capital
Ratio 7. Capital Employed 3. Return on Equity
Capital
3. Inventory Turnover Turnover 4.Return on Total
Resources
ratio 5. Earnings per share
6. Price-Earning Ratio

Show the proportions of debt and equity in financing of the firm. These ratios
measure the contribution of financing by owners as compared to financing by outsiders. The
leverage ratios can further be classified as:-
1) Financial Leverage
2) Operating Leverage
3) Composite Leverage.
(c) Activity Ratios
Activity Ratios are calculated to measure the efficiency with which the resources of a
firm have been employed. These ratios are also called turnover rats because they indicate the
speed with which assets are being turned over into sales, e.g., debtors turnover ratio. The
various activity or turnover rations have been named in the chart classifying the ratios.
(d) Profitability Ratios
These ratios measure the results of business operations or overall performance and
effectiveness of the firm, e.g., gross profit ratio, operating ratio or return on capital employed.
The various profitability ratios have been given in the chart exhibiting the classification of
58
ratios according to test. Generally, two types of profitability ratios are calculated(i) in
relation to sales, and (ii) in relation to investments.
C) Classification According to Significance or Importance
The ratios have also been classified according to their significance or importance.
Some ratios are more important than other and the firm may classify them as primary and
secondary ratios. The British Institute of Management has recommended the classification of
ratios according to importance for inter-firm comparisons. For inter-firm comparisons, the
ratios may be classified as Primary Ratios and Secondary Ratios. The primary ratio is one
which is of the prime importance to a concern; thus return on capital employed is named as
primary ratio. The other ratios which support or explain the primary ratio are called
secondary ratios, e.g., the relationship of operating profit to sales or the relationship of sales
to total assets of the firm
ANALYSIS OF SHORT-TERM FINANIAL POSITION OR TEST OF LIQUIDITY
The short-term creditors of a company like suppliers of goods of credit and
commercial bank providing short-term loans are primarily interests in knowing the
company’s ability to meet its current to short-term obligations as and when these become
due. The short-term obligations of a firm can be met only when there are sufficient liquid
assets. Therefore, a firm must ensure that it does not suffer from lack of liquidity or the
capacity to pay its current obligation. If a firm fails to meet such current obligations due to
lack of good liquidity position, its goodwill in the market is likely to be affected beyond
repair. it will result in also of creditors confidence in the firm and may cause even closure of
the firm. Even a very high degree of liquidity is not good confidence in the firm and may
cause even closure of the firm. Even a very high degree of liquidity is not good for a firm
because such a situation represents unnecessarily excessive funds of the firm being tied-up in
current assets. Therefore, it is very important to have a proper balance in regard to the
liquidity of the firm. Two types of ratios can be calculated for measuring short-term financial
position or short-term solvency of a firm.
(A) Liquidity Ratio
(B) Current Assets Movement or Efficiency Ratios.
(A) Liquidity Ratio
It is extremely essential for a firm to be able to meet its obligation as they become
due. Liquidity Ratios measure the ability of the firm to meet its current obligation
(liabilities). In fact, analysis of liquidity needs the preparation of cash budgets and cash and
fund flow statements; but liquidity ratios, by establishing a relationship between cash and
other current asset to current obligations, provide a quick measure of liquidity. A firm should
ensure that it does not suffer from lack of liquidity, and also that it does not have excess
liquidity. The failure of a company to meet its obligations due to lack of sufficient liquidity,
will result in a poor credit worthiness, loss of creditor’s confidence, or even in legal tangles
resulting in the closure of the company. A very high degree of liquidity is also bad; idle assets
earn nothing. The firm’s funds will be unnecessarily tied up in current assets. Therefore, it is
necessary to strike a proper balance between high liquidity and lack of liquidity. To measure
the liquidity of a firm, the following ratios can be calculated:

59
 I) Current Ratio
II) Quick or Acid Test or Liquid Ratio
III) Absolute Liquid Ratio or Cash Position Ratio
(A) Current Ratios
Current Ratio may be defined as the relationship between current assets and current
liabilities. The ratio, also known as working capital ratio, is a measure of general liquidity
analysis of a short-term financial position or liquidity of a firm. It is calculated by dividing
the total of current assets by total of the current liabilities. Thus
Current Assets
Current Ratio = ——————————————
Current Liabilities
The two basic components of this ratio are: Current assets and current liabilities.
Current assets include cash and those assets which can be easily converted into cash within a
short period of time generally, one year, such as marketable securities, bills receivable,
sundry debtors, inventories, work-in-progress, etc. Prepaid expenses should also be included
in current assets because they represent payment made in advance which will not have to be
paid in near future. Current liabilities are those obligations which are payable within a short
period of generally one year and include outstanding expenses, bills payables, sundry
creditors, accrued expenses, short-term advances, income-tax payable, dividend payable, etc,
Bank overdraft should also generally be included in current liabilities because it represents
short-term arrangements with the bank and is payable within a short period. But where bank
overdraft is permanent or long-term arrangement with the bank it should be excluded. The
following table gives the components of current ratio.
COMPONENTS OF CURRENT RATIO
Current Assets Current Liabilities
1. Cash in Hand 1. Outstanding Expenses/ Accrued Expenses
2. Cash at Bank 2. Bills payable
3. Marketable Securities (Short-term) 3. Sundry Creditors
4. Short-term Investments 4. Short-term Advances
5. Bills Receivable 5. Income-tax payable
6. Sundry Debtors 6. Dividends payable
7. Inventories (Stocks) 7. Bank Overdraft (if not a permanent
8. Work in process arrangements)
9. Prepaid Expenses.
How to interpret current ratio?
A relatively high current ratio is an indication that the firm is liquid and has the ability
to pay its current obligations in time as and when they become due. On the other hand, a
relatively low current ratio represents that the liquidity position of the firm is not good and
the firm shall not be able to pay its current liabilities in time without facing difficulties. An
increase in the current ratio represents improvement in the liquidity position of a firm while a
decrease in the current ratio indicates that there has been a deterioration in the liquidity
60
position of the firm. As a convention the minimum of “two to one ratio” is referred to as a
banker’s rule of thumb or double the current liabilities is considered to be satisfactory. Un
less otherwise it is specially mentioned that bank overdraft is along-term arrangement, it
should be taken as a current liability.
A high current ratio may not be favorable due to the following reasons:
(i) There may be slow moving stocks. The stocks will pile up due to poor sale.
(ii) The figures of debtors may go up because debt collection is not satisfactory.
(iii) The cash or bank balances may be lying idle because of insufficient investment
opportunities.
On the other hand, a low current ratio may be due to the following reasons
(1) There may not be sufficient funds to pay off liabilities.
(2) The business may be trading beyond its capacity. The resources may not warrant the
activities.
Limitations of Current Ratio
Current ratio is a general and quick measure of liquidity of a firm. It represents the
‘margin of safety’ or ‘cushion’ available to the creditors and other current liabilities. It is
most widely used for making short-term analysis of the financial position or short-term
solvency of a firm. But one has to be careful while using current ratio as a measure of
liquidity because it suffers from the following limitations.
a) Crude Ration: It is a crude ratio because it measure only the quantity and not the
quality of current assets
b) Window Dressing: Valuation of current assets and window dressing is another
problem of current ratio. Current assets and liabilities are manipulated in such way
that current ratio loses its significance. Window dressing may be indulged in the
following ways:
I) Over-valuation of closing stock.
II) Obsolete or worthless stocks are shown in the closing inventory at their costs
instead of writing them of..
III) Recording in advance cash receipts applicable to the next year’s sales.
IV) Omission of a liability for merchandise included in inventory.
V) Treating a short-term obligation as a long-term liability.
VI) Inadequate provision for bad and doubtful debts.
VII) Inclusion in debtors advances payment for purchase of fixed assets.
Window dressing is done to show current ratio at a particular figure. It does not
present the real financial position of the concern. The inferences drawn on such a ratio will
be faulty and deceptive.

61
Calculation of Current Ratio
This ratio is calculated by comparing current assets with current liabilities. Take, for
example current assets of a concern as Rs. 2,50,000 and current liabilities as Rs. 1,00,000;
current ratio will be calculated as follows:
Current Assets
Current Ratio = ——————————
Current Liabilities

Rs. 2,50,000
Current Ratio = ——————————
Rs. 1,00,000
The current ratio of 2.5 means the current assets are 2.5 times of current liabilities.
This ratio can also be presented as 2.5:1. In current ratio, current liabilities are taken as 1 and
current assets are given in comparison to it.

Illustration 1.
Calculate current ratio from the following information:
Rs. Rs.

Stock 60,000 Sundry Creditors 20,000

Sundry Debtors 70,000 Bills Payable 15,000
Cash Balances 20,000 Tax Payable 18,000
Bills Receivable 30,000 Outstanding Expenses 7,000
Prepaid Expenses 10,000 Bank Overdraft 25,000
Land and Buildings 1,00,000 Debentures 75,000
Good will 50,000

Solution
Current Assets
Current Ratio = ————————
Current Liabilities

Current Assets = Rs. 60,000+70,000+20,000+30,000+10,000 = Rs. 1,90,000

Current Liabilities = Rs. 20,000+15,000+18,000+7,000+25,000 = Rs. 85,000
1,90,000
Current Ratio = ————— = 2.24
85,000

Time Adjusted Current Ratio

We have noted earlier that all types of current assets are not equally liquid and all
current liabilities are not repayable with the same degree of quickness. Further, the value of
money received today is more than the value of same mount of money received after a certain
62
period. The sooner one receives money, the better it is. Thus, if current ratio is to be used as
an index of liquidity, it has to be adjusted for time value of money. Various current assets an
current liabilities can be adjusted for time value of money by multiplying with the discount
factor calculated as below:

1
D.F = ——— -
(1+r)n

Where, D.F. = Discount Factor

R = Discount Rate, i.e. Annual Earnings Rate Before Tax
N=Time taken for each current asset and current liability to be converted into cash.

Time Adjusted Value of Current Assets

Time Adjusted Current Ratio = ——————————————————
Time adjusted values of current liabilities

Example:
Time taken to Book Value Discount Factor Time Adjusted
Convert in cash (Rs.) at 20% Values (Rs.)
Current Assets
Cash at Bank - 10,000 1.0000 10,000
Receivables 4 25,000 0.9560 24,650
Inventories 10 20,000 0.9655 19,310
55,000 53,960
Current Liabilities
Bills Payable 2 8,000 0.9930 7,944
Sundry Creditors 6 15,000 0.9791 14,686
Other C.L 8 3,000 0.9723 2,917
23,000 25,547
Note:
1 1
(a) D.F = ———— = —————— = 0.9680
(1+r)n (1+.20)4/52

1 1
(b) D.F = ———— = ——————— = 0.9655.
(1+r)n (1+.20)10/52

53,960
Time adjusted Current Ratio = —————— = 2.112
25,547

63
 55,000
Where as, Simple Current Ratio = ————— = 2.391
23,000

QUICK OR ACID TEST OR LIQUID RATIO

Quick Ratio, also known as Acid Test or Liquid Ratio, is a more rigorous test of
liquidity than the current ratio. The term ‘liquidity’ refers to the ability of a firm to pay its
short-term obligations as an when they become due. The two determinates of current ratio, as
a measure of liquidity, are current assets and current liabilities. Current assets include
inventories and prepaid expenses which are not easily convertible into cash within a short
period. Quick ratio may be defined as the relationship between quick/acid assets and current
or liquid liabilities. An asset is said to be liquid if it can be converted into cash within a short
period without loos of value. In that sense, cash in hand and cash at bank are the most liquid
assets. The other assets which can be included in the liquid assets are bills receivable, sundry
debtors, marketable securities and short-term or temporary investments. Inventories cannot be
termed to be liquid assets because they cannot be converted into cash immediately without a
sufficient loos of value. In the same manner, prepaid expenses are also excluded from the list
of quick/liquid assets because they are not expected to be converted into cash. The quick
ratio an be calculated by dividing the total of the quick assets by total current liabilities.

Thus,
Quick or Liquid Assets
Quick/Liquid or Acid Test Ratio = ———————————
Current Liabilities
Some times, bank overdraft is not included in current liabilities while calculating
quick or acid test ratio, on the argument that bank overdraft is generally a permanent way of
financing and is not subject to be called on demand. In such cases, the quick ratio is found
out by dividing the total quick assets by quick liabilities.
However, in questions quick assets and current liabilities have been used for
calculating. Acid Test Ratio
Components of Quick/Liquid Ratio
Quick/Liquid Assets Current Liabilities
Cash in hand Outstanding or Accrued Expenses
Cash at Bank Bills payable
Bills Receivables Sundry Creditors
Sundry Debtors Short-term advances Marketable Securities
Temporary Investments Income-tax payable
Dividends payable
Bank overdraft

Quick assets can also be calculated as

64
 Current Assets-(Inventories+Prepaid Expenses). Inventories here will mean all types
of stock i.e, finished, work-in-progress, and raw materials.
Take for example, a concern has liquid assets of Rs. 2,00,000 and current liabilities of
Rs. 1,50,000, the quick or liquid ratio will be calculated as :
Liquid Assets
Quick/Acid Test. Liquid Ratio = ————————-
Current liabilities

Rs. 2,00,000
Quick/Acid Test. Liquid Ratio = ———————— = 1.33
Rs. 1,50,000

Interpretation of Quick Ratio

Usually, a high acid test ratio is an indication that the firm is liquid and has the ability
to meet its current or liquid liabilities in time and on the other hand a low quick ratio
represents that the firm’s liquidity position is not good.
As a rule of thumb or a convention quick ratio of 1: is considered satisfactory. It is
generally thought that if quick assets are equal to current liabilities then the concern may be
able to meet its short-term obligations. Although quick ratio is a more rigorous test of
liquidity than the current ratio, yet it should be used cautiously and 1:1 rule should not be
used blindly. A quick ratio of 1:1 does not necessarily mean satisfactory liquidity position if
all the debtors cannot be realized and cash is needed immediately to meet the current
obligations. In the same manner, a low quick ratio does not necessarily mean a bad liquidity
position as inventories are not absolutely non-liquid. Hence, a firm having a high quick ratio
may not have a satisfactory liquidity position if it has slow-paying debtors. On the other
hand, a firm having a low quick ratio may have a good liquidity position f it is has fast
moving inventories.
Significance of Quick Ratio
The quick ratio is very useful in measuring the liquidity posting of a firm. It measure
of the firm’s capacity to pay off current obligations immediately and is more rigorous test of
liquidity than the current ratio. It is used as a complementary ratio to the current ratio.
Illustration
Calculate quick ratio from the following information gives as such.

Rs. Rs.
Bank Loan 1,00,000 Stock-in-trade 1,35,000
Sundry Creditors 1,50,000 Sundry Debtors 72,000
Bills Payable 20,000 Less Provision for doubtful debts 2,000 70,000
Creditors for expenses 10,000 Cash-in-hand 15,000
6% Debentures 2,00,000 Cash at Bank 1,00,000
Plant & Machinery 3,00,000 Short-term Investments 1,50,000

65
 Prepaid Insurance 5,000
Solution
Quick Assets
Quick Ratio = —————————
Current Liabilities

Quick Assets = Rs. 70,000+15,000+1,10,000+1,50,000 = Rs. 3,45,000

Current Liabilities = Rs. 1,50,000+20,000+18,000 = Rs. 1,80,000
Rs. 3,45,000
Quick Ratio = ——————— = 1.916
Rs. 1,80,000

Notes
(a) Bank Loan is a long-term liability. However, bank overdraft should be taken as a current
liability.
(b) For calculating quick assets, stock-in-trade and prepaid insurance are excluded from
current assets.
(c) Sundry debtors should be taken after deducing provision for bad and doubtful debts.
ABSOLUTE LIQUID RATIO OR CASH RATIO
Although receivables, debtors and bills receivable are generally more liquid than
inventories, yet there may be doubts regarding their realization into cash immediately or in
time. Hence, some authorities are to the opinion that the absolute liquid ratio should also be
calculated together with current ratio and acid test ratio so as to exclude even receivables
from the current assets and find out the absolute liquid assets.
Absolute Liquid Assets
Absolute Liquid Ratio = ————————————-
Current Liabilities
Or
Cash& Bank+ Short-term Securities
Cash Ratio = ———————————————
Current Liabilities
Absolute Liquid assets include cash in hand and at bank and marketable securities or
temporary investments. The acceptable norms for this ratio is 50% or 0.5:1 or 1:2 i.e, Re. 1
worth absolute liquid assets are considered adequate to pay Rs. 2 worth current liabilities in
time as all the creditors are not expected to demand cash at the same time and then cash may
also be realised from debtors and inventories.
Illustration 4. The following is the Balance Sheet of New India Ltd., for the year ending
Dec. 31, 1999.
Rs. Rs.
9% Preference Share Capital 5,00,000 Goodwill 1,00,000
Equity Share Capital 10,00,000 Land & Building 6,50,000
66
8% Debentures 2,00,000 Plant 8,00,000
Long-term Loan 1,00,000 Furniture & Fixture 1,50,000
Bills Payable 60,000 Bills Receivables 70,000
Sundry Creditors 70,000 Sundry Debtors 90,000
Bank Overdraft 30,000 Bank Balance 45,000
Outstanding Expenses 5,000 Short-term Investments 25,000
Prepaid Expenses 5,000
Stock 30,000
19,65,000 19,65,000

From the balance sheet calculate:

(a) Current Ratio
(b) Acid Test Ratio
(c) Absolute Liquid Ratio
(d) Comment on these ratios.

(a) Current Ratio

Current Assets
Current Ratio = ————————
Current liabilities
Current Assets = Rs. 70,000 + Rs. 90,000 + Rs. 45,000 + Rs. 25,000 + Rs.5000 +
Rs. 30,000 = Rs. 2,65,000
Current Liabilities = Rs. 60,000+Rs. 70,000+Rs. 30,000+Rs. 5,000 = Rs. 1,65,000

Rs. 2,65,0000
Current Ratio = ———————— = 1.61
Rs. 1,65,000

(b) Acid Test Ratio

Liquid Assets
Acid Test Ratio = ———————— -
Current liabilities

Liquid Assets = Rs. 70,000+Rs. 90,000+Rs. 45,000+Rs. 25,000 = Rs. 2,30,000

Stock are prepaid Expenses have been excluded from current assets in order to arrive at liquid
assets Current Liabilities = Rs. 1,65,000
Rs. 2,30,000
Acid Test Ratio = ———————— = 1.39
Rs. 1,65,000

67
(C) Absolute Liquid Ratio
Absolute Liquid Assets
Absolute Liquid Ratio = ———————————
Current Liabilities
Absolute Liquid Assets = Rs. 45,000+Rs. 25,000
Rs. 70,000
Absolute Liquid Ratio = ——————— = 0.42
Rs. 1,65,000
(d) Comments
Current ratio of the Company is not satisfactory because the ratio (1.61) is much
below the accepted standard of 2:1 Acid-test ratio, on the other hand, is more than the normal
standard of 1:1. Liquid assets are quite sufficient to provide a cover to the current liabilities.
The more rigorous ratio i.e. absolute liquid ratio is slightly low because it is 0.42 where as the
accepted standard is 0.5. In all, the company needs to improve its short-term financial
position.
CURRENT ASSETS MOVEMENT OR EFFICIENCY/ACTIVITY RATIOS
Funds are invested in various assets in business to make sales and earn profits. The
efficiency with which assets are managed directly affect the volume of sales. The better the
management of assets, the large is the amount of sales and the profits. Activity ratios
measure the efficiency of effectiveness with which a firm manages its resources or assets.
These ratios are also called Turnover ratios because they indicate the speed with which assets
are converted or turned over into sales. For example, inventory turnover ratio indicates the
rate at which the funds invested in inventories are converted into sale. Depending upon the
purpose, a number of turnover ratios can be calculated as debtors turnover, stock turnover,
capital turnover, etc.
The current ratio and the acid test ratio give misleading results if current assets
include high amount of debtors due to low credit collections. In the same manner, current
ratio may be further misleading if the assets include high amount of slow moving inventories.
As both these ratios ignore the movement of current assets, I is important to calculate the
following turnover or efficiency ratios to comment upon the liquidity or the efficiency with
which the liquid resources are being used by a firm.
ANALYSIS OF SHORT-TERM FINANCIAL POSITION
LIQUIDITY RATIOS CURRENT ASSETS MOVEMENT OR
EFFICIENCY RATIOS
1. Current Ratio 1. Inventory/Stock Turnover Ratio
2. Quick or Acid Test or Liquid Ratio 2. Debtors Turnover Ratio
3. Absolute Liquid Ratio 3. Creditors/Payables Turnover Ratio
4. Working Capital Turnover Ratio

INVENTORY TURNOVER OR STOCK TURNOVER RATIO

Every firm has to maintain a certain level of inventory of finished goods so as to be able
to meet the requirements of the business. But the level of inventory should neither be too high
nor too low. It is harmful o hold more inventory for the following reason:
68
 a) In unnecessarily blocks capital which can otherwise be profitably used somewhere
else.
b) Over-stocking will require more godown space, so more rent will be paid.
c) There are chance of obsolescence of stocks. Consumers will prefer goods of latest
design, etc.
d) Slow disposal of stocks will mean slow recovery of cash also which will adversely
affect liquidity.
e) There are chances of deterioration in quality if the stocks are held for more periods.
It will therefore, be advisable to dispose off inventory as early as possible. On the
other hand, too low inventory may mean loss of business opportunities. Thus, it is very
essential to keep sufficient stocks in business.
Inventory turnover ratio also know as stock velocity is normally calculated as
sales/average inventory or cost of goods sold/average inventory. It would indicate whether
inventory has been efficiently used or not. The purpose is to see whether only the required
minimum funds have been locked up in inventory. Inventory Turnover Ratio (I.T.R)
indicates the number of times the stock has been turned over during the period and evaluates
the efficiency with which a firm is able to mange its inventory.
The figure of inventory at the end of the year should not be taken for calculating stock
velocity because normally the stock at the year end is low. Generally, efforts are made to
dispose of inventory before the close of the year. So average inventory should be taken for
calculating stock turnover ratio. If possible, stock figures at the beginning and at the end of
every moth should be taken and added up and thus should be divided by 13 to get a proper
average. In questions, the stock figures are not given for different months; rather inventory in
the beginning and at the end of the year is given; so the average of these two figure should be
taken. The ratio is calculated by dividing the cost of goods sold by the amount of average
inventory at cost.
Cost of goods sold
(a) Inventory Turnover Ratio = ——————————————
Average Inventory at cost
Average Inventory is calculated by adding the stock in the beginning and at the end of
the period and dividing it by two. In case of monthly balance of stocks, all the monthly
balances are added and the total is divided by the number of months for which the average is
calculated. For example, the opening stock at the beginning of a year is Rs. 30,000 and the
closing balance is Rs. 50,000 the average inventory is calculated as:
Opening Stock + Closing Stock
—————————————-
2
30,000 + 50000
——————————- = Rs. 40,000
2
And say, opening stock of January 1996 is Rs. 20,000 and the closing stocks are :
January – Rs. 30,000; February-Rs. 40,000; March –Rs. 35,000; April Rs. 25,000; May – Rs.
45,000; June – Rs. 45,00;0; July – Rs. 20,000; August – Rs. 30,000; September – Rs. 35,000;

69
October – Rs. 15,000; November – Rs. 25,000 and December-Rs.20,000. The average
Inventory/Stock calculated as below:
20,000+30,000+40,000+35,000+25,000+45,000+50,000+20,000+30,000+35,000+
15,000+25,000+20,000
13
3,90,000
= ————— = Rs. 30,000
13
Generally, the cost of goods sole may not be known from the published financial
statements. In such circumstance, the inventory turnover ratio may be calculated by dividing
net sales by average inventory at cost. If average inventory at cost is not known then
inventory at selling price may be taken as the— denominator and where the opening
inventory is not known the closing inventory figure may be taken as the average inventory.

Thus.

Net Sales
(b) Inventory Turnover Ratio = ————————————
Average Inventory at cost

Net Sales
(c) Inventory Turnover Ratio = ——————————————
Average Inventory at Selling Price.

Net Sales
(d) Inventory Turnover Ratio = ————————
Inventory

Inventory Conversion Period

It may also be of interest to see average time taken for clearing the stocks. This can
be possible by calculating inventory conversion period. This period is calculated by dividing
the number of days by inventory turnover. The formula may be as:

Days in a year
(d) Inventory Turnover Ratio = —————————————-
Inventory Turnover Ratio.

= ? No. of days

If 365 days are taken then

365
Inventory Turnover Ratio = ——————————
Inventory Turnover Ratio

70
Illustration
M/s Rakesh & Co supplies you the following information for the year ending 31st
Dec 1999. Credit sales: Rs. 1,50,000; Cash sales: Rs. 2,50,000; Returns inward; Rs. 25,000;
Opening Stock; Rs. 25,000; Closing Stock R.35,000
Find out (i) Inventory Turnover when Gross profit is20%
(ii) Inventory Conversion Period.

Solution
Cost of goods sold
(a) Inventory Turnover Ratio = —————————————
Average Inventory at cost

First of all, cost of goods sold will be calculated

Net Sales = Rs. 1,50,000+2,50,000-Rs. 25,0000 = Rs. 3,75,000

3,75,000 x 20
Gross Profit on Sales = —————————- = Rs. 75,000
100

Cost of Goods Sols = Net Sales – Gross Profit

= Rs. 3,75,000-Rs. 75,000
= Rs. 3,00,000

Opening Stock + Closing Stock

Average Stock = ————————————————-
2

Rs. 25,000+35000
——————————- = Rs. 30,000
2

Rs. 3,00,000
Inventory Turnover = ————————
Rs. 30,000

= 10 times

365
Inventory Turnover Ratio = —————————
Inventory Turnover

365
—— = 36.5 or 37 days
10

71
Interpretation of Inventory Turnover Ratio
Inventory Turnover ratio measures the velocity of conversion of stock into sales.
Usually, a high inventory turnover/stock velocity indicates efficient management of inventory
because more frequently the stocks are sold, the lesser amount of money is required to
finance the inventory. A low inventory turnover ratio indicates an inefficient management of
inventory. A low inventory turnover implies over investment in inventories, dull business,
poor quality of goods, stock accumulations, accumulation of obsolete and slow moving goods
and low profits as compared to total investment. A too high turnover of inventory may not
necessarily always imply a favourable situation. A very high turnover of inventory does not
necessarily imply higher profits. The profits may be low due to excessive cost incurred in
replacing stocks in small lots, stock-out situations, selling inventories at very low prices, etc.
DEBTORS OR RECEIVEABLE TURNOVER RATIO AND A VERAGE
COLLECTION PERIOD.
A concern may sell goods on cash as well as on credit. Credit is one of the important
elements of sales promotion. The volume of sales can be increased by following a liberal
credit policy. But the effect of a liberal credit policy may result in tying up substantial funds
of a firm in the form of trade debtors (or receivables, i.e., debtors plus bills receivables).
Trade debtors are expected to be converted into cash within a short period and are included in
current assets. Hence, the liquidity position of a concern to pay its short-term obligations in
time depends upon the quality of its trade debtors. Two kinds of ratios can be computed to
evaluate the quality of debtors.
Net Credit Annual Sales
Debtors(Receivables) Turnover/velocity = ————————————
Average Trade Debtors

= No.of times.
Trade Debtors = Sundry Debtors + Bills Receivables and Accounts Receivables

Opening Trade Debtors + Closing Trade Debtors

Average Trade Debtors = ————————————————————
2
Note:
Debtors should always be taken at gross value. No provision for band and doubtful
debts be deduct from them.
But when the information about opening and closing balance of trade debtors and
credit sales is not available, then the debtors turnover ratio can be calculated by dividing the
total sales by the balance of debtors (inclusive of bills receivables) given.

Total Sales
Debtors Turnover Ratio = ————————-
Debtors

72
Interpretation of Debtors Turnover/Velocity
Debtors velocity indicates the number of times the debtors are turnover during a year.
Generally, the high the value of debtors turnover the more efficient is the management of
debtors/sales or more liquid are the debtors. Similarly, low debtors turnover implies
inefficient management of debtors/sales and less liquid debtors. But a precaution is needed
while interpretation a very high debtors turnover ratio because a very high ratio may imply a
firm’s inability due to lack of resource to sell on credit thereby losing sales and profits. There
is no rule of thumb which may be used as a norm to interpret the ratio as it may be different
from firm to firm, depending upon the nature of business. This ratio should be compared
with ratio of other firms doing similar business and a trend may also be found to make a
better interpretation of the ratio.
(b) Average Collection Period Ratio
The average collection period represents the average number of days for which a firm
has to wait before its receivables are converted into cash. The ratio can be calculated as
follows:
Average Trade Debtors (Drs+B/R)
(i) Average Collection Period = ———————————————
Sales per day
Net Sales
(ii) Sales per day = ———————————-
No.of working days

Or Average Collection period

Average Trade Debtors

= ————————————
Net Sales
No. of working days

Average Trade Debtors x No.of working days

———————————————————
Net Sales
In the period is in moths:
Average Collection Period.

Average Trade Debtors x No.of Months

= —————————————————————
Net Sales
Or Average Collection Period.

No.of Working Days

= ————————————
Debtors Turnover Ratio

= No. of days
73
 The two basic components of the ratio are debtors and sales per day. Trade debtors
are inclusive of bills receivables and should be average trade debtors (Opening stock +
Closing stock/2) but if information about opening and closing debtors is not available, then
total sales may be taken to compute the ratio. Further, to find out sales per day the sales
figure should be divided by the number of working days given in a year; the number of
working days may be assumed to be 360 as it is customary to take 360 or 365 days in a year
for calculating this ratio although some authors take even 300 days in year.

Illustration
Find out (a) Debtors Turnover, and (b) Average Collection period from the following
information:
31st March 1999 31st March 2000
Rs. Rs.
Annual Credit sales 5,00,000 6,00,000
Debtors in the beginning 80,000 90,000
Debtors at the end 1,00,000 1,10,000

Days to be taken for the year : 360

Opening Debtors + Closing Debtors

Average Debtors = —————————————————
2

Net Credit Annual Sales

Debtors Turnover = ——————————————-
Average Trade Debtors

Year 1999 Year 2000

80,000 + 1,00,000 90,000+1,10,000
= ——————————— - ————————
2 2
Rs. 90,000 Rs. 1,00,000

5,00,000 6,00,000
(a) Debtors Turnover = ————— ———— -
90,000 1,00,000
= 5.56 times = 6 times

No.of Working Days

(b) Average Collection Period = ———————————-
Debtors Turnover

Year 1999 Year 2000

74
 360 360
= ———- ———-
5.56 6

= 64.7 days 60 days

65 days (Approximately)
Interpretation of Average Collection Period Ratio.
The average collection period ratio represents the average number of days for which a
firm has to wait before its receivables are converted into cash. It measures the quality of
debtors. Generally, the shorter the average collection period the better is the quality of
debtors as a short collection period implies quick payment by debtors. Similarly, a higher
collection period implies as inefficient collection performance which in turn adversely affects
the liquidity or short-term payment capacity of a firm out of its current liabilities.
(b) Average Collection Period Ratio
The average collection period represents the average number of days for which a firm
has to wait before its receivables are converted into cash. The ratio can be calculated as
follows:
Average Trade Debtors (Drs+B/R)
(i) Average Collection Period = —————————————————
Sales per day

Net Sales
(ii) Sales per day = ————————
No.of working days

Average Trade Debtors

Or Average Collection period = ———————————
Net Sales
No. of working days

Average Trade Debtors x No.of working days

———————————————————
Net Sales
In the period is in moths:
Average Collection Period.
Average Trade Debtors x No.of Months
= —————————————————
Net Sales
Or Average Collection Period.
No.of Working Days
= ———————————
Debtors Turnover Ratio
= No. of days

75
 The two basic components of the ratio are debtors and sales per day. Trade debtors
are inclusive of bills receivables and should be average trade debtors (Opening stock +
Closing stock/2) but if information about opening and closing debtors is not available, then
total sales may be taken to compute the ratio. Further, to find out sales per day the sales
figure should be divided by the number of working days given in a year; the number of
working days may be assumed to be 360 as it is customary to take 360 or 365 days in a year
for calculating this ratio although some authors take even 300 days in year.

Illustration
Find out (a) Debtors Turnover, and (b) Average Collection period from the following
information:
31st March 1999 31st March 2000
Rs. Rs.
Annual Credit sales 5,00,000 6,00,000
Debtors in the beginning 80,000 90,000
Debtors at the end 1,00,000 1,10,000

Days to be taken for the year : 360

Opening Debtors + Closing Debtors

Average Debtors = —————————————————
2

Net Credit Annual Sales

Debtors Turnover = ——————————————-
Average Trade Debtors

Year 1999 Year 2000

80,000 + 1,00,000 90,000 + 1,10,000

= ——————————- ————————
2 2
Rs. 90,000 Rs. 1,00,000
5,00,000 6,00,000
(a) Debtors Turnover = ————— ——————-
90,000 1,00,000

= 5.56 times = 6 times

No.of Working Days
(b) Average Collection Period = ——————————-
Debtors Turnover

Year 1999 Year 2000

76
 360 360
= ————- ———— -
5.56 6

= 64.7 days 60 days

65 days (Approximately)

Interpretation of Average Collection Period Ratio

The average collection period ratio represents the average number of days for which a
firm has to wait before its receivables are converted into cash. It measures the quality of
debtors. Generally, the shorter the average collection period the better is the quality of
debtors as a short collection period implies quick payment by debtors. Similarly, a higher
collection period implies as inefficient collection performance which in turn adversely affects
the liquidity or short-term payment capacity of a firm out of its current liabilities.
Moreover, longer the average collection period, larger are the chance of bad debtors.
But a precaution is needed while interpreting a very short collection period because a very
low collection period may imply a firm’s conservative policy to sell on credit or its inability
to allow credit its customers (due to lack of resources) and thereby losing sales and profits.
CREDITORS/PAYABLES TURNOVER RATIO
In the course of business operations, a firm has to make credit purchases and incur
short-term liabilities. A supplier of goods i.e., creditor, is naturally interests in find out how
much time the firm is likely to take in repaying its trade creditors. The analysis for creditors
turnover is basically he same as of debtors turnover ratio except that in place of trade bettors,
the trade creditors are taken as one of the components of the ratio and in place of average
daily sales, average daily purchases are taken as the other component of the ratio. Same as
debtors turnover ratio, creditors turnover ratio can be calculated in two forms.
Net Credit Annual Purchases
(i) Creditors/Payable Turnover Ratio = —————————————— -
Average Trade Creditors
In information about credit purchases is not available, the figure of total purchases
may be taken as the numerator and the trade creditors include sundry creditors and bills
payables. If opening and closing balances of creditors are not known, the balance of creditors
given may be taken to find out the ratio. The ratio indicates the velocity with which the
creditors are turnover over in relation to purchases. Generally, higher the creditors velocity
better it is or otherwise lower the creditors velocity less favourable are the results.

Average Trade Creditors (Creditors+Bills Payable)

(ii) Average Payment Period Ratio = ————————————————————
Average Daily Purchases

Annual Purchases
Average Daily Purchases = ——————————————-
No.of working Days in a year

77
Or Average Payment Period
Trade Creditors x No.of Working Days
= ——————————————————
Net Annual Purchases

Or Average Payment Period

No.of Working Days
= ———————————
Creditors Turnover Ratio
(In case information about credit purchases is not available total purchase may be assumed to
be credit purchases).
Interpretation of Average Payment Period Ratio
The average payment period ratio represents the average number of days taken by the
firm to play it creditors. Generally, ower the ratio, the better is the liquidity position of the
firm and higher the ration, less liquid is the position of the firm. But a higher payment period
also implies greater credit period enjoyed by the firm and consequently larget the bnefit
reaped from credit suppliers. But one has to be careful in interpreting this ratio, as a higher
ration may also imply less discount facilities availed or higher prices paid for the goods
purchased on credit. To make correct interpretation of this ratio, a comparative analysis of
different firms in the same industry and the trend may be found for various years.
Illustration
From the following information calculate creditors turnover ratio and average payment
period:
Rs.
Total Purchases 4,00,000
Cash Purchases (Included in above) 50,000
Purchase Returns 20,000
Creditors at the end 60,000
Bills payable at the end 20,000
Reserve for discount on Creditors 5,000
Take 365 days in a year 5,000

Solution:
Annual Net Purchases
Creditors Turnover Ratio = ————————————-
Average Trade Creditors
Net Credit Purchases Rs.
Total Purchases 4,00,000
Less Cash Purchases 50,000
3,50,000
Less Returns 20,000
3,30,000
Rs. 3,30,000
Creditors Turnover Ratio = ——————————
Rs. 60,000+Rs. 20,000
78
(Trade Creditors include creditors and bills payable)

Rs. 3,30,000
= ——————— = 4.13 times
Rs. 80,000

No.of days
Average Payment Period = —————————-
Creditors Turnover Ratio

365
= ————— = 88 days (approx)
4.13

alternatively:
60,000+20,000
Average Payment Period = —————————— x 365
3,30,000

80,000
= —————— x 365 = 86 days
3,30,000
Note:
Reserve for discount on creditors is not considered while calculating average
collection period because total creditors before deducting such reserve are to be taken.
WORKING CAPITAL TURNOVER RATIO
Working Capital of a concern is directly related to sales. The current assets like
debtors, bills receivables, cash stock etc. change with the increase or decrease in sales. The
working capital is taken as:
Working Capital Turnover Ratio indicates the velocity of the utilization of net
working capital. This ratio indicates the number of times the working capital is turned over
in the course of a year. The ratio measures the efficiency with which the working capital is
being used by a firm. A higher ratio indicates efficient utilization of working capital and a
low ratio indicates otherwise. But a very high working capital turnover ratio is not a good
situation for any firm and hence care must be taken while interpreting the ratio. This ratio
can at best be used by making of comparative and trend analysis for different firms in the
same industry and for various periods. This ratio can be calculated as:
Cost of sales
Working Capital Turnover Ratio = ——————————————
Average Working Capital

Opening Working Capital + Closing Working Capital

Average Working Capital = ———————————————————————
2
79
 In the figure of cost of sales is not given, then the figure of sales an be used instead.
On the other hand if opening working capital is not disclosed, then working capital at the
year-end will be used. In that case the ratio will be.
Cost of Sales (or Sales)
Working Capital Turnover Ratio = ———————————————-
Net Working Capital
If the term working capital is used in broad sense as gross working capital, then;
Cost of Sales (or Sales)
Working Capital Turnover Ratio = ———————————————-
Net Working Capital
LEVERAGE RATIOS
The short-term creditors, like bankers and suppliers or raw material, are more
concerned with the firm’s current debt-paying ability. On the other hand, long-term creditors
like debenture holders, financial institutions etc. are more concerned with the firm’s long-
term financial strength. In fact, a firm should have a strong short-as well as long-term
financial position. To judge the long-term financial position of the firm, Financial leverage,
or Capital Structure Ratios are calculated. These ratios indicate mix of funds provided by
owners and lenders. As a general rule there should be an appropriate mix of debt and owner’s
equity in financing the firm’s assets.
The manner in which assets are financed has a number of implications. First, between
debt and equity, debt is more risky from the firm’s point of view. The firm has a legal
obligation to pay interest to debt holders, irrespective of the profits made or losses incurred
by the firm. If the firm fails to pay to debt holders in time, they can take legal action against
into get payment and in extreme cases, can force the firm into liquidation. Second use of
debt is advantageous for shareholder in two ways;
a) They can retain control of the firm with a limited stake and
b) Their earnings will be magnified, when the firm earns a rate of return on the total
capital employed higher than the interest rate on the borrowed funds.
The process of magnifying the shareholder’s return through the use of debt is called
“Financial leverage” or Financial gearing” or “Trading on Equity”. However, leverage
can work in opposite direction as well. If the cost of debt is higher than the firm’s overall
rate of return, the earnings of shareholders will be reduced.
I) DEBT-EQUITY RATIO
Debt-Equity Ratio, also known as External-Internal equity Ratio is calculated to
measure the relative claims of outsiders and the owners (i.e, shareholders) against the firm’s
assets. This ratio indicate the relationship between the external equities or the outsiders funds
and the internal equities or the shareholder’s fund, thus
Outsiders Funds
Debt-Equity Ratio = ———————————-
Shareholder’s Funds

80
 External Equities
Or Debt to Equity Ratio = ——————————
Internal Equities
The two basic components of the ratio are outsider’s funds, i.e, external equities and
shareholder’s funds, i.e, internal equities. The outsider’s fund include all debts/liabilities to
outsiders, whether long-term or short-term or whether in the form of debentures bonds,
mortgage or bills. The shareholder’s funds consist of equity share capital, preference share
capital, capital reserves, revenue reserves and reserves representing accumulated profits and
surpluses like reserves for contingencies, sinking funds, etc. The accumulated losses and
deferred expenses, if any, should be deducted from the total to find out shareholder’s funds.
When the accumulated losses and deferred expenses are deducted from the shareholder’s
funds, it is called net worth and he ratio may be termed as debt net worth ratio.
Some writers are of the opinion that preference share capital should be included in
external equities or outsider’s funds and not in the internal equities or the shareholder’s fund.
The reasons for including preference shares in the outsiders funds are that a fixed rate of
dividend is payable on these shares and further they may be redeemable after a certain period.
Thus, there are differences of opinion regarding the treatment of preference shares while
calculating this ratio. However, it advised that depending upon the nature of preference
shares and the purpose of analysis, redeemable preference shares may be included in
outsider’s funds and irredeemable preference shares in shareholder’s funds. Further in case
time for redemption of preference shares is 12 years or more, redeemable preference share
capital may be included in shareholder’s funds. In the same way, there is a controversy
regarding current liabilities also. Some writers are of the view that current liabilities do not
reflect long-term commitments and hence should be excluded from outsider’s
funds. The reasons given in favour of excluding current liabilities are
(i) the current liabilities are payable in very short period and the firm’s ability to pay is
judged by liquidity ratios.
(ii) No significant amount of interest is payable on them, and
(iii) The amount of current liabilities widely fluctuates during a year.
There are some other writers who suggest that current liabilities should also be
included in the outsider’s find calculate debt-equity ratio for the reason that like long-term
borrowings, current liabilities also represent firm’s obligations to outsiders and they are an
important determinate of risk. However, we are of the opinion that to calculate, debt
equity ratio current liabilities should be included in outsider’s funds. The ratio
calculated on the basis of outsider’s funds excluding current liabilities may be termed as
Ratio of long-term debt to shareholder’s funds, which is:
Long-term Debt
Long-term Debt to Share Holder’s Funds = ——————————-
(Debt-Equity Ratio) Shareholder’s fund

Total Debt
Debt Equity Ratio = —————————
Net Worth
81
Interpretation of Debt-Equity Ratio
The debt-equity ratio is calculated to measure the extent to which debt financing has
been used in a business. The ratio indicates the proportionate claims of owners and the
outsiders against the firm’s assets. The purpose is to get an idea of the cushion available to
outsiders on the liquidation of the firm. As a general rule, there should be an approximate
mix of owner’s funds and outsiders funds in financing the firm’s asset. However owners
want to do the business with maximum of outsider’s funds in order to take lesser risk of their
investment and to increase their earnings (per share) by paying a lower fixed rate of interest
to outsiders. The outsiders (creditors), on the other hand, want threat shareholder (owners)
should invest and risk their share proportionate investment.
(II) FUNDED DEBT TO TOTAL CAPITALIZATION RATIO
The ratio establishes a link between the long-term funds raised from outsiders and
total long-term funds available in the business. The two words used in this ratio are
I) Funded Debt
II) Total Capitalisation
Funded Debt = Debentures + Mortgage loans + Bonds + Other long-term loans.
Total Capitalisation = Equity Share Capital + Preference Share Capital + Reserves
And surplus + Other Undistributed Reserves + Debentures +
Mortgage Loans + Bonds + Other long-term loans.
Funded Debt
—————————— x 100
Total Capitalisation
Funded debt is that part of total capitalization which is financed by outsiders.
Funded debt is no ‘rule of thumb’ but still the lesser the reliance on outsiders the better it will
be. If this ratio is smaller, better it will be, up to 50% or 55% this ratio may be tolerable and
not beyond.
III) PROPRIETORY RATIO OR EQUITY RATIO
A variant to the debt-equity ratio is the proprietory ratio which is also known as
Equity Ratio or Shareholder’s to Total Equities Ratio or Net worth to Total Assets Ratio.
This ratio establishes the relationship between shareholder’s funds to total assets of the firm.
The ratio of proprietor’s funds to total funds (Proprietors+outsider’s funds or total funds or
total assets) is an important ratio for determining long-term solvency of a firm. The
components of this ratio are “shareholders” funds or Proprietor’s funds and total assets. The
shareholder’s funds are Equity Share Capital, Preference Share Capital, undistributed profits,
reserves and surpluses. Out of this amount, accumulated losses should be deduced. The total
assets on the other hand denote total resources of the concern. The ratio can be calculated as
under:
Shareholder’s Funds
Proprietory Ratio or Equity Ratio = ———————————
Total Assets

82
If share holder’s funds are Rs. 4,00,000 and total assets are Rs. 6,00,000
Proprietory Ratio or equity Ratio
4,00,000
= —————— = 2:3
6,00,000
This ratio can also be represented in percentage which indicates the parentage of
owner’s capital to total capital of the firms as follows:
4,00,000
= ————— x 100 = 66.67%
6,00,000
Interpretation of Equity Ratio
As equity ratio represents the relationship of owner’s funds to total assets, higher the
ratio or the share of the shareholder in the total capital of the company, better is the long-term
solvency position of the company. This ratio indicates the extent to which the assets of the
company can be lost without affecting the inters of creditors of the company.
IV) SOLVENCY RATIO OR THE RATIO OF TOTAL LIABILITIES TO TOTAL
ASSETS
This ratio is a small variant of equity ratio and can be simply calculated as 100-equity
ratio, i.e., continuing the example taken for the equity ratio, solvency ratio = 100-66.67 or say
33.33%. The ratio indicates the relationship between the total liabilities to outsiders to total
assets of a firm and can be calculated as follows;
Total Liabilities to Outsiders
Solvency Ratio = ———————————————
Total Assets
If the total liabilities to outsiders are Rs. 2,00,000 and total assets are Rs. 6,00,000, then
2,00,000
Solvency Ratio = ———————— x 100 = 33.33%
6,00,000
Generally, lower the ratio of total liabilities to total assets, more satisfactory or stable
is the long-term solvency position of a firm.
V) FIXED ASSETS TO NET WORTH RATIO OR FIXED ASSETS TO
PROPRIETOR’S FUNDS
The ratio establishes the relationship between fixed assets and shareholder’s funds.
I.e., share capital plus reserves, surpluses and retained earnings. The ratio can be calculated
as follows:
Fixed Assets to Net Worth Ratio
Fixed Assets (After depreciation)
= —————————————————
Shareholder’s Funds

83
 Thus, where the depreciated book value of fixed asset is Rs. 4,00,000 and
shareholder’s funds are also Rs. 4,00,000 the ratio of fixed assets to net worth/Proprietor’s
funds represented in terms of percentage would be.
4,00,000
= —————— x 100 = 100%
4,00,000
The ratio of fixed assets to net worth indicates the extent to which shareholder’s funds
are sunk into the fixed assets. Generally, the purchase of fixed assets should be financed by
shareholder’s equity including reserves surpluses and retained earnings. If the ratio is less
than 100%, it implies that owner’s funds are more than total fixed assets and a part of the
working capital is provided by the shareholders. When the ratio is more than 100% it implies
that owner’s funds are not sufficient to finance the fixed assets and the firm has to depend
upon outsiders to finance the fixed assets. There is no ‘rules of thumb’ to interpret this ration
but 60 to 65 percent is considered to be satisfactory ratio in case of industrial undertakings.
VI) FIXED ASSETS TO TOTAL LONG TERM FUNDS OF FIXED ASSETS RATIO
A variant to the ratio of fixed assets to net worth is the ratio of fixed assets to total
long-term funds which is calculated as:
Fixed Assets 9after depreciation)
Fixed Assets ratio = —————————————————
Total Long-term Funds
The long-term funds consist of shareholder’s funds as calculated in the debt-equity
ratio plus long-term borrowings. Thus, when fixed assets after depreciation are Rs. 4,00,000
and total long-term funds are Rs. 5,00,000, the fixed assets ratio as a percentage.
4,00,000
————— x 100 = 805
5,00,000
The ratio indicates the extent to which the total of fixed assets are financed by long
term funds of the firm. Generally, the total of the fixed assets should be equal to the total of
the long-term funds or, say, the ratio should be 1005. But in case the fixed assets exceed the
total of the long-term funds it implies that the firm has financed a part of the fixed assets out
of current funds or the working capital which is not a good financial policy. And
requirements is met out of the long-term funds of the firms.
VII) RATIO OF CURRENT ASSETS TO PROPRIETOR’S FUNDS
The ratio is calculated by dividing the total of current assets by the amount of
shareholder’s funds. For example if current assets are Rs. 2,00,000 and shareholder’s funds
are Rs. 4,00,000, the ratio of current assets to proprietor’s funds in terms of percentage would
be.
Current Assets
= ——————————— x 100
Shareholder’s funds

84
 2,00,000
= —————— x 100 = 50%
4,00,000
The ratio indicates the extent to which proprietor’s funds are invested in current
assets. There is no ‘rule of thumb’ for this ratio and depending upon the nature of the
business there may be different ratio for different firms.
VIII) DEBT SERVICE RATIO OR INTEREST COVERAGE RATIO
Net income to debt service ratio or simply debt service ratio is used to test the debt-
servicing capacity of a firm. The ratio is also known as Interest Coverage Ratio or Coverage
Ratio or Fixed Charges Cover or Times Interest Earned. This ratio is calculated by dividing
the net profit before interest and taxes by fixed interest charges.
Net Profit (before interest and taxes)
Debt-Service Ratio or Interest Coverage = ————————————————
Fixed Interest Charges

BOOKS SUGGESTED
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

85
GUIDELINE 6 : ROLE OF FINANCIAL MANAGER IN MODERN
ENVIRONMENT

A financial manager is a person who is responsible, in a significant way, to carry out

he finance functions. It should be noted that, in a modern enterprise, the financial manager
occupies a key position. He or she is one of the members of the top management team, and
his or her role, day-by-day, is becoming more pervasive, intensive and significant in solving
the complex funds management problems. Now his or her function is not confined to that of
scorekeeper maintaining records, preparing report and funds when needed, nor is he or she a
staff officer – in a passive role of an adviser. The finance manager is now responsible for
shaping the fortunes of the enterprise, and is involved in the most vital decision of the
allocation of capital. In his or her new role, he or she needs to have a broader and farsighted
outlook, and must ensure that the funds of the enterprise are utilized in the most efficient
manner. He or she must realize that his or her actions have far-reaching consequences for the
firm because they influence the size, profitability, growth, risk and survival of the firm, and
as a consequence, affect the overall value of the firm. The financial manager, therefore, must
have a clear understanding and a strong grasp of the nature and scope of the finance
functions.
The financial manager has not always been in the dynamic role of decision-making.
About three decades ago, he or she was not considered an important person, as far as the top
management decision-making was concerned. He or she became an important management
person only with the advent of the modern or contemporary approach to the financial
management. What are the main function of a financial manager?
Funds Rising
The traditional approach dominated the scope of financial management and limited
the role of the financial manager simply to funds raising. It was during the major events,
such as promotion, reorganization, expansion or diversification in the firm that the financial
manager was called upon to raise funds. In his or her day-to-day activities, his or her only
significant duty was to see that the firm had enough cash to meet its obligation. Because of
its central emphasis on the procurement of funds, the finance textbooks, for example, in the
USA, till the mid 1950s covered discussion of the instruments, institutions and practices
through which funds were obtained. Further, as the problem of raising funds was more
intensely felt in the special events, these books also contained detailed description of the
major events like mergers, consolidations, reorganizations and recapitalization involving
episodic financing. The finance books in India and other countries simply followed the
American pattern. The notable feature of the traditional view of financial management was
the assumption that the financial manager had no concern with the decision of allocating the
firm’s fund. These decisions were assumed as given, and he or she was required to raise the
needed funds from a combination of various sources.
The traditional approach did not go unchallenged even during the period its
dominance. But the criticism related more to the treatment of various topics rather than the
basic definition of the finance function. The traditional approach has been criticized because
it failed to consider the day-to-day managerial problems relating to finance of the firm. It
concentrated it self to looking into the problems from management’s the insider’s point of
view. Thus the traditional approach of looking at the role of the financial manager lacked a
86
conceptual framework for making financial decisions, misplaced emphasis on raising of
funds, and neglected the real issues relating to the allocation and management of funds.
Funds Allocation
The traditional approach outlived its utility in the changed business situation
particularly after the mid – 1950s. A number of economic and environmental factors, such as
the increasing pace of industrialization, technological innovations and inventions, intense
competition, increasing intervention of government on account of management inefficiency
and failure, population growth and widened markets, during and after mid-1950s,
necessitated efficient and effective utilization of the firm’s resources, including financial
resources. The development of a number of management skills and decision-making
techniques facilitated the implementation of a system of optimum allocation of the firm’s
resources. As a result, the approach to, and the scope of financial management, also changed.
The emphasis shifted from the episodic financing to the financial management, from raising
of funds to efficient and effective use of funds. The new approach is embedded in sound
conceptual and analytical theories.
The new or modern approach to finance is an analytical way of looking into the
financial problems of the firm. Financial management is considered a vital and an integral
part of overall management. To quote Ezra Solomon:
In this broader view the central issue of financial policy is the wise use of funds, and
the central process involved is a rational matching of advantages of potential uses against the
cost of alternative potential sources so as to achieve the broad financial goals which an
enterprise sets for itself.
Thus, in a modern enterprise, the basic finance function is to decide about the
expenditure decision and to determine the demand for capital for these expenditures. In other
words, the financial manager, in his or her new role, is concerned with the efficient
allocation of funds. The allocation of funds is not a new problem, however. It did exist in
the past, but it was not considered important enough in achieving the firm’s long run
objectives.
In his or her new role of using funds wisely, the financial manager must find a
rationale for answering the following three questions.

How large should an enterprise be, and how fast should it grow?

In what form should it hold its assets?

How should the funds required be raised?
As discussed earlier, the question stated above related to three broad decision areas of
financial management; Investment (including both long and short-term assets), financing and
dividend. The “modern” financial manger has to help making these decision in the most
rational way. The have to be made in such a way that the funds of the firm are used
optimally. We have referred to these decisions ss managerial finance functions since they
require special care and extraordinary managerial ability.
As discussed earlier, the financial decisions have a great impact on all other business
activities. The concern of the financial manager, besides his traditional function of raising
money, will be on determining the size and technology of the firm, in setting the pace and

87
direction of growth and in shaping the profitability and risk complexion of the firm by
selecting the best asset mix and financing mix.
Profit Planning
The functions of the financial manager may be broadened to include profit-planning
function. Profit Planning refers to the operating decisions in the areas of pricing, costs,
volume of output and the firm’s selection of product lines. Profit planning is, therefore, a
prerequisite for optimizing investment and financing decision. The cost structure of the firm,
i.e., the mix of fixed and variable costs has a significant influence on a firm’s profitability.
Fixed Costs remain constant while variable costs change in direct proportion to volume
change. Because of the fixed costs, profits, fluctuate at a higher degree than the fluctuations
in sales. The change in profits due to the change in sales is referred to as Operating
leverage. Profit planning helps to anticipate the relationships between volume, costs and
profits and develop action plans to face unexpected surprises.
Understanding Capital Markets
Capital market bring investors (lenders) and firms (borrowers) together. Hence the
financial manager has to deal with capital markets. He or she should fully understand the
operations of capital markets and the way in which the capital markets value securities. He or
she should also know-how risk is measured and how to cope with it in investment and
financing decision. For example, if a firm uses excessive debt to finance its growth, investors
may perceive, it as risky. The value of the firm’s sshare may, therefore, decline. Similarly,
investors maynot like te decision of a highly profitable, growing firms to distribute dividend.
They may like the firm to reinvest profits in attractive opportunities tht would enhance their
prospects for making high capital gains in the future. Investments also involve risk and
return. It is through their operation in capital markets that investors continuously evaluate the
actions of the financial manager.
BOOKS SUGGESTED
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

88
 UNIT - II
INVESTEMENT DECISIONS

The investment decision of a firm involves selecting the best possible alternative
investment proposal by analysing their risk and return. Every business, during the course of
their business operations, will be investing huge amount of capital on their business
operations. Most of this expenditure may be for acquiring long term assets or fixed assets
like plant and machinery, land and building and other capital equipment. These long term
assets are required for the purpose of generating sales which is the source of revenue. Since
these long term assets demand investment of huge amount of capital, usually sixty to seventy
percent of the total capital of the business, management usually will be very careful in the
capital expenditure decisions. Capital budgeting is the appropriate tool with which the
company analyses the pros and cons of the capital expenditure decisions and guides to invest
money in the most profitable investment opportunities. The terms capital expenditure
decisions, capital budgeting decisions and investment decisions are used inter changeably.

This unit covers the following concepts:

1. Time value of money

2. Capital Budgeting and its Process

3. Capital Budgeting Techniques

4. Modern Techniques of Capital Budgeting

5. Risk and Return

6. Analysis of Investment Decisions Under Risk and Uncertainty

89
GUIDELINE 7 : TIME VALUE OF MONEY

Time value of money is one of e important concepts of financial analysis. The study
of the time value of money is essential to understand the concept of the maximization of
corporate wealth, especially in understanding the process of investment decisions. In capital
expenditure decisions the benefits that a firm expects to receive from an investment are
usually spread out over a long period of time. Comparing of those future benefits with present
investment is not meaningful. Such benefits need to be translated into their present value so
as to facilitate their comparison with the initial investment and thereby to ascertain whether
the investment has really added something to corporate wealth or not. The concept of time
value of money is also relevant to the shareholders. The shareholders of the company
sometimes forego their present cash inflows in the form of dividends for the sake of future
benefits. They would like to know the present value of future benefits so as to find out
whether these future benefits exceed their present sacrifice. Their decision whether to prefer
dividends or retention of earnings depends on time value concept.
THE CONCEPT OF TIME VALUE
Time value of money deals with the basic fact that money received today is worth more
than money received tomorrow. In other words, an amount of money received in the future is
not as valuable as the same amount of money received in the present. This is because:
1. Future is Uncertain;
2. Preferences of individuals for early cash flows; (Bird in the hand principle)
3. Opportunity for Re-investment.
4. Impact of inflation.
The above points specifies that future cash inflows can be equated with present cash
inflows only when the investors benefited with adequate compensation for waiting for future
cash inflows. In other words the future cash inflows are equal to present cash inflows plus
some additional benefit as compensation. Suppose a person gets 10% per annum as interest
on a fixed bank deposit. He would be indifferent between the two options of getting Rs 100
today and receiving Rs 105 after a year. Here the sum:
(a) Rs 100 is the present value of the receipt.
(b) Rs 10 is the compensation for waiting.
(c) Rs 110 is the future value of the receipt.
It can also be said that the future value is the sum of the present value compounded at
a given rate of interest. The present value is therefore calculated be reverse compounding.
COMPUTATION OF FUTURE VALUE
Future Value of a Single cash flow
The future value of an amount at the end of period 1 (A1) will be equal to the product of the
initial investment (P) and the rate of interest for one year. This can be expressed as:

90
At the end I year = A1 = P (1 + r)
At the end II year = A2 = P(1+r)(1+r) or A2 = P (1+r)2
At the end n year = An = P(1+r)n
Example
If P is Rs 100 and r is 10%, What is ‘A’ ?
After 1st year ‘A’ = Rs 100x1.10 = Rs 110.
After 2nd year ‘A’ = Rs. 100 x 1.102 = Rs 121.
If n = 10 years,
After 10 years ‘An’ = A10 = Rs 100 (1.10)10 = Rs. 259.37
Normally, it is difficult to raise (1 + r) to the nth power. In order to overcome this
difficulty, one uses numerical tables. The present value is multiplied by the compound factor
(CF) given in the table in order to arrive at the future (P x CF r, n).
As per the table, the CF for 10% rate of interest for 10 years is 2.5937. On multiplying it
by Rs 100, one gets the future value as follows:
Rs 100 x 2.5937 = Rs 259.37
Future Value of a Series of Payments
When a series of receipts occurs over a specific period of time, the total future value
of these receipts can be found out by adding up the individual future values at the same future
time. If P1, P2, P3 and so on are the receipts, their future value at Period n will be:
An = P1 (1 + r) n-1 + P2 (1 +r)n-3 +…+Pn-1(1 + r) + Pn
Example:
The future value of a series of three annual receipts of Rs 1,000, Rs 500 and Rs 800
respectively at the end of the third year at 5% rate of interest will be:
A3 = Rs 100 (1.05)2 + Rs 100 (1.05) + Rs 100
A3 = 100 × 1.1025 + Rs 100 × 1.0500 + 100
A3 = 110.25 + 105 + 100 = 315.25
Future Value in Case of Annuities
Uniformity of cash flows represents a case of annuity. But there are cases when the
size of receipts over time is uniform. Annuity may be of two types:
1. regular annuity where the cash flows, equal in size, occur at the end of each time
period;
2. Annuity due where the uniform cash flows occur at the beginning of each period.
Irrespective of whether the cash flow occurs at the beginning or at the end of each period,
P is equal and so it becomes a common factor. The equation can be written in cases of
regular annuity as follows:
An = P {(1 + r) n-1 + (1 + r) n-2 + (1 +r) +1}

91
 or An = P [{(1 + r) n – 1}/r]
To minimise the complication in calculation, the equation can be expressed as:
An = P (ACF r, n – 1)
Example
The future value of an equal annual investment of Rs 1,000 at the end of a 10-year
period at 10% rate of interest will be:
Rs 1000 [{1.10)10 – 1}/0.10] = Rs 15937.40
Alternatively, P multiplied by ACF r, n – 1 and then divided by r will be: Rs 1000 x
1.59374/0.10 = Rs 15,937.40
In case of an annuity due where cash flows occur at the beginning of a particular
period, the amount is invested for the year. As a result, in this case, the equation can be
written as follows:
An = P [{1 + r) n -1)-1}/r] x (1 +r)
Example
The future value of equal annual investment of Rs 1,000 made at the beginning of
each year for 10 years at 10% rate of interest will be;
Rs 1000 [{(1.10)10 – 1}/ 0.10] x 1.10 = Rs 17,531.14
COMPOUNDING
The interest rates are usually given per annum. Compounding is also done on an
annual basis. Sometimes, compounding is done on a half- yearly or quarterly basis. In
specific cases, it is even done monthly. If the frequency of compounding increases, the future
value of the receipt will be greater. This is because the effective rate of interest per annum or
the Annual Percentage Yield (APY) is greater than the annual percentage rate (APR). The
greater the frequency of compounding, the greater is the APY and the larger the future value
of the receipt.
The effective rate of interest is calculated as follows:
APY = {1 + (APR/m)} m -1
Where:
M = the number of compounding periods per year
Example
If the annual interest rate is 12% and compounding is done on a monthly basis, the
APY will be:
{1 +(0.12/12)}12 – 1 = 12.68%.
COMPUTAION OF PRESENT VALUE OF CASH FLOWS
The present value of cash flow means today’s value of a future sum of cash inflows. If
today’s investment of Rs 100 at 10% rate of interest brings in Rs 110 after a year, the latter is
the future value and Rs 100 the present value. It means that if future value is found out
through compounding, the present value can be calculated through discounting.
92
Present value of a single amount
The formula for determining the future value (A1) of an amount of money (P) is given
in the following equation. Given the future value of an amount (A1) the formula for arriving
at its present value (P) can be derived as follows:
P = A1/ (1 + r)
The equation to arrive at P for Period n will be:
P = An/ (1 + r) n
Example
The present value of Rs 1000 to be received after 5 years at 10% rate of discount will be:
Rs 1000/(1.10)5 = Rs 621.
Present Value of a series Future Values
When a series of receipt occurs over a specific period of time, the present value of all
the future values can be found out by adding up the present value of individual future values.
If A1, A2, A3 and so on are the receipts during different years, their present value will be:
P= a1/ (1 +r0 + a2/ (1 +r)2 +…+An/(1+r)n
Summing up the above equation, we get:
Where:
n
∑ At/ (1+r)t
P=
t=1

Example
A1,A2 AND A3 are Rs. 2,000, Rs 3,000 and Rs 4,000 respectively. Therefore, the
present value at the discount rate of 5% will be:
P= Rs 2000/1.05 + Rs 3000/(1.05)2 + Rs 4000/(1.05)3 = Rs 8,801.
Present value in case of annuity
In case of an annuity, the value of A is uniform and so the present value (P) of an
annuity can be written in the form of an equation as follows:
Pa = a{1/(1 + r) + 1 / (1 +r)2 + 1/(1 +r)3 +…+1/(1 +r)n}
Or
Pa = a [{1-(1/1 +r)n}/r}
Alternatively, one can go for a tabular solution. In this process, the value of annuity is
multiplied by the annuity discount factor. It can be shown as:
Pa = a(adf r, n)
Example
The present value of an investment yielding Rs.1,000 annually for 20 years at a
discount rate of 8% will be:
93
 Rs 1000[{1-(1/1 +r)20}/0.08} = Rs 9,818,15
Alternatively,
Rs 1000(9.81815) = rs 9,818.15
If it is a case of annuity due which means that cash flows occur at the beginning of
each period, the result will be multiplied by (1 + r) and on the basis of above example, the
present value will be:
Rs 9818.15 x 1.08 = Rs 10,603.60
Special cases of Annuity
Perpetuity
There are some special cases of annuity. The first is perpetuity where annuity is
infinite. In other words, a perpetuity assures the investor/ owner of the funds, periodic cash
flows over an infinite period of time (at least in theory). It is normally found in case of
preference shares. Since n approaches infinity, the term {1/(1 +r)}n approaches zero. As a
result, the equation reduces to:
Pa = a [(1-0)/r] =A/r
Example
If a company offers an annual dividend of Rs 20 per share and the risk of investment
justifies a rate of return of 10%, the present value of perpetuity annuity will be:
Rs 20/0.14 = Rs 142.86
Deferred Annuity::
The other special case of annuity is deferred annuity. It is regular annuity with the
exception that the cash begins to flow only after the deferral period. If in a six-year annuity
the deferral period is 2 years, cash flows will begin at the end of the third year. In this case,
the present value of the cash flow during the deferral period will be subtracted from the
present value of the cash flow for the entire period.
Example
If the annual cash flow is Rs 500, the total period of annuity is 6 years and the deferral
period is 2 years, the present value at a rate of discount of 10% will be:
Rs 500 ( 4.35526 – 1.73554) = Rs 1,309.86
Present value of a cash flow with growth element:
There may be a situation where the future cash flows grow at given rates. The growth
element can be interpreted in two ways. The first is the arithmetic growth rate where the cash
flows grow at a constant rupee value. The second is the computation of the present value in
these differs slightly.
Arithmetic Growth Rate:
In this case, the process of computing the present value begins with splitting the cash
flows into two parts one being the amount of annuity (without growth element) and the other
being the growth value. The present value for both of them is computed separately and then
they are added up. This can be expressed in the form of an equation as follows:
94
 Pa= a (ADFr,n) + G(GDFr,n)
Where

n
∑ {1/(1+r)t}
t =t=1 ) – n {1/(1+r) n}

GDF r,n =
Example
An annuity stream for Rs 500 continues for a 5 year period. There is annul growth of
Rs 60. The present value of the total cash flow involving a rate of discount of 10% will be:
P= Rs 500(3.7908) + 1/0.10[3.7908- 5 (0.6209)] = Rs 2,307.18
Compound growth
In case of compound growth, cash flow grows at a certain percentage rate. A, be the
cash flow during Period 1, the cash flow during Period t would be A (1 +g)t. here g is the
growth rate.
The present value is computed in a similar manner as fixed annuity but, at the same
time, care is taken of the growth factor. The present value of an annuity with a growth factor
can be factor can be expressed as an equation as follows:
Pag = At/(r – g) [ 1-{(1 + g))/(1 + r)}n]
Example
A cash flow of Rs 500 grows for 4 years at the rate of 3%. The present value of this
growing annuity if the discount rate is 10% will be:
P3,4 = Rs 500/(0.10 – 0.03) [1 – {1.03)/(1.10)}4] = Rs 1,651.02
QUESTIONS
1. Briefly explain and illustrate the concept of ‘time value of money’
2. What is the different between the future value and present value?
3. What is annuity? Explain how can future value of an annuity be determined?
4. How is the present value of a mixed stream of cash flow calculated?
5. What is perpetuity? How may the present value for such stream of cash flow be
determined?
6. Describe the procedure used to mortise a loan into a serried of equal payments. What is a
loan amortisation schedule?
7. Explain briefly the effective rate of discount.
8. Distinguish between nominal rates of interest and effective rate of interest.
9. Explain the effective rates of interest and flat rates of interest.

95
10. Calculate the compound value of Rs 1,000 invested today to earn 10 per cent, if the
amount is invested for a period of (a) 46 days, (b) 182 days, (c) 364 days and (d) 2 years?
(Assume 360 days to a year)

PROBLEMS
1. The future value of equal annual investment of Rs 2,000 made at the beginning of each
year for 10 years at 10% rate of interest will be; Find out the future value.
2. Find the present value of the series. Discount rate = 10 per cent.
Year Amount (Rs)
1-5 125,000
6-10 28,000
11-15 136,000
3. Production Target (for 1997) = 5 million tones
Current Production (for 1991) = 2 million tones
What is the implied growth rate?
4. Exactly ten years from now Sri Murali will start receiving a pension of Rs 3,000 a year.
The payment will continue for sixteen years. How much is the pension worth now, if Sri
Murali’s interest rate is 10 per cent?
5. XYZ Bank pays 12 per cent and compounds interest quarterly. If Rs 1,000 is deposited
initially, how much shall it grow at the end of 5 years?
6. An annuity stream for Rs 1,0000 continues for a 5 year period. There is annul growth of
Rs 60. What will be the present value of the total cash flow involving a rate of discount of
10%.:
7. If a company offers an annual dividend of Rs 20 per share and the risk of investment
justifies a rate of return of 10%. What is the present value of perpetuity annuity.

BOOKS SUGGESTED
1. Managerial Finance : J.Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

96
GUIDELINE 8 : CAPITAL BUDGETING MEANING,
SIGNIFICANCE AND PROCESS

Capital budgeting is the process of evaluating and selecting long term investments
proposals that are consistent with the goal of shareholders’ wealth maximisation. Capital
budgeting decisions are of significant importance in financial decisions making. The
management thinks twice before spending huge amount of capital on various capital
expenditure decisions. The importance of capital budgeting stems from the point that the
business is investing money on various long term assets today with the hope of generating
funds in the future which is quite uncertain. Hence, the management has to be cautious before
making capital expenditure.
Capital budgeting decision of a firm has significant influence on its wealth. More
profitable investment proposal leads to maximum wealth to the firm. Introduction of a new
product, expansion of the plant, change in the methods of distribution, undertaking an
advertising campaign are some of the examples of capital budgeting decisions. Therefore, any
investment decision should be appraised in terms of its contribution to the wealth of the firm
and thereby maximizing the wealth of the shareholders.
IMPORTANCE OF CAPITAL BUDGETING
The following points ventilate the importance of Capital budgeting decisions in
practice.
1. Capital budgeting involves investing huge amount of financial resources. As such,
proper care should be taken to see that these funds are invested productively.
2. The capital expenditure decision requires long time span and inevitably affects the
companies future cost structure.
3. Capital investment decisions, once made, are not easily resolvable without much
financial loss to the firm.
4. Capital investment involves costs and majority of the firms have scarce capital
resources. Hence, they must be wise in capital expenditure.
5. The consequences of a wrong decision will be disastrous for the survival of the firm.
6. Since capital budgeting decisions are policy decisions, they are very crucial and affect
all the departments of the firm-production, marketing and so on.
PROCESS OF CAPITAL BUDGETING
1. Generation of New Ideas
The first step in capital budgeting process is generation of as many new ideas as
possible from different sources. The ideas may be generated by the top management itself or
the ideas may be invited from the consultants, or from professional magazines, government
agencies and so on. The ideas thus generated may be related to:
1. Expansion of existing operations
2. New operations

97
 3. Replacement of equipment or buildings
4. Research and development.
5. Exploration.
6. Others (Ex. acquisition of pollution control devices etc.,)
Investment proposals should be generated for the productive employment of firm’s
funds. However, a systematic procedure must be evolved for generating profitable proposals
to keep the firm healthy.
2. Evaluation of the Ideas
The ideas thus generated may be evaluated from two angles. Firstly, the idea may be
evaluated from the view point of restrictions of the government and legal aspects. The project
may be highly profitable venture but in view of government restrictions, implementation of
the project may not be practicable. Hence, the ideas are to be dropped. Secondly, the ideas
are to be evaluated from the core objectives and business philosophy of the company. In other
words, what ever may be the profitability of the idea; the new ideas should not affect the
existing business philosophy. For example, a company like Dabur which is manufacturing
health care products in India, giving an impression to the public that all the products of the
company are mainly to safeguard the health of Indian citizens. Therefore, it cannot enter into
any business for producing the products which effect the health of the citizens, like
production of liquor etc.
3. Business analysis
After making the fundamental screening, the company now analyses the ideas from
the business angle. The business analysis needs the following steps:
1. Estimating cash out flows
2. Estimating the life of the project
3. Estimating the cash inflows
4. Estimating the cash inflows after depreciation and taxes
5. Estimating the cash inflows on incremental basis
6. Application of capital budgeting techniques
Estimation of Cash flows
The first and important step in capital budgeting is estimation of future cash flows,
both inflows and outflows. Capital budgeting always analyses the cash flows generated from
the project but not the profit or income that comes from the project. If any project is to be
objectively evaluated, the benefits are to be measured in terms of cash flows rather than in
terms of income. It is because cash forms the crucial point for all decisions of the firm or
paid to shareholders in the shape of dividends. This is the reason why cash flows are
considered to be important.
Estimation of Life of the project
Cash flows occur in series over the entire life of the project. The life of the project
sometime has significant bearing on selection of the project. Hence, estimation of life of the
project forms another crucial step in capital budgeting.
98
The following example clarifies the process of estimation of cash flows and life of the
project.
Example: 1
Company X is planning to invest ten lakhs rupees in a project. The life of a project is
five years. The project is expected to generate rupees three lakhs per annum during its life.
The project is depreciated on straight line bases. The tax bracket of the company is fifty per
cent. Calculate cash inflows on after tax and depreciation.
Solution
Cash out flows = Rs.10,00,000 at time zero i.e., today.
The life of the project = 5 years
Depreciation per annum 10,00,000
_______________
(Straight line basis) = = 2,00,000
5 years
Cash inflows per annum before taxes and depreciation = Rs. 3 lakhs
Cash inflows per annum after taxes and depreciation are calculated as follows:
Net cash
inflows
Cash Cash inflows Taxes Cash
after
inflows Depreciation after inflows
Year taxes and
depreciation after taxes
depreciati
Rs. Rs. Rs. Rs. Rs.
on
Rs.
1 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
2 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
3 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
4 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
5 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000

The above table shows clearly the process for calculation of net cash inflows after
taxes and depreciation. These net cash flows after taxes and depreciation are used for
business analysis.
Net cash inflows after taxes and depreciation on incremental basis
The cash inflows on incremental basis are calculated in two ways. Let us assume that
the firm requires an initial cash out lay of Rs.10,00,000 and also generates the net cash
inflows after taxes and depreciation as shown in the earlier example 1.
After operating the same project for two years the company wants to sell of the
present equipment and purchase new equipment as the new equipment is supposed to be more
sophisticated and more productive than the old equipment. The new equipment needs an
investment of Rs. 14,00,000 and generates an annual cash inflow of 4,00,000 per annum for
five years. The tax bracket of the company as already stated is 50 per cent and depreciation is

99
calculated on straight line basis. In this case the incremental cash out flows and incremental
cash inflows are calculated as follows.
The present book value of the equipment = Initial Book Value – depreciation for two years
= Rs.10,00,000 – 4,00,000 (Rs.2,00,000 per year)
The present book value of old equipment = Rs. 6,00,000
The cost of new equipment = Rs.14,00,000
The incremental cash out flows = Rs.8,00,000 (14 – 6)
Incremental cash inflows are calculated as follows:
Cash
Cash Depreciation Taxes Cash Net cash
inflows
inflows inflows inflows after
after
after taxes and
depreciatio
taxes depreciation
n
Rs. Rs. Rs. Rs. Rs.
Rs.
1 4,00,000 2,80,000 1,20,000 60,000 60,000 3,40,000
2 4,00,000 2,80,000 1,20,000 60,000 60,000 3,40,000
3 4,00,000 2,80,000 1,20,000 60,000 60,000 3,40,000
4 4,00,000 2,80,000 1,20,000 60,000 60,000 3,40,000
5 4,00,000 2,80,000 1,20,000 60,000 60,000 3,40,000

Incremental Cash inflow = Cash inflows of Cash inflow of

New Machinery – old machinery
= 3,40,000 - 2,50,000(example 1 )
= 90,000
The project evaluated now by matching the incremental cash out flows of Rs.8.00.000
and incremental cash inflows of Rs. 90,000 per annum.
Example: 2
Company ABC limited is planning to invest twenty lakhs rupees in a project. The life
of the project is five years. The project is expected to generate rupees six lakhs per annum
during its life. The project is depreciated on straight line basis. The tax bracket of the
company is fifty per cent. Calculate cash inflows on after tax and depreciation.
Solution
Cash out flows equals to Rs.20.00.000 at time zero i.e., today.
The life of the project = 5 years
Cash inflows per annum before taxes and depreciation = Rs. 6 lakhs

100
Cash inflows per annum after taxes and depreciation are calculated as follows:
(In Rupees)
Cash Net cash
Cash inflows
Cash inflows inflows after
Depreciation after
Year inflows Taxes after taxes and
Rs. depreciation
taxes depreciation
Rs. Rs.
Rs.
Rs. Rs.
1 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000
2 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000
3 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000
4 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000
5 6,00,000 4,00,000 2,00,000 1,00,000 1,00.000 5,00,000

Example 3
A company is presently operating with a lathe machine which involved an investment
of Rs.20.00.000 initially. The life of the machine is 10 years and is expected to generate cash
inflow of Rs.4.00.000 per annum. After operating the machine for 4 years the company has
come across a sophisticated lathe machine which needs an investment of Rs.30.00.000. The
life of the machine is 10 years and generates an income of Rs.8.00.000 per annum. The
company has to purchase this new machinery in view of the prevailing competition in the
market. The company is paying a tax rate of 50%. Calculate the incremental cash out flows
and incremental cash inflows.
Solution
The present book value of the lathe machine = (initial book value – depreciation for
four years)
= Rs.20.00.000 – 8.00.000
(DepreciationRs.2.00.000per year)
The present book value of old lathe machine = Rs.12,00,000
The cost of new lathe machine = Rs.30.00.000
The incremental cash out flows = Rs.18.00.000 (30 – 12)
Incremental cash inflows are calculated as follows:

101
Cash inflows on old machine:
Depreciat Taxes Net cash
Cash Cash inflows Cash
-ion inflows after
inflows after inflows
Year On old taxes and
depreciation after taxes
machine depreciation
Rs. Rs. Rs.
Rs. Rs. Rs.
1 4,00,000 2,00,00 2,00,000 1,00,000 1,00,000 3,00,000
2 4,00,000 2,00,00 2,00,00 1,00,000 1,00,000 3,00,000
3 4,00,000 2,00,00 2,00,00 1,00,000 1,00,000 3,00,000
4 4,00,000 2,00,00 2,00,00 1,00,000 1,00,000 3,00,000
5 4,00,000 2,00,00 2,00,00 1,00,000 1,00,000 3,00,000

Depreciat Net cash

Cash Cash inflows Cash
ion Taxes inflows after
inflows after inflows
Year On New taxes and
depreciation after taxes
machine depreciation
Rs. Rs. Rs.
Rs. Rs.
Rs.
1 8,00,000 3,00,000 5,00,000 2,50,000 2,50,000 5,50,000
2 8,00,000 3,00,000 5,00,000 2,50,000 2,50,000 5,50,000
3 8,00,000 3,00,000 5,00,000 2,50,000 2,50,000 5,50,000
4 8,00,000 3,00,000 5,00,000 2,50,000 2,50,000 5,50,000
5 8,00,000 3,00,000 5,00,000 2,50,000 2,50,000 5,50,000

Incremental Cash inflow = Cash inflow of Cash inflow of

New Machinery – Old machinery
= Rs 5,50,000 _ Rs 3,00,000
= 2,50,000
Cash flows Vs Accounting profit
Investment decisions are evaluated on the basis of cash flow analysis. In other words,
the cash outflows and cash inflows of a project are estimated and analyzed for the purpose of
evaluating investment proposals. The investment decisions never consider the profitability on
a project for accepting or rejecting the project. The idea behind the cash flow analysis is that
it is the cash that is invested in the project and in turn it is estimated what is the cash
generated by the project. The difference between cash flows and profitability is understood
from the following illustration.

102
Example: 4
Company Y is planning to invest 20 lakhs rupees in a project. The life of a project is
five years. The project is expected to generate rupees six lakhs per annum during its life. The
project is depreciated on straight line bases. The tax bracket of the company is fifty per cent.
Calculate accounting profit cash inflows on after tax and depreciation.
Solution
Cash out flows = Rs.20,00,000 at time zero i.e., today.
The life of the project = 5 years
Depreciation per annum 20,00,000
_______________
(Straight line basis) = = 4,00,000
5 years
Cash inflows per annum before taxes and depreciation = Rs. 6 lakhs
Cash inflows per annum after taxes and depreciation are calculated as follows:
Cash Net cash
Cash inflows
Cash inflows inflows after
after
Year inflows Depreciation Taxes after taxes and
depreciation
taxes depreciation
Rs. Rs. Rs.
Rs.
Rs. Rs.
1 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000
2 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000
3 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000
4 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000
5 6,00,000 4,00,000 2,00,000 1,00,000 1,00,000 5,00,000

The accounting profit of the project is Rs.1,00,000 which is arrived at after deducting
the taxes from the cash inflows. Whereas, the cash inflows are
Rs. 5,00,000, calculated by adding depreciation to the accounting profit.

QUESTIONS
1. What is capital budgeting? What is its significance?
2. Explain the concept of capital budgeting. How a firm would be benefited by it?
3. Discuss the major steps involved in capital budgeting process.
4. As a financial manager of a firm, how do you go about capital budgeting?
5. Explain the steps involved in Capital Budgeting process.
6. Explain the difference between cash inflows and accounting profit with suitable
illustration.

103
PROBLEMS
1. Company XYZ Ltd is planning to invest 20 lakhs rupees in a project. The life of a project
is 8 years. The project is expected to generate rupees Rs.3.5 lakhs per annum during its
life. The project is depreciated on straight line bases. The tax bracket of the company is
55 per cent. Calculate cash inflows on after tax and depreciation.
2. Take the date of first problem. After operating the same project for two years the company
wants to sell off the present equipment and purchase new equipment as the new
equipment is suppose to be more sophisticated and more productive than the old
equipment. The new equipment needs an investment of Rs. 34,00,000 and generates an
annual cash inflow of Rs.6,00,000 per annum for five years. The tax bracket of the
company as already stated is 55 per cent and depreciation is calculated on straight line
basis. In this case the incremental cash out flows and incremental cash inflows are
calculated as follows
3. Company ABC limited is planning to invest 5 lakhs rupees in a project. The life of the
project is five years. The project is expected to generate rupees one lakh per annum
during its life. The project is depreciated on straight line basis. The tax bracket of the
company is fifty per cent. Calculate cash inflows on after tax and depreciation.
4. Company z is planning to invest 10 lakhs rupees in a project. The life of a project is five
years. The project is expected to generate rupees 3 lakhs per annum during its life. The
project is depreciated on straight line bases. The tax bracket of the company is fifty per
cent. Calculate accounting profit cash inflows on after tax and depreciation.
BOOKS SUGGESTED
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

104
GUIDELINE 9 : TECHINQUES OF CAPITAL BUDGETING

Capital budgeting techniques are applied to take major investment decisions. The first
step in the capital budgeting process is estimation of cash flows, both cash in flows and
outflows. Once the cash flows are estimated, different techniques of capital budgeting are
applied in order to take decisions to accept the project or to reject the project. All the
techniques of capital budgeting are broadly classified as Traditional Techniques and Modern
Techniques of Capital Budgeting
The Traditional Techniques of Capital Budgeting are:
1. Payback Method
2. Accounting Rate of Return on Investment (ARORI)
Modern Techniques of Capital Budgeting are:
1. Net Present Value (NPV)
2. Internal Rate of Return Method (IRR) and
3. Profitability Index (PI)

Appraisal Criteria

Non-DCF Criteria DCF Criteria

Payback Accounting Net Present Internal Profitability

Period Rate of Return Value Rate of Return Index

PAY BACK METHOD

Pay back method is also known as pay off method. In this method the pay back
period is calculated in number of years, required to recover the initial investment in the
project. When the project generates fixed annual cash inflows, the payback period is
calculated by dividing the initial investment with annual cash inflows.
Initial Cash Outlay
Pay Back Period =
Annual cash inflow

105
 For example, A project has initial cash outflow Rs. 10,00,000 and a constant annual
cash inflow of Rs. 3,00,000, before depreciation and taxes. The company is following a
straight line depreciation policy and the tax rate is 50 per cent. Then, the pay back period is
calculated as follows:
Cash
Cash Tax inflows Net Cash inflows
inflow Cash flow after after after
depreciation @50 depreciation and
Year Depreciati Taxes
% Taxes
on Rs.
Rs. Rs. Rs.
Rs. Rs.
1 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
2 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
3 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
4 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
5 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000

Pay Back Period = Initial cash outlay

-----------------------
Annual cash inflow

10, 00,000
= ------------ = 4 years
2, 50,000
When the annual cash inflows of the project are not fixed and vary from year to year
the pay back period is calculated by equating the initial cash outlay with cumulative net cash
inflows after taxes and depreciation.
Example:
Initial Cash outlay is Rs. 10,00,000,
The annual cash inflows for 5 years are;
1 year – Rs. 3,00,000
2 nd year- Rs. 4,00,000
3 rd year – Rs. 3,00,000
4 th year – Rs. 4,00,000
5 the year – Rs. 4,00,000

106
Solution
Tax
Depreciation Cash flow Cash Net Cash
Cash
after @50% inflows inflows after
inflow
Year depreciation after depreciation
Taxes and Taxes
Rs. Rs. Rs. Rs.
Rs. Rs.
1 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
2 4,00,000 2,00,000 2,00,000 1,00,000 1,00,000 3,00,000
3 3,00,000 2,00,000 1,00,000 50,000 50,000 2,50,000
4 2,00,000 2,00,000 0 0 0 2,00,000
5 4,00,000 2,00,000 2,00,000 1,00,000 1,00,000 3,00,000

Then, the cash inflows are added up to find out with in what period of time, the cash
outflow of 10,00,000 will be recovered. From the above example the payback period is 4
years. (Rs 2,50,000 + 3,00,000 + 2,50,000 + 2,00,000)
Cash outflow = 10,00,000
Cash inflow 1= 2,50,000
2 = 3,00,000 10,00,000
3 = 2,50,000
4 = 2,00,000

When a project is to be selected among the available projects the project with a
shorter pay back period is selected. For example, projects A,B,C and D have the pay back
period of 5,4,3 and 4 year respectively. Then project C whose Payback period is only 3 years
is preferred.
Accepted or Project Rule
According to the pay back criterion, the shorter the payback period, the more desirable
the project is. Every firm will be having its own pre-determined pay back period with in
which it wants to recover its investment. If the project’s pay back period is less than pre-
determined payback period of the company, the project is selected or other wise, the project
is rejected. For example, no project is selected among A, B, C and D projects (mentioned
above) when the predetermined pay back period of the company is 2 years. Because all
projects have pay back period more than the company’s predetermined pay back period.
Merits of Pay Back Method
1. It is very simple and widely used concept.
2. It doesn’t involve any complicated calculations and assumptions.

107
3. Since, it always favors a project with less pay back period, it minimises the risk in the
business. It helps in weeding out the risky projects.
4. The cost of application of method is less.
5. This is an appropriate method for firms with liquidity crises as it emphasises more and
early cash inflows.
Demerits of Pay Back Method
1. There is no rationality in fixing the predetermined pay back period for the company.
2. It doesn’t give importance to time value of money.
Example, Project A and B are similar in all respects. The cash outflow for both projects is
Rs 10,00,000. The cash inflows are as flows:
Project A Project B
Rs. Rs.
1 Year 7,00,000 3,00,000
2 year 3,00,000 7,00,000
An analysis of cash inflows indicates that project A is preferable to Project B as
project ‘A’ is generating Rs 7,00,000 in the first year itself. But according to payback
method, both the projects are same as the payback periods are same.
3. This method doesn’t give importance to the cash inflows after the recovery of initial
cash outflow.
Example

Year Cash flow of Cash flow of

Comp ‘A’ Company ‘B’

0 DIVEDEND
Rs.1,00,000 DECISIONRs. 1,00,000
1 Rs. 50,000 Rs. 45,000
2 Rs. 30,000 Rs. 35,000
3 Rs. 20,000 Rs. 15,000
4 Rs. 0 Rs. 50,000

The above table shows that the payback period of company A is 3 years and Company
B is more than 3 years. Hence, the payback technique says that company A is preferable to
Company B. But, a careful analysis of cash inflows indicates that the company B is
preferable to company A in all respects. Any rational investor prefers company B to
Company A, in view of considerable cash inflow in the fourth year for the project B
4. This technique is not a measure of profitability.
ACCOUNTING RATE OF RETURN ON INVESTMENT (ARORI)
The accounting rate of return on investment is calculated by dividing the average cash
inflows after depreciation and taxes by the average investment. i.e. average book value of
108
investment after depreciation. In other words, it is the ratio of average cash inflows after
depreciation and taxes to average investment. The difference between ARORI and ROI is, in
the case of ROI the ratio of annual profit is calculated as a percentage of average investment.
Whereas, in the case of ARORI the average cash inflows are taken as a percentage of average
investment. The difference between profit and cash inflows is already explained.
However, some experts in the area of finance feel that taking average accounting
profits as a ratio of average outflows is more appropriate measure of ARORI. All the
examples are given,taking average accounting profits instead of average cash inflows as a
ratio of average outflows.
The following illustration explains clearly the concept of calculation of ARORI on the
basis of cash inflows.
Example
Determine the average rate of return from the following data of two machines, A and B.
Particulars Machine A Machine B
Cost Rs.60,000 Rs 56,125
Annual estimated income after
depreciation and income tax:
Year 1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375
5 11,375 3,375
_________ _________
Total Cash Inflows 36,875 36,875
_________ _________
Estimated life (years) 5 5
Estimated salvage value 3,000 3,000
Depreciation has been changed on straight line basis.
Solution
Average income
ARR= × 100
Average investment

Rs 36,875
Average income of both the Machines A and B = = Rs 7,375
5
Average investment of A = Salvage value + 1/2 (cost of machine – salvage value)
= Rs.3,000 +1/2( Rs.60,000 – Rs.3,000) = Rs.31,500

109
Average investment of B = Rs 3,000 + 1/2 (Rs 56,125 – Rs 3,000) = Rs 29,562.50
AROR I (for machines A) = Rs. 7,375/Rs.31,500 x100= 23.73 per cent
AROR I (for machines B) = Rs 7,375/Rs.29,562.50x100=24.9 per cent
Accept or Reject Criteria
A project is accepted when accounting rate of return on investment is more than
predetermined or required rate of return of a company. Other wise the project is going to be
rejected. All the projects which are analyzed with the help of ARORI are ranked in
descending order, starting with the proposal with the highest ARORI and ending with the
proposal having the lowest ARORI. The project which gives higher accounting rate of return
is preferred to lower accounting rate of return.
Merits of the Method
1. It is simple and easy to calculate.
2. It averages the benefits over the life of the project.
3. It follows many accounting principles with which the financial manager is very
familiar.
Demerits of the Method
1. It doesn’t consider time value of money.
2. This method is not at all rational when there is wide gap and difference between cash
flows of one year and the other.
3. Averaging of cash inflows and averaging of cash outflows does not provide any
scientific basis for evaluation in financial management.
Example
Assume that a project entails Rs. 60,000, its scrap value being Rs. 15,000. Its income
before depreciation and taxes during the first three years is Rs. 25,000, Rs. 30,000 and Rs.
35,000 respectively. Assuming tax rate at 50% and depreciation on straight line basis,
accounting rate of return can be calculated as follows:
Computation of ARR
First Second Third Average
Year Year Year
Earnings before Depreciation and taxes 25,000 30,000 35,000 30,000
Less Depreciation 15,000 15,000 15,000 15,000
Earnings before taxes 10,000 15,000 20,000 15,000
Less Tax @ 50% 5,000 7,500 10,000 7,500
Earnings after Taxes 5,000 7,500 10,000 7,500
Investment
Beginning of the year 60,000 45,000 30,000
Ending of the year 45,000 30,000 15,000
Average 52,500 37,500 22,500 37,500

110
 AROR = Average Income

Average Investment

= 7,500 x100= 20%

37,500
If the average rate of return is higher than the rate established by management, the
project would be selected, otherwise it will be rejected.
QUESTIONS
1. What is the importance of capital budgeting appraisal? What are the methods available
for it?
2. Explain the merits and demerits of Payback Method. Illustrate the computation of
payback period.
3. How do you calculate the accounting rate of return? What are its shortcomings?
4, Pay back technique does not give importance to time value of money. Comment.
5. Capital expenditure decisions involve huge amount of capital.
PROBLEMS
1. A company is considering an investment of Rs 50,000. The facility has a life expectancy
of 5 yeas and no salvage value. The tax rate is 35 per cent. Assume the firm uses straight
line depreciation and the same is allowed for tax purposes. The estimated cash flows
before depreciation and tax from the investment proposal are as follows: 1st year-
Rs.10,000. 2nd year Rs.12,000, 3rd year Rs12,000, 4th year Rs. 10,000, 5th year
Rs.11,000.Calculte
i. Pay back period,
ii. Average rate of return.
2. The project requires an investment of Rs. 2,00,000. It yields an annual cash flow of Rs.
40,000 for first three years and Rs 20,000 thousand for next 6 years. Find out the
payback period of the project.
3. Cash flows of projects X and Y requiring an investment of Rs 3,000 each are given
below:

111
Year Cash Flow (After Taxes) Depreciation
X Y X Y
1 1,300 900 600 600
2 1,100 900 600 600
3 900 900 600 600
4 640 900 600 600
5 640 900 600 600
Total 4,580 4,500 3,000 3,000

The cash flow includes Rs 40 as interest payment for each year. Find out the average
rate of return. TAXE ARE AT THE RATE OF 60%.

BOOKS SUGGESTED
1. Financial Management and Policy : James C. Van Home
2. Managerial Finance : J. Fred Weston Eugene
F. Brigham
3. Financial Management : I.M. Pandey
4. Financial Decision Making Concepts
Problems and Cases : John J. Hampton
5. Management Finance : Varanasy S. Murty

112
GUIDELINE 10 : MODERN TECHNIQUES OF CAPITAL
BUDGETING

All the modern techniques of capital budgeting are also known as Discounted Cash Flow
(DCF) techniques or Time Adjusted Techniques. As the name suggests, in these methods of
capital budgeting, the cash flows are discounted at a particular discounting factor to find out
their present values. Thus, present values of all the cash inflows are compared with present
values of cash outflows or initial cash investment in order to evaluate whether the project is
worth taking or not. Thus the discounted cash flow techniques involve the following steps.
1. Estimation of cash outflows or initial investment.
2. Estimation of cash inflows.
3. Estimation of the discounting factor appropriate to the technique of capital budgeting
applied for evaluation of the project.
4. Estimation of cost of capital. Cost of capital is the minimum required rate of return to
be earned on the project. Sometimes, cost of capital may be used as the discounting
factor.
5. Estimation of life of the project.
The following are the modern techniques or DCF techniques for capital budgeting.
1. Net Present Value
2. Internal Rate of Return
3. Profitability Index
Net Present Value
Net present value of cash inflows of a project may be described as the summation of
the present values of cash inflows in each year minus the present values of total net cash
outflows. Symbolically,

CF1 CF2 CF3 CFn

NPV = 1
+ 2
+ 3
................ − CF0
(1 + k ) (1 + k ) (1 + k ) (1 + k ) n

n
CFt
= ∑
t =1 (1 + k )t
− CF0

NPV = Net Present value.

CFt = Cash flow at the end of every year t.
n = Life of the project.
k = Discounting factor or cost of capital.
CF0 = Cash outflow or initial investment

113
 The above equation indicates that all the cash inflows during time period ‘t’ are
discounted at a discounting factor k. The discounting factor used in this is known as cost of
capital. The discounting factor reflects the risk of the project. The higher the risk of the
project, the more will be the K. To illustrate the calculation of NPV, Consider a project which
has the following cash flows stream.

Year Cash Flow

Cash outflow at time 0 Rs. 1,00,000

Cash inflows 1 Rs. 2,00,000

2 Rs. 2,00,000
3 Rs. 3,00,000
4 Rs. 3,00,000
5 Rs. 3,50,000
The cost of capital for the firm is 10 per cent.

2, 00, 000 2, 00, 000

NPV = 1
+ +
(1.10) (1.10) 2

3, 00,000 3, 00, 000 3,50, 000

3
+ 4
+ − 10, 00, 000 = 5, 278
(1.10) (1.10) (1.10)5
The net present value represents the net benefit over and above the compensation for
time and risk. Hence the decision rule associated with the net present value criterion is:
Accept the project if the net preset value is positive and reject the project if the net present
value is negative. (If the net present value is zero, it is a matter of indifference.)
Accepting and Rejecting Rule
When the present value of total cash inflows are more than or equal to present value
of total cash outflows, the project is accepted. Otherwise; the project is rejected.
According to NPV method the project is Accepted or Rejected on the following criteria.
NPV ≥ 0 ------- ACCEPT THE PROJECT
(‘0’ NPV implies that all the present values of cash inflows
are equal the present values of cash outflows. Still the project is
accepted because the project is ensuring the earning of K, the
minimum required rate of return on the project.)
NPV < 0 ------- REJECT THE PROJECT

114
Merits
1. It takes into account of the time value of money.
2. This method takes into consideration the objective of financial management that is
maximisation of the wealth of the share holders.
3. This method is very useful for the selection of mutually exclusive projects.
4. The net present values of various projects can be calculated at a time.
5. Since the cost of capital, K, is determined by the firm itself on the basis of risk
involved in the business, the K is most appropriate discounting factor.
Demerits
1. This method does not give scope for correct caparison of two projects when they differ
in span of life.
2. The time of cash inflows and size of cash inflows also create confusion in the
evaluation of project.
3. The discounting factor, K, is decided by the investor, sometimes without proper base
and logic.
4. It involves many mathematical calculations.
INTERNAL RATE OF RETURN (IRR)
The second import DCF technique of capital budgeting is internal rate of retune
method (IRR). The internal rate of return is defined as the discount factor which equates
the present values of the net cash inflows with the present value of cash out flows of a
project. In other words, the internal rate of return makes the net present value equal to 0.
Steps in determining IRR
The equation that is used in NPV method is same as the equation that is followed for
IRR method. In case of NPV method K is used as the discounted factor to find out the
present value of cash flows, whereas in the case of IRR method r is used as the
discounting factor. K, the cost of capital is known to the investor as it depends on his risk
perception. On the other hand, r is an on known discounting factor which has to be
arrived at. K is the expected rate of return or the required rate of return on investment,
whereas as r, the internal rate of return that is actually generated in the business.
When the cash flows are uneven the r is identified by trial and error process. On other
hand when the cash flows are even the r is determined by equating the net present value
of the project to 0.
Mathematically, the IRR can be written as follows:
CF1 CF2 CFn
CF0 = 1
+ 2
..........
(1 + r ) (1 + r ) (1 + r ) n
n
CFt
CF0 = ∑
t =1 (1 + r )t

115
Where,
CF0= Cash out flow at time 0
CFt = cash flow during time period t
r = discount rate
n = life of the project.
In the net present value calculation we assume that the discount rate (cost of capital)
is known and determine the net present value of the project. In the internal rate of return
calculation, we set the net present value equal to zero and determine the discount rate
(internal rate of return) which satisfies this condition.
The following example illustrates the process of identifying the IRR
Illustration
Initial out lay of the project = Rs 16,000
Cash inflows of Rs 8,000, Rs. 7,000 and Rs.6,000 at the end of each year for next 3
years.( After taxes and depreciation.) Calculate IRR.
Solution
It is understood IRR equates present values of inflows and outflows exactly. In other
word the NPV is zero.
Arbitrarily let us stat with IRR of 20 per cent (discount rat. The project’s NPV at 20 per
cent is:
NPV = Rs 16,000 –( Rs 8,000 (PVF 1,020) + 7.000 (PVF2,020) + RS 6,000(PVF 3,020))
=-Rs 16,000-(RS 8,000×0.833+Rs7,000×0.694+ Rs 6,000× Rs 14,996)
= Rs1,004
It indicates that 20% is not IRR as the PV of inflows are not equalant to PV of outflows.
Let us try with 16% as the discount rate (IRR).
At 16 per cent, the projects NPV is:
RS 16,000 –( Rs7,000(PVF2,016) NPV = +Rs 8,000(PVF 1,016
+ RS 6,000 (PVF 3,016))
= Rs 16,000-(RS 8,000×0.862+Rs7,000×0.743
+ Rs 6,000×0.641)
= -Rs 16,000-Rs 15,943=Rs57
It indicates that 16% is not IRR as the PV of inflows are not equalant to PV of outflows.
When 15 per cent as the trial rate, we find that the project’s NPV is Rs 200.
NPV=-Rs16,000-(Rs8,000(PVF1,015)+Rs7,000(PVF2,015)
+ Rs 6,000 (PVF 3,015))

116
 = -Rs 16,000-(Rs 8,000×0.870+Rs7,000×0.756
+ Rs 6,000×0.658)
= Rs 16,000-Rs 16,200=-Rs200
Since the NPV are closer. The IRR should lie between 15-16 per cent. IRR is found
out by the method of linear interpolation as follows:

Difference
PV required Rs 16,000
200
PV at lower rate, 15% 16,200
257
PV at higher rate, 16% 15,943
IRR= 15% + (16%-15%) 200/257
= 15%+0.80% =15.8
Accept – Reject Decision
In IRR method, a project is accepted when IRR is grater than or equal cost of capital
(K). It the IRR is equal to cost of capital (K) the project is still accepted because the
required of return is equal to the expected the rate of return. If the IRR, the internal rate of
return is less than the required rate of return the project is rejected.
r ≥ k ------ ACCEPT THE PROJECT

r < k ------ REJECT THE PROJECT

Merits
1. Time value of money is taken into consideration.
2. By discounting with r, this method exactly estimates the actual return from the project.
3. This method is consistent with objective of financial management.
4. This method considers the total cash inflows through out the life of of project for
calculating r.

Demerits
1. It involves more mathematical calculations.
2. The method gives deceptive results when the project life varies.
3. This method gives different results when the cash inflows and outflows vary.
4. This method does not specify the superiority of using r instead of K

117
PROFITABILITY INDEX
The third important technique of discounted cash flow techniques is Profitability Index
method. Profitability Index (PI) is calculated with the help of ratio of present value of cash
inflows to present value of cash out flows. In other words, it is a measure of present value of
cash inflow generated for every present value of a rupee invested. The steps involved in the
calculation of PI are similar to that of steps in NPV. In the case of NPV, the difference
between present value of cash inflow and present value of cash outflow is calculated. Where
as in the case of PI, the ratio of present value of cash inflows and cash outflow are measured.
PI is considered as a superior method to NPV method, because NPV evaluates the project in
absolute terms and PI evaluates the project in relative terms.
Thus,
PI = Present Value of Total Cash inflows
---------------------------------------------
Present Values of Cash Outflows
Mathematically,
n
CFt
∑
t =1 (1 + k )t
PI =
CF0
Where,
PI =Profitability Index
CFt = Cash flows during time period t
CF0 = cash outflows in the beginning of the year
k = Cost of capital
n = Life of the project
Steps in the Calculation of PI
1. Identify the cash Inflows through out the life of project,
2. Identify the discounting factor, K, is used as the discounting factor,
3. Calculate the present values of cash inflows by discounting with discounting factor,
4. Calculate the present values of cash outflows,
5. Find out PI by establishing the ratio of PV of inflows and out flows.
Accept- reject rule
The project proposal is accepted when the PI is more than one. The firm may be
indifferent to accept or reject when the PI is equal to one, When PI is less than one, the
project is rejected.
PI ≥ 1 ------ ACCEPT THE PROJECT
PI < 1 ------ REJECT THE PROJECT

118
Illustration
The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of Rs
40,000, in first year, Rs 30,000, in second year, Rs 50,000 and Rs 20,000 in fourth year.
Assume a 10 per cent rate of discount. The PV of cash inflows at 10 per cent discount rate is:
Year Cash inflow PV factor@10%
1 40,000 × .909 +
2 30,000 × .826 +
3 50,000 × .751 +
4 20,000 × .681

PV of cash inflows = 1,12,350

Out flows = 1,00,000

P1 = PV of cash inflows

Out flows
= 1,12,350
= 1.1235
1,00,000

The project is accepted since PI is more than 1

Merits:
1. It recognises the time value of money.
2. It is consistent with the shareholder value maximisation principle. A project with PI
greater than one will have positive NPV and if accepted, it will increase share-holders’
wealth.
3. This method not only measures acceptability of the project but also specifies relative
measure of a project’s profitability.

Demerits
1. This method does not give scope for correct comparison of two projects when they
differ in span of life.
2. The time of cash inflows and size of cash inflows also create confusion in the
evaluation of project.
3. The discounting factor, K, is decided by the investor, sometimes without proper base
and logic.
4. It involves many mathematical calculations.

119
WORKED OUT PROBLEMS
Problem 1
A firm is faced with the problem of choosing between two mutually exclusive projects.
Project X requires a cash outlay of Rs. 2,00,000 and cash running expenses of Rs. 70,000 per
year. On the other hand, project Y will cost Rs. 3,00,000 and require cash running expenses
of Rs. 40,000 per year. Both the machines have a eight-year life. Project X has a Rs. 8,000
salvage value and Project Y has a Rs. 28,000 salvage value. The firm’s tax rate is 50 per cent
and has a 10 per cent required rate of return. Assume depreciation on straight line basis.
Which project should be accepted?
Solution:
Project -X Project-Y Differential
Cash flow Net Cash Flow
Rs. Rs. Rs. Rs.
Cash Outlay 2,00,000 3,00,000 -1,00,000 -1,00,000
Cash running expenses before taxes 70,000 40,000 30,000
(for 8 yrs)
Taxes on expenses saving (for 8 years) -15,000 15,000
Net Savings Depreciation (for 8 years) 24,000 34,000 10,000
Tax savings on dep. (for 8 yrs.) 5,000 5,000
20,000
Net Savings (total) Salvage (at the end of
8th year) 8,000 28,000 20,000 20,000
Thus if Project Y is chosen it would require an additional outlay of Rs. 1,00,000 but
would save in term of cash inflows Rs. 20,000 each year. This project should be accepted if
it has a positive net present value at a 10% discount rate.
PV of Rs. 20,000 each for eight years @ 10%
20,000 5.335 = 1,06,700
PV of Rs. 20,000 at the end of eight
year @ 10% 20,000 0.467 = 9,340
1,16,040
Cash outlay = 1,00,000
Net Present Value = 16,040
As Project Y will offer whatever Project X offers and also helps in generating an
additional net present value of Rs.16,040. It should be preferred over Project X.
Problem No. 2
Prasad Company is using a fully depreciated machine having a current market value of
Rs.40,000 (the machine was purchased fifteen years before for Rs. 1,80,000). The salvage
value of the machine fifteen years from now would be zero.
120
 The company is considering to replace this machine by a new one costing Rs. 2,05,000
and having estimated salvage value of Rs. 25,000. With the use of new machine, annual sales
are expected to increase from Rs. 1,60,000 to Rs. 1,85,000. Operating efficiencies with the
new machine will save Rs. 25,000 per year as operating expenses. Depreciation will be
charged on straight-line basis. The cost of capital is 10 percent. The new machine has a 15
years life and the company’s taxation rate is 50 percent on ordinary income and 35 percent on
capital gains.
On a differential basis, show whether the company should replace the old machine or
not?
Solution:
The initial cash outlay will consist of (1) the payment for the cost of new machines (2)
cash proceeds from the sale of old machine and (3) effect of tax on capital gains. In this
problem, the new machine has a cost of Rs. 2,05,000, but the company has to pay tax on
capital gain arising out of the sale of old machine. The old machine, having zero book value,
is sold for Rs. 40,000; therefore tax on capital gain is Rs. 14,000 (35 per cent on Rs. 40,000).
The company will receive Rs. 40,000 from the sale of old machine.
Net Cash Outlay:
Cost of new machine Rs. 2,05,000
Add : Capital gain tax 14,000
Rs. 2,19,000
Less: Sale proceeds of old machine 40,000
Rs. 1,79,000
Calculation of Differential Cash Flows:
Increase in sales (Rs. 1,85,000 - Rs. 1,60,000) Rs. 25,000
Savings in operating expenses Rs. 25,000)
Less: Excess Depreciation (Rs. 12,000) 13,000
38,000
Less: Taxes (50%) 19,000
19,000
Add: Depreciation 12,000
31,000
Salvage Value of new machine: The salvage value of new machine at the end of 15th year
will influence net cash inflows in the 15th year through the gross proceedings. In this
problem, the salvage value of the new machine is Rs. 25,000. Therefore, the different cash
inflows in the 15th year will be rs. 31,000 + 25,000 = Rs. 56,000.
Now the differential cash flows are as follows:
Net cash outlay = Rs. 1,79,000
Net cash inflow: 1 - 14 years = Rs. 31,000 (annual)
15 years = Rs. 56,000
121
Now let us calculate the present value of the inflows:
PV of Rs. 31,000 received annually
for 14 years @ 10% = Rs. 31,000 7.367 = 2,28,377
PV of Rs. 56,000 received at the end
of 15 year @ 10% = Rs. 56,000 0.2389 = 13,384
PV of inflows = Rs.2,28,377 + Rs. 13,384 = Rs. 2,41,761
Net present value = Rs. 241,761 – Rs. 1,79,000 = Rs. 62,761
Problem No. 3
What are the internal Rate of Return and Net Present value for the following
projects?
Year Project -A Project -B
Rs. Rs.
0 -12,000 -27,000
1 + 4,000 + 10,000
2 + 4,000 + 15,000
3 + 6,000 + 15,000
The cost of capital is 10 percent. When project do you select on the basis of each
criterion?
Solution :
Net Present Value - Project - A :
Year Cash inflows PV Factor at 10% PV
Rs. Rs.
1 4,000 909 3,636
2 4,000 0.826 3,304
3 6,000 0.751 4,508
11,446
Net Present Value = Present Value of cash inflows - Initial Outlay
= Rs.11,446 – Rs.12,000 = – Rs.554
Net Present Value of Project - B :
Year Cash inflows PV Factor at 10% PV
Rs. Rs.
1 10,000 909 9,090
2 15,000 0.826 12,390
3 15,000 0.751 11,265
32,745
Net Present Value = Present value of cash inflows – initial Outlay
= Rs.32,745 – Rs.27,000 = Rs.5,745
122
Internal Rate of Return : The Internal Rate of Return (IRR) if the rate which, when applied
to discount the cash flow, makes the Net Present Value equal to Zero.
Project A : The cash flow stream is not an even series. To determine the internal rate, trial
and error approach may be used. Let us start with 8% discount rate.
Cash inflows PV Factor at 8% PV
Rs. Rs.
4,000 0.926 3,704
4,000 0.857 3,428
6,000 0.794 4,764
11,896
The Present value at 8 percent discount rate is less by Rs.104. To satisfy the conditions
of zero Net Present Value, a lower rate, say 7 percent may be tried out.
Cash inflows PV Factor at 7% PV
Rs. Rs.
4,000 0.935 3,740
4,000 0.873 3,492
4,000 0.816 4,896
12,128
It is obvious that the actual rate lies between7% and 8%. By interpolation the actual
rate can be determined :
Difference
PV required Rs.12,000
PV at 7% Rs.12,128 Rs.128 1%
PV at 8% Rs.11,896 Rs.232
= 7% + 1% = 7,55%
Project B : The cash flow stream is not an even series. To determine the internal rate, trial
and error approach may be used. Let us start with 22% discount rate :
Cash inflows PV Factor at 22% PV
Rs. Rs.
10,000 0.820 8,200
15,000 0.672 10,080
15,000 0.551 8,265
26,545
The present value at 22% discount rate is less by Rs.455. To satisfy the condition of
zero Net Present Value is lower rate, 20 percent may be tried out.

123
 Cash inflows PV Factor at 8% PV
Rs. Rs.
10,000 0.833 8,330
15,000 0.694 10,410
15,000 0.579 8,785
27,525
It is obvious that the actual rate lies between 22% and 24%. By interpolation the actual
rate can be determined.
Difference
PV required Rs.27,000
PV at 22% Rs.26,545 Rs.455 2%
PV at 24% Rs.27,525 Rs.525
Thus, the actual rate = 20% + 2% = 20 + 1.73 = 21.73%
Which Project should be selected?
According to the NPV method Project-B should be selected as it has more present
value. According to the IRR method also Project B should be selected since it has greater
IRR. Moreover Project A cannot be selected, even if it is considered alone, as it has a
negative NPV and its IRR being less than the cost of capital.
Problem No.4
X Company Ltd., owns various investment projects one project is doing poorly and is
being considered for replacement. Two mutually exclusive projects have been proposed.
Both the projects will be depreciated on a straight line basis. The Company’s required rate of
return is 10 percent and the tax rate is 50 percent. The before tax cash flows are :
Year Project-A Project-B
Rs. Rs.
0 – 40,000 – 30,000
1 8,400 8,400
2 9,600 9,600
3 14,000 8,000
4 16,000 10,000
5 10,000 8,000
Rank the project applying the following methods of evaluation.
a) Payback period b) Accounting Rate of Return
c) Net Present Value d) Profitability Index

124
Solution :
As net income and Net Cash flows after taxes are necessary for the calculation of the
requirements given in the problem, let us calculate them.
Calculation of Net Income and Net Cash flows
after Taxes for Project - A
(Amount in Rupees)
Cash flows Dep. Income Taxes Net Net Cash
Year before before Income flow after
taxes taxes taxes
1 2 3 4 5 6(4 – 5) 7
1 8,400 8,000 400 200 200 8,200
2 9,600 8,000 1,600 800 800 8,800
3 14,000 8,000 6,000 3,000 3,000 11,000
4 16,000 8,000 8,000 4,000 4,000 12,000
5 10,000 8,000 2,000 1,000 1,000 9,000

Calculation of Net Income and Net Cash flows

after Taxes for Project - B
(Amount in Rupees)
Cash flows Dep Income Taxes Net Net Cash
Year before before Income flow after
taxes taxes taxes
1 2 3 4 5 6(4 – 5) 7
1 8,400 6,000 2,400 1,200 1,200 7,200
2 9,000 6,000 3,000 1,500 1,500 7,500
3 8,000 6,000 2,000 1,000 1,000 7,000
4 10,000 6,000 4,000 2,000 2,000 8,000
5 8,000 6,000 2,000 1,000 1,000 7,000
a) Pay back period :
Project A : Rs.8,200 + Rs. 8,800 + 11,000 + 12,000 = 40,000
Time needed to recoup Rs. 40,000 = 4 years
Pay back period = 4 years
Project B : Rs. 7,200 + 7,500 + 7,000 + 8,000 = Rs. 29,700 (4 years)
Amount remaining to be recouped in fifth year Rs. 30,000 - Rs. 29,700 = Rs. 300. As
the total amount realised in fifth year is Rs.70,000, the time needed to recoup is 3 / 70 years.
Thus the payback period = 4 years + 3 / 70 years = 4 3/70 years.
125
b) Accounting Rate of Return:
Accounting Rate of Return =
Average Income:
Project-A = =
Project-B = =
Accounting Investment:
Project A =
Project B =
Accounting Rate of Return:
Project A =
Project B =
c) Net Present Value:
Project A :
Year Cash inflows PV Factor at 10% PV
Rs. Rs.
1 8,200 909 7,453.80
2 8,800 0.826 7,268.80
3 11,000 0.751 8,261.00
4 12,000 0.683 8,196.00
5 9,000 0.621 5,589.00
36,768.60
Net Present Value = PV of inflows – initial outlay
= Rs. 36,768.60 – Rs. 40,000 = Rs. 3,231.40
Project B:
Year Cash inflows PV Factor at 10% PV
Rs. Rs.
1 7,200 909 6,544.80
2 7,500 0.826 6,195.00
3 7,500 0.751 5,257.00
4 8,000 0.683 5,464.00
5 7,000 0.621 4,347.00
27,807.80
Net Present Value = PV of inflows – initial outlay
= Rs. 27,807.80 – Rs. 30,000 = Rs. 2,191.20

126
 Profitability Index =
Project A =
Profitability index =
Rank
A B A B
Payback period 4 years 4.3/7 yrs. 1 2
Accounting Rate of Return 9% 8.93% 1 2
Net Present Value -3.231.40 -2,192.20 2 1
Profitability 0.919 0.927 2 1
Problem No. 5
A company has an investment opportunity costing Rs. 80,000 with the following
expected net cash flow (i.e., after taxes and before depreciation):
Year Net Cash Flow
Rs.
1 14,000
2 14,000
3 14,000
4 14,000
5 14,000
6 16,000
7 20,000
8 30,000
9 20,000
10 8,000
Using 10% as the cost of capital, determine the following:
a) Pay back period
b) Net present value at 10% Discounting Factor
c) Profitability index at 10% Discounting Factor
d) Internal Rate of Return with the help of 10% Discounting factor and 15% Discounting
Factor.
Solution:
a) Payback Period:
(Rs. 14,000 + Rs. 14,000 + Rs. 14,000 + Rs. 14,000 + Rs, 14,000) = Rs. 70,000 5 years

127
 Amounting remaining to be recouped in sixth year Rs. 80,000 - 70,000 = Rs. 10,000.
As the total amount realised in sixth year is Rs. 16,000, the time needed to recoup Rs. 10,000
= 10,000 / 16,000 = 5 / 8 years.
Thus the payback period is 5 year + 5/8 = 5 5/8 years.
b) Net Present Value at 10% Discounting Factor:
Year Cash inflows PV Factor at 10% PV
Rs. Rs.
1 to 5 14,000 3,791 53,074.00
6 16.000 0.564 9,024.00
7 20,000 0.513 10,260.00
8 30,000 0.467 14,010.00
9 20,000 0.424 8,480.00
10 8,000 0.386 3,088.00
97,936.00
Net Present Value = PV of inflows – initial outlay
= Rs. 97,936 – Rs. 80,000 = Rs. 17,936
c) Profitability Index at 10% Discounting Factor :
Profitability = =
d) Internal Rate of Return: The Present Value by using 10% discount rate is already
calculated above in computing the NPV. Now let us calculate the present value with
15% discount rate.
Year Cash inflows PV Factor at 10% PV
Rs. Rs.
1 to 5 14,000 3.352 46,928.00
6 16,000 0.432 6,912.00
7 20,000 0.376 7,520.00
8 30,000 0.327 9,810.00
9 20,000 0.284 5,680.00
10 8,000 0.247 1,976.00
78,826.00
It is clear from the above calculation that the IRR lies between 10% and 15%. By
interpolation it can be determined:
Difference
PV required Rs.80,000
PV at 10% Rs.97,936 Rs.17,936 5%
PV at 15% Rs.78,826 Rs.19,110
Thus, the actual rate = 10% + 5% = 14.69%
128
 Note: The student is advised to note that while calculating present value of cash flows,
a single PV factor is used for the first five years. This is done because of the fact that the cash
inflows for the first five years are uniform. When cash inflows are uniform over a period of
time. Annuity Table (Table -2) that gives the present value of Rupee 1 received annually for
n years, can be used to determine for PV factor.

QUESTIONS
1. Explain the importance of DCF techniques of Capital Budgeting.
2. How DCF techniques are superior to traditional techniques of Capital Budgeting?
3. Explain the steps involved in the calculation of NPI.
4. Do you prefer to use ‘r’ or ‘k’ as the discounting factor? Why?
5. Is it advisable to evaluate the project in absolute terms or relative terms?

BOOKS SUGGESTED
1. Financial Management and Policy : James C. Van Home
2. Managerial Finance : J. Fred Weston Eugene
F. Brigham
3. Financial Management : I.M. Pandey
4. Financial Decision Making Concepts
Problems and Cases : John J. Hampton
5. Management Finance : Varanasy S. Murty

129
GUIDELINE 11 : RISK ANALYSIS IN CAPITAL BUDGETING

Any business is not free from risk. Every activity relating to the business is subject to
one kind of risk or the other. Risk in business begins with investment as the returns on an
investment project extend beyond one year which makes it too difficult to forecast the distant
future with accuracy. Further, risk poses a problem to the investor while choosing one
project from among the available project with veryfing returns and risks. One cannot merely
rely upon either cash flows or pay back period in selecting a project. On the other hand, one
should go further to look into the risk factor if at all a wise selection of the project is to be
made. Thus risk is a critical factor to be dealt with in capital budgeting. The riskiness of a
project is defined in terms of the likely variability of future returns resulting from the project.
It can be illustrated with an example. An individual purchases Rs. 30,000 worth of short-
term Government bonds which yield 5 per cent. In this case, the investor can precisely
estimate the return. This kind of investment is relatively risk-free. On the other hand, if the
investor purchase shares in a company with the same amount of Rs.30, 000, the investment
cannot said to be risk-free as above. The reason is the return on their investment cannot be
estimated accurately as it is likely to vary depending upon the business conditions. Here one
important point should not be lost sight of. That degree of risk changes form one project to
the other, but it is certainly associated with future returns of a project.
Having established the fact that no investment project is totally devoid on risk, it is
important to know the risk involved and to select project in the face of risk. For this purpose,
various techniques are available. The following techniques are widely used in Capital
Budgeting for analysing the risk in investment.

RISK - ADJUSTED DISCOUNT RATES (RADR):

Risky investments require more rate of return than that of less risky investments. In
other words, risk can be provided for by allowing the investor a premium over and above an
alternative which is risk-free. Therefore, the amount of premium to cover the risk changes in
proportion to the amount of uncertainty of returns. In capital budgeting, in order to consider
the time preference for money, estimated future cash flows may be discounted at a risk-free
rate, to their present value and also to provide for the riskiness of those future cash flows. A
risk premium rate may be added to risk free discount rate. This is what called risk-adjusted
discount rate. Taking into account the riskiness of the project either a higher rate or lower rate
is used. RADR may use NPV method for evaluating the project by adjusting cost of capital,
k, for additional risk in he project. Thus, k* may be used as discounting factor instead of k.
Thus RADR is calculated as follows:
n
α CFt
NPV = ∑
t =1 (1 + k )t
− CF0

K* in the above formula represents the risk-adjusted discount rate which consists of
risk-free rate plus risk premium rate.

130
CERTAINTY EQUIVALENT METHOD
Under certainty equivalent approach, the investor requires some amount with
certainty so that he remains indifferent to the quantum of excess of expected cash flow. For
example while, expecting acash flow of Rs. 50,000 the investor required Rs. 30,000 with
certainty. It is just sufficient for him if the expected cash flow proves to be more than Rs.
30,000. Certainty equivalent method can be expressed by the following formula:
n
α CFt
NPV = ∑
t =1 (1 + k )t
− CF0

αt represents certainty equivalent adjustment factor and K indicates risk free rate. If the risk
involved in the project is greater, a low α will be used and vice versa. This method to be
understood more clearly can be illustrated as follows. A project costs of Rs. 5,000 and has
cash flows of Rs. 3,000, Rs. 2,000, Rs. 2,000 and Rs. 3,000 for the four years respectively.
The certainty equivalent adjustment factors (α)are: 0 =1.00, 1= .90, 2 = .70, 3 = .50, 4 = .30
and the risk-free discount rate is 10 percent.
Then the net present value is:
0.90(3,000) 0.70(2,000) 0.50(2,000) 0.30(3,000)
NPV = 1.0 (-5000) + ___________ + __________ + ___________ + __________ = 65.40
(1+.10)1 (1+.10)2 (1+.10)3 (1+.10)4

ROBABILITY DISTRIBUTION:
Probability is the likelihood that an incident will take place. It varies between the
values 0 and 1. If the incident definitely takes place, probability is one. If it does not
definitely take place, probability is zero. Any other possible occurance lies between 0 and 1.
For example probabilities can be assigned as follows:
Cash flow Probability
Rs. Rs.
10,000 0.40
12,000 0.80
15,000 0.31
In this case, a cash flow of Rs. 12,000 is more likely than others, since its probability is
more (0.80) when compared to the other two. Form good understanding, let us solve an
illustration,
Project A Project B
Probability Net Cash Inflow Probability Net Cash Inflow
.10 Rs. 3,000 .10 Rs. 4,000
.25 Rs. 4,000 .20 Rs. 5,000
.30 Rs. 5,000 .40 Rs. 6,000
.25 Rs. 6,000 .20 Rs. 7,000
.10 Rs. 7,000 .10 Rs. 8,000
From the above particulars expected value may be calculated

131
 Project A Project B
Probability Net Cash Inflow Cash Expected Probability
Net Cash Expected inflow
Inflow Value bilit inflow value
(1) (2) (1) (2)
Rs. Rs.
.10 3,000 300 .10 4,000 400
.25 4,000 1,000 .20 5,000 1,000
.30 5,000 1,500 .40 6,000 2,400
.25 6,000 1,500 .20 7,000 1,400
.10 7,000 700 .10 8,000 800
5,000 6,000
Expected value is obtained by multiplying column 1 and column 2.
It can be observed that since the total expected value of Project B (Rs. 6,000) is greater
than that Project A (Rs. 5,000), Project B would be preferred to the latter one.

Standard Deviation :
Accurate measurement of risk presents a problem. In capital budgeting analysis the
degree of risk is indicated by the dispersion of cash flows. Risk is commonly measured by
standard deviation. Standard deviation measures the deviation of variance about the expected
cash flow of each of the possible cash flows. Risk is commonly measured by standard
deviation measures the deviation or variance about the expected cash flow of each of the
possible cash flows. Risk is commonly measured by standard deviation. Standard deviation
measures the deviation or variance about the expected cash flow of each of the possible cash
flows. This can be the following formula standard deviation.
Ajt stands for cash flow for the event forth time period and At stands for expected cash
flow; Pt represents the probability of cash flow. Now taking data from the previous problem
standard deviation can be calculated as under.
Calculation of Standard Deviation
Project A Project B
(Ajt – At) (Ajt – At)2 (Ajt – At)2 Pjt (Ajt – At) (Ajt – At)2 (Ajt – At)2 Pjt
-2,000 40,00,000 4,00,000 -2,000 40,00,000 4,00,000
-1,000 10,00,000 2,50,000 -1,000 10,00,000 2,00,000
0 0 0 0 0 0
1,000 10,00,000 12,50,000 1,000 10,00,000 2,00,000
2,000 40,00,000 4,00,000 2,000 40,00,000 4,00,000
13,00,000 12,00,000
OB
OB = 1,140 (Approx)
It is revealed from the above table that project B is less riskiner than project A. It is
because the standard deviation of Project A is greater than that of Project B.

132
CO-EFFICIENT OF VARIATION:
In the above method, deviation is shown in absolute terms. But sometimes it proves to
be deceptive. Hence a conclusion should not be arrived at only on the basis of standard
deviation. For this purpose a relative measure of risk like co-efficient of variation may be
calculated. Co-efficient of variation can be obtained by dividing standard deviation by its
expected value. It provides a useful measure for comparing projects which have (a) same
standard deviations but different expected values (b) different standard deviations but same
expected values and (c) different standard deviations and different expected values. It proves
to be more adequate in measuring the risk than standard deviation method. The choice of a
particular project depends upon the investor’s willingness or averseness to assume risk.

PROBABILITY DISTRIBUTION APPROACH:

The importance of probability distribution in dealing with the riskiness of the project
has been emphasized earlier. A detailed analysis of risk by using probability theory is
discussed here.

INDEPENDENCE OF CASH FLOWS OVER TIME:

It indicates that the probability distribution regarding the future period are independent.
The expected value of net present value would be
NPV =
At represents the expected value of net cash flow in a period t and i stands for risk-free
rate. Whether the cash flows conform to the expected values, depends upon risk involved. If
standard deviations are calculated for various periods, a measure of risk can be developed for
any project. The following formula would be useful for the purpose:
The symbol is standard deviation of probability distribution of possible net cash flows
while t represents the variance of each period. The standard deviation for independent cash
flows over time is calculated in the following illustration:
A project costs Rs. 4,000 at t = 0. It yields cash flows for three years. Risk-free
discount rate may be assumed at 10%. Further information is given here under:

First Year Second Year Third Year

Cash Proba- Cash Proba- Cash Proba-
flow bility flow bility flow bility
Rs. Rs. Rs.
6,000 0.10 3,000 0.15 6,000 0.25
5,000 0.40 4,000 0.50 5,000 0.20
4,000 0.30 5,000 0.25 4,000 0.35
3,000 0.20 6,000 0.10 3,000 0.20
Calculation of expected value and variance for each period:

Year Ajt Pjt AjtPjt (Ajt-At) 2 (Ajt-At)2 Pst

1. 6,000 0.10 600 25,60,000 2,56,000
5,000 0.40 2,000 3,60,000 1,44,000
4,000 0.30 1,200 1,60,000 48,000
133
 3,000 0.20 600 19,60,000 3,92,000
A1 = 4,400 1 8,40,000

2. 3,000 0.15 450 16,90,000 2,53,500

4,000 0.15 2,000 90,000 45,000
5,000 0.25 1,250 4,90,000 1,22,500
6,000 0.10 600 23,90,000 2,89,000
A2 = 4,300 2 7,10,000

3. 6,000 0.25 1,500 22,50,000 5,62,500

5,000 0.20 1,000 2,50,000 50,000
4,000 0.35 1,400 2,50,000 87,500
3,000 0.20 600 22,50,003 4,50,000
A3 = 4,500 3 11,50,000

PV Factor Expected PV of Expec- Variance PV of

@ 10% Value of ted value of Variance
Cash Flow Cash Flow
0.909 4,400 4,000 3,40,000 7,63,560
0.826 4,300 3,552 7,10,000 5,86,460
0.751 4,500 3,380 11,50,000 8,63,650
10.932 22,13,670
Expected net present value = Rs. 10,932 – 8,000 = 2,932 =

Dependence of Cash flows over time:

In majority of investment projects the cash flows would be dependent over time.
Generally a favourable outcome will be followed by an unfavourable outcome and vice versa.
If the cash flows are dependent over time the standard deviation would be more than what is
in the case of independent cash flows. Further the standard deviation will be very high when
the correlation between cash flows is greater. In this case expected value of net present value
remains intact whether the cash flows over dependent or independent. The cash flows are
said to be perfectly correlated when the deviation of cash flows for one period is the same in
case of expected cash flow for the next period. In this case standard deviation is calculated
with the following formula:
At times cash flows may be neither independent nor perfectly correlated. These can be
referred as moderately correlated. When cash flows are moderately correlated, concepts of
conditional probability or decision trees would be useful for the purpose of analysis. The
standard deviation in the case of moderately correlated cash flows can be calculated with the
following formula:
NPV in the above formula represents the present value for series of net cash flows.
NPV indicates the expected value of net present Pj shows the probability of occurrence of
that series. It should be remembered that for the measurement of risk the correlation between
cash flows should be calculated accurately. If there is any wrong in this calculation, the
results would be misleading.

134
SENSITIVITY ANALYSIS
The cash flows used for computation of NPV is based on assumptions regarding selling
price, sales quantity, market share, market growth, capacity utilization, and so on. The NPV
corresponding to the most likely values of these variables is referred to as the base case. Due
to uncertainty, the variables can take on a rage of vales rather than a single value. For
instance, the ZEL assumed a selling price of RS 500 for 20-inch picture tubes. But the selling
price can vary between Rs 475 and Rs 525. The management has estimated Rs 500 as the
most likely value. The sensitivity of the NPV (or IRR or ROI) can be found for various likely
values of selling price or any variable which cab affect the decision rule significantly.
Sensitivity analysis refers to he process of changing variables or assumptions to determine
their impact on a project’s profitability. It doest not involve the use of probabilities.
Steps in Sensitivity Analysis:
1. Estimate the base case NPV or IRR based on most likely values of variables.
2. Identify the key variables (those expected to affect the project profitability
significantly).
3. Change one variable, say selling price, at a time, keeping all others unchanged and
compute NPV or IRR. Carry out the exercise for all the possible values of the
variable.
4. Repeat for all variables.
Illustration:
Lee Company, Ltd calculated the NPV for the picture tube project based on the following
assumptions:
1. Sales price per unit
20-inch picture tube = Rs 50
14-inch picture tube = Rs 325
2. Output as percentage of plant capacity 60 per cent, 76.24 per cent 100 per cent for the 1st,
2nd and 3rd years respectively for both the sizes. The output is expected to remain at the 3rd
year levels for the remaining years.
3. Project life = 10 years.
4. Number of units sold in lakhs (number).

Year 20-inch 14-inch

1 1.50 2.70
2 1.875 3.375
3 2.50 4.50

5. Average EBIT as a percentage of revenues = 10.5 per cent.

With this set of assumptions the NPV for the base case is Rs 124 lakh.
To determine the sensitivity of NPV and IRR, change selling price keeping other
variables constant.
Selling price for 20-inch tube = Rs 475
Selling price for 14-inch tube = Rs 300
135
The revenues and cash flows are shown below,
Year Revenue (Rs in lakh)
Cash flow
1 1522.50 (112.45)
2 1903.12 (48.0)
3 2537.50 233.50
4 2537.50 185.0
5 2537.50 176.80
6 2537.50 167.50
7 2537.50 156.0
8 2537.50 145.0
9 2537.50 132.0
10 2537.50 916.0
Initial investment = Rs 1410 lakh
NPV = Rs 754.60 lakh
When price decreased by 5 per cent for 20-inch tube and 7.7 per cent for 14-inch tube,
NPV decreased to – 754.60 lakh. The change in NPV for changes in selling price could be
calculated for the likely range as shown below; N1 being the NPV when prices are Rs 475
and Rs 300 respectively and N2 being the NPV when prices are Rs 490 and Rs 315 and
(Rs in lakh)
Selling price NPV
______________________________________
*475,300 N1
490,315 N2
500,325 N3
525,350 N4
550,375 N5
________________________________________
*for 20-inch & 24-inch respectively.

Similarly, the sensitivity of NPV and IRR to changes in other variables like sales growth rate,
market growth could be ascertained individually and in combination. For instance, we can
find the sensitivity of NPV to a combination of,
Project life = 8 yeas
Price = Rs 475 and 300 respectively
Number of units sold = 10% less than the base case.
Wit assumed a project life of 10 years. If the life shrinks to 8 years, cash flows and
NPV would be,
(Rs in lakh)
Year Cash flow
0 (1410)
1 128.0
2 180.0
136
 3 389.0
4 365.0
5 342.0
6 307.0
7 288.0
8* 1068.0
*The 8th year cash flow includes salvages value of Rs 800 lakh.
NPV = - 199.50
Sensitivity of NPV to cash flow
Year 1 1.1 1.2 0.9 0.8
0 -1410 -1410 -1410 -1410 -1410
1 128 140.80 153.6 115.20 102.4
2 180 198.80 216 162.00 144
3 389 427.90 466.8 350.10 311.2
4 365 401.50 438 328.50 292
5 342 376.20 410.4 307.80 273.6
6 307 337.70 368.4 276.30 245.6
7 288 316.80 345.6 259.20 230.4
8 268 294.80 321.6 241.20 214.4
9 248 272.80 297.6 223.20 198.4
10 1027 1129.70 1232.4 924.30 821.6
124.87 278.36 431.84 (28.62) (182.11)
The end result of sensitivity analysis is a rage of NPVs. The management should take
the decision to accept or reject the project based on the friskiness of the project. Sensitivity
analysis gives us the range of NPV, but does not indicate which NPV is more likely to occur.
SIMULATION
Since each of the factors that enter into investment analysis is subject to some amount
of uncertainly (in isolation and in combination). Simulation, a method of risk analysis, tries to
combine the variability in each of the factors under consideration and assess the odds of
earning a healthy return.
Steps in Simulation:
Step 1: Construct an ‘uncertainty profile’ for each key input factor like market size, market
share, price per unit, selling costs, variable costs, etc., The uncertainty profile is
constructed by attaching probability of occurrence to different values it can take on.
For instance, suppose price can take any value ranging from Rs 30 to Rs 50.
Further, suppose there is 5 per cent chance of the realised price being Rs 30, 10 per
cent chance of price being Rs 35, 20 per cent chance of price being 40, and so on.
The uncertainty profile for the price factor could be constructed. The probabilities
are set subjectively based on expert opinion and past experience. Uncertainty
profiles are constructed for all key factors on similar lines.
Step 2: One value is chosen from each of the profiles randomly and combined to compute
NPV or IRR.

137
Step 3: The process is repeated several hundred times. Each time NPV and IRR are noted.
Step 4: Each result is listed form the higher to the lowest and the percentage of total
situations falling within a given range of NPV or IRR is determined as shown
below:

NPV range (Rs) Percentage of situations=Probability of Cumulative Probability

Occurrence (per cent) (per cent)
150,000-200.000 28 28
100,000-150,000 14 42
50,000-100,000 21 63
0-50,000 16 79
-50,000-0 21 100
Step 5: Risk profiles are constructed for all the investments in hand. Those projects offering
a greater probability of achieving any level of return or NPV are chosen (within
capital constraints).
Step 6: The expected value and standard deviation of the risk profile are computed and a
summary is presented.
Decision Tree:
Important decisions are not made at a single point of time. On the other hand, every
decision passes through a number of stages when it is finally made. It implies that a decision
cannot be made in isolation. In practice, there are investment decisions which require a
sequence of many other decisions to be made over a period of time. The sequential
investment can be evaluated and analyzed through the use of decision trees. A decision taken
at present will influence the future events and a happening of an event changes the future
sequential decisions. Thus a decision tree is a graphic display of the relationship between
present decision and future events, future decisions and their consequence. When the
sequence of events is mapped out, it appears like branches of a tree. If a decision tree is to be
mapped out some important factors are to be noted:
1. The investment proposal must be properly designed.
2. Available decision alternative must be identified.
3. The decision tree should be graphed in such a way that it indicates the decision
points, chance events etc.
4. The relevant information regarding cash flows, probability distribution etc., should
be presented on the branches of decision tree.
5. Results should be properly analyzed and an alternative considered to be best should
be selected.

QUESTIONS:
1. What is meant by risk? How can it be measured?
2. Explain the risk-adjusted discount rate method to handle risk in capital budgeting.
3. How certainty equivalent method deals with the risk associated with a capital project?
4. To what extent probability distribution would be useful in analyzing financial risk?
138
5. Discuss standard deviation method as a measure of risk with the help of an illustration.
6. Why co-efficient of variation is considered superior to standard deviation in the
measurement of risk? Explain with an example.

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management: Ezra Solomon & John J. Pringle.

139
GUIDELINE 12 : DCF TECHNIQUES AND THEIR COMPARISON

In most of the cases the NPV, IRR and PI methods would give the same accept-reject
decision in the process of evaluation of projects.. But there are situations where they differ
and give mutually contradictory opinions. Therefore it is necessary to analyse (i) the
similarities between them, and (ii) their differences, as also the factors which are likely to
cause such differences.
Similarities between NPV, IRR and PI:
When the projects are sound, cash flows are similar and when there is no much
difference in the timing of cash flows, the DCF methods give consistent results in terms of
acceptance or rejection of investment proposals in certain situations.
The situation in which the DCF methods will give a concurrent accept-reject decision
will be in respect of conventional and independent projects. A conventional investment is one
in which the total cash outflow occur at the beginning of the project. Cash flow pattern is
such that an initial investment is followed by a series of cash inflows. Thus, in the case of
such investments, cash outflow are confined to the initial period. The independent proposals
refer to investment in a project the acceptance of which do not precludes the acceptance of
other so that all profitable proposals ca be accepted and there are no constraints in accepting
all profitable projects.
According to the NPV, IRR and PI methods, the decision rule is that a project will be
accepted when NPV ≥ 0, IRR ≥ k, and when PI ≥ 1.The project is rejected when NPV < 0,
IRR < k and when PI < 1
If there is no capital budget constraint, any DCF criterion may be employed when
investment projects are independent. In such a situation the set of projects selected by all the
three DCF criteria would be the same though there may be differences in internal ranking. In
the real world, however, firms are faced with mutually exclusive projects and limited
availability of funds. Due to these imperfections not all projects with NPV ≥ 0, IRR ≥ k and
PI ≥ 1 can be adopted. Hence differences in project ranking cannot be regarded as
inconsequential. Conflicts in project ranking may arise because of disparity in size of
operation, timing of cash flows and life of the project.
1. Disparity in the size of initial outlays is a major source of ranking conflicts. Such
conflicts arise mainly because the NPV represents comparison of cash inflows and outflows
on absolute terms whereas the IRR and PI compare the cash flows on relative terms. To
illustrate such conflicts consider two mutually exclusive projects, A and B, being analyzed by
a firm whose cost of capita is 10 per cent.
A and B are two mutually exclusive investments involving different outlays. The details are:
Particulars Project A Project B
Cash outlays (Rs 5,000) (Rs 7,500)
Cash inflows at the end of year1 6,250 9,150
IRR 25% 22%
NPV 681.25 817.35
PI 0.80 0.83

140
 Thus, the two methods rank the projects differently. Project A has a higher IRR (25%)
than project B (22%) but the NPV of project B (817.35) is more than project A (681.25)
similarly the PI of project A is less than project B.
In case of mutually exclusive projects like above, NPV method is preferable to IRR
method. IRR method gives only what is the rate of return ( r ) generated by the business. It
has not directly linked to the wealth maximisation objective of the company. Where as the
NPV measures the additional wealth created by the project. In the above example, B is
preferable project because it created more wealth than project A. PI is also indicates the
same.
1. If the firm has enough funds available to it at a given cost of capital, project B is
preferable to project A. because it contributes more to the NPV of the firm.
2. If the firm has limited funds and acceptance of project B means giving up project A
(because projects A and B are mutually exclusive) and some other project(s) because of
capital rationing, then the NPV of project B must be compared wit the sum of NPV of project
A and t NPV of other project(s) which may be sacrificed in order to choose project B in
preference t project A. Suppose the adoption of project B means the project A and project C,
which has the following characteristics, are sacrificed.
Project C
Initial outlay Rs. 12,00,000
Net present value 1,00,000
In this case, given the limited availability of funds, it makes sense to choose projects
A and C in preference to project B because the combined NPV of projects A and C is Rs.
3,14,460, whereas the NPV of project B is only Rs. 2,43,380.
2. Project may differ with respect to the timing of the pattern of cash inflows associated
with them. Such time disparities of cash inflows may lead to conflict in ranking. For example,
consider two projects, Y and Z, being evaluated by a firm whose cost of capital is 10 per cent.
___________________________________________________________________________
Project Y Project Z
___________________________________________________________________________
Initial outlay Rs. 1,10,000 Rs. 1,10,000
___________________________________________________________________________
Cash inflows
Year 1 31,000 71,000
Year 2 40,000 40,000
Year 3 50,000 40,000
Year 4 70,000 20,000
___________________________________________________________________________
The NPV, IRR and PI of these projects are:
Project Y Project Z
Net Present Value 36,613 31,314
Profitability Index 1.333 1.285
Internal Rate of Return 22 per cent 25 per cent

141
 The NPV and PI of project Y are higher than that of project Z. The IRR of project Z
higher is than that of project Y. This conflict occurs because the IRR method assumes that the
intermediate cash inflows can be re-invested at the IRR and hence favors a project like Z
which has higher earlier cash inflows. The NPV and PI methods, on the other hand, assume
that the intermediate cash inflows cab be re-invested at the firm’s cost of capital (a lower
rate) and hence do not discriminate much against a project which has larger cash flows later
in its life.
Such a conflict can be resolved by defining the re-investment rates that are applicable
to the cash flow of the firm and calculation modified versions of NPV and PI. This
calculation may be described in two steps:
3. In some cases the mutually exclusive alternatives have varying lives. Life disparity
may lead to conflict in ranking. For example, consider two projects, N and M, being
evaluated by a firm which has a cost of capital of 12 per cent:
Project N Project M
Initial outlay Rs. 2,00,000 Rs. 2,00,000
Cash inflows
Year 1 3,00,000 80,000
Year 2 - 80,000
Year 3 - 2,80,000
The NPV, PI, and IRR for projects N and M:
Project N Project M
Initial outlay Rs. 2,00,000 Rs. 2,00,000
Present value of
cash inflows Rs.2,67,857 Rs. 3,34,512
NPV Rs. 67,857 Rs. 1,34,512
PI 1,339 1,673
IRR 50% 40%
Which project should be selected when there is a time disparity? One approach is to compare
the alternatives on the basis of their equivalent annual benefit (EAB) and select the
alternative with the highest EAB. The EAB of a project is equal to:
Net present value × Capital recovery factor
To illustrate, the EAB of ht projects N and M are calculated below:
Project N Project M
Net present value Rs. 67,857 Rs. 1,34,512
Life 1 year 3 years
Capital recovery factor-1
(given k = 10%) 1.100 0.402
EAB Rs. 74,643 Rs. 54,074
While the EAB concept appears appealing because it express the gains from the project in an
annualised form and hence renders easy comparison between projects with differing lives, it
is based on a certain assumption which is crucial to its validity: It assumes that each
investment will be replaced with another investment which will be equally profitable. When
this assumption is suspect, we have to compare the two alternatives in a common horizon
time-frame using appropriate re-investment rate assumptions.

142
 Particulars Project A Project B
Initial outlay Rs 10,000 Rs 20,000
Cash inflows after taxes
Year-end 1 8,000 8,000
2 7,000 9,000
3 nil 7,000
4 nil 6,000
Service life (years) 2 4
Required rate of return 0.10

Solution
Project A
Year Cash flows PV factor Total present
value
0 Rs 10,000 1,000 (Rs 10,000)
1 8,000 0.909 7,272
2 7,000 0.826 5.782
3 (10,000)a 0.826 (8,260)
4 8,000 0.751 6.008
5 7,000 0.683 4.791
NPV
a Machine replaced at the end of year 2.
Project B
Year Cash flow PV factor Total present value
0 Rs 20,000 1,000 Rs 20,000
1 8,000 0.0909 7,272
2 9,000 0.826 7,434
3 7,000 0.751 5,257
4 6,000 0.683 4.098
Net present value 4,061

A firm is considering buying one of the following two mutually exclusive investment
projects:
Project A: Buy a machine that requires an initial investment outlay of Rs 1,00,000 and will
grate the CFAT of Rs 30,000 per year for 5 years.
Project B: Buy a machine that requires an initial investment outlay of Rs 1,25,000 and will
generate the CFAT of Rs 27,000 per year for 8 years.
Which project should be undertaken by the firm. Assume 10 per cent as cost of
capital.
Solution
(i) Determination of NPV of Projects A and B
Project year CFAT PV factor (0.10) Total NPV
A 1-5 Rs 30,000 3.791 RS 1,13,730 Rs 13,730
B 1-8 27,000 5.535 1,44,045 19,045
143
(ii) determination of EANPV:
Net present value of the project
EANPV = __________________________________________________________ (12.1)
PV of annuity corresponding to life of the project at given cost of capital

Rs 13,730
EPNPV (A) = _____________ = Rs 3,621.74
3.791
Rs 19,045
EANPV (B) = __________ = Rs 3,569.82
Rs 5.335
On the basis of NPV criterion, Project B is preferred. However, on the basis of
EAPNV, project A becomes more desirable, with higher EAPNV, In fact, acceptance of
project A would be a right decision.
(Cost-reduction Investment Proposal) A firm is considering to install a large steaming
machine. Two machines currently being marketed will do the job satisfactorily. Machine A
costs Rs 50,000 and will require cash running expenses of Rs 15,000 per year. It has a useful
life of 6 years and is expected to yield Rs 2,000 salvage value at the end of its useful life.
Machine B costs Rs 65,000 but cash running expenses are expected to be Rs 12,000. This
machine is expected to have a useful life of 10 years with salvage value of Rs 5,000. Assume
both the machine would be depreciated on straight line basis for tax purposes.
If the corporate tax rate is 35 per cent and cost of capital is 10 per cent, which
machine should be bought by the company/
Solution
Equivalent Annual Costs of Machines A and B
Particulars costs PV factor (0.10) Adjusted PV
_____________________ ____________________________
Machine A Machine B Machine A Machine B
0 (initial cost) Rs 50,000 Rs 65,000 1,000 Rs 50,000 Rs 65,000
(Operating cost)
1-6 years (A) 6,950 4,355 30,267.25
1-10 years (B) - 5,700 6,145 35,026.50
___________ ___________
80,267.25 1,00,096.50
Less: Salvage value:
6th year (A) 2,000 0.564 1,128.00 -
10th year (B) 5,000 0.386 - 1,930
__________ __________
Present value of total costs 79,139.25 98,096.50
Dividend by annuity PV factor for 10 per cent
Corresponding to the life of the project
(capital recovery factor) 4.355 6.145
Equivalent annual cost (EAC) 18,172 15,963.63

144
Recommendation: Since Machine B has a lower equivalent annual cost, it is preferred
investment.

Problems:
1. There are two options in painting a building. The first option involves durable paint
which lasts 5 years and costs Rs. 1,00,000. The second option involves less-than-
normal durable paint which lasts 3 years and costs Rs. 75,000. If the minimum
required rate of return is 20 per cent, which option should be chosen?
2. A bulldozer costs Rs 2,00,000 and has a service life of 10 years. Its purchaser expects
to use it for 3 years and sell it for Rs. 1,50,000. What is the equivalent annual cost if
the minimum required rate of return is 12 per cent?
3. Give two hypothetical 3-year cash flow streams for which net present value (at 10 pr
cent discount rate) and internal rate of return criteria give different rankings.
4. Consider the cash flows of two projects, R and S;
(a) Calculate the NPV for R and S.
(b) Calculate the NPV* and IRR* for R and S, assuming a re-investment rate of 15
per cent.
Year R S
0 Rs. (50,000) Rs. (50,000)
1 30,000 -
2 30,000 -
3 30,000 1,00,000
In the above calculations assume that the cost of capital is 12 per cent.
5. A steel tank costs Rs. 12,000 and lasts 6 years. Is it worthwhile to extend its life by 3
years by painting it annually at Rs. 800? Assume a 12 per cent cost of capital and no
salvage value.
6. The Dawn Textile Corporation is considering a capital investment that can be
undertaken this year or after two years. The cash flows for the investment if
undertaken now would ba as follows:
Period Cash flow
0 Rs. (2,50,000)
1 1,60,000
2 1,00,000
If the project is undertaken after two years, the cash flows would be as follows:
Period Cash flow
2 Rs. (3,00,000)
3 1,80,000
4 2,20,000
If the discount rate is 10 per cent, which alternative should the company choose?

145
7. Consider the cash flows of two projects, P and Q:
Year Cash flow
P Q
0 Rs. (1,00,000) Rs. (1,00,000)
1 30,000 50,000
2 40,000 50,000
3 50,000 30,000
4 50,000 30,000
(a) Calculate the NPV and IRR of these projects.
(b) Calculate the NPV* and IRR* of these projects, assuming a re-investment rate of
12 per cent.
Assume that the discount rate 10 pr cent.

QUESTIONS:
1. Explain under what circumstances IRR, NPV and PI give conflicting opinions in the
selection of projects.
2. Timing of Cash outflows and Outflows is one of the important considerations in
project appraisal. Do you agree?
3. IRR gives importance rate of return whereas NPV measures wealth generation. Justify
4. NPV is absolute measure whereas PI is absolute measure. Comment.

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management: Ezra Solomon & John J. Pringle.

146
 UNIT - III

FINANCING DECISION

Every business needs capital to keep existing projects going and also to take on new

projects. A firm can raise this required capital from any long term source of capital.

Financing decision is broadly concerned with rising of long term sources of funds such as

equity share capital, preference share capital and borrowed capital, and constructing an

appropriate optimum capital structure through the composition of an appropriate mix of long

term sources. While determining the optimum capital structure, the financial manager keeps

in mind the basic goal of financial management i.e. maximization of wealth of share holders.

Usually, it is argued that companies don’t actually plan optimum capital structure as they are

not free in choosing the alternative sources of capital. As such, they prefer the sources from

which they can easily raise the required capital. Therefore, the question of planning optimum

capital structure doesn’t arise in practice. Theoretically, it is argued that there is a close

relationship between capital structure and wealth of the shareholders and as such it is highly

essential to plan for an optimum capital structure.

This unit covers the following concepts:

1. Capital structure - A theoretical perspective

2. Capital Structure - A practical perspective

3. Determinants of Capital Structure

4. Leverage

5. Cost of Capital

147
GUIDELINE 13 : OPTIMUM CAPITAL STRUCTURE - A
THEROTICAL PERSPECTIVE

Optimal capital structure may be defined as a proper mix of long-term sources of

capital such as debt, preference share capital and equity that maximises the wealth of
shareholders. A firm should select a financing mix which will help in achieving the objective
of financial management. As corollary, the capital structure should be examined from the
view point of its impact of the value of firm.
There are conflicting views about the influence of capital structure on EPS and
consequently on the wealth of shareholders. One school of thought believes that there is a
close relationship between capital structure and market value of the firm and therefore, the
financial manager must cautious in determining the capital structure of a firm. Another school
of thought believes that there is no relationship between capital structure and market value of
the firm. Therefore, the financial manager need not pay any attention for a proper mix of debt
and equity. They strongly argue that there is no particular optimum capital structure that is
determined by proper mix of debt and equity. They felt all capital structures are optimum
capital structures. They also pointed out that market value the firm will be maximum only by
maximizing the operating income of the company. Another group of researchers put totally a
different argument on capital structure and its impact on the market value of the firm. They
have taken the arguments of both the above schools and stated that the financial leverage
undoubtedly influences the market value of the firm. But they further argued that only
judicious use of financial leverage can only maximise the wealth of the shareholders. In other
words, they felt that debt must be used in capital structure judiciously to certain extent
beyond which the use of debt capital will be having negative impact on the market value of
the firm. Lastly, the popular economists, Modigliani and Miller on the basis of their empirical
research work argued that the capital structure decisions are irrelevant to the market value of
the firm. Both are totally independent. They defended their arguments with the concepts of
arbitrage process and home made leverage. These two concepts are explained in the latter
part of this section.
All these views on capital structure and its relationship with the market value of the firm
are known as relevant and irrelevant approaches to capital structure. These approaches are
popularly known as theories of capital structure and are grouped as follows.
1. Net Income Approach(NI Approach )
2. Net Operating Income Approach (NOI approach)
3. Traditional Approach
4. Modigliani-Miller(MM) Approach
Before discussing the theories in detail, let us understand the symbols used in these
theories and also the assumption of the theory.
ASSUMPTIONS:
1. Only two sources of funds are used by firms: debt and equity.
2. There are no corporate taxes. This assumption is deleted later on.

148
 3. All the earnings are paid out as dividend to the shareholders, i.e. 100 percent dividend
pay out ratio.
4. The operating profits of the firm are not expected to decline.
5. The firm’s business risk is assumed to be constant and independent of its Capital
structure and financial risk.
6. The total assets of the firm are given and do not change.
7. The firm’s total capital does not change. It can change its degree of leverage either by
raising more debt to repurchase shares or by selling shares and use the proceeds to
retire debt.
8. Investors are assumed to have the same subjective probability distribution of expected
future operating earnings for a given firm.

DEFINITIONS AND SYMBOLS:

In the analysis of Capital Structure Theories, the following symbols are used:
S = Market value of equity shares
D = Market value of debt
V = Total market value of the firm, (S + D)
I = Interest charges on debt
NOI (X) = Net Operating Income
NI (X-I) = Net income available to equity shareholders (NOI-I)
Some basic equations are also made use of:

I Annual interest charges

kd = =
D Market value of debt

Assuming that the debt capital is perpetual, kd represents the cost of debt.

E X−I Equity earnings

ke = = or =
S S Market value of equity

When the dividend payout ratio is 100 per cent, and earnings constant, ke, as defined here,
represents the cost of equity capital.

X Net operating income

ko = =
V Market value of the firm

Where V = B + S. ko is the over-all capitalisation rate for the firm. Since it is the weighted
average cost of capital, it may be expressed as:

ko = ke* w + kd* w + k *p w
Where W = weight of respective source of capital.
Or

149
  D   S 
ko = k d   + ke  
 D+S  D+S 
In this equation preference share capital is nit taken into consideration.
These values of the firm are applicable for all the capital structure theories. Let us study the
theories one by one.

NET INCOME APPROACH

According to net income approach financial leverage is an important variable to the
capital structure and financial leverage influences the market value of the firm. This approach
believes that as long as ROI is more than the interest paid on debt capital, it is advisable to do
business with more amounts of debt capital and less amount of equity capital in order to
maximise the market value of the firm. The underlying meaning of this approach is that a
firm is borrowing money at lower rate of interest and these funds are invested for generating
more ROI . Hence, the market value of the firm will be maximized. This approach also
believes that the cost of debt and cost of equity remains constant irrespective of the ratio of
debt and equity. The following are the assumptions of this theory
1. There are no taxes
2. Financial leverage doesn’t change the risk perception of investor.
3. The cost of debt is always less than cost of equity.
On the basis of the above assumptions this approach is in favour of high financial
leverage. NI approach believes that by using high financial leverage,
1. A firm can minimise its weighted average cost of capital
2. Increase market price of the share and in turn market value of the firm and ultimately
3. A firm can arrive at an optimum capital structure.
The following illustration clarifies the observations of NI:
Illustration:
A company has an annual net operating income of Rs. 70,000. It has Rs. 3,00,000 of 8
percent debt. The equity capitalisation rate (ke) of the company is 10%. Find out the value of
the firm, according to the NI approach.
Solution:
Value of the Company (Net Income Approach)
Net operating Income (NOI) (X) = Rs. 70,000
Less Interest on 8% debt (I) 24,000
Income available to shareholders (X – I) Rs. 46,000
Equity Capitalisation rate (ke) .10
Market value of equity (S) = X-I/ke = 46,000/10. Rs. 4,60,000
Market value of Debt (D) = Rs. 3,00,000
Market value of the Company (V) = S + D Rs. 7,60,000

NOI
Overall cost of Capital = (ko) =
V
150
 Rs.70, 000
= = 0.0921 percent or 9.21 percent
Rs.7, 60, 000

D S
Or k d   + ke  
V  V 
It can also be calculated as follows K
3, 00, 000 4, 60, 000
= 08 + 10
7, 60, 000 7, 60, 000
= .0316 + .0605 = .0921 or 9.21 percent

In order to examine the effect of a change in the financial leverage on the firm's
weighted average cost of capital and its value, let us suppose a debt of Rs. 6,00,000 instead of
Rs. 3,00,000 is employed. Then the market value of the company would be as follows.
Value of the Company (Net Income Approach)
Net Operating Income (NOI) (X) = Rs. 70,000
Less: Interest on 8% debt, (I) 48,000
Income available to shareholders (X–I) Rs. 22,000
Equity Capitalisation rate .10
Market value of equity (S) = X–1/ke = 22,000/.10 Rs. 2,20,000
Market value of Debt (D) = Rs. 6,00,000
Market value of the firm (V) = S + D Rs. 8,20,000

Overall cost of Capital

ko = = 0.854 or 8.54 percent
Or
D  S  NOI Rs.70, 000
ko = kd   + ke   =
V  V  V Rs.8, 20, 000
 6,00, 000   2, 20, 000 
= .08   + .10  
 8, 20, 000   8, 20, 000 
= .586 + .268 = .854 or 8.54%

Thus, a increase in leverage caused the overall cost of capital to decline and the value
of the company to increase.
Under the NI Approach, the optimum capital structure would be the one at which the
value of the firm is maximum and the overall cost of capital is minimum.
If the firm does not employ any debt or the financial leverage is zero, the weighted
average cost of capital is tantamount to cost of equity and it will approach cost of debt as the
degree of financial leverage approached one.
The relationship among the three variables (ke, kd and ko) can also be graphed.

151
 Figure
Y

ke 10%
Cost of Capital
ke, kd and ko

k0 kd 8%

0 X
Financial Leverage (D/S)
In the above diagram, the degree of leverage is plotted along the horizontal axis while
the cost of capital on the vertical axis. Since NI approach assumes that cost of debt and equity
are constant, kd and ke curves are parallel to horizontal axis. But as the financial leverage
increases, weighted average cost of capital (ko) decreases and approach cost of debt (kd), but
it does not touch kd for the reason that ko will never be equal to kd as it implies the business
is entirely financed by debt capital only. This is not practicable.

NET OPERATING INCOME APPROACH:

This approach argues that the market value of the firm is independent of capital
structure of the firm. David Durand who advocated NOI approach argues that the market
value of the firm depends on its Net Operating Income and operating risk. The financial
leverage or the capital structure does not have any impact either on EPS, EBIT or Market
value of the firm. The weighted average cost of capital does not alter because of the changes
in the financial leverage. Even though the company is able to borrow more debt capital and
uses these funds productively, the increase of debt component in the total capital increases
the cost of equity capital as the equity shareholders expect more return in view high risk in
the form of more debt component. Therefore, the change in the financial leverage merely
distributes the risk between debt and equity. The changes in financial leverage may alter the
cost of debt and cost of equity with out affecting the weighted average cost of capital and it is
constant irrespective of leverage. Maximisation of market value or reaching optimal capital
structure is not practically possible as long as weighted average capital is constant.

The following are the assumptions of NOI:

1. The cost of debt is constant
2. There are no corporate taxes
3. Cost of equity, the expected rate of return of the equity shareholders increases with
the increase in financial leverage. Because of higher debt component, the risk of the
shareholders increases. Therefore, the equity shareholders also expect more return to
compensate their risk exposure.
4. Net operating income is capitalised at the weighted average cost of capital. As long as
business risk is constant, ko also remains constant.
5. The market value of the firm depends upon its investment and net operating income.
But not separately on debt component and equity component.
152
Example:
A company has an annual net operating income of Rs. 60,000. It has Rs. 2,00,000 of 10
percent debt. The overall capitalisation rate (ko) is 15 percent.
What is the market value of the firm?
Solution:
Value of the Company (NOI Approach)
Net operating income (NOI) (X) = Rs. 60,000
Overall Cost of Capital (ko) 0.15
Market value of the company (V) = (60,000/.15) Rs. 4,00,000
Market value of Debt (D) Rs. 2,00,000
Market value of Equity (S) = V-D Rs. 2,00,000
X −1 Rs. 60, 000 − 20, 000
Cost of Equity (ke) = = = 0.20 or 20 percent
S Rs. 2, 00, 000
To check that the overall cost of Capital (ko) constant, let us calculate:
D S  2, 00, 000   2, 00, 000 
= ko = kd   + ke   = .10   + .20  
v v  4, 00, 000   4, 00, 000 
= .05 + .10 = 0.15 or 15 percent.
In order to examine the impact of leverage let us assume that the company enhances
the amount of debt from Rs. 2,00,000 to Rs. 3,00,000 and uses the proceeds to repurchase
equity shares.
Therefore the value of the company would remain at Rs. 4,00,000 but the cost of
equity would rise to 30 percent as shown below.
Value of the Company (NOI Approach)
Net operating income (NOI) (X) = Rs. 60,000
Overall Cost of Capital (ko) 0.15
Market value of the company (V) = X/ko = (60,000/15) Rs. 4,00,000
Market value of Debt (D) Rs. 3,00,000
Market value of Equity (S) = V – D =(4,00,000 – 3,00,000) 1,00,000

X −I Rs.60, 000 − 30, 000

Cost of equity (ke) = = = 0.30 or 30 percent
S Rs.1, 00, 000

D S  3, 00, 000   1, 00, 000 

Overall cost Capital ko = kd   = ke   = .10   + .30  
V  V   4, 00, 000   4, 00, 000 
= .075 + .075 = .150 or 15 percent
In order to ensure that the equity capitalisation rate (ke) would come down with the
decrease in the amount of debt, let us suppose that the company retires debt of Rs. 1,00,000
by issuing new equity shares of the same amount. Then the cost of equity would come down
to 16.67 percent as indicated below:

153
 Value of the company (NOI Approach)
Net operating income (NOI) Rs. 60,000
Overall cost of Capital (ko) 0.15
Market value of the company (V) = X/ko = (60,000/.15) Rs. 4,00,000
Market value of Debt (D) Rs. 1,00,000
Market value of Equity (S) = V – D Rs. 3,00,000
X −I Rs.60, 000 − 10, 000 50, 000
Cost of equity (ke) = = = = .1667 or 16.67%
S Rs.3, 00, 000 3, 00, 000

D S
Overall cost capital ko = kd   = ke  
V  V 
 1, 00, 000   3, 00, 000 
= .10   + .1667   = .25 + .125
 4, 00, 000   4, 00, 000 
= 0.15 or 15 percent
From the above analysis, it can be concluded that cost of equity increases when there
is an increase in the amount of debt and decreases when the amount debt was reduced.
The graphical representation of NOI approach is given below:

Figure
ke
Y

ko 15%
Cost of Capital
ke, kd and ko

k0 kd 10%

0 X
Financial Leverage (D/S)

In the above diagram, ko and kd are constant and ke increases with leverage. Since the
overall cost of Capital (ko) is constant, according to this approach, there will not be any
unique optimum capital structure and any capital structure is optimum.

TRADITIONAL APPROACH
The traditional approach of capital structure accepts the arguments of both the NI
approach and NOI approach with certain limitations. Thus, it is an intermediary approach.
Like NI approach it argues that debt capital is a cheaper source of capital and the funds rose
from this source if at all used productively and generate more return than the payment of
154
interest on debt, the firm is very much benefited. In other words, the market value of the firm
increases by using more funds forms this cheaper source of debt. But it is at the same time,
the traditional approach also argues that there is a limit for using the debt capital in the total
capital structure. If the firm increases debt capital beyond certain limits, the risk of the
company will be undoubtedly more in the form of payment of interest and principal on
maturity date. Therefore, beyond certain point, the use of more and more debt capital
influences the market value of the firm negatively. Therefore, the traditional approach argues
a firm which uses the financial leverage judiciously can only maximise its market value.

The main conclusions of traditional approach are:

1. The cost of debt capital (kd) remains constant only upto a certain degree of financial
leverage. There after, the cost of debt increases at an increasing rate in view for more
and more demand for debt capital.

2. As long as kd is constant, the cost of equity capital (ke) will also be constant as there is
no change in the risk of the equity shareholders. But when kd starts increasing ke will
increase sharply at faster rate than kd.

3. ko, the cost of total capital will be influenced by changes in kd and ke. As long as kd or
ke are constant, ko decreases because of productive use of funds raised from cheaper
source of debt capital. When both the costs, ke and kd increase, ko will start raising
moderately upto a certain degree of leverage and there after increases sharply.

Illustration:
A firm has net operating income of Rs. 54,000. Its cost of equity is 14 percent. It has
8% debentures of Rs. 1,50,000. Find out the value of the firm under traditional approach. The
market value of the firm and overall cost of capital would be as follows:
Solution:
VALUE OF THE FIRM (Traditional Approach)
Net operating income (NOI), Rs. 54,000
Less: interest on 8% debt (I) 12,000
Income available to shareholders (NOI – I) Rs. 42,000
Equity Capitalisation rate (ke) .14
Market value of equity (S) = NOI – I/ke = 42,000/.14 Rs. 3,00,000
Market value of Debt = I/kd = 12,000/.08 Rs. 1,50,000
Market value of the firm (V) = S + D Rs. 4,50,000
Overall cost of capital = NOI/V = 54,000/4,50,000 = 12%
Debt Equity Ratio (D/S) = 1,50,000:3,00,000 = 1:2
In order to study the impact of changes in leverage on the value of the firm, let us
assume that the firm is considering to increase its leverage by issuing Rs. 1,00,000 additional
debentures and using the proceeds to repurchases that amount of equity. It is also assumed,
with the increase of leverage the cost of equity rose to 15 percent and cost of debt to 9
percent.
155
 VALUE OF THE FIRM (Traditional Approach)
Net operating Income (NOI) Rs. 54,000
Less: interest on 9% on total debt (I) 22,500
Income available to shareholders (NOI – I) Rs. 31,500
Equity Capitalisation rate (ke) .15
Market value of equity NOI – I/ke = 31,500/.15 Rs. 2,10,000
Market value of Debt (D) = Rs. 2,50,000
Market value of the firm (V) = S + D Rs. 4,60,000
Overall cost of capital = NOI/V = 54,000/4,60,000 = 11.7%
Debt Equity Ratio (D/s) = 2,50,000/2,10,000 = 1.19
Let us further assume that the firm issues additional Rs. 1,50,000 debentures instead of
Rs. 1,00,000 and uses the proceeds to repurchase the shares of same amount. As a result of
this the cost of equity (ke) would rise to 18 percent and cost of debt (kd) to 12 percent. Then
the value of the firm and its overall cost of capital would be as follows:
VALUE OF THE FIRM (Traditional Approach)
Net operating income (NOI) Rs. 54,000
Less: interest on 9% debt (I) 36,000
Income available to shareholders (X – I) Rs. 18,000
Equity Capitalisation rate (ke) .18
Market value of equity (S) = X – I/ke = 18,000/.18 Rs. 1,00,000
Market value of Debt (D) = 1/kd = 36,000/1.12 Rs. 3,00,000
Market value of the firm (V) = S + D Rs. 4,00,000
Overall cost of capital = NOI/V = 54,000/4,00,000 = 13.5%
Debt Equity Ratio (D/S) = 3,00,000/1,00,000 = 3
In the above illustration, when the firm increased its debt equity ratio from .50 to
1.19, the overall cost of capital declined from 12% to 11.7%. But, as the debt equity ratio
increased to 3, the overall cost of capital shot up to 13.5%, thus reducing the market value of
the firm. Hence we can conclude, upto a certain level of leverage, the overall cost of capital
declines and beyond that it increase with leverage.
The relationship between cost of capital and the degree of leverage under the
traditional approach is shown below graphically.

Figure
Y
ke
ko
Cost of Capital
ke, kd and ko

kd

0 X
Financial Leverage (D/S)

156
 As can be seen from the above diagram, the overall cost of capital curve (ko) is U
shaped indicating that it reduces upto a certain point and then starts rising. At that point the
cost of capital is minimum. In other words it is the optimum capital structure.
A variation to the Traditional Approach suggests that there is a range of capital
structures instead of a single capital structure at which the cost of capital is minimum. Then,
the overall cost of capital (ko) is saucer shaped with a horizontal range as shown below:

Figure
Y
ko ke
Cost of Capital
ke, kd and ko

kd

0 X
Financial Leverage (D/S)

Another variation of this approach relates to the behaviour of cost of equity. In the
above two diagrams, cost of equity (ke) is assumed to rise slowly from the beginning itself
and then at a brisk rate. Some writers are of the opinion that it rises only after a certain degree
of leverage and not before.
The traditional approach has been criticised on the ground that it is the net operating
income and risk attached to it that determine the market value of the firm and the form in
which funds are raised has nothing to do with them.

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

157
GUIDELINE 14 : MODIGLIANI AND MILLER APPROACH

Modigliani and Miller (MM) are the two economists demonstrated that with perfect
financial markets, capital structure is irrelevant to the market value of the firm. In their
original position, they advocate the same relationship as believed by NOI approach that exists
between financial leverage, cost of capital and market value of the firm. In other words, MM
approach also argues that capital structure does not have any impact on market value of the
firm. They make a formidable attack on the traditional approach by offering behavioral
justification for the constant cost of capital (ko).
The following are the important assumptions of their approach:
1. Capital markets are perfect and are charcterised by free and readily available
information, no transaction cost, and investments are divisible and investors are
rational.
2. The dividend pay out ratio is 100 percent.
3. There are no taxes. MM removes this assumption later.
4. All firms with in a class have the same degree of business risk
Basic propositions;
There are mainly three propositions of MM hypothesis:
1. The overall cost of capital (ko) and the value of the firm (V) are independent of its
capital structure. They are constant for all degrees of leverage. The total market value
of a firm is arrived at by capitalising the NOI at a discount factor appropriate for its
risk class.
2. The second proposition of the MM approach is that the ke is equal to the capitalisation
rate of two equity streams plus a premium for financial risk equal to the difference
between ke and kd times the ratio of debt and equity. In other words, ke increases in a
manner to offset exactly the use of a less expensive source of funds represented by
debt.
3. The cut off rate for investment proposals is completely independent of the way in
which an investment is financed.
The operational justification for the MM hypothesis is the existence of two important
concepts known as Arbitrage Process and Homemade Leverage.
Arbitrage process involves buying a security in a market where price is low and
selling in another market where the price is high when the risk is same in the both the
markets. As a result, MM argue that equilibrium is resorted in the market price of a security
in different markets over a period of a time. According to MM, the arbitrage process is a
balancing operation. Homemade leverage supports the arbitrage process. According to MM,
when a company is try to maximise its market value through its financial leverage, the same
process may be adopted by the individual investor who will try to maximise his own wealth
by constituting a personnel leverage or homemade leverage for his investment. In this
process, the personnel leverage may be used as a substitute for corporate leverage.

158
Arbitrage Process:
According to Modigliani - Miller, if two firms are identical in all respects except the
degree of leverage, will have different market values only temporarily. Equilibrium is
restored through arbitrage process. Arbitrage means buying security at lower prices in one
market and selling it in another market at higher prices.
Every rationale investor in the process of investment prefers to invest in less risky
firm than risky firm when the returns are same in both the firms. When the risk is same in
both firms, the investor prefers to invest in a firm which gives more return. A levered firm
with debt capital in the capital structure is risky firm when compared to a an unlivered firm
which is doing business only with equity capital. Since the livered firm because of leverage
have more market value than the unlivered firm initially. According to MM, the investors of
the firm whose value is higher will dispose off their shares and purchase shares of the firm
whose value is lower. By doing so, they will be able to earn the same return at lower
investment and less risk. This behaviour of the investors will lead to an increase in the share
prices of the firm whose shares are being bought and to a decline in the share prices of the
firm whose shares are being sold. This could continue till equilibrium is restored in prices of
the identical firms. In case the investor do not have sufficient own capital they borrow capital
for investment. Thus, personnel leverage is made with their own capital and borrowed capital.
M.M. assume that the investors are able to substitute corporate leverage with personal
leverage.
The procedure involved in arbitrage process can be better understood with an
illustration.
Illustration:
Two firms 'P' and 'Q' are identical in all respects except that firm 'P' has 8% Rs.
3,00,000 debt. The net operating income of both the firms is Rs. 80,000. The cost of equity
(ke) of firm 'P' is 14% and cost of equity of firm ‘Q’ is 2.5%. The cost of equity of ‘P’ is more
because, shareholders are exposed to more risk.
Solution:
Based on the given information, the market values of these firms are calculated as follows:
Market value of Firms 'P' and 'Q'
Firm 'P' Firm 'Q'
(Livered firm) (Unlivered firm)
Net Operating Income, (NOI) (X) Rs. 80,000 80,000
Less: Interest on 8% debt, (I) Rs. 24,000 --
Earnings available to equity holders
(NOI – I) Rs. 56,000 80,000
Cost of equity (ke): 14% 12.5%
Market value of Equity (S) =
(NOI– I/ke) Rs. 4,00,000 6,40,000
Market value of Debt (D)= Rs. 3,00,000 --
Total Market value (S + D), V= Rs. 7,00,000 6,40,000
Overall cost of capital, (X/V) 11.4% 12.5%
159
 Thus, the market value of firm 'P' which employs debt in its capital structure is more
than that of firm 'Q'. But, because of arbitrage process this cannot continue and the value of
the two firms will be brought to the same level.
Suppose an investor, holds 10% of the levered firm's (firm P) shares. His investment
in it is Rs. 40,000 (10% of Rs. 4,00,000) and return is Rs. 5,600 (10% of Rs. 56,000).
In order to reduce the risk and get same return, will sell his holdings in firm 'P' and
investment in firm 'Q'. In order to reach the level of financial risk of firm 'P', he will resort to
personal leverage. He will borrow Rs. 30,000 at 8% rate of interest. His proportionate holding
(10%) in the firm 'Q' will be Rs. 64,000 on which his return would be Rs. 8,000, out of this,
he will pay Rs. 2,400 as interest on his personal borrowings. Then, he will be left with Rs.
5,600, which is equal to the amount he was getting from firm 'P'. But his investment outlay in
firm 'Q' Rs. 34,000 is less as compared with that in firm 'P' (Rs. 40,000). The effect of
arbitrage process is shown in the following table.
Effect of Arbitrage process
1. Investor’s Position in Firm 'P' with 10% equity holding:
a. Investment Rs. 40,000
b. Dividend (Return) Rs. 5,600
2. Investor’s position after shifting to ‘Q’ Position in firm 'Q' with 10% to equity
holding:
a. Investment (own capital + Borrowed capital) Rs. 64,000
b. Amount borrowed personally Rs. 30,000
c. Net Investment Rs. 34,000
d. Income from Investment (Dividend) Rs. 8,000
e. Interest payable on personal loan Rs. 2,400
f. Net return Rs. 5,600
Thus, the investor will be better-off by resorting to arbitrage process which is
supported by home made leverage as he gets the same return of Rs. 5,600 with less
investment (Rs. 34,000). Other investors will also do the same thing. As a result, the demand
for equity shares of ‘Q’ will increase leading to increase in the prices. Simultaneously,
demand for equity shares of ‘P’ decreases resulting in fall of its prices. Consequently,
equilibrium will be reached.
In the above illustration, we have seen that the value of levered firm cannot be more
than that of unlivered firm. Similarly the value of unlivered firm cannot be more than that of
levered firm. This is because; the arbitrage process will work in the opposite direction also.
This is illustrated with an example.

Example:
The value of two firms, Y an unlivered firm and Z a levered firm with Rs. 3,00,000
debt at 6 percent rate of interest are given as follows:
Y Z
(Unlivered firm) (livered firm)
Net Operating Income Rs. 90,000 90,000
Interest on 6% debt,( I) -- 18,000
Earnings available to shareholders Rs. 90,000 72,000
160
 Cost of equity (ke) .10 .15
Market value of equity (S) Rs. 9,00,000 4,80,000
Market value of debt (D) -- 3,00,000
Market of the firm V = S + D Rs. 9,00,000 7,80,000
Overall cost of capital (ko) .10 .1154

Let us suppose Mr. A has 10% holding of Firm 'Y'(of Rs. 90,000 and investment is Rs.
90,000)His earnings are Rs. 9,000 (10% of Rs. 9,00,000). He will sell his shares in firm 'Y'
and purchase the shares and debentures in firm 'Z'. By acquiring equal ownership in the firm
'Z' (i.e., purchasing 10% of Firm 'Z's shares as well as 10% of debt), he can earn the same
return of Rs. 90,000 by investing Rs. 78,000 only against Rs. 90,000 by investing Rs. 78,000
only as against Rs. 90,000. This is shown below:

Effect of Arbitrage Process (Reverse Direction)

1. Mr. A's position in Firm 'Y' with 10% equity - holding
a. Investment Rs. 90,000
b. Dividend Rs. 9,000
2. Mr. A's position in Firm 'Z' 10% holding
a. Equity Rs. 48,000
b. debt Rs. 30,000
c. Total investment Rs. 78,000
d. Dividend on equity Rs. 7,200
e. Interest on Debt Rs. 1,800
f. Total return Rs. 9,000
Thus, the arbitrage process will bring the market values for both the firms to an
identical level.
Limitations:
The focal point of MM approach is the arbitrage process as it provides a behavioral
justification. But the arbitrage process lacks practical relevance because of it unrealistic
assumptions.
The following are the criticisms leveled against MM Approach:
1. Generally, large borrowers with high credit-standing are able to borrow at lower
rates of interest than borrowers who are small and have weak credit standing.
Hence, the assumptions that firms and individuals can borrow and lend at the same
rate of interest go wrong in practice. Since the firm can borrow at a cost lower than
what an individual investor would be required to pay, the advantage of personal
leverage would disappear and the equalization process will not take place.
2. The risk-exposure is different in personal and corporate leverages. It is greater with
personal leverage than with corporate leverage. In case of liquidation, the liability
of investors in companies is limited to their proportionate holding. On the other
hand, the liability of an individual borrower is even extended to his property.
Hence these two leverages are not perfect substitutes.

161
 3. Because of transaction costs like brokerage, the investor would not receive the
entire investment holding when he sells his shares in the market. Therefore, he
would be required to invest a large amount to earn the same return.
4. Institutional restrictions also impede the smooth operation of the arbitrage process.
Several institutional investors would not be allowed to engage in personal
leverage. Hence, they can not substitute corporate leverage with personal leverage.
5. MM Approach ignores corporate taxes. But their existence gives a higher return to
debt and equity holders of levered firm than that of a unlevered firm. This is made
possible by the fact that interest changes are tax deductible. Hence, the value of the
levered firm is likely to be more than that of the unlivered firm.

M.M.APPROACH AND CORPORATE TAXES:

M.M's argument that the value and the overall cost of firm do not vary with changes
in degree of leverage lacks practical relevance because of the existence of corporate taxes.
Since interest, changes, payable on debt, are tax-deductible, the levered firm will have a
greater market value than an unlivered firm. Later they realised that the overall cost of capital
will decrease or the value of the firm will increase with leverage, if the corporate taxes are
taken into consideration.
They state that the market value of the firm is equal to the market value of an
unlivered firm plus the discounted percent value of the tax savings realizing from tax-
deductibility of interest charges.
Symbolically: VL = Vu + Dt
VL = Value of the levered firm
Vu = Value of the unlevered firm
D = Amount of Debt
t = Tax rate
According to MM as the overall cost of Capital decreases with leverage, a firm should
employ as much debt as possible in the capital structure to achieve an optimum capital
structure. But the excessive use of debt will expose the firm to greater business risk: it will
find it difficult to pay interest charges and principal amounts when they become due.
Similarly, beyond a certain level of leverage, creditors may not come forward to extend loans
to the firm as it is already overburdened with debt. Hence, cost of debt (kd) increases either
leverage and overall cost of capital (ko) after reaching minimum, will start increasing with
leverage. Therefore, it can be concluded that the optimum capital structure is not the one that
has 100 percent, debt and no equity but, one that has the desired level of debt. Realizing this
limitation, M.M. justified their stance on the ground that the firm would adopt a 'target debt
ratio' so as not to violate the limits of level of debt imposed by creditors. This is indirectly
submitting that there is a sage limit for the use of debt and beyond that the overall cost of
capital will increase. It implies that there is an optimum capital structure.
To conclude, different opinions have been expressed on the relationship between
capital structure, cost of capital and valuation. At one extreme, Net Income Approach argues
that leverage influences the overall cost of capital and the value of the firm and the capital
structure would be optimum with maximum debt. On the other extreme, Net Operating

162
Income Approach says that capital structure has no relevance in determining the cost of
capital and value of the firm and every capital structure is optimum. Modigliani and Miller
agree with NOI approach and put forth logical justification in support of their arguments. But
their assumptions are of doubtful validity. Heir later submission, that because of corporate
taxes the cost of capital will decline continually with leverage resembles Net Income
Approach. The traditional Approach strikes a balance between these two extreme view
points. It advocates that a firm can increase its value or reduce the overall cost of capital upto
a point. Beyond this point, the use of additional debt leads to an increase in the overall cost of
capital. That point is the optimum capital structure.
Of all the three approaches, the Traditional Approach provides an explanation that is
nearer to real life situations. But the optimum capital structure may vary from firm to firm
depending upon a number of factors.

PROBLEMS
Problem 1: A company issues debentures worth Rs. 12,00,000 at 12%. Its earnings before
interest and tax amount to Rs. 3,00,000. Its overall cost of capital is 14%. You are required to
find out the cost of equity stock according to the assumption of the Modigliani-Miller theory.
Problem 2: From the following information, you are required to find out the market value of
each firm, based on the assumption of the Modigliani-Miller theory. Every firm expects the
return on investment at the rate of 12%.
Problem 3.Two firms 'Y' and 'Z' are identical in all respects except that firm 'Y' has 8% Rs.
5,00,000 debt. The net operating income of both the firms is Rs. 80,000. The cost of equity
(ke) of firm 'Y' is 14% and cost of equity of firm ‘Z’ is 12.5%.
Suppose an investor, holds 10% of the levered firm's (firm Y) shares. His investment in it is
Rs. 40,000 (10% of Rs. 4,00,000) and return is Rs. 5,600 (10% of Rs. 56,000).
How can the investor reduces his risk through arbitrage process?

QUESTIONS:
1. Explain irrelevance concept of capital structure of MM.
2. What is arbitrage? How it helps in explaining MM concept?
3. W hat is the significance of home made leverage? How it can be a substitute to
corporate leverage?
4. What are the limitations of MM theory of capital structure?
5. Do you support Walter model of Dividend policy or MM policy? Why?

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

163
GUIDELINE 15 : DETERMINANTS OF OPTIMUM CAPITAL
STRUCTURE

The optimum capital structure is obtained as market value for share is maximum or the
weighted average cost of capital is minimum. In practice, determination of an optimum
capital structure is a formidable task. The capital structure is influenced by many factors. It
may vary from company to company in the same industry depending upon the management
policies, the company philosophy and other internal and external factors. Managers do not
make the capital structure decision only once and then forget about it. Instead, firms regularly
raise capital to invest in assets to support growth and each time they must choose the mix of
equity and debt. Many firms also pay dividends which reduces retained earnings and thus
increase the amount they must raise additionally to support their operating plans. Therefore,
the capital structure decision is inter-related with dividend policy.
For all practical purposes, all the long term sources of capital are broadly classified under
two heads. viz., Equity capital and Borrowed capital. Equity capital is raised by issuing
equity shares and it is the owners’ capital. Debt capital includes any amount that is borrowed
either in the form of debentures or borrowed from financial institutions. It involves a fixed
obligatory payment towards interest. Preference share capital, on the other hand, is included
either into equity capital or debt capital depending on the period for which it is issued. Thus,
ultimately there are only two elements of capital structure, viz., and Debt and Equity capital.
When a firm expands, it needs capital which is raised in the form of either debt or equity.
Debt has two important advantages.
1. Interest paid on debt deductible expense is a tax which lowers effective costs of debt
2. Debt holders get a fixed return. So, equity share holders do not have to share the
profits with debt holders if the business is extremely successful.
More debt as a ratio of total capital has also disadvantages
1. The higher the debt ratio, the more will be the risk for the company. Hence, the higher
is the cost of both debt and equity.
2. If a company falls on hard times and operating income is not sufficient to cover
interest charges, its share holders have to make up the short fall, and if they can not,
bankruptcy will result.
Company’s whose earnings and operating cash flows are volatile should therefore, limit
their use of debt and on the other hand company’s with less business risk and more stable
operating cash flow can take on more debt in the capital structure. The advantages and
disadvantages of various sources of capital give a scope for discussion that which source of
capital is a better source of capital and what should be the appropriate mix of various source
of capital. The optimal mix of various sources of capital depends on various factors. They are
discussed below.
FACTORS DETERMINING OPTIMUM CAPITAL STRUCTURE:
All the factors influencing capital structure or broadly classified under three heads, there are:

164
 1. Internal factors
2. External factors and
3. General factors.
The following figure shows the factors influencing capital structure:

Factor Influencing Capital Structure

Internal Factors External Factors General Factors
a. Cost of Capital a. The general level of a. The age of the firm
b. Risk business activity b. The corporate taxation
c. Flexibility b. The prevailing level of c. Government
1.The flexibility in fixed charges interest rate on debt characteristics of
2.The restrictive covenants c. The accessibility businessetc.,
in loan agreement to the stock market
3. The terms of redemption and d. The responses of the
4. The debt capacity. Investors towards
d. Size of the company new issues
e. Timing e. Tax policy of a
f. Regulatory Norms government on
g. Taxes interest and dividends
h. Profitability
i. Growth Rate
j. EBIT-EPS Analysis
k. Debt Capacity
l. Management Policies
m. Shareholders Preference

I. Internal factors:
a. Cost of Capital: Capital structure is influenced by cost of capital. Cost of capital means a
minimum required rate of return or expected rate of return by the providers of capital. By
definition optimum capital structure is one where the weighted average cost of all the sources
of capital is minimum.
Every source of capital involves cost. Interest to be paid to the borrowed capital is the
cost of debt, fixed dividends payment to the preference shareholders is the cost of preference
share capital, opportunity cost is the cost of retained earnings and expected rate of return of
equity share holders is the cost of equity shares.
In case of debt capital, the rate of interest to be paid is fixed and it is a statutory
obligation irrespective of the profit position of the company. The company is bound to pay
the interest annually or semi annually as per the speculated terms and conditions. This fixed
obligatory payment increases the riskyness of the company when the company is financed
more by debt capital. On the other hand, when the capital structure contains more equity

165
capital and less debt capital there is possibility of dilution of earning per share and therefore
the objective of maximisation of wealth of the share holders may not be achieved.
Thus in deciding the optimum capital structure, the financial manager has to verify the cost of
various sources of capitals and ultimately arrive at the minimum weighted average cost of
capital with the proper mix of all the sources of capital.
b. Risk: As every source of capital involves some degree of risk, the financial manager
always tries to minimize the total risk of the business with appropriate mix of the sources of
capital. It is needless to state that debt capital is more risky source of capital as it involves
fixed obligatory payment as per the stipulated terms. If the company doesn’t generate
sufficient revenue to meet this fixed obligation, the financial risk of the company increases.
However debt capital is a preferable source of capital when company generates more revenue
than its fixed obligation. Therefore, risk analysis is an important issue for consideration in
deciding optimum capital structure.
Risk is primarily of two types, viz., business risk and financial risk.
Business risk refers to fluctuations in the earnings of a company before interest and
taxes. It is influenced by demand variability, price variability, proportion of fixed cost in the
total cost and changes in the prices of inputs. Financial risk, on the other hand, refers to the
risk emerging from financial leverage. Financial risk is a function of capital structure. The
high degree of financial leverage which arises with high proportion of debt in the total
capital, results in high financial risk in the form of payment of more fixed financial
commitments towards interest.
An optimum capital structure will strike a balance between these types of risk and
minimizes the total risk of various sources of capital.
c. Flexibility: The capital structure is to be determined in such a way that it is flexible
enough for any changes in the future. In other words, flexibility means that the firm can
change or adjust its capital structure without any difficulty in the future. The degree of
flexibility in the capital structure of a company depends on:
1. The flexibility in fixed charges
2. The restrictive covenants in loan agreement
3. The terms of redemption and
4. The debt capacity.
1. The flexibility in fixed charges means that every source of capital as some
commitment of payment either in the form of dividends or interest. Interest on debt is
less flexibility as they payment of interest is fixed statutory obligation. It has to be
paid whether the company’s financial position is good or bad. Where as payment of
dividend on preference shares is relatively less fixed commitment. Though payment
of dividends on preference shares is fixed, it is not legally binding to pay the
dividends every year. The non-payment of dividends on preference shares can cause
some damage to the reputation of the company but it doesn’t result in insolvency. The
dividend on equity capital is not at all fixed. There is no any statutory obligation of
payment of dividends. Therefore, the financial manger has to consider all this issues
to construct a capital structure with more flexibility.

166
 2. Restrictive covenants in loan agreement refer to rules and regulations that are
stipulated in raising long-term loans and issue of debentures. These restrictions
minimise the company freedom in financial matters. For example, when the company
wants to raise loans from development banks, the development banks may put some
restrictions on declaration of dividends, in purchasing of assets, the ratio of working
capital to the total capital, conditions to raise additional capital from external sources
and so on. These conditions restrict the flexibility of capital structure and
management decisions.
3. The terms of redemption of debt and preference share capital also determine the
flexibility of capital structure. The flexibility of capital structure is high when the
company has right to redeem debt or preference share capital at its discretion.
4. The flexibility of capital structure also depends on the company debt capacity. If a
company borrows more debt initially it may not be in position to borrow additional
funds to finance unforeseen and un- predictable demand except at restrictive and
unfavorable terms. Therefore, a company should not borrow to the maximum limit
of debt capacity in order to have considerable flexibility in the capital structure.
d. Size of the Company: The size of operations of the company influences the availability
of funds form different sources. It is very difficult for small companies to raise equity capital
from the capital markets on favorable terms. The cost of equity capital will also be more.
The small companies also find it difficult to raise loans from financial institutions on easy
terms and conditions. Such small companies may find it difficult in planning their sources of
capital and therefore may not be in a position to have optimum capital structure.
On the other hand, a large company because of their large operations may be in a
position to convince both debt sources and equity source and obtain their required capital and
can plan for optimum capital structure to maximize the wealth of share holders.
e. Timing: Timing refers to appropriate time for raising capital from various sources. A time
which is favorable for raising equity capital from capital markets may not be appropriate time
for raising debt capital from financial institutions. Therefore, the financial manager has to
verify and observe the conditions in the capital market, the changing policies of developing
banks and RBI towards credit and the changing attitudes of investors on debt instruments and
equity instruments and act according to favorable timing.
f. Regulatory norms: While determining the capital structure the legal issues cannot be
ignored. In India, the capital issues act and SEBI specifies rules and regulations for capital
issues in the capital market. The debt equity ratios specified by law are 2:1 in the case of
manufacturing firms. For capital intensive industries, the debt equity ratio is 4:1 and for
shipping companies it is 6:1.
g. Taxes: Another important factor that determines the capital structure of company is its tax
payment position. The interest on debt capital is tax deductible expense; Therefore, the
effective rate of interest is to be less to the company. Where as payment of dividend on
equity is not tax deductible. Hence a company which belongs to higher income tax bracket
may prefer to have more debt capital in their capital structure and vice-versa.
h. Profitability: In practice, it is noticed that companies which are highly profitable, use
relatively less debt in their capital structure. But theoretical argument affirms that it is
always advisable to go for more debt capital in the capital structure as long as the ROI is
167
more than the fixed obligations of the company. This results in increasing of EPS and there
by maximise the wealth of share holders.
i. Growth Rate: Firms which are expanding their operations may prefer to finance their
expansion from external sources preferably through debt source. It is logically argued that,
usually only the firms with high profitability or firms hoping more profits through expansion
go for more debt. Company with high profitability must prefer to have more debt in their
capital structure.
j. EBIT –EPS Analysis: As the capital structure aims at optimizing the EPS, an optimum
capital structure must analyse the sensitivity of EPS to EBIT under different alternative
financing opportunities. The following illustration shows relationship between EBIT – EPS.
Illustration:
The present capital structure of a company is Rs 10,00,000. Equity raised at the rate of Rs. 10
per share. The tax rate of the company is 50%. The company planning to raise additional
capital of Rs. 100 lacs for expanding their operation. The additional capital can be raised by
issuing additional equity shares of 10,00,000 at the rate of Rs. 10 per share or by issuing
debentures caring 14% interest. Calculate EPS at EBIT levels of Rs.20,00,000 and Rs.
40,00,000 under both the alternative sources of capital.

Earnings Per Share Under Alternative Financing Plans

(Plan 1) Equity Financing (Plan 2) Debt Financing
Rs. Rs. Rs. Rs.
EBIT: 20,00,000 40,00,000 20,00,000 40,00,000
Interest ----- ------ 14,00,000 14,00,000
Profit before 20,00,000 40,00,00 6,00,000 26,00,000
taxes
Taxes 10,00,000 20,00,00 3,00,000 13,00,000
Profit after tax 10,00,000 20,00,00 3,00,000 3,00,000
Number of Equity
Shares 20,00,000 20,00,000 10,00,000 10,00,000
Earnings Per = Profit after tax
Share Number of Equity Shares
0.50 1.0 0.30 1.30

In general, the relationship between EBIT and EPS is as follows:

(EBIT − I)(1 − t)
EPS =
n
Where EPS = earnings per share
EBIT = earnings before interest and taxes
I = interest
n = number of equity shares
t = tax rate
168
Indifference point of EBIT
The EBIT indifference point between the two alternative financing plans can be
obtained mathematically by solving the following equation for EBIT*

(EBIT * − I1 )(1 − T) (EBIT * − I2 )(1 − T)

=
n1 n2
Where,
EBIT* = Indifference point of EBIT between two plans.
I1and I2 = Interest in plan 1and interest in plan 2.
n1, n2 = Number of equity shares in plan 1 and plan 2.

With the data given, we get

(EBIT* - 0) (0.5) (EBIT* - 10,00,000) (0.5)
--------------------- = --------------------------------
20,00,000 10,00,000
we get,
0.5(EBIT*) (10,00,000) = 0.5 (EBIT*) (20,00,000)
- 0.5 (14,00,000) (20,00,000)
5,00,000 EBIT* = 0.5 (14,00,000) (20,00,000)
EBIT* = 28,00,000
The calculation of indifference point indicates that as long as EPS is less than 28,
00,000 rupees, Plan 1 is preferable as it gives more EPS. Plan 2 is preferable when EBIT is
more than Rs. 28, 00,000. At EBIT of Rs 28, 00,000 both the plans give same EPS.

RELATIONSHIP BETWEEN EPS AND EBIT

EPS
1.50
1.30
Plan 2
1.00
Plan 1
0.50
0.30
0
28,00,000 EBIT (in lakhs of rupees)
(EBIT)

It can be observed from the above graph, Plan I shows more EPS when EBIT is less
than Rs.28,000. Plan 2 gives more EPS when EBIT is more than Rs.28,000.
k. Debt Capacity: Using of debt capital as a part of total investment involves to obligations;
Payment of interest regularly and repayment of principal on the maturity date. Therefore
before going for debt capital as a financing alternative, a firm must analyse their interest
coverage ratio, and solvency position.

169
(a). Interest Coverage Ratio: The interest coverage ratio is defined as:
EBIT
Interest on debt
This ratio measures the riskiness of the firm in terms of payment of interest towards
debt. It measures that how many times the EBIT is more than the interest obligation and
verifies what is the safety of the company if the EBIT falls by certain percentage.

(b). Cash Solvency:

Gordon Donaldson in his article on corporate debt capacity has suggested that the
analysis of debt capacity for cash solvency broadly involve four steps:
1. Determination of the tolerance limit on the probability of cash solvency.
2. Specification of the probability distribution of cash flows under recessionary
conditions.
3. Calculation of fixed charges associated with various levels of debt.
4. Distribution of debt capacity of the firm as highest level of debt which is acceptable.

L. Management Policies:
The capital structure composition to a major extent depends upon the philosophy and
policy of management. The management may follow aggressive policy, conservative policy
and moderate policy towards capital structure. The aggressive management will go for more
debt and less equity with a philosophy that the burden of payment of interest and principle of
debt always caution them constantly to do hard work and generate adequate profits.
Therefore, they prefer high financial leverage. Where as, the conservative management wants
to play always a safe game with low financial leverage. On the other hand, the moderate
management philosophy will go for appropriate capital structure as per changing trends.

M. Shareholders Preference:
The composition of debt and equity of capital structure also depends on the
shareholders preference towards risk. When more number of shareholders are risk averters,
the management may be compelled to determine their capital structure with low debt capital
and vise-versa.

EXTERNAL FACTORS:
The external factors include
1. the general level of business activity,
2. the prevailing level of interest rate on debt,
3. the accessibility to the stock market,
4. the responses of the investors towards new issues
5. tax policy of a government on interest and dividends.

170
GENERAL FACTORS:
General Factors covers
The age of the firm,
The corporate taxation,
Government influence on the business,
The operational characteristics of business etc.,

In determining the optimum capital structure, financial manager has to consider all the
internal, external and general factors.

QUESTIONS:
1. Discuss the various factors influencing the capital structure of a corporation.
2. What do you mean by optimal capital structure? What is its significance?
3. Explain the concept of indifference point of EBIT-EPS analysis.
4. What are the various internal factors that are to be considered while determing the
optimum capital structure?
5. What is the brean – even point of EBIT at which all capital structures give same EPS?

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

171
GUIDELINE 16 : COST OF CAPITAL

MEANING AND DEFINITION:

Cost of capital is one of the cornerstones of the theory of financial management. In
recent years, it has received considerable attention from both theories and practices. Cost of
capital is a very important tool in determining the optimal capital structure of the company, in
evaluating the risk and return of various investment opportunities through the application of
capital budgeting techniques and also in determining the dividend policies of the company.
Thus, the role of cost of capital is significant in financing, investment and dividend decisions.
Cost of capital is the minimum rate of return that a firm must earn on its investment to
meet all the fixed obligatory payments towards various sources of capital and to maintain its
market value. The cost of capital is a concept which should be expressed in quantitative
terms, if it is to be useful. It is a technical term which can be defined in one of the following
ways;
1. The minimum required rate of return on various sources of capital invested in the
business.
2. The cut-off rate for capital expenses
3. The target return on investment which must be serviced if the capital used is to be
justified and
4. A financial standard.
The cost of capital is a concept which should be expressed in quantitative terms, if it
is to be useful.
Types of costs:
All the costs incurred by a firm during its operations are classified under different
types. All these costs are not relevant for determining the of cost of capital. The following are
the important cost concepts which are useful in the analysis of cost of capital.
Explicit cost and Implicit cost:
The cost of capital can be either explicit or implicit. Explicit cost is any source of
capital is a discount rate which equates the present values of cash inflows and cash outflows.
In other words, it is the internal rate of return of a business. Whenever, a firm raises funds
from a particular source, there will be a series of cash inflows followed by a series of cash
outflows. For example, when a company raises capital in the form of debt worth Rs.5 lacks
@ 8 percent interest rate per annum, the cash inflow is Rs. 5 lacks and cash outflow is
interest @ 8 percent on Rs.5 lacks p.a. The same is true when the company raises funds in the
form preference shares and equity shares.
The explicit cost of specific source of capital may be determined with the help of
following equation:
CF1 CF2 CF3 CFn
IO = 1
+ 2
+ 3
+ n
(1 + k ) (1 + k ) (1 + k ) (1 + k )

172
 n
CFt
= ∑ t
t =1 (1 + k )
Where,
I0 is the net amount of funds received by a company at time 0
CFt is the outflow in period t,
k is the discounting factor or cost of capital
The discount factor is the same as the explicit cost of capital
Implicit Cost :
It is also known as opportunity cost. Opportunity cost means the cost of opportunity
which is given up in order to pursue a particular action. It is the rate of return associated with
the best investment opportunity for the firm and its shareholders that would be forgone, if the
project is presently under the consideration by the firm were accepted. The basic concept
underling implicit cost is that by availing itself of a particular investment opportunity, a
company has to scarify other investment opportunities. The cost of retained earnings is an
opportunity cost, for a share holder who is deprived of the opportunity of getting dividends
and invest them else where.
Thus, the explicit cost arises when funds are raised, where as the implicit cost arises
when the funds are used.

WEIGHTED AVERAGE COST OF CAPITAL :

Cost of capital of a firm is the weighted average cost of all the long-term sources of
capital invested in the business. For example, a firm uses debt capital, borrowed @ 10
percent interest per annum and preference share capital raised with a fixed dividend payment
of 14 percent and equity capital raised with the cost of 18 percent expected rate by the
investors, in the proportions of 50:10:40 respectively. Then the weighted average cost of
capital is :
Weighted average cost of capital = Proportion of Debt x Cost of Debt + Proportion of
Preference Share Capital x Cost of Preference shares + Proportion of Equity Capital x Cost
of Equity Share Capital
= .50 x 10%+.10 x14%+.40 x 18%
= 13.6%.
It can be noted from the above analysis that the calculation of weighted average cost
of capital involves three steps
1. Measurement of cost of specific source of capital,
2. Assignment of weights to each source of capital and
3. Calculating the total cost of capital or weighted average cost of capital.
The specific source of capital is measured as the rate of discount which equates the
present value of the expected payments to the source of finance with the cash inflows
received from that source of finance. The following is the method of calculation of specific
source of capital:

173
 n
CFt
IO = ∑ t
t =1 (1 + k )
Where,
I0 is the net amount of funds received by a company at time 0
CFt is the outflow in period t,
k is the discounting factor and
It is also essential to measure the explicit cost on a post tax basis because the cost of capital
is used to evaluate cash flows before payment of taxes.
ASSUMPTIONS
The following are the assumptions to be satisfied at the time of calculation of the
weighted average cost of capital.
1. The change in the proposals of investment does not change the risk complexion of the
business.
2. The composition of various sources of capital does not change by new financing
policies.
3. The new financing policy of the firm must be in the same lines of the existing
financing policy of the firm.

COST OF DEBT CAPITAL:

The cost of debt capital is measured as the rate of discount, which equates the present
value of post tax interests and principal repayments. The following equation describes the
method of calculation of debt calculation when the interest on debt is paid annually.
C1 (1 − T ) C2 (1 − T ) Cn (1 − T ) Fn
P = 1
+ 2 n
+ n
(1 + kd ) (1 + kd ) (1 + kd ) (1 + kd )
n
Ct (1 − T ) Fn
P = ∑ t
+ n
t =1 (1 + kd ) (1 + kd )
The Simplified Version of Cost of Debt is :
F −P
C (1 − T ) +
kd = n
(P − F )
2
Where,
P = net amount realised on debt issue
C1 = annual interest payable
T = tax rate applicable to the firm
F = redemption price
n= maturity period of debt
kd = cost of debt
174
Example:
Kiran Ltd issues 12% debentures. Its face value is Rs. 100 and net amount realised is
Rs. 92 per debenture. The maturity period is 10 years. Tax rate is 50% what is cost at debt.
F−P 100 − 92
C (1 − T ) + 12 (1 − 0.50 ) +
kd = n = 10
(P + F ) (100 + 92)
2 2
= 7.084%
It can be noted from the equation that the interest paid annually (C) is adjusted for the
tax, the company supposed to pay on its income. This adjustment is necessary because the
interest paid on tax is a tax deductible expense. The adjustment is also essential because it
brings a tax-shield. The following example clarifies the concept clearly.
Example:
Particulars Company A Company B
Earnings before interest and taxes(EBIT) Rs 200 Rs 200
Interest --- 120
Profit before taxes (PBT) 200 80
Tax at the rate of 50 per cent (T) 100 40
Profit after taxes (PAT) 50 40
It is evident from the above analysis that interest payment of 120 in case of company
B brings a tax shield of 60. This implies that the effective (post tax) cost of an interest
payment of 120 is only 60 per the company.

Flotation Costs:
When a company raises debt capital by issuing debentures or from financial
institutions, this involves flotation costs i.e., expenses towards brokerage, underwriting, legal
fesses and various other fesses towards the issue of debentures. Therefore, there will be
always difference between net amount realised on debt issue (P) and redemption price of the
debentures (F). If the difference between F and P is allowed for amortisation during the
period of debt finance, the cost of debt capital is then calculated as follows.

C (1 − T ) −
( F − P)T
n
n F
P = ∑ t
+ n
t =1 (1 + kd ) (1 + kd )
The above equation can also be written with an approximation.

C (1 − T ) +
( F − P)
(1 − T )
kd = n
(P + F )
2
175
COST OF PREFERENCE SHARE CAPITAL:
Preference Share Capital also carries a fixed obligatory payment in the form of
dividends on the total preference share capital. However, payments on dividends are not
taxable expenses. Moreover, unlike interest on debt, dividends are paid only when the firm
has sufficient cash profits. But, non payment of preference dividends may damage the
reputation of the company and also lead to participation of preference shareholders in the
management of the a firm. Non payment of dividends to preference shareholders may also
affect adversely the credit worthiness of the firm. As a result the firm may find it difficult to
raise funds and short term funds for their future operations. Therefore, dividends on
preference share capital forms the basis for the calculation of cost of preference shares.
Preference share capital is redeemable and irredeemable. The cost of preference share
capital which is redeemable is calculated as follows:
n
D F
P= ∑ t
+ n
t =1 (1 + k ) p (1 + k ) p

A simplified version at the above equation is as follow:

D+
( F − P)
kp = n
(P + F )
2
Where,
kp = Cost of Preference Share Capital
D = Dividends on Preference Share Capital
P = Realised Value of Preference Share Capital
F = Face Value of Preference Share Capital
n = number of years of maturity
Example:
ABC Company ltd issued redeemable preference with a face value of Rs 100 per
share carrying a fixed dividend rate of 14 per cent for a period of 12 yrs. The net amount
realised per share is Rs 92. the cost of preference share capital is

D+
( F − P) 14 + 1000 − 92
kp = n = 12 = 15.3%
(P + F ) (100 + 92)
2 2
In case of perpetual preference share capital, the cost of preference share capital is the
discount factor which is equating present values of dividends per share paid annually and the
net amount realised per share of preference. Thus, the cost of preference shares is calculated
with the following equation.
∞
D
P= ∑ t
t =1 (1 + k ) p

176
 D
Or kp =
P
COST OF EQUITY CAPITAL:
Equity capital of a company covers:
i) External Equity Capital which is raised by issuing equity shares,
ii) Retained earnings
The cost of equity capital is the minimum rate of return, a firm earns on the equity
financed portion of an investment project in order to leave the market prices of equity shares
unchanged. Whenever, a firm issues equity shares it should ensure the existing equity
shareholders will retain their ownership position in the company both in terms of the
expected dividends and the market price of shares. If the return on the project that is financed
by new equity is less than the required rate of return, the earning per share on equity will be
reduced. As a result, the market price per share will also decline. This required rate of return
is the cost of equity.
The following are the basic methods in estimating the minimum required rate of
return on equity capital.
1) Dividend capitalisation approach
2) Earnings capitalisation approach
Dividend Capitalisation Approach:
According to this approach the market price per share at time zero is equal to the
present values of total expected dividends. Thus, the future course of dividends on equity
shares provides the base for calculation of cost of equity. The present values of future
dividends are arrived at by discounting the dividends at a discounting factor which is known
as cost of equity shares. Thus, cost of equity equals to:
D1 D2 D∞
PO = 1
+ 2
+ LLL ∞
(1 + ke ) (1 + ke ) (1 + ke )
D
If equity share holders expect a constant dividend annually, the value of ke =
P
D
ke =
P
Usually, the dividends declared to the equity shareholders are not constant. The equity
shareholders also expect the dividends to grow annually at a rate of g per cent forever. By
incorporating growth in dividends the cost of equity capital can be calculated as follows.
D1 D1 (1 + g ) D1 (1 + g ) ∞ − 1
PO = 1
+ 2
+ LLL ∞
(1 + ke ) (1 + ke ) (1 + ke )
By solving the equation we get:
D1
ke =
Po − g
177
The above equation is based on the following assumptions.
1) The dividend pay out ratio (DPS/EPS) is constant
2) Dividends have a constant growth rate
3) The initial payments of dividends (D0 ) is positive. (i.e., D0 > 0)
4) The Market Price of the Share is dependant on the expected dividends
Illustration:
The current market price of a share is Rs 100. The expected dividend per share is Rs
10 and dividend is expected to grow at a constant rate growth rate of 5 per cent per annum.
What is the cost of equity?
D1
ke =
Po − g
= 10/100+0.05
= .10 + 0.05
= .15 or 15%
Sometimes, because of flotation costs there will be difference between realised value
per share and the face value of the share. The flotation costs are to be adjusted in order to
calculate the actual cost of equity capital.
EARNINGS APPROACH:
This approach measures the cost of equity as a ratio of total current earnings to
current market price per share.
Thus, ke = E0/ P0
Where E0 = current earnings per share
P0 = current market price per share
Example:
A company is currently earning Rs 80,000. The outstanding shares of the company
numbering 10,000 with current market price of Rs 100. What is the cost of equity capital?
Solution:
Current earning per share (EPS) = Rs 80,000 / 10,000 = Rs 8;
Current market per share = 100
Cost of equity ke = E0/ P0
= Rs 8/ Rs 100
= .08 or 8 %
Earnings - price is not a satisfactory measure of cost of equity, as it does represent
unrealistic expectation of equity share-holders. For instance, if the market price per share is
Rs. 200 and the earnings per share is Rs. 3 the earnings- price ratio will be Rs. 3 ÷ Rs 200
=1.5 %. Here, it can be said that the investors would expect a rate of return higher than the
earnings price ratio.
Nevertheless, it would give a fairly reliable measure in two situations.

178
First Situation:
Earnings price ratio gives a good measure when the following conditions are satisfied:
1) Stable earnings, i.e., growth rate of earnings is 0.
2) Dividend payout ratio is 100%
3) Only equity is employed.
Second Situation:
In an expansion situation, the earning-price ratio provides a proper measure of cost of
equity. When investment opportunities available to a firm are expected to provide a rate of
return equal to the cost of equity, the firm is said to be expanding.
As done earlier in Dividend Approach, the market price per share is to be adjusted for
flotation costs if any.
COST OF RETAINED EARNINGS:
Retained earnings are one of the major internal sources of capital. Most of the firms
prefer to use retained earnings as preferable source for financing their expansion and
diversification. There is no any contractual agreement to a fixed rate of interest as in the case
of debt or payment of fixed dividends as in the case of preference shares. Retained earnings
also do not involve repayment of principal on maturity dates. But retained earnings do not
involve any flotation costs. Thus, there is a feeling that the retained earnings are free source
of capital are part of net worth, the equity shareholders money. Hence, using of retained
earnings deprive the equity shareholders from getting dividends. Thus, the opportunity cost of
equity shareholders provides the base for computation of cost of retained earnings.
The cost of retained earnings is therefore equal to the cost of opportunity that is
foregone by the equity shareholders. There are two methods for computing the cost of
retained earnings.
First Method:
kr = Ea (1-TR/2)/P
Where
kr =the cost of retained earnings
Ea = the anticipated earnings
P = the current market price and
TR = the amount of the shareholders tax rate.
Example:
The current market price of a share is Rs. 85. A company anticipated earnings of Rs. 1
lakh to be distributed among 10,000 shareholders. The shareholders’ tax rate is 30 per cent.
Find out the cost of internally retained earning.
Solution:
Cost of internally retained earnings = 10 ( 1- .30/2)/85 = 10(1-.15)/85
= 10 x .85/85
= 8.5/85
= .10 = 10 per cent

179
This method is not very popular and is criticized on the following grounds:
i) It is difficult to establish the tax rate of shareholders and
ii) Equity stockholders generally consider retention policies of the firm and adjust
their price accordingly.
It is therefore, not necessary to adjust anticipated earnings.
Second Method:
Under this method, the cost of retained earnings is computed in the same way as that
of equity stock capital.
kr =E/ P0 + g
Where
kr = the cost of retained earnings
E = the earning per share
P0 = the price of the share of stock, if sold
g = growth rate of dividends
The market price of a share is Rs. 80 and the growth rate of dividend is 8 per cent.
The earnings per share are Rs. 10. Find out for cost of retained earnings.
Solution:
Cost of retained earnings = 10/80 + .08
= .125 + .08
= 20.5 per cent.
PROBLEMS AND REVIEW QUESTIONS
Problem 3:
From the following information, you are required to find out the cot of equity capital
for Firm A, Firm B, and Firm C, assuming that the cost of equity (Ke) is varying at different
levels of debt, and the cost of overall capital is 12%, 14% and 16%, for firm A, Firm B and
Firm C, respectively.

Problem 4:
A company issues debentures of Rs. 35,00,000 at 12.5%. The EBIT amounts to Rs.
12,00,000. The cost of equity capital is fixed as a constant % for the company of the risk
class of 20%. You are required to find out the overall cost of capital of the company
according to the theory which assumes the fixed cost of equity capital and also assumes that
there is no preferred stock.
1. The market price of a share is Rs. 125 and a company plans to pay a dividend of Rs. 5
per share. The growth in dividends is expected to be at the rate of 8 percent. Find out
the cost of equity capital.
2. A company issues Rs. 50,00,000 in five years debentures with a 9% coupon rate
through the underwrite. It pays the underwriters Rs. 2,00,000 in addition to 2% of the
proceeds of the issues. If the company’s tax rate is 50%, find out the explicit cost of
the debenture issue after taxes.

180
 3. A corporation has the following capital structure at the end of July 1988:
(Rs.)
12% 1988 Debentures 15, 00,000
9% Preferred Stock 10, 00,000
Equity Stock (1,20,000 shares of Rs. 10 each) 12, 00,000
A company has the marginal tax rate of 50%. It is expected to pay dividend of Rs.
1.50 per share this year and this dividend is expected to grow at the annual rate of 10% in the
future. From the above information you are required to find out the firm’s cost of capital.
4. A company has the following capital structure: Rs.
12% Debentures 26, 00,000
8% Preferred Stock 20,000
Shares of Rs. 50 each 1, 00,000
Equity Stock (50,000 shares of Rs. 50 each) 25, 00,000
The equity stock is currently selling at Rs. 60 per share and is expected to get the
dividend of RS. 4. Stockholders anticipate that the equity stock dividend will grow at a rate of
6% per annum in the near future. The company has a tax rate of 60%. From the above
information, you are required to calculate the cost of capital of the company.
4. State briefly the different types of costs.
5. Enumerate the methods of computing the cost of (a) Equity capital. (b) Preferred
capital. (c) Debt capital. (d) Internal generated funds.
6. Explain the approach of weighted average cost of capital and state its limitations.

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

181
GUIDELINE 17 : WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of total capital is calculated after arriving at the cost of
each source of capital namely debt, preference and equity shares and retained earnings. The
cost of total capital is also known as the overall cost of capital or the weighted average cost of
capital.
The calculation of weighted average cost of capital involves broadly four steps.
1) Estimating the cost of each source of capital
2) Assigning weights to each source of capital in the total capital of the firm
3) Multiplying the cost of each source of capital with their respective weights
4) Adding up the weighted costs of all sources of funds
Weighted Average Cost of Capital:
So far we have seen the calculation of costs specific sources such as cost of debt, cost
of equity etc., now let us study the meaning and mechanics of calculation of weighted
average cost of capital.
In financial decision - making, whenever the term cost of capital' is used, it refers to
the composite or overall cost of capital. It was used in the past, to reflect the cost of specific
sources of finance which are used to finance the project. Recently, it is proved to be
erroneous. This is because the use of any one source in capital structure does influence the
costs of other sources. For instance if a firm decides to make use of debt in financing a new
project, it will weaken the equity base and as a result the risk to equity shareholders will
increase. This in turn leads to an increase in cost of equity. Similarly, if it opts for equity to
finance projects, its equity base will be strengthened and it will be able to raise debt without
any difficulty. Hence, it is imperative to use cost of capital in composite sense.
The average or overall cost of capital may be defined as weighted average of the cost
of various sources of funds weights being the relative proportions of different sources of
funds in the capital structure. It should be kept in mind that it is the weighted average, not the
simple average which is to be used. This is because, the firm does not use various sources
equally.
Since after-tax cost of capital is useful in financial decision making, the costs of costs
of specific sources that go into the determination of weighted average cost of capital should
be the after-tax costs. The following illustration highlights, the procedure involved in
computing the weighted average costs of capital.
Illustration:
The capital structure of a company is as follows:
Source of finance Amount
Equity share capital 5,00,000
Retained Earnings 1,00,000
Preference share capital 1,50,000
Debt 2,50,000
Total Rs. 10,00,000
182
The following are the after-tax costs of various sources of finance:
Source Cost
Equity capital 12%
Retained Earnings 10%
Preference Capital 8%
Debt 5%
Compute the weighted average Cost of Capital.
Solution:
Computation of weighted Average Cost of Capital
Source Amount Weight After-tax Cost Weighted Cost
(1) (2) (3) (4) (3) (4) = (5)
Equity Capital Rs. 5,00,000 0.50 12% 6.00%
Retained Earnings Rs. 1,00,000 0.10 10% 1.00%
Preference Capital Rs. 1,50,000 0.15 8% 1.20%
Debt Rs. 2,50,000 0.25 5% 1.25%
Rs. 10,00,000
Weighted average cost of Capital : 9.45%
Alternatively, the weighted average cost of capital can be calculated as follows:

Computation of Weighted Average Cost of Capital (Alternative Method)

Source Amount After-tax Cost Weighted
(1) (2) (4) (3)(4)(5)
Equity Capital Rs. 5,00,000 12% Rs. 60,000
Retained Earnings Rs. 1,00,000 10% 10,000
Preference Capital Rs. 1,50,000 8% 12,000
Debt Rs. 2,50,000 5% 12,500
Rs. 10,00,000 Rs. 94,500
Rs.94,500
Weighted average Cost of Capital = × 100 = 9.45%
Rs.10, 00, 000
BOOK VALUE VS. MARKET VALUE WEIGHTS:
In computing the weighted average cost of capital, either book-value weights or
market-value weights are used. If book-value weights and market-value weights are different,
the weighted average cost of capital would vary according to the weights used. The weighted
Average cost of Capital computed by using the book - value weights will be overstated if the
book value of the share is higher than the market value and vice-versa.
Illustration:
In the preceding illustration if the firm has 20,000 equity shares outstanding and that
the current market price per share is Rs. 26. Assume that the market values and the book
values of the debt and the preference capital are same and no retained earnings. If the specific
costs are the same as before, the weighted average cost of capital based on market value
weights would be:

183
 Computation of Weighted Average Cost of Capital
(Market value weights)
Source Amount Weight After-tax Cost Weighted Cost
(1) (2) (3) (4) (3)(4)(5)
Equity Capital Rs. 5,20,000 56.53% 12% 6.78%
(20,000 shares @ Rs. 26)
Preference Capital Rs. 1,50,000 16.30% 8% 1.30%
Debt 2,50,000 27.17% 5% 1.36%
Weighted average cost of Capital: 9.44%
It is clear from the above illustrations, that the weighted average cost of capital based
on book - value weights (9.45) and the weighted average cost of capital based on market-
value weights (9.44%)
Technically the use of market value weights for calculation of weighted average of
capital is appropriate than the use of cost of book value weights. Because (i) market values of
securities indicate the amount that will be received from their sale, and (ii) the cost of specific
sources of finance are calculated on the basis of prevailing market prices. But the market
values are likely to fluctuate widely and frequently.
In practice, the use of book-value weights is preferred because (i) book values are
readily available from published information; (ii) Firms set their target capital structures in
terms of book value with the help of debt equity ratio.
WEIGHTED AVERAGE COST OF NEW CAPITAL:
The weighted average cost of capital can be compared for the various sources of
finance in the existing capital structure. This cost (also known as historical cost) is useful to
assess the management's performance in raising funds. But, as discussed already, cost of
capital plays a prominent role in evaluating capital budgeting, the problem before the
management is whether to select a project or not. In such cases, it is the cost of new funds
(used in financing the project) that should be used as an investment criterion but not the
historical cost and thus the weighted average cost of new capital or marginal cost of capital.
The term marginal cost of capital refers to the cost of raising additional funds to finance
new projects. By using the marginal weights in the computation of weighted average cost of
capital, marginal cost of capital is obtained. The marginal weights represent the proportion of
each source to the total funds to be raised.
Illustration:
The following information pertains to Vivek Ltd.
Source Amount Weight Cost Weighted Cost
Debt Rs. 1,50,000 30% 5% 1.5%
Preference Capital Rs. 1,00,000 20% 8% 1.6%
Equity Capital Rs. 2,50,000 50% 10% 5.0%
Total Rs. 5,00,000 8.1%
Vivek Ltd. intends to raise Rs. 2,00,000 during the current year to finance its
investment projects. Assume that the equity capital structure of the company is optimum and
the funds are raised in the same proportion. The equity is obtained in the form of retained
earnings. Compute average and Marginal cost of capital.
184
Solution:
The required capital of Rs. 2,00,000 will be raised in the existing proportion. Debt Rs.
60,000 preference capital Rs. 40,000 and Equity capital Rs. 1,00,000. Since there is no
change in the costs of components as well as the proportion in which they are raised the
marginal cost of capital will be equal to the historical cost of 8%. This is given below.

Computation of Average cost of Capital

Source Amount Weight Cost Weighted Cost
Debt Rs. 2,10,000 30% 5% 1.5%
Preference Capital Rs. 1,40,000 20% 8% 1.6%
Equity Capital Rs. 3,50,000 50% 10% 5.0%
Rs. 7,00,000 8.1%
Computation of Marginal Cost of Capital
Source Amount Weight Cost Weighted Cost
Debt Rs. 60,000 30% 5% 1.5%
Preference Capital Rs. 40,000 20% 8% 1.6%
Equity Capital Rs. 1,00,000 50% 10% 5.0%
Total Rs. 2,00,000 8.1%

Though, it is desirable to raise funds in the same proportion in which they are in the
existing capital structure (optimum capital structure), in practice, many constraints come in
the way of raising funds from different sources. In some cases, it raises funds from equity and
in some other cases from debt. But, in the long run the firm can maintain the required
proportion in capital structure. Hence the marginal cost of capital should be used in the
composite sense.
Cost of different sources does not remain constant forever. They remain constant upto
certain point and then start raising. For instance, the cost of debt up to Rs. 2,10,000 may be
5%. Between Rs. 2,10,000 to Rs. 5,00,000 the cost may be 6%. Similarly, the firm may be
forced to issue new equity shares, when retained earnings are not available, whose cost is
higher because of floatation costs.
When the cost of various sources increases, the average cost of capital will increase and
the marginal cost of capital will also increase but at a faster rate. This is made clear in the
following illustration.
Illustration:
In the previous example, suppose the Vivek company proposes to raise Rs. 3,00,000
next year and its retained earnings are Rs. 1,00,000. Out of Rs. 3,00,000, the proportion of
equity should be Rs. 1,50,000 (50%). Therefore, the company has to raise (Rs. 1,50,000 – Rs.
1,00,000) by issuing new shares. Assuming the floatation costs on new equity issues are 10%,
the cost of new equity will be 11.11% (10% 100/90). Debt should be raised to the extent of
Rs. 90,000 (30% of Rs. 3,00,000) and the after - tax on this new debt will be 6% as it has
already employed Rs. 2,10,000 as debt.

185
Solution
This average cost of capital and marginal cost of capital are calculated below:
Source Amount Weight Cost Weighted
Average Cost
Debt (old) Rs. 2,10,000 21% 5% 1.05%
New Debt Rs. 90,000 9% 6% 0.54%
30%
Preference Capital Rs. 2,00,000 20% 8% 1.60%
(1,40,000 + 60,000) -
Ordinary Capital :
Old + Retained 4,50,000 45% 10% 4.50%
New issues 50,000 5% 11.11% 0.62%
50% 8.30%
MARGINAL COST
Debt Rs. 90,000 30% 6% 1.80%
Preference Capital 60,000 20% 8% 1.60%
Ordinary Capital : 1,00,000 33.33% 10% 3.33%
New Issues 50,000 16.67% 11.11% 1.85%
Total 3,00,000 8.58%
One major difficulty associated with using marginal weights is that they ignore the
long run implications of the firm's current financing decision. But, since capital budgeting
decisions have long term implication, proper importance would be given to them. For
instance, a firm may be able to get at an after tax cost of 4%. If the return on best investment
project (currently available) is 5% and the weighted average cost of capital based on marginal
weights is used as a selection criterion, the project would be accepted. If next year, the firm
must rise at a cost of 10%, it has to reject a project that gives a return of 9%. In this context,
words of Gitman deserve mentioning the fact that today's financing effects tomorrow's cost is
not considered in using marginal weights.
Problems :
1. The capital structure of a company is as follows:
Source of finance Amount
Equity share capital 5,00,000
Retained Earnings 1,00,000
Preference share capital 1,50,000
Debt 2,50,000
Total Rs. 10,00,000
The following are the after-tax costs of various sources of finance:
Source Cost
Equity capital 12%
Retained Earnings 10%
Preference Capital 8%
Debt 5%
Compute the weighted average Cost of Capital.
186
2. In the preceding illustration if the firm has 20,000 equity shares outstanding and that
the current market price per share is Rs. 26. Assume that the market values and the book
values of the debt and the preference capital are same and no retained earnings. If the specific
costs are the same as before, the weighted average cost of capital based on market value
weights would be:
Computation of Weighted Average Cost of Capital
(Market value weights)
Source Amount Weight After-tax Cost Weighted Cost
(1) (2) (3) (4) (3)(4)(5)
Equity Capital Rs. 5,20,000 56.53% 12% 6.78%
(20,000 shares @ Rs. 26)
Preference Capital Rs. 1,50,000 16.30% 8% 1.30%
Debt 2,50,000 27.17% 5% 1.36%
Weighted average cost of Capital: 9.44%

3. The following information pertains to Vivek Ltd.

Source Amount Weight Cost Weighted Cost
Debt Rs. 1,50,000 30% 5% 1.5%
Preference Capital Rs. 1,00,000 20% 8% 1.6%
Equity Capital Rs. 2,50,000 50% 10% 5.0%
Total Rs. 5,00,000 8.1%
Vivek Ltd. intends to raise Rs. 2,00,000 during the current year to finance its
investment projects. Assume that the equity capital structure of the company is optimum and
the funds are raised in the same proportion. The equity is obtained in the form of retained
earnings. Compute average and Marginal cost of capital.
4. In the previous example, suppose the Vivek company proposes to raise Rs. 3,00,000
next year and its retained earnings are Rs. 1,00,000. Out of Rs. 3,00,000, the proportion of
equity should be Rs. 1,50,000 (50%). Therefore, the company has to raise (Rs. 1,50,000 – Rs.
1,00,000) by issuing new shares. Assuming the floatation costs on new equity issues are 10%,
the cost of new equity will be 11.11% (10% 100/90). Debt should be raised to the extent of
Rs. 90,000 (30% of Rs. 3,00,000) and the after - tax on this new debt will be 6% as it has
already employed Rs. 2,10,000 as debt.

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

187
GUIDELINE – 18 : LEVERAGE AND ITS APPLICATIONS

The financial performance of a company is ultimately judged on the basis of the

earnings per share of the company. The earnings per share in turn are influenced by the
operating expenses and the fixed financial obligations which the company has to meet every
year. Hence, every firm has to analyse separately the influence of fixed operating costs and
fixed financial charges and their relationship between output, revenues and earnings per share
which is otherwise known as analysis of leverage.
Leverage is of two types namely, Operating leverage and financial leverage.
Operating leverage measures the operating risk of the company while financial leverage
determines the financial risk of the company.
Operating leverage establishes the relationship between sales revenues of the firm in
terms of quantity of sales and its earnings before interest and taxes. Operating risk or
Business risk is concerned with uncertainty and variability of operating profits over a period
of time. Usually, the business risk of the firm is high when the ratio of fixed expenses to the
total expenses is more. With the increase in the sales volume or sales revenue, the business
risk declines.
On the other hand, financial leverage measures the relationship between earnings
before interest and taxes (EBIT) and earnings per share (EPS). Financial risk is the function
of capital structure of a company. In other words, the ratio of debt capital to the capital of the
company determines the financial risk in terms of the fixed obligatory interest payment at
stipulated period irrespective of the profits of the company.
The following are the basic equations that establish the relationship between sales
revenue, EBIT and EPS.
Earnings before interest and taxes(EBIT)= Total Revenue (Q x P) – Total
Variable Cost (Q x V) - Fixed Cost
EBIT = (Q x P) – (Q x V) - F
EBIT = Q (P-V)-F ---------------------(1)
EPS = (EBIT – Interest on debt) - (1- Tax rate) –
Preferred dividend (D )/ Number of Equity
Shares(N)
EPS = [EBIT-I] (1-T) – Dp /N ------- (2)
Where,
Q= Quantity of Output or Sales
P= Price per Unit
V= Variable Cost per Unit
F= Total Fixed Cost
I= Interest
T= Tax Rate
188
 Dp= Dividends on Preference Share Capital
N = Number f Equity Shares
Combining, both the equations of EBIT (1) and EPS (2). We get,
EPS = [Q (P-V)-F- I] (1-T) - Dp /N
The above equation indicates that there is close relationship between EBIT and
Quantity of sales (Q), the ratio of fixed costs in total cost and their impact on EBIT, EBIT
and EPS and the ratio of fixed interest charges on EPS. The following analysis makes these
concepts more clear.

OPERATING LEVERAGE:
The operating leverage of a firm measures its operating risk. The operating risk
depends upon the operating costs of the business. The operating costs are of three types,
namely,
1) fixed costs- which are constant irrespective of production
2) variables costs- which vary directly with the production and
3) semi- variable or semi- fixed cost which are partly fixed and partly variable
Out of these operating costs, fixed cost determines the operating risk of business to a
major extent. The operating leverage of a business is said to be high when the ratio of fixed
cost to total cost is more. The firm can reduce its operating risk only by increasing its sales
revenue. The following example clarifies this concept.
Example:
A firm’s total sales may be 2,000 units 3,000 units and 4,000 units. The selling price per
unit is Rs. 100, the variable cost per unit is Rs.50 and the total fixed costs are Rs.50,000.
What is EBIT at various above levels of sales volumes?
Solution:
Sales volume 2,000 units 3,000 units 4,000 units
Sales Revenue: 2,00,000 3,00,000 4,00,000
Less Variable cost: 1,00,000 1,50,000 2,00,000
Contribution: 1,00,000 1,50,000 2,00,000
Less Fixed cost 50,000 50,000 50,000
EBIT 50,000 1,00,000 1,50,000
The above table shows the EBIT at various levels of sales volumes indicating that
EBIT is increasing at a rapid rate with the increase in the sales volume of the company. This
is because the operating fixed costs are constant for any level of sales volume and hence the
fixed cost per unit of production reduces with the increase in the volume of production.
Therefore, the operating risk of the company also reduces.
Degree of Operating Leverage (DOL):
The degree of operating leverage is measured as follows.
189
 DOL = (∆EBIT/ EBIT)/ (∆Q/Q)
The degree of operating leverages measures a proportionate change in EBIT for a
given proportionate change in Q.
By simplifying the above equation, we get:
Q(P − V)
DOL = In other words,
Q(P − V) − F
DOL = Contribution/Profit
Contribution depends on the ratio of variable cost to sales and profit depends on both the
variable and fixed cost.
Example:
Calculate the DOL for Q of 4,000 units and Q of 6,000 units
Where P = Rs 300, V = Rs 200 and F = Rs 1,20,000
Solution:
DOL for Q of 4,000units = 4,000( 300-200)/ 4000(300-200)- 1,20,000
= 4,00,000/ 2,80,000
= 1.43
DOL for Q of 6,000 Units = 6,000(300-200)/6,000(300-200)-1,20,000
= 6,00,000/4,80,000
= 1.25

Graph
The relationship between DOL and output can be plotted as follows:

DOL Y

0 X
OUTPUT

It can be seen from the above graph that DOL decrease with the increase in output.

190
FINANCIAL LEVERAGE:
Financial leverage of a firm measures the financial risk in terms of total fixed
financial charges (Interest), the company is committed to pay. In other words, the financial
leverage of a firm is the function of its capital structure. The ratio of debt capital to the total
capital quantifies whether the financial leverage of the firm is high or low. High financial
leverage results in high financial risk and vice versa. However, the financial risk of a firm
reduces with the increase in the EBIT. In other words, the higher the EBIT, the more will be
the ability of a firm to meet the interest obligations and therefore, the less will be the financial
risk. The following illustration explains the relationship between EBIT and EPS.
Example:
Calculate EPS at various levels of EBIT of Rs 12,000 ; 28,000 and Rs 40,000 when
the rate of interest is 10 per cent on borrowed capital of Rs 40,000. The tax bracket of the
company is 50 per cent and the number of equity shares is 1000.
Solution:
Rs. Rs. Rs.
EBIT 12,000 28,000 40,000
Less Interest 4,000 4,000 4,000
EBT 8,000 24,000 36,000
Less Taxes @ 50 % 4,000 12,000 18,000
Earnings after taxes 4,000 12,000 18,000
(EAT)
EPS = ( EAT/
no. equity shares) 4 12 18
The above table points out the relationship between EBIT and EPS. With the increase
in EBIT, EPS is changing considerably. The table also clarifies that though the company’s
ability to cover its fixed interest obligation is more, it is not effectively utilizing its financial
leverage. Hence, the EPS is not increasing as faster as EBIT. It is advisable, therefore, the
company should go for more debt capital and less equity capital. In other words the company
should go for high financial leverage, so that the EPS would be more.
The Degree of Financial Leverage:
Financial leverage establishes the relationship between EBIT and EPS. The degree of
financial leverage measures the sensitivity of EPS to the changes in EBIT.
The degree of financial leverage is defined as
DFL = (∆EPS/ EPS)/ (∆EBIT/EBIT)
By simplifying this equation we get,
DFL = EBIT/( EBIT- I – Dp/ 1-T)
In the absence of preference share capital, there is no dividend payment (Dp). Then,
EBIT
DFL =
EBIT − I

191
Example:
Calculate DFL at EBIT levels of Rs50,000 and Rs 1,00,000 with the following data

P= Rs300, V= 200 F= 1,20,00 and I = Rs 20,000 and Tax rate (T) = 50%; Dp = Rs 10,000

DFL for EBIT of 50,000 = 50,000/ (50,000-20,000-10,000/1-0.5) = 5.00

DFL for EBIT of 1,00,000 = 1,00,000/ (1,00,000-20,000-10,000/(1-0.5)) = 1.67

If Dp is zero, then, DFL =

50, 000 5
DFL for EBIT of 50,000 = = = 1.67
50, 000 − 20, 000 3

1,00, 000 10
DFL for EBIT of 1,00,000 = = = 1.25
1, 00, 000 − 20, 000 8

The relation ship between DFL and EBIT is given diagrammatic representation as follows.

DFL Y

0 X
EBIT

The graph shows increase relationship between DFL and EBIT

Combined Leverage:
Combined leverage of a firm measures the total risk of business. In other words,
combined leverage measures the fixed operating cost in the total cost and fixed financial
charges and ultimately decides the impact of these two costs on EPS . The degree of
combined leverage is equal to:
DCL = DOL x DFL
Where DCL = Degree of Combined Leverage
DOL = Degree of Operating Leverage
DFL = Degree of Financial Leverage

192
 (∆EBIT/EBIT) (∆EPS / EPS)
In other words, DCL = ×
(∆Q / Q) (∆EBIT / EBIT)

(∆EPS / EPS)
=
(∆Q / Q)

It may be noted that the value of DCL may be obtained as the product of DOL and DFL:
DCL = DOL x DFL
Q(P − V) Q(P − V) − F
= ×
Q(P − V) − F Q(P − V) − F − I − Dp
(I − T)
Q(P − V)
=
Dp
Q(P − V) − F − I −
(I − T)
To illustrate the calculation of DCL consider the data for Ayudha Limited:
P = Rs 150, V = Rs. 100, F = Rs. 120,000, I = Rs. 20,000, T = 50 pr cent, and
Dp = Rs. 10,000. DCL, which is a function of the level of Q at which it is calculated, may be
computed for Q = 5,000 units and Q = 6,000 units.
6, 000(150 − 100)
DCL (Q = 5, 000) = = 2.78
10,000
5,000(150-100) - 1,20,000-20,000-
1-0.5
5, 000(150 − 100)
DTL (Q = 6, 000) = = 2.14
10,000
6,000(150-100) - 1,20,000-20,000-
1-0.5
So, the above equation indicates the ability of the firm to meet its fixed obligations
through its sales revenue that is generated from its quantity of sales. Ultimately the combined
leverage measures the percentage of change in earnings per share for a given proportionate
change in the volume of sales.
DTL Y Graph

0 X
Output

The graph shows that with the increase in output, the DCL decreases.
193
PROBLEMS ON LEVERAGE
1. An analytical statement of Vivek Company is shown below:
It is based on an output (sales) level of 80,000 units.
Sales Rs. 4,80,000
Variable Cost 2,80,000
Revenue before fixed costs 2,00,000
Fixed Costs 1,20,000
Earnings before interest 80,000
Interest 30,000
Earnings before Tax 50,000
Tax 25,000
Net Income 25,000
Calculate the degree of (i) operating leverage (ii) financial leverage and (iii) the
combined leverage from the above data.

Contribution 2,00,000
= 2.5
(i) Degree of operating Leverage = EBIT = 80,000

EBIT
(ii) Degree of Financial Leverage = EBT

(iii) Degree of combined leverage = Op.leverage fin.leverage.

Contribution EBIT Contribution

× =
= EBIT EBT EBT

Alternatively combined leverage = 2.5 1.6 = 4II. Ganesh Company is considering

three financing plans: all equity, 60 percent equity and 40 percent debt, and 40 percent
equity and 60 percent debt. Total funds needed are Rs. 6,00,000. EBIT is expected to be
Rs. 90,000. Shares can be sold at the rate of Rs. 20 per share.
Funds can be borrowed as follows:

Upto and including Rs. 1,20,000 at 8 percent

Rs. 1,20,000 to Rs. 3,00,000 at 12 percent

and over Rs. 3,00,000 at 18 percent

Compute the EPS for each plan. Assume a tax rate of 50 percent.

194
Solution:
The earnings per share under the three financial plans are calculated as follows:
Alternative
I II III
(Rs. 6,00,000 Rs. 3,60,000 Rs. 2,40,000
equity equity equity
(Rs. 2,40,000 Rs. 3,60,000
debt.) debt.)
EBIT Rs. 90,000 Rs. 90,000 Rs. 90,000
Interest --- 24,000 42,000
EBIT Rs. 90,000 Rs. 66,000 Rs. 48,000
Taxes @ 50% 45,000 33,000 24,000
EAT Rs. 45,000 Rs. 33,000 Rs. 24,000
No. of shares 30,000 18,000 12,000
EPS Rs. 1.50 Rs. 1.83 Rs. 2.00

Since the III alternative gives the maximum EPS it is the best alternative.
Note: 1. The interest charges for alternative II and III are calculated as follows:
Alternative II:

Rs. 1,20,000 @ 8% Rs. 9,600

1,20,000 @ 12% 14,400

Rs. 2,40,000 Rs. 2,40,000

Alternative III:

Rs. 1,20,000 @ 8% Rs. 9,600

1,80,000 @ 12% 21,600

60,000 @ 18% 10,800

Rs. 3,60,000 Rs. 42,000

2. The number of shares are found out by dividing the amount to be raised through equity
issue by the market price per share.
The market price per share is Rs. 20 in all the three alternatives.

195
III. A company is considering to raise Rs. 4,00,000 to finance a project. The following
three financing alternatives are feasible:
i. The company may issue 40,000 shares at Rs. 10 per share.
ii. The company may issue 20,000 shares at Rs. 10 per share and 2,000 debentures of
Rs. 100 denominations bearing a 6 percent coupon rate of interest.
iii. The company may issue 10,000 shares at Rs. 10 per share and 3,000 debentures of
Rs. 100 denominations bearing a 6 percent coupon rate of interest.
If the Company's profits before interest are (a) Rs. 10,000 (b) Rs. 24,000 (c) Rs.
50,000 what are the respective earnings per share and rates of return on equity capital for
each of there alternatives? Which alternative would you recommend and why assume a
corporate tax rate of 50 percent.
Solution :
I. Alternative :
EBT Rs. 10,000 Rs. 24,000 Rs. 50,000
Interest 0 0 0
EBIT Rs. 10,000 Rs. 24,000 Rs. 50,000
Taxes @ 50% 5,000 12,000 25,000
EAT Rs. 5,000 Rs. 12,000 Rs. 25,000

No. of shares 40,000 40,000 40,000

EPS Rs. .125 Rs. 300 Rs. 625
Return on equity 1.25% 3% 6.25%

II. Alternative :
EBT Rs. 10,000 Rs. 24,000 Rs. 50,000
Interest @ 6%
Rs. 2,00,000 12,000 12,000 12,000
EBIT (2,000) 12,000 38,000
Taxes @ 50% 1,000 6,000 19,000
EAT (1,000) 6,000 19,000
No.of shares 20,000 20,000 20,000
EPS (Rs. 0.05) Rs. .030 Rs. 0.95
Return on equity (0.5%) 3% 9.5%
* Tax credit is assumed

196
III. Alternative :
EBT Rs. 10,000 Rs. 24,000 Rs. 50,000
Interest @ 6%
Rs. 3,00,000 18,000 18,000 18,000
EBIT (8,000) 6,000 32,000
Taxes @ 50% (4,000) 3,000 16,000
EAT (4,000) 3,000 16,000
No.of shares 10,000 10,000 10,000
EPS (Rs. 0.40) Rs. 0.30 Rs. 1.60
Return one equity (4%) 3% 16%
* Tax credit is assumed.
The selection of best financing alternative is influenced by the state of economic
conditions. If the company's sales are increasing under favourable conditions, the EPS
will be maximum under the third alternative in which more debt is made use of than the
other two alternative. This is because of the fact interest on debt is tax deductible.
IV. A firm has sales of Rs. 20,00,000 variable cost of Rs. 14,00,000 and fixed costs of Rs.
4,00,000 and debt of Rs. 10,00,000 at 10% rate of interest. What are the operating
financial and combined leverages? If the firm wants to double up its earnings before
interest and tax (EBIT) how much of a rise in sales would be needed on percentages
basis?
Sol: Sales Revenue Rs. 20,00,000
Variable Costs 14,00,000
Contribution 6,00,000
Fixed Costs 4,00,000
EBIT 2,00,000
Interest @ 10% on Rs. 10,00,000 1,00,000
EBT 1,00,000
Operating Leverage =
=
Financial Leverage =
Combined Leverage = Operating Leverage Financial Leverage = 3 2 = 6
Operating leverage shows the relationship between the sales revenue and earnings
before interest and taxes (EBIT). The operating leverage of 3 indicates that if the sales change
by 1%, the EBIT will change times, Now coming to the requirement.
doubling of EBIT means that it should increase by 100%
When EBIT increase by 3% sales increase by 1%
When EBIT increase by 100% sales increases by 1/3 100 = 33 1/3%
197
V. Rame Corporation has estimated that for a new product the break even point is 4,000
units. If the item is sold for Rs. 14 per unit, the cost accounting department has
currently identified variable cost of Rs. 9 per unit. Calculate the degree of operating
leverage for sales volume of 5,000 units and 6,000 units. What do you infer from the
degree of operating leverage at the sales volumes of 5,000 units and 6,000 units and
their difference, if any?
Sol: To calculate the degree of operating leverage, it is necessary have its two determinants
viz., contribution and fixed expenses. So first let us calculate the fixed expenses with
the help of given information.
At the break-even point, contribution = fixed expenses
Break-even point = 4,000 units
Unit contribution = Selling price per unit – Variable cost per unit
= Rs. 14 – Rs. 9 = Rs. 5
Total contribution at Break-even point = Rs. 54,000 = Rs. 20,000
Since contribution = Fixed Expenses
Fixed Expenses = Rs. 20,000
Calculation of degree of operating leverage at the sales volumes of 5,000 units and
6,000 units.
5,000 units 6,000 units
Sales Revenue Rs. 70,000 Rs. 84,000
Valuable Costs 45,000 54,000
Contribution Rs. 25,000 Rs. 30,000
Fixed Expenses 20,000 20,000
EBIT Rs. 5,000 10,000

Contribution
Degree of operating leverage =
EBIT
Rs.25,000
At 5,000 Units = =5
Rs.5,000

At 6,000 Units = Rs.30,000

=3
Rs.10,000

Operating leverage of 5 and 3 at the sales volumes of 5,000 units and 6,000 units
indicate that when there is a one percent change in sales revenue it will lead to 5% and 3%
change in EBIT respectively. When the sales volume increased to 6,000 units, operating
leverage come down to 3. This is because operating leverage will decrease with each increase
in sales above the break-even point, as fixed costs became relatively smaller compared to
revenues and variables costs.

198
VI. The capital structure of the DYNAMIC Corporation consists of an ordinary share
capital of Rs. 50,00,000 (shares of Rs. 100) and Rs. 5,00,000 of 10 debentures. Sales
increased by 20% from 50,000 units to 60,000 units: the selling price is Rs. 10 per unit.
Variable cost amounts to Rs. 6 per unit and fixed expenses amount to Rs. 1,00,000. The
income-tax rate is assumed to be 50 percent.
You are required to calculate the following :
i. the percentage increase in earnings per share
ii. the degree of operating leverage at 50,000 units and 60,000 units.
iii. the degree of financial leverage at 50,000 units and 60,000 units.
Solution:
Calculation of Earning per share
Sales Sales
50,000 Units 60,000 Units
Sales Revenue Rs. 5,00,000 Rs. 6,00,000
Less: Variable Costs 3,00,000 3,60,000
Contribution Rs. 2,00,000 Rs. 2,40,000
Fixed Costs 1,00,000 1,00,000
EBIT Rs. 1,00,000 Rs. 1,40,000
Interest @ 10% on Rs. 5,00,000 50,000 50,000
EBT Rs. 50,000 Rs. 90,000
Tax @ 50% 25,000 45,000
Earning available to shareholders Rs. 25,000 Rs. 45,000
No.of shares 5,000 5,000
Earnings per share (EPS) Rs. 5 Rs. 9

i. Increase in Earnings per share = Rs. 9 – Rs. 5 = Rs. 4

Rs.4
×100
Percentage increase in EPS = Rs.5 = 80%
Contribution
ii. Degree of operating leverage =
EBIT
Rs.2, 00,000
At 50,000 Units = =2
Rs.1, 00, 000

Rs.2, 40, 000

At 60,000 Units = = 1.71
Rs.1, 40, 000

199
 EBIT
iii. Degree of operating leverage = EBT
Rs.1,00,000
=2
At 50,000 Units = Rs.50,000
Rs.1,40,000
= 1.55
At 60,000 Units = Rs.90,000
VII. Calculate operating leverage and financial leverage under situations A, B and C and
Financial plans, I, II and III respectively from the following information relating to the
operation and capital structure of Rajeev & Company. Also find out the combinations
of operating and financial leverage which give the highest value and the best value.
How are these calculations useful to financial manager in a company.
Installed capacity 2,400 units
Actual production and sales 1,600 units
Selling price per unit Rs. 15
Variable cost per unit Rs. 10
Fixed Cost :
Situation A Rs. 2,000
Situation B Rs. 4,000
Situation C Rs. 6,000
Capital Structure :
Financial Plan
I II III
Equity Rs. 10,000 Rs. 15,000 Rs. 5,000
Debt 10,000 5,000 15,000
Cost of Debt 12%
Solution:
Calculation of operating leverage
Situations
A B C
Sales level (units) 1,600 1,600 1,600
Sales Revenue
(units price) 24,000 24,000 24,000
Variable Costs 16,000 16,000 16,000
Contribution Rs. 8,000 8,000 8,000

200
 Fixed Costs 2,000 4,000 6,000
EBIT Rs. 6,000 4,000 2,000

Contribution 8,000 8,000 8,000

= = 1.33 =2 =4
Operating Leverage = EBIT 6,000 , 4,000 , 2,000

Calculation of Financial Leverage

Situation A
Financial Plan
I II III
EBIT Rs. 6,000 6,000 6,000

Interest 1,200 600 1,800

EBT Rs. 4,800 5,400 4,200

Financial Leverage = , ,
Situation B:
Financial Plan
I II III
EBIT Rs. 4,000 4,000 4,000

Interest 1,200 600 1,800

EBT Rs. 2,800 3,400 2,200

EBIT 6,000 6,000 6,000
= = 1.25 = 1.11 = 1.43
Financial Leverage = EBT 4,800 , 5, 400 , 4, 200
Situation C:
Financial Plan
I II III
EBIT Rs. 2,000 2,000 2,000

Interest 1,200 600 1,800

EBT Rs. 800 1,400 200

EBIT 4,000 4,000 4,000

= = 1.43 = 1.18 = 1.82
Financial Leverage = EBT 2,800 , 3,400 , 2,200 = 10
Calculation of the highest and the lowest value of combined leverage.

201
Situation
Financial Plan
I II III
A 1.33 ×1.25 = 1.66 1.33×1.11 = 1.48 1.33×1.43 = 1.90

B 2 ×1.43 = 2.86 2 ×1.18 = 2.36 2 ×1.82 = 3.64

C 4 × 2.5 = 10.00 4 ×1.43 = 5.72 4 ×10 = 40.00

From the above computation, it is clear that the highest value of combined leverage is
in situation C financed by financial Plan III and the lowest value of combined leverage is in
situation A financed by financial plan II.
As the operating leverage, financial leverage and combined leverage reflect the total
risk complexion of a concern, the financial manager will get an insight into the risk with the
help of these calculations. When a firm uses high operating and financial leverage, even a
small change in sales will lead to significant fluctuation in EDs. So in unfavourable
conditions the firm will be hit hard and no financial manager wants this type of high risky
situation. On the other hand, in flow operating and financial leverages are used, in favourable
conditions, the shareholders would not receive the benefits of average. If the financial
leverage is high, the financial manager will try to have low operating leverage or vice versa,
so that the risk can be kept at a reasonable level.

QUESTIONS:
1. What is meant by leverage? How financial structure is affected by it?
2. Give the meaning of financial leverage. What are the advantages to which this leverage
can be made use of?
3. Define trading on equity. How it would be useful in arriving at a decision about
financial structure?
4. Explain operating leverage, for what purpose it can be used?
5. Give an illustration of how operating leverage can be used to the benefit of the firm.

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston Eugine F. Brigham
2. Financial Management : I.M. Pandey
3. Financial Management and Policy : James C-Vanhorne
4. An Introduction to Financial Management : Ezra Solmon John J. Pringle

202
 UNIT - IV

DIVIDEND POLICY

Dividend decision is the third important decision in finance function. The financial

manager raises capital from various sources and constructs an appropriate optimum capital

structure for maximizing the wealth of equity share holders. Similarly the financial manager

also make investment decision by striking a balance between risk and return and select

profitable projects that helps to increasing the market value of the firm. Once the business

ventures generate profit, the question before the financial manager is whether to declare these

profits as dividends to equity share holders or retain them for the purpose of financing the

expansion or diversification plans of business. If the company declares dividends to the

shareholders to satisfy their expectations, there may not be sufficient funds for meeting their

expansion plans. The company may be compelled to raise the required funds for their

expansion from the external sources by spending lot of money, energy and by undergoing

cumber some capital market procedures. On the other hand, if the company does not declare

dividends to the share holders, the dissatisfied shareholders may sell of their shares and thus

cause a fall in the market price of the share and thereby market value of the firm. The

financial manager has also to take again appropriate dividend decisions both for satisfying the

equity shareholders expectations and also see that liquidity position of the company is

reasonably sound.

203
GUIDELINE 19 : A THEORITICIAL PERSPECTIVE

The primary goal of financial management is to maximise the wealth of shareholders.

Hence, the goal of dividend decision must help to achieve the goal of financial management.
The basic objective of dividend policy is to satisfy the equity shareholders by giving
satisfactory return on their investment. The investors purchase the equity shares for two
reasons. One is to get regular return on their investment in the form of dividends. The second
one is anticipation of appreciation in the market value of equity share and thereby to get
capital gains. If the company does not declare sufficient returns on equity, there is ever
possibility that the dissatisfied equity shareholders may dispose of the equity shares in search
of profitable alternative investment opportunity. This may result in fall in the market value of
the share and their by the market value of the firm. Since the basic goal of financial
management is maximisation of the wealth of share holders, dividend decision must be taken
to achieve the basic goal.
DIVIDEND DECISION : A THEORITICIAL PERSPCTIVE
Dividend decision of the firm has significant bearing on the long term financing of the
firm and the wealth of the share holders. However there are conflicting views about the
influence of dividend policy on the market value of the firm. There is a school of thought
which feels that there is a close relationship between market value of the firm and dividend
policy of the company. With their empirical research, they proved that a company which
declares high rate of dividend claimed more market value for their equity share and thus the
market value of the firm is high. Therefore, firm must be cautious in their dividend decision.
There is another school of thought who argues that there is no any practical relationship
between dividend decisions of a firm and their market value. Hence, the dividend policy is
irrelevant to the market value of firm.
All these views about dividend policies and share valuation are grouped as follows:
1. Traditional position
2. Walter model
3. Gordon model
4. Miller and Modigliani position
TRADITIONAL POSITION:
B. Graham and D.L Dodd argued emphatically that the equity share holders give more
weight to the dividend declared by the company than to retained earnings which are ploughed
back for the purpose of required funds. According to them, the stock market is overwhelming
in favour of liberal dividends as against low and uncertain dividends. They gave the
following valuation model establishing relationship between market price per share and
dividend declared by the company

 D+R 4D mR
P = m D+  =m +
 3  3 3

204
Where,
P = Market price per share
D = Dividend per share
E = Earning per share
R = Retained earning
m = Multiple per share
According to this model for the valuation of share, the weight given to dividend is
equal to four times of the weight given to retained earnings. In other words, they are of the
opinion that the equity share holders give more preference to dividend while investing in the
equity shares of various companies.
WALTER MODEL:
J. E. Walter is another researcher who believes that the market value of the firm is
significantly influenced by the dividend policy of the company. He suggested a share
valuation model establishing, relationship between the market price of the share and the
dividends declared by the company. His valuation model is based on the following
assumptions.
1. The firm has an infinite life.
2. The cost of capital of the firm remains constant
3. The ROI of the firm remains constant
4. The model believes that there is only one source of finance i.e. retained earnings.
Walter Valuation model:
r
D + ( E − D)
P= k
k
r
D ( E − D)
P= + k
k k
P = Market price per share
D = Dividend per share
E = Earnings per share
r = Firm’s rate of return
k = Firm’s cost of capital or capitalisation rate.
The first part of the equation is the present value of an infinite stream of dividends
declared by a firm. The second part of the equation is the present value of an infinite stream
of returns from retained earnings. In other words, Walter feels that the market price of share
is equilent to the present values of total dividend declared by the company plus the present
values of earnings on retained earnings. It can be noted from the equation that the second part
of the equation would be zero when E equals to D. Thus P is influenced only by D which
means dividends. Thus, Walter concludes that the market price of a share is influenced by the
dividends declared by the company and hence the dividend policy of the firm is relevant to
market value of the firm.
205
SUGGESTED DIVIDEND POLICY BY THE WALTER:
Apart from giving relationship between market price of the share and dividend policy
of the company, Walter also suggested what should be the dividend policy of company when
r > k, r = k and r < k.
The following illustration clarifies the concept
r= 20 per cent; r= 15 per cent; r= 10 per cent
k= 15 per cent
E= Rs. 4
D= Rs. 4
IF D= Rs. 4,
From the above table it can be noted that :
1. When r>k, the price per share increases when dividend pay out ratio decreases.
In other words, the firm must declare fewer dividends to the equity
shareholders when rate of return is more than the cost of capital.
2. When r<k, the price per share increases when dividend pay out ration
increases. In other words, the firm must declare more dividends to the equity
shareholders when rate of return is less than the cost of capital.
3. When r>k the price per share is constant irrespective of dividend pay out ratio.
GORDON MODEL:
M.G Gordon is another leading contributor to the dividend policy is also of the
opinion that the market price of the share is influenced to a grater extent by the dividend
policy of the company. He is of the view that the market price of a share is equal to the
present value of an infinite stream of dividends to be received by the share holders. The basic
assumptions of the model are:
1. There are no taxes
2. The firm has a perpetual life
3. The rate of return of the firm on its investments is constant
4. The cost of capital of the firm is constant and it is more than the growth rate in
dividends of the firm.
5. Retained earnings are the only source of finance.
ORDON VALUATION MODEL
Later Gordon developed an argument that dividends declared by the company are not
constant. They grow over time. Therefore, the growth of dividend must be incorporated in the
valuation model of the shares.
The following is the valuation model suggested which is inclusive of the growth in
dividend.
When the above equation is solved, we get Gordon’s models conclusions on dividend
policies are similar to that of Walter’s model. Thus, a growth company (r>k) must follow
100% retention policy a declining (r<k) firm must declare 100 % dividend. The market value
of the share is not effected by dividend policy when r=k.
206
Problems:
1. A company earns Rs 10 per share at an internal rate of 15 per cent. The firm has a police of
paying 40 per cent of earnings as dividends. If the required rate of return is 10 per cent,
determine the price of the share under (i) Walter’s model, (ii) Gordon’s model.
2. The following data is available for Parkson Company:
Earnings Per Share = Rs. 3.00
Internal Rate of Return = 15 per cent
Cost of capital = 12 per cent
If Walter’s valuation formula holds, what will be the price per share when the dividend
payout ratio is 50 per cent? 75 per cent? 100 per cent?
3. The following data are available for Rajdhani Coroporation:
Earnings Per Share = Rs. 8.00
Rate of Return on Investment = 16 per cent
Rate of return required by Shareholders = 12 per cent
If Gordon’s basic valuation formula holds, what will he the price pr share when the dividend
payout is 25 per cent? 50 per cent? 60 per cent? 100 per cent?
4. Saraswati Glass Works has an investment of Rs 30 crore divided into 30 lakh ordinary
shares. The profitability rate of the firm is 20 per cent and the capitalisation rate is 12.5 per
cent. What is the optimum dividend payout for the firm if Walt’s model is used? What shall
be the price of the share at optimum payout? Shall your answer change if the profitability rate
is assumed to be 15 per cent? What would happen if profitability rate is 10 per cent? Show
computations.
5. The following data relate to a firm: earnings per share Rs 10, capitalisation rate 10 per
cent, and retention ratio 40 per cent. Determine the price per share under Walter’s and
Gordon’s model if the internal rate of return is 15 per cent, 10 pr cent and 5 per cent.

QUESTIONS :
1. What are the essentials of Walter’s dividend model? Explain its shortcomings.
2. What are the assumptions which underlie Gordon’s model of dividend effect? Does
dividend policy affect the value of the firm under Gordon’s model?
3. “Walter’s and Gordon’s model are essentially based on the same assumptions. Thus,
there is no basic difference between the two models.” Do you agree or not? Why?
4. “According to Walter’s model the optimum payout ratio is either zero or 100 per cent.”
Explain the circumstances, when this is true.
5. “The contention that dividends have an impact on the share price has been charcterised
as the bird-in-the-hand argument. “Explain the essentials of this argument. Why this
argument is considered fallacious?

207
BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

208
GUIDELINE 20 : MODIGLIANI- MILLER
DIVIDEND IRRELEVANCE MODEL

According to Modigliani and Miller (MM), the dividend policy of firm is not relevant
and therefore, does not affect the market value of the firm. They developed arguments, as in
the case of capital structure that the firms’ net operating income is going to affect the market
value of a firm but not the dividend policies. The following are the assumption of MM
Hypothesis
1. There are no taxes
2. Investment opportunities and future profit of the firm are known with certainty
3. No floatation cost
4. Capital markets are perfect
5. Investors are rational
A firm operating in perfect capital market conditions may face one of the following
situations for payment of dividends.
1. The firm has sufficient cash to pay dividends
2. The firm does not have sufficient cash to pay dividends and there fore, rise
additional equity capital for the payment of dividend.
3. The firm does not pay dividend.
1. Since the equity share holders are the owner of the company, the payment of cash
dividends involve transfer of their claim in profits in the firm of dividend to their hand. There
is no net gain or loss. Under perfect capital market conditions the payment of cash dividend
does not affect the value of the firm.
2. When the firm issues new equity shares to raise additional funds for the payment
of dividends, the share holders no doubt get cash dividends. But they issue of additional
shares involve increase in the number of total equity shares which may lead to dilution of
EPS. Hence the value of firm remains unchanged.
If the firm does not pay dividends, the share holders who are in need of cash may sell
a part of their holdings in the market at a market price. The number of shares held by they
existing share holders automatically reduces and as a result the new share holders we have a
claim for dividends on their investments this transaction does not result in either gain or loss
to the firm.
Illustration:
The XYZ Company Limited currently has 2 crore outstanding shares selling at a
market price of Rs 100 per share. The firm has no borrowing. It has internal funds available
to make a capital expenditure of Rs 30 crore. The capital expenditure is expected to yield a
positive net present value of Rs 20 crore. The firm also wants to pay a dividend per share of
Rs 15. Given the firm’s capital expenditure plan and its policy of zero borrowing, the firm
will have to issue new shares to finance payment of dividends to its shareholders. How will

209
the firm’s value be affected (i) if it does not pay any dividend; (ii) if it pays dividend per
share Rs 15?
Current Face Value: 2 crores × Rs. 100 = Rs 200 crore. After the capital expenditure,
the market value will increase to: 200 + 20 = Rs 220 crore. If the firm does not pay dividends,
the value per share will be: 220/2 = 110.
If the firm pays a dividend of Rs 15 per share, it will entirely utilise its internal funds
(15 × 2 = Rs 30 crore), and it will have to raise Rs 30 crore by issuing new shares to
undertake capital expenditure. The value of a share after paying dividend will be: 110 – 15 Rs
95. Thus, the existing shareholders get cash of Rs 15 per share in the form of dividends, but
incur a capital loss of Rs 15 in the form of reduced share value. They neither gain nor lose.
The firm will have to issue: 30 crore / 95 = 31,57,895 (about 31.6 lakh) shares to raise Rs 30
crore. The firm now has 2.316 crore shares at Rs 95 each share. Thus, the value of the firm
remains as: 2.316 × 95 = Rs 220 crore.

MM DEVELOPED THE FOLLOWING MODEL TO PROVE THEIR HYPOTHESIS.

D1 + P1
PO =
(1 + k )
When
PO = Market price per share at time 0
D1= Dividends per share at the end of the first year
P1= Market price per share at the end of the first year
k = Discount rate applicable to the risk class.

The total market value of n number of equity shares equals to,

1
nPO = ( nD1 + nP1 )
1+ k
When m numbers of shares are issued at P1 price at the end of first year, then the
market value of n number of shares will be:
1
nPO = ( nD1 + m ) P1 ( −mP1 )
1+ k
Where
n = number of outstanding equity shares at time 0
nPO = Total market value of outstanding equity shares at time 0
nD1 = Total dividends in year 1 payable on equity shares outstanding at time 0
m = number of equity shares issued at the end of 1st year at price P1
mP1 = Market value of shares issued at time
(n +m)P1 = total market value of all outstanding equity shares at time 1
k = Discount rate
The market value of new issue (m) equal to mP1 = I - (X - nD1)

210
 Where I = Total investment required at the end of first year
X= Total net profit of the firm
Substituting the above value for mP1 in the above equation we get
1
nPO = ( n + m ) P1 − 1 − X 
k 
The above equation shows that market value of n number of shares is influenced by P1, k,,
and X but not by D1. D1 is not found in the equation.

Dividend Irrelevance: Alternative Explanation

The price of a share is equal to the present value of the expected future dividends. If
dividends are expected to grow at a constant rate in perpetuity g, and the discount rate is k,5
D1
PO = _____ (1)
( Ke − g )
If the firm retains a constant fraction, b, of its earnings per share and earns a constant
average rate of return, r, on its investment, then;
g = b×r _____ ( 2 )
Where g = growth rate; b = fraction of earning retained and r is the average rate of
return

Further,
Dividend, D = Payout ration times × EPS
(1 − b ) × E _____ ( 3)
Substituting in equation 1, we get
(1 − b ) E 
P=  _____ ( 4 )
[ k − br ]
What would happen to P if retention ratio were to be changed?
Differentiating eq.(4) partially with respect to b,

∂p ( r − k ) E 
= =
∂b [ k − br ]
2

For price to be independent of retained earnings,

∂p / ∂b = O, i.e., r = k
In simple words, dividend policy is irrelevant if rate of return on the marginal
investment is equal to the discount rate, i.e., NPV = 0, and if r and k are independent of
payout ratio.

211
Uncertainty of Dividends:
If dividends are less than desired, investors can sell portions of their stock to obtain
the desired cash distribution. If dividends are more than desired, investors can use dividends
to purchase additional shares in the company. Thus, investors are able create return either in
the form of dividends or in the form of capital gain. Thus dividends policy is irrelevant when
dividends are perfect substitutes in the perfect capital market.
Irrelevance of Corporate Income Taxes
Corporate income taxes have no bearing on dividend relevance. Under present law,
earnings of a company are taxed at the corporate level, regardless of whether or not a
dividend is paid. In other words, it is the profit after corporate taxes that are dividend between
dividends and retained earnings.
Taxes on the Investor and Negative Effect
A differential tax on dividends and capital gains may result in a yield tilt. That is, a
dividend-paying stock will need to provide a higher expected before-tax return than will a
non-dividend-paying stock of the same risk. This is said to be necessary to offset the tax
effect on dividends. According to this notion, the greater the dividend yield of a stock, the
higher its expected before-tax return, all other things being the same.
Investors Preference:
Even with a tax wedge between dividend and capital-gains income, it is not clear that
investors at the margin are those who prefer capital gains to dividends.
Because of different tax situations, investors may have different preferences for
dividend or non-dividend-paying stocks. Many corporate investors will prefer dividend-
paying stocks, whereas wealthy individual investors may prefer stocks that pay no dividends.
Tax-exempt investors will be in different, all other things the same. If the dividend – paying
stocks were priced in the market place to provide a higher return than non-dividend –paying
stocks, however, they would not be indifferent. They would prefer dividend –paying stocks.
Apart from tax issues, we must recognize an argument for a positive dividend effect. This is
the possibility of a preference for dividends on the part of a sizable number of investors for
behavioral reasons. For one thing, the payment dividends may resolve uncertainty in the
minds of some. Also, such payments may be useful in diversifications of investments in an
uncertain world. If in fact investors can manufacture homemade dividends, such a preference
is irrational. Nonetheless, sufficient statements from investors make it difficult to dismiss the
argument. Perhaps, for either psychological or inconvenience reasons, investors are unwilling
to manufacture homemade dividends.
Flotation Costs:
The irrelevance of dividend payout is based on the idea that in accordance with the
investment policy of the firm, funds paid by a company must be replaced by funds acquired
through external financing. The introduction of flotation costs favors the retention of earnings
in the company.
Transaction Costs and Divisibility of Securities:
Transaction costs involved in the sale of securities tend to restrict the arbitrage
process in the same manner as that described for debt. Stockholders who desire current

212
income must pay brokerage fees on the sale of portions of their stock if the dividend paid is
not sufficient to satisfy their current desire for income. This fee varies inversely, per dollar of
stock sold, with the size of sale. For a small sale, the brokerage fee can be a rather significant
percentage. Because of this fee, stockholders with consumption desires in excess of current
dividends will prefer that the company pay additional dividends. Perfect capital markets also
assume that securities are infinitely divisible. The fact that the smallest integer is one share
may result in “lumpiness” with respect to selling shares for current income. This, too, acts as
a deterrent to the sale of stock in lieu of dividends. On other hand, stock holders not desiring
dividends for current consumption purposes will need to reinvest their dividends. Here again
transaction costs and divisibility problems work to the disadvantage of the stockholder,
although in opposite direction. Thus, transaction costs and divisibility problems cut both
ways, and one is not able to draw directional implications about dividends versus retained
earnings.
Institutional Restrictions
There are restrictions for the institutional investors to buy certain types of common
stock. The prescribed list of eligible securities is determined in part by the duration over
which dividends have been paid. If a company does not pay a dividend or has not paid
dividends over a sufficiency long period of time, certain institutional investors are not
permitted to invest in the stock.

QUESTIONS
1. Explain MM Dividend Policy
2. What is basic argument of MM to justify that dividend policy is not relevant?
3. Explain the Mathematical Model of MM.
4. What are the assumptions and limitations of MM Model?
5. What are the factors to be considered in the application of MM Model?

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

213
 GUIDELINE 21 : DETERMINANTS OF DIVIDEND POLICY

A dividend may be defined as a distribution to the shareholders of something of value

that belongs to the firm. As per Indian Companies Act distribution of dividends is not
obligatory. However, the companies declare the dividends to the equity share holders as
there is a belief that dividends influence the market value of price. There are three principal
kinds of dividends: (1) Cash Dividend (2) Property Dividend and (3) Stock dividend.
A Cash Dividend is a distribution to stockholders of cash. This is by far the most
common form of dividend today. Property dividend involves a distribution of some kind of
property belonging to the company to the stockholders. Because of the necessity of paying
dividends on per share basis, the property is always personal (as opposed to real property). In
recent years, the most common kind of property dividend in use has involved a distribution to
the stockholders of securities in a subsidiary owned by the firm. In the usual circumstances
the firm decides for one reason of another to divert itself of (usually) a minority common
stock interest in a subsidiary and does, distributing the shares as a property dividend to its
own stockholders. Such a distribution is called "spin-off. We need to emphasis that the shares
involved in the property dividend are those of a company other than the one paying the
dividend. Distribution of its own shares by the company to its shareholders is called stock
dividend. These are additional shares usually common shares in the same company. The
argument has been put forward with justification, that the stock dividend is not a true
dividend as nothing is being distributed to the shareholders, i.e. the commitment of funds for
the firm is not reduced by the payment of stock dividend. The usual reason given for paying a
stock dividend rather than a cash dividend is to conserve cash. It is relatively common lace to
read in an annual report in the president talk to the shareholders that a decision was made to
pay a stock dividend rather than a cash dividend because of unusual cash drains on the firm
(for new plant, acquisitions etc.,) during the year.
The reasoning behind this kind of argument is some what strained. However, if the
firm wanted to conserve cash, it could have passed the dividend altogether. There is further
fact that stock dividends are relatively expensive to process and pay out. Frequently, too, the
total dividend payment on the new shares outstanding actually increases in that the per share
dividend is not reduced in proportion to the increase in the number of shares outstanding.
Finally, there is an objection that stock-holders may be deluded into thinking that they have
received some thing of value that they otherwise would not have received when, in fact this is
not the case.

OBJECTIVES OF DIVIDEND POLICY:

The firm's dividend policy represents a plan of action to be followed whenever the
dividend decision must be made. The dividend policy must be formulated with two objectives
in mind - (i) maximising the wealth of the firm's owners and (2) providing sufficient sources
of funds. These objectives are not mutually exclusive but, rather, are interrelated. They must
be fulfilled in the light of number of constraints legal, contractual, internal, owner - related
and market - related - that limit the alternatives of the decision maker in establishing a
dividend policy.

214
DETERMINANTS OF DIVIDEND POLICY:
It has already been pointed out that dividend determination and dividend decision
depend on dividend policy which has already been discussed. The dividend policy as also
stated earlier has to function within a number of constraints which may also be called the
factors affecting dividend policy. It will therefore be relevant discuss the constraints or the
determinants of dividend policy.

LEGAL CONSTRAINTS:
There are four legal constraints confronting the corporation with respect to each
dividend payments. They concern capital, net profit, insolvency and the accumulation of
excess profits.
Dividends cannot be paid out of capital. It may be noted that these provision state a
maximum limit and not a minimum one. Legal enactments limit the amount of cash dividends
that a firm may pay. A firm cannot pay dividends out of its paid-up capital; otherwise there
would be a reduction in the capital adversely affecting the security of its lenders. The
rationale of this rule lies in protecting the claims of preference shareholders and creditors on
the firm’s assets by providing a sufficient equity base since thee creditors have originally
relied upon such an equity base while extending credit. Any dividends that impair capital are
illegal and the directors are personally held liable for the amount of illegal dividend.
Therefore, the financial manager should not violate capital impairment rules.
They do not prevent management from voluntarily distributing less nor do they prevent
creditors or preference shareholders from restricting the payment of dividend by contract.
Dividend restrictions are stipulated in the agreements entered into with the suppliers of credit.
The underlying purpose of legal restrictions on dividends is to prevent management
from reducing the equity capital below the amount that was originally paid in for the
protection of creditor’s case of complete liquidation of the company.
Dividend can be paid from earnings either from current year's earnings or from past
years earning as reflected in earned surplus. The net profits requirement is essentially a
corollary of the capital impairment requirement; in that it restricts the dividend to be paid out
of the firm’s current profits plus past accumulated retained earnings. Alternatively, a firm
cannot pay cash dividends greater than the amount of current profits plus the accumulated
balance of retained earnings. For instance, section 205 of the Indian Companies Act provides
that dividends shall be paid only out of the current profits or past profits after providing for
depreciation. The point to be recognised is that the company can count on the profits of
previous years, if thee current year’s profits fall short of the required funds for maintaining a
desired stable dividend policy.
If the firm is currently insolvent, it is prohibited form paying dividends. A firm would
not pay dividends when its liabilities exceed the assets: or when it is unable to pay its bills.

CONTRACTUAL CONSTRAINTS:
Often the firm's ability to pay cash dividends is constrained certain protective
covenants in a term loan agreement, a bond indenture, a preferred stock agreement, or a lease
contractor. Generally these constraints either prohibit the payment of cash dividends until a
certain level of earnings has been achieved or limit the amount of dividends paid to a certain

215
amount of percentage of earnings. Since cash is required to pay dividends, constraint on
dividend payments help to protect creditors, preferred stockholders, and lenders from losses
due to insolvency on the part of the firm. Contractual constraints on dividend payment are
quite common, and their violation is generally, the ground for an immediate request for re-
payment by the funds supplier.

INTERNAL CONSTRAINTS:
The firm's ability to pay cash dividends is generally constrained by the amount of
excess cash available. Of course, it is possible for a firm to borrow funds to pay dividends,
but, if borrowings were necessary, the minimum dividend would most likely be paid lenders
are not especially interested in loaning money for dividend payments, since they produce no
tangible or operating benefits that will help the firm to repay the loan. It is important to keep
in mind that, although a firm may have high earnings, its ability to pay dividends may be
constrained by a low level of liquid assets (cash and marketable securities)

GROWTH PROSPECTS:
The growth prospect of the firm must be evaluated in establishing a dividend policy.
The firm must plan its needed financing in light of its future growth prospects. The ability of
outside financing and the exact timing of funds needs will greatly affect the needed for
retained earnings to finance growth. Two factors related to growth-financial requirements and
the availability of funds-are discussed separately below.

FINANCIAL REQUIREMENTS:
The firm's financial requirements are directly related to the degree of asset expansion
anticipated. If the firm is in a growth stage, it may need all the funds it can get to finance
capital expenditure. A growing firm also requires funds to maintain and improve its assets.
High growth firms typically find themselves constantly ion need of funds. Other firms
exhibiting little or growth may not have a constant need for new funds but they may need
funds to replace or modernise assets. Hence the nature of the firm's funds need has a large
effect on the disposition of its earnings.

THE AVAILABILITY OF FUNDS:

A firm must evaluate its financial position from both a profitability and a risk
standpoint in order to develop into its ability to raise capital externally. It must determine not
only its ability to raise funds, but also the cost and quickness with which financing can be
obtained. Generally a large mature firm has greater access to new capital than the firm, in a
state of rapid growth. For this reason, the funds available to the rapidly growing firm may not
be sufficient to support the numerous acceptable projects. A growth firm is likely to have to
depend heavily on internal financing through retained earnings in order to take advantage of
the profitable projects available to it. It is therefore quite likely to pay - out a very small
percentage of its earnings as dividends. However not all growth firms are small. IBM is
considered a growth firm with a low dividend payout.
The more stable firm that needs capital funds only for planned outlays is better
advised to pay out a large proportion of its earnings, especially if it has ready sources of
financing, instead of retaining these earnings and investing them in marketable securities
until the planned outlay must be made. The firm's owners, it is assumed can ear greater return
216
on other investments. When funds are needed the firm should obtain them externally. Only
when the firm's external sources of funds are limited should it retain earnings for a planned
future outlay. If funds are needed currently, the retention of earnings may also be justifiable.
The important point for the manager to keep in mined, regardless of whether his firm is a
growing or mature firm is that his actions with respect to the retention or payout of earnings
should be aimed at maximising the owner's wealth.

Stability of Earnings:
The financial manager should remember that dividends have information value.
Withholding the payment of dividends will raise the required rate of return of the investors
and, therefore, depress the market price of the shares. The increase in earnings should be such
that it can offset the unfavorable effect of the increased cost of equity. Such firms are more
confident of maintaining a higher payout ratio.

Control:
If management is more concerned about control, either through substantial holdings or
because the shares are widely held, and the firm has a good image, it can afford to have a
high dividend payout ratio. If it requires funds later, the firm can easily raise additional funds
owing to its reputation.
Sometimes management employs dividend policy as an effective instrument to
maintain its position of command and control. The management, in order to retain control of
the company in its own hands, may be reluctant to pay substantial dividends and would prefer
a smaller dividend payout ratio.

OWNER CONSIDERATIONS:
In establishing a dividend policy, the primary concern should be how to maximise the
firm's owner’s wealth over the long run. Although it is impossible to establish a policy that
will maximise each owner's wealth, the firm must establish a policy that has a favourable
effect on the wealth of the majority of the owners. Three factors that must be considered are
the tax status of the owners, their other investment opportunities and the dilution of
ownership.

THE TAX STATUS OF THE FIRM'S OWNERS:

The tax status of a firm's owners can have a significant effect on the firm's dividend
policy. If a firm has a large percentage of wealth, stockholders who are in high tax bracket, it
may payout a low percentage of; its earnings in order to provide its owners with income in
the form of capital gains as opposed to dividends. On the other hand, a firm may have mostly
lower income shareholders who need dividend income and are in a low tax bracket, these
owners will prefer a higher payout of earnings since their tax status is not a source of
concern.
It is quite difficult for the financial manager of large, diversely held firm to know the
tax status of the owners. He can base his assessment only on feed back of directors and data
obtained on payment rate is preferable, any owners disagreeing with this strategy can divert
themselves of their holding and purchase the stock of a firm paying out a high percentage of
earnings.

217
OWNER OPPORTUNITIES:
A firm should not retain funds for investment in projects yielding lower returns than
the owners could obtain from external investments. The firm should evaluate the returns
expected in its investment opportunities from external investments such as government
securities or other corporate stocks. If it appears the owners have better opportunities
externally the firm should payout a high percentage of its earnings. If the firm's investment
opportunities are at least as good as similar - risk external investments, a low payout of
earnings is justifiable. A firm should not retain funds in the form of marketable securities in
order to make some future outlay, rather, it should pay out these earnings now and raise the
needed funds later when the outlay must be made. The external investment opportunities of
owners must be appraised and considered when dividend payment policy decisions are
formulated otherwise the maximisation of wealth may not be achieved.

THE DILUTION OWNERSHIP:

Since the most comparable alternative to the use of retained earnings as a source of
equity financing is the sale of new common stock, consideration must be given to the dilution
of ownership interests that may result from a high payout percentage of earnings, new equity
capital will have to be raised with common stock, which may result in the dilution of both
control and earnings for the existing (i.e., retaining a high percentage of its earnings) the firm
can minimise the possibility of dilution of control. High percentage payout increase the
likelihood that the firm will experience dilution in the future.
These are not all factors which may affect a dividend policy likely to be adopted by a
company. There may be other factors also which may not be discussed objectively under
convenient heads because these factors will vary according to the nature and policy of the
firm, its shareholders and management's view point. It may however be kept in mind that
there is not clash between shareholders interest and the payout policy to be adopted by the
firm.

Capital Market Considerations

Yet another set of factors that can strongly affect dividend policy is the extent to
which the firm has access to the capital markets. In case the firm has easy access to the
capital market, either because it is financially strong or large in size, it can follow a liberal
dividend policy. However, if the firm has only limited access to capital markets, it is likely to
adopt low dividend payout ratios. Such firms are likely to rely more heavily on retained
earnings as a source of financing their investments.

Inflation
Every investor wants to safeguard his investment from financial risk. Investment in
stock markets always exposed to higher inflationary risk. Therefore the investors measure
the effective rate of return either in the form of capital gains or dividend. but not in the
nominal rate of return. Thus, inflation is another factor which affects the firm’s dividend
decision.

218
Questions
1. Discuss the objects and types of dividend policies.
2. What are the determinants of a sound dividend policy?
3. Explain the nature of the factors which influence the dividend policy of a firm.
4. What are the factors that influence management’s decision to pay dividend of a certain
amount?
5. What are the internal factors that limit the dividend policy of a firm?
6. Explain various legal aspects that are to be considered in declaring dividends.

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

219
GUIDELINE 22 : CORPORATE DIVIDEND BEHAVIOUR

John Lintner conducted a survey in 1956 on corporate dividend behaviour. On the

basis of his survey he has drawn some important conclusions. They are:
1. Most of the firms decide basically the proportion of earnings to be declared as
dividends instead of the proportion of earnings to be ploughed back in the firm.
2. Since shareholders prefer a study growth and dividends firms don’t declare a high
dividend pay out ratio initially. Firms gradually reach the target payout ratio over a period of
time.
Lintner expressed corporate dividend behaviour in the form following model:

Dt = br Et + (1-b) Dt-1
Where D1 = dividend per share for year t
b = adjustment rate
r = target payout rate
E1 = earnings per share for year t
Dt-1 = dividend per share for year t-1.
Example:
XYZ Ltd. has earnings per share of Rs. 6.00 for year t. Its dividend per share for year
t-1 was Rs. 2.00. The target payout ratio is .60 the adjustment rate of dividends 0.5. What
would be the dividend per share for the company for year t if Lintner’s model applies to it?
Dt = 0.5 × 0.6 × Rs. 6.00 + 0.5 × Rs. 2.0 = Rs. 2.80
According Lintner’s, current dividend depends partly on current earnings and partly
on previous year’s dividend. Likewise the dividend for the previous year depends on the
earnings of that year and the dividend of the previous year. Thus, as per Lintner’s model,
dividend is described in terms of weighted average of past earnings.
In practice, firms do not change the dividend per share immediately with change in
the earnings per share. Shareholders like a steadily growing dividend per share. Thus, firms
change their dividends slowly and gradually even when there are large increases in earnings.
This implies that firms have standards regarding the speed with which they attempt to move
towards the full adjustment of payout to earnings.
FORMS OF DIVIDENDS
The usual practice is to pay dividend in cash. Other options are payment of the bonus
shares.
Cash dividends:
Companies mostly pay dividends in cash. A company should have liquidity position
to pay cash dividends. Payment of cash dividend involves adequate cash drain. As such,
companies after payment of cash dividend sometimes suffer from financial crunch. They may
not have adequate funds for expansion. Therefore, normally the firms will be very cautious
when they pay cash dividends.

220
TYPES OF CASH DIVIDENDS:
Although there are a number of dividend policies available to the business firms, most
of them have a number of common features. Hence we have to discuss here only three
important policies namely (i) Constant payout ratio policy (ii) A constant rupee policy and
(iii) A regular and extra - dividend policy. A particular firm's cash dividend policy may
incorporate elements of each of these policies.
CONSTANT - PAYOUT - RATIO POLICY:
The payout - ratio by definition is the firm's cash dividend per share to its earnings per
share. It indicated the percentage of each rupee earned that is distributed to the owners in the
form of cash. The firm simply established a certain percentage of earnings to be paid out each
period. The problem with this type of policy is that if the firm's earnings drop or a loss occurs
in a certain period, the dividends will be low or even non-existent. Since dividends are looked
on as supplying certain information about the firm's future, the firm's stock will most likely
be adversely affected by this type of action. The following example will make the concept
further clear:
Illustration:
The National Motor Company has a policy of paying out 40 percent of earnings. In
periods where a loss occurs the firm's policy is to pay no cash dividend. National's earnings
per share and dividends per share for the past six years are given below:
Year Earnings/share Dividends/share
1994 Rs. 4.50 Rs. 1.80
1995 Rs. 2.00 Rs. 0.80
1996 Rs. 1.50 Rs. 0.60
1997 Rs. 1.75 Rs. 0.70
1998 Rs. 3.00 Rs. 1.20
1999 Rs. 0.50 Rs. 0.20
Generally in years of decreased dividend the firm's stock price drops. When dividends
increase the price of stock increases. National, sporadic dividends payment may make its
owners very uncertain about the return they can expect from their investment in the firm and
generally depress the stock's price. Although a constant payout-ratio dividend policy is used
by some firm, it is not generally considered desirable in the larger interest of the company.

EPS
EPS
and DPS
DPS

Time

A CONSTANT - RUPEE POLICY:

This is another type of dividend policy in which a payment of a fixed rupee dividend
is paid in each period. This policy does not provide the owners with either good or bad

221
information. Instead it minimises their uncertainty. Often, firms using this policy will
increase the fixed rupee dividend once a proven increase in earnings has occurred. Under this
policy dividends are almost never decreased. The following illustration will make it further
clear.

Illustration:
The Ganga Oil Company's dividend policy is to pay annual dividend of Rs. 1.00 per
share earnings per share have exceeded Rs. 4.00 for three consecutive years at which time the
annual dividend will be raised to Rs. 1.50 per share and a new dividend policy was
established. The firm does not anticipated decreasing its dividend unless its liquidity is in
jeopardy. Ganga's earning and dividends per share for the last twelve years are given below:
Year Earnings/share Dividends/share
1988 3.00 1.00
1989 0.80 1.00
1990 0.50 1.00
1991 0.75 1.00
1992 3.00 1.00
1993 6.00 1.00
1994 2.00 1.00
1995 5.00 1.00
1996 4.40 1.00
1997 4.60 1.00
1998 4.90 1.00
1999 4.50 1.00
The above illustration is self-explanatory. The policy tend-to treat ordinary
shareholders somewhat like preference shareholders and gives no particular consideration to
the rile played by the investment of retained earnings. The danger in using this policy is that
if the distribution are too large and the dividend takes a large part of accumulated working
capital, the company may not be able to withstand the shock of operating losses. This policy
may however by operative with certain checks and balances.

EPS
Error!

DPS
EPS and DPS (Rs)

Time (Years)

Dividend policy of constant payout ratio

222
A REGULAR AND EXTRA DIVIDEND POLICY:
Some firms establish a policy of a constant rupee dividend referred as a regular
dividend. If earnings are higher than normal in a given period, the firm may pay an additional
dividend. Which will be designated as extra dividend. By designating the amount by which
the dividend exceeds the normal payments as an extra dividend, the firm avoids giving
existing and prospective shareholders false-hope of increased dividends in coming periods.
The use of the regular-extra-designation is especially common among companies that
experience cyclical shifts in earnings.
By establishing a regular dividend which is periodic, the firm gives investors the
stable divided income necessary to build their share in the soils if the firm experiences an
especially good period. Firm is using this type of dividend policy once proven increases in
earnings have been achieved. The extra dividend should not be allowed to become a regular
event, or it becomes meaningless. The use of a target payment ratio in establishing the regular
dividend level is advisable.
The three dividend policies which have been discussed above are only the basic
policies, even these policies have to function within many constraints which have to be kept
in view by the firm. There are other policies also which may be adopted according to the
needs of the firm and its policy.

Merits of Stability of Dividends

The stability of dividends has several advantages as discussed below:

Certainty in Dividends:
If a company follows a policy of changing dividend with cyclical changes in the
earnings, share holders would not been certain about the amount of dividends. If there are
temporary changes in its earnings. Thus, when earnings of a company fall and it continues to
play same amount of dividend as in the past it conveys to investors that the future of the

223
company is brighter than suggested by the drop in earnings. Similarly, the amount of
dividend is increased earnings off level only when it is possible to maintain it in future on the
other hand.

Desire for regular income:

There are many investors, such as old and retired persons, women etc., who desire
regular periodic income. They invest their savings in the shares with a view to use dividends
as a source of income to meet their living expenses. Dividends are like wages and salaries for
them. These investors will prefer a company with stable dividends to one with fluctuating
dividends.

Institutional investors’ requirements Financial:

Educational and social institutions and unit trusts also invest funds in shares of
companies. In India, financial institutions such as IFCI, IDBI, LIC and UTI are some of the
largest investors in corporate securities. Every company is interested to have these financial
institutions in the list of their investors. These institutions may generally invest in the shares
of those companies, which have a record of paying regular dividends. These institutional
investors may not prefer a company, which as a history of adopting an erratic dividend
policy. Thus, to cater the requirement of institutional investors, a company prefers to follow a
stable dividend policy.

Builds image and goodwill:

Stable and regular dividend policy tends to make the share of a company as quality
investment rather than a speculation. Investors purchasing these shares intend to hold them
for long periods of time. The loyalty and goodwill of share holders towards a company
increases with stable dividend policy. They would be more receptive to an offer by the
company further issues of shares. A history of stable dividends serves to spread ownership of
outstanding shares more widely among small investors.

Disadvantage of Stability of Dividends:

The company which is following a stable dividend policy is constantly under stress
and strain. Because they are supposed to constantly pay the dividends even in the bad
periods. Once the confidence of the investors is shattered, they company may also its
goodwill and they by market value.

Questions
1. What is a stable dividend policy? Why should it be followed? What can be the
consequences of changing a stable dividend policy?
2. How is the corporate dividend behaviour determined? Explain Linter’s model in this
regard.
3. What are the different payout methods? How do shareholders react to these methods?
4. What are the advantages and disadvantages of stable dividend policy?
5. Which type of dividend policy is preferable and why?

224
BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

225
GUIDELINE 23 : BONUS SHARES AND STOCK SPLITS
POLICIES AND PRACTICES

Some times companies issue bonus shares to the existing equity shareholders instead
of cash dividends. Bonus share are also known as stock dividends. Bonus shares are issued
out of capital reserves of the company. In India bonus share are issued in addition to the cash
dividends and not in lieu of cash dividends. By issuing the bonus shares, the number of equity
shares of the company will increase. However, the total net worth of the company is
unaffected by the bonus issue. Bonus shares issue involves only an accounting transfer of
reserves and surplus to paid-up capital. The following example illustrates the point.

ILLUSTRATION:
Kiran Ltd., pays bonus shares in 1: 10 ratio. At the time of the issue of bonus shares,
the market price pr share is Rs 30. The bonus shares are issued at the market price – a
premium of Rs. 20 over the face vale of Rs 10 each share.
(Rs in crore)
Paid-up share capital (1 crore shares, Rs. 10 per) 10
Share premium 15
Reserves and surplus 8
Total net worth 33
A 1: 10 bonus issue implies that the shareholders holding 10 shares shall get one
additional share this requires an issue of 10 lakh new shares to the existing shareholders. At a
market price of Rs 30 per share, the total value of new share issued will be Rs 3 crore. This
amount would be transferred from the reserves and surplus account into the paid – up share
capital account and the share premium account. The share capital account will be increased
by Rs 1 crore (10 lakh X Rs 10) and the remaining Rs 2 crore will be transferred to the share
premium account. The new capitalisation will be as follows:

Rs. Crore
Paid up share capital (1.10 crore shares × Rs 10 per share) 11
Share premium 17
Reserves and surplus 5
35

Advantages of the Bonus Shares

To the Company
1. The issue of bonus share doesn’t involve any cash out flow. Hence the company is in
position to retain its profits and simultaneously satisfy the acceptation the equity share
holders. The profits thus retained by the company may be used for expansion and
diversification plans. However, India this argument is not much valued argument
because bonus share can be issue in lieu of dividends.

226
 2. Some times company resort to the issue of bonus share in case of financial crisis. The
receipt bonus share satisfies the equity share holder’s psychologically. Therefore, in
order to satisfy the share holders and there by to maintain the marketing value of the
share, companies prefer to issue bonus shares.
3. Issue of bonus shares increase the number of outstanding equity shares. The larger
equity base may promote more active trading of equity shares in the market.
4. When the market price of the equity share increases abnormally to higher level, the
trading on the equity share may not be active. In order to reduce the market price to
the trading range, companies may issue bonus shares as bonus share issue increases
total number of equity shares.

Advantages Shareholders;
1. The equity share holders usually prefer bonus shares as they get the additional shares
in proportion to their equity holding in the company, all most free of investment.
2. Though the issue of bonus shares leads to reduction in the market price share, still it is
beneficial as normally the loss due to fall in market price is less then the overall
benefit the equity share holders get from the bonus issue.
3. Bonus share issue is a kind of additional information to the equity share holders that
the company is confident of generating more profits on the business and keep up or
increase the market price share in the future.
4. The total cash dividend of the share holders will increase in future as the equity
holding of the share holders will increase because of the bonus issue.

Legal Aspects
The amount of dividend that can be legally distributed is governed by company law, judicial
pronouncements in leading cases, and contractual restrictions. The important provisions of
company law pertaining to dividends are described below.
1. Companies can pay only cash dividends (with the exception of bonus shares). Apart
from cash, dividend may also be remitted by cheque or by warrant. The same may
also be transmitted electronically to shareholders after obtaining their consent in this
regard to the bank account number specified by them. The step has been proposed by
the Department of Company affairs to avoid delay in the remittance of dividend.
2. Dividends can be paid only out of the profits earned during the financial year after
providing for depreciation and after transferring to reserves such percentage of profits
as prescribed by law. The Companies (Transfer to Reserve) Rules, 1975, provide that
before dividend declaration, a percentage of profit as specified below should be
transferred to the reserves of the company.
(a) Where the dividend proposed is upto 10 percent of the paid up capital. No amount
of the current profits needs to be transferred.
(b) Where the dividend proposed exceeds 10 per cent but not 12.5 per cent of the
paid-up capital, the amount to be transferred to the reserves should not be less than
2.5 per cent of the current profits.

227
 (c) Where the dividend proposed exceeds 12.5 per cent but not 15 per cent, the
amount t he transferred to reserves should not be less than 5 per cent of the current
profits.
(d) Where the dividend proposed exceeds 15 per cent but not 20 per cent the amount t
he transferred to reserves should not 6 be less than 7.5 pr cent of the current profits.
(e) Where the dividend proposed exceed 20 per cent, the amount to he transferred to
reserves should not be less 10 per cent.
(f) A company may voluntarily transfer a percentage higher than 10 per cent of the
current profits to reserve in any financial year provided the following conditions are
satisfied:
(i) It ensures that the dividend declared in that financial year is sufficient to
maintain average rate of dividend declared by it over three years
immediately preceding the financial year.
(ii) In case, it has issued bonus shared in the year in which dividend is declared
or in the three eas immediately preceding he financial year, it maintains the
amount of dividend equal to the average amount of dividend declared over
the three years immediately proceeding the financial year.
However, maintenance of such minimum rate or quantum of dividend is not
necessary if, the net profits after tax in a financial years are lower by 20 per cent or
more than the average profits after tax of the two immediately preceding financial
years.
(g) a newly incorporated company is prohibited from transferring more than ten per
cent of its profits to reserves. The current profit for the purpose of transfer to reserves
will be profits after providing for statutory transfer to the Development Rebate
Reserve and arrears of depreciation if any.
3. Due to inadequacy or absence of profits n any year, dividend may be paid out of the
accumulated profits of previous years. In this context, the following conditions, as
stipulated by the Companies (Declaration pf dividend out or Tesves) Rules, 1975,
have to be satisfied.
(a) The rate of the declared dividend should not exceed the average of the rate at
which dividend was declared by the company in 5 years immediately preceding that
year or 10 per cent of its paid-up capital, whichever is less.
(b) The total amount to be drawn from the accumulated profits earned in previous
years and transferred to the reserves should not exceed an amount equal to one-tenth
of the sum of its paid-up capital and free reserves and the amount so dream should
first be utilized to set off the losses incurred in the financial year before any dividend
in respect of preference or equity share is declared.
4. Dividends cannot be declared for past years for which account have been adopted by
the shareholders in the annual general meeting.
5. Dividend declared, interim or final, should be deposited in a separate bank account
within 5 days from the date of declaration and dividend will be paid within 30 days
from such a date.
6. Dividend including interim dividend once declared becomes a debt. While the
payment of interim dividend cannot be revoked, the payment of final dividend can be
revoked with the consent of the shareholders.

228
Conditions for the issue of bonus shares
The following the conditions for issue of bonus share in India.
1. Bonus shares are issued only on fully paid-up shares.
2. Bonus shares are to be declared only out of non obligatory reserves.
3. A company declares bonus shares not in lieu of cash dividends.
4. The company should declare only after making provision for taxes and depreciation.
5. The issue of bonus shares should be approved by all the concern bodies.

Determining the Bonus Ratio:

Residual reserve criterion:
It specified that the reserves remaining after the amount capitalised for bonus, issue
should be at least equal to 40 per cent of the increased paid-up capital. Redemption reserve
and capital reserve on account of assets revaluation are excluded while investment allowance
reserve is included in computing the minimum residual reserve. This criterion can be
expressed as follows:
(R-Sb) ≥ 0.4S (1+b)
Where,
R = Reserves before bonus declaration
B = bonus ration
S = paid up share capital before bonus issue
Profitability Criterion:
It requires that 30 per of the previous three year’s average pre-tax profit (PBT) should
be at least equal to 10 per cent of the increased paid-up capital. This criterion can be
expressed as follows:
0.3 PBT ≥ 0.1S (1+b)
Where
PBT = average profit before tax of the company in the previous three years.

Consider an example. A company has the following data:

Rs
Paid-up share capital 100

Reserves 150

Net worth 250

Average PBT of previous three years 80

229
We can plug these data respectively in Equations (1) and (2) as follows to determine the
maximum bonus ratio:

Residual reserve criterion

150 × 100b ≥ 0.4 × 100 (1+b)
Profitability criterion
.3 × 80 ≥ 0.1 × 100 (1+b)
By sum problems the equation we get
110 14
≥ b and ≥b
140 10

Rs. In lakhs
Paid-up share capital 178.60

Reserve (100 – 80 × 17/28) 71.40

Net worth 50.00

Thus the issue of bonus shares increased paid up capital and reduced the reserves and
surplus. The net worth remains same.
SHARE SPLIT
Share split involves reducing the face value of the share and simultaneously
increasing the total number of equity share proportionately. In the case of stock split also the
total net worth of the company remains unchanged. It is also an accounting adjustment in the
balance sheet of a company where the total number of equity shares increase and the face
value of the share decrease. Hence, the total paid-up is also constant. The following
illustration explains the process of stock split.
In a stock split the par value per share is reduced and the number of shares is
increased proportionately.

Effects of a Stock Split in the Equity Portion of the Balance Sheet

EQUITY BEFORE STOCK SPLIT
Paid-up Share Capital Rs. 1,00, 00,000
(1, 00,000 Share of Rs. 100 Each Fully paid)
Reserves and Surplus Rs 50,00,000
Part B: EQUITY PORTION AFTER STOCK SPLIT IN THE RATIO 5:1
Paid-up share Capital Rs 1,00, 00,000
(50, 00,000 Share of Rs 20 each Fully Paid)
Reserves and Surplus Rs 50, 00,000
230
Comparison between Bonus Issued and Stock Split
Bonus Issue
• Reserves are capitalised partially
the few value of the stock is unchanged
• The stockholders’ net worth remains
unchanged
• The book value per share, the earnings
per share, and the market price per share
decline
• The market price per share is brought
within a more acceptable trading range
Stock Split
• No capitalisation of reserves the few
value of the stock is reduced
• The stockholders’ net worth remain
remain unchanged
• The book value per share, the earnings
per share, and the market price per share
decline
• The market price per share is brought
within a more acceptable trading range

PROBLEMS:
1. K. N. Simon Co. has been a fast-growing firm and has been earning very high return on its
investment in the past. Because of the availability of highly profitable investment internally,
the company has been following a policy of retaining 70 per cent of earnings and paying 30
per cent of earnings as dividends. The company has now grown matured and does not have
enough profitable internal opportunities t reinvest its earnings. But it does not want to deviate
from its past dividend policy on the ground that investors have been accustomed to it and any
change may not be welcome by them. The company, thus, invests retained earnings in the
short-term government securities. Is the company justified in following the current dividend
policy? Give reasons to support your answer.
2. ABC Co LTD. is a fast-growing firm in the engineering industry. In the past, the firm has
earned a return of 25 per cent on its investments and this trend id likely to continue. The firm
has been retaining 25 per cent of its earnings and paying 75 per cent of earnings as dividends.
This policy has been justified on the grounds that dividends are generally preferred over
retained earnings by shareholders.
Is the current dividend policy justified if most of the shareholders are wealthy persons
in high tax brackets? Will your answer change if most of the shareholders of the company
were (a) retired persons with no other sauce of income and (b) the financial institutions?
3. Ashok Ltd. has a capital structure shown below:
Rs (crore)
Equity share capital (Rs 10 par, 5 crore share) 50
Preference share capital (Rs 100 par, 50 lakh shares) 50
Share premium 50
Reserves and surplus 80
Net worth 230
Show the changed capital structure if the company declares a bonus issue of shares in
the ratio of 1:5 to ordinary shareholders when the issue price per share is Rs. 100. How would

231
the capital structure be affected if the company had split its stock five-for-one instead of
declaring bonus issue?
4. Rentech Ltd.’s current capital structure as on 31 March, 2004 is as follows:
Rs (crore)
Share capital (Rs 100 par, 2 crore shares) 200
Share premium 100
Reserves and surplus 190
490
The current market price if the company’s share is Rs 140 per share. The earnings per
share for the year 2003 was Rs 17. The company has been paying a constant dividend of Rs
6.50 per share for the last ten years.
What shall be the effect on earnings per share, dividend, share price and the capital
structure if the company (i) splits its shares two-for-one or (ii) declares a bonus issue of one-
for-twenty?

5. Suman auto Limited is considering a bonus shares issues. The following data are available:
Rs (crore)
Paid up share capital 12
Reserves 16
Previous three years’ pre-tax profit Year 1 8.0
Year 2 8.6
Year 3 8.3
Recommend the maximum bonus ratio. Give reasons.

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

232
GUIDE LINE 24 : RETAINED EARNINGS – POLICIES AND
PRACTICES

Earnings are the backbone of a business enterprise. They have to be maximized with a
view to meet the expenses incurred in the production and distribution of goods, to make
provision for the replenishment of assets when they become obsolete, to pay the tax liability,
to pay adequate dividend to share holders and to retain sufficient amount to be ploughed back
as capital. This is not a simple exercise it has many facets managerial, accounting, legal and
even political to a certain extent. The management will look to production, marketing,
finance and personnel areas of the business enterprise; the managers shall have to make
efforts to ensure that the firm operates at optimum level of production so as to ensure
minimum cost of production to be competitive in the market. For this purpose, they will have
to execute all the five functions of management effectively from planning, organizing to
coordination, motivation and control. The marketing department will forecast demand and
build up estimates for future sale in the light of marketing conditions prevailing. It will take
into account the existing and the future competitions, the demand for the products, the role of
substitutes, the strategies adopted by the competitors from home and abroad and other socio-
political and economic environments which are likely to affect market demand. In the same
context they will study will study thoroughly the consumers preference and their capacity to
pay so that products could be produced which are easily acceptable to them. The production
department in the light of the estimates made by the marketing department will make
preparation to products. In this process it will take assistance from the personnel and finance
departments in addition to other auxiliary departments which are directly or indirectly related
to production of goods and services.
Income from sale has got to be maximized otherwise the business will not be able to
meet the cost of production and distribution and will not be able to retain sufficient earnings
after paying of dividends which are essential for capital formation. Further even the retained
earnings depend to a great extent on dividend policy and decisions.

RETAINED EARNINGS:
It is primarily internal generated source of long-term finance Loans, bonds, preferred
stock, and common stock, retained earnings provide capital to the firm. And like capital from
other sources, funds from retained earnings are not free. Since the alternative to the retention
of earnings is the payment to the firm's owners in the form of cash dividends, there is a
reciprocal relationship between retained earnings and cash dividends.
Once a firm has satisfied its obligations to its creditors, the government and the
preference shareholders (if any), remaining earnings can be retained, paid out as cash
dividends or split between retained earnings and cash dividends. Retained earnings can be
invested in assets which will help the firm to expand or to maintain its present rate of growth.
If earnings were not retained, additional funds would be raised through one of the other
sources of long-term financing. The owners of the firm generally desire some payment of a
cash dividend which reduces the amount of earnings retained, generally fulfils this
requirement. A difficult and quite critical decision affecting the firm's overall objective of
owner's wealth miximisation revolves round the firm's retained earnings - dividend decisions.

233
 It is pertinent to remark that it is the dividend decision which determines the desired
level of retained earnings. In other words, the dividend decision is actually a financing
decision, since paying a dividend directly affects the firm's financing. This may be illustrated
by the following example.
Management Company has an earning of Rs. 32,000 after paying all claims other than
those of equity holders. The company has two options: One - it can pay of the entire amount
as dividend to shareholders and two - it may retain the entire earnings.

TABLE: Company's financial statement when a earnings are paid out as dividends :
BALANCE SHEET
Liabilities Rs. Assets Rs.
Accounts payable 30,000 Cash 20,000
Notes payable 1,50,000 Marketable Securities 30,000
Creditors 20,000 Accounts Receivable 1,00,000
Total Current Liabilities 2,00,000 Inventory 2,00,000
Long term debt 3,00,000 Prepaid Expenses 10,000
Common stock at Par 1,00,000 Total current 3,60,000
Paidup capital in excess 2,00,000 Assets
Preferred stock @ 8% 1,00,000 Fixed assets (net) 6,40,000
Retained earnings 1,00,000
Total liability and
Stockholder's equity 10,00,000 Total Assets 10,00,000

INCOME STATEMENT
Sales 15,00,000
Less: cost of goods sold 10,00,000
Gross Profit 5,00,000
Less: expenses 4,20,000
Profit before tax 80,000
Less: Tax 40,000
Profit after tax 40,000
Less: preferred stock dividends 8,000
Earnings available for Common Stockholders 32,000
Less: Common stock dividends 32,000
Retained earnings 00,000

234
Table: Company's Balance Sheet when all earnings are retained.
Liabilities Rs. Assets Rs.
Accounts payable 30,000 Cash 52,000
Notes payable 1,50,000 Marketable Securities 30,000
Creditors 20,000 Accounts Receivable 1,00,000
Total current Liabilities 2,00,000 Inventory 2,00,000
Long term debt 3,00,000 Prepaid Expenses 10,000
Common stock at par 1,00,000 Total current assets 3,92,000
Paidup capital in excess 2,00,000
Preferred stock @ 8% 1,00,000 Fixed Assets (net) 6,40,000
Retained earnings 1,32,000
Total liabilities &
Stockholder's equity 10,32,000 Total Assets 10,32,000

The above example makes it clear that the dividend decision is actually the financing
decision since paying a dividend directly affects the firm's financing.

COST OF RETAINED EARNINGS:

The cost of retained earnings has to be perceived in the context of internal financing.
In other words, the cost decision in internal financing has to be seen in relation to the cost of
distributing such retained earnings. The cost problem resolves into deciding by a company
whether it is cheaper and more profitable for its shareholders to retain corporate earnings in
the business or get them in the form of cash dividend. For this purpose, a comparison of two
costs has to be made i.e., the cost of retained earnings and the cost of distributing earnings.
The cost of retained earnings is an opportunity cost i.e. the benefits that the shareholders
forego by leaving the funds in the business. Such benefits differ for individuals since the
funds would be taxed and used differently for consumption and for reinvestment. Since the
benefits are difficult to be measured, it will be appropriate to study as closely as possible
economic status and investments practices of the present shareholder group. It becomes all
the more difficult in a large company in which the shareholding is largely scattered in the
country. In the light of these facts, it will be better to adopt the following technique to find
out the cost of retained earnings.
Firstly, determine the net amount of funds available for distribution. In this
connection, it has to be assumed that the company is not interested in curtailing its future
operating by reducing capital structure. Secondly, adjustment for taxes that the shareholders
will pay have to be made in order to assess the correct situation.
The cost of retained earnings may be worked out with the help of the following
formula:
X = (D – C) (1 – STR) (1 – BTR) X (1 – STR) X R
X = Rupee cost of retained earnings

235
 D = Gross amount of dividend
C = Cost of replacing the funds paid out as dividends
BTR = Business tax rate
STR = Shareholder tax rate
R = Rate of return that the stockholder is able to earn by investing his
dividend income.
The entire concept may be explained with the help of the following illustration :

Illustration:
A company has to analyse the cost of retaining Rs. 50,000 (D) which are otherwise
available for dividends. The cost of replacing the capital paid out as dividends is assumed at 8
percent i.e., 8/100 50,000 = 4000 (C): the tax rate for company's income is 55% (BRT): the
dividends received by the shareholders are assumed to be taxes at 25% (STR) on the average
as also their income from reinvesting their dividends @ 10%. Then the cost of retained
earnings will be as follows:
X = (D - C) (I - BTR) (I - STR) X (I - STR) X R
X = Rs. (50,000 - 40,000) (1 – 55) (1 – 25) X (1 – 25) X .10
= Rs. 50,000 – 40,000 X 75 X.75 = Rs. 2711
Against Rs. 2,711 income cost to the shareholders by retaining the earnings, we have
to balance the cost of distributing the earnings which is an opportunity cost equal to the
profits that might have been earned for the shareholders by using the funds in the business.
This is the rate of return earned by the business after taxes on the amount of retained
earnings. Let us assume three internal rate of return -8%, 6% and 4% to make this point clear.
The cost of distributing earning under these assumed rates of return is as follows:
After tax 8% 50,000 = 8/100 = 4,000
After tax 6% 50,000 = 6/100 = 3,000
After tax 4% 50,000 = 4/100 = 2,000
Ratio of cost of retaining earnings -
Rupees cost of retaining earnings
Rupees cost of distributing earnings
a. 2,711/4,000 - 678
b. 2,711/3,000 - 904
c. 2,711/2,000 - 1,356
The value of this ratio gives a meaningful indication, which makes it clear that in
situation (a) and (c) the cost to shareholders of leaving funds in the business is less than the
cost of having them distributed. In other words, it is profitable to the shareholders to leave
this particular sum in the business. As the ratio rises it becomes less profitable to retain funds.

236
When the rate of return falls to 4 (Situation C) the ratio increase to 1,356. At this stage it is
advisable not to encourage retention of earnings.
As a rule, it may be stated that the financial executives should retain earnings as along
as ratio or cost of retaining earnings is less than 1, Further, funds should be retained to the
point that the incremental rate of return for the company just exceeds the average rate of
return for the industry. But the financial manager has to make a balanced judgment between
the needs of the company for expansion and the requirement of shareholders for regular
income and capital appreciation.

QUESTIONS :
1. What are retained earnings? How are retained earnings a source of funds to the business
concern?
2. If earnings were to retained, what might be financial consequences to the firm?
3. What do you understand by cost of retained earnings? How would you work it out?

BOOKS SUGGESTED:
1. Managerial Finance : J. Fred Weston and Eugene - Brigham.
2. Financial Management and Policy : James C. Van Home.
3. Essential of Financial Management : Ernest Walker.
4. Financial Management : I.M. Pandey
5. An introduction in Financial Management : Ezra Solomon & John J. Pringle.

237
GUIDELINE 25 : WORKING CAPITAL MANAGEMENT

OBJECTIVES
The objectives of this guideline are to
1. throw light on significance of working capital management.
2. provide conceptual understanding of working capital management.
3. focus on adequacy and determinants of working capital.
INTRODUCTION
Working capital is regarded as life blood of business. Its effect in management
ensures success of business while its inefficient management leads to loss of profits and
ultimate downfall. A study of working capital is of major importance to internal and external
analysis because of its close relationship with the day to day operations in business. Working
capital management is a significant part of business decisions. Maintaining optimal level of
working capital is the crux of the problem with which a finance manager has to deal with
because it involves the trade off between risk and return. A firm is required to carry adequate
amounts of working capital so as to deal with productive and distributive activities smoothly.
Holding adequate amounts of raw material smoothly in stock ensures uninterrupted
production activity. Similarly sufficient stock of finished goods has also to be maintained in
anticipation of future demand and for this purpose, also needs to be maintained in
anticipation of future demand and for this purpose the firm needs funds. Goods sold on credit
do not return cash immediately. The firm will have to arrange for funds to finance their
accounts receivable for the period until they are collected. Along with this, a minimum level
of cash is required for ordinary operations of business. However, these assets have to be
maintained at appropriate level as both excess and shortage of working capital will pose
problems for the successful running of business. This calls for setting an optimal level of
working capital.
Working capital management is particularly important for small firms. A small firm
may reduce its fixed assets requirements by renting or leasing plant and equipment but there
is no way before it to avoid an investment in current assets. A finance manager should
therefore devote considerable time to manage current assets. Further, owing to limited access
to the capital markets, the small firm has to rely heavily on trade credit and short term bank
loans. Both affect net working capital by increasing current assets.

CLASSIFICATION OF WORKING CAPITAL

Working capital can be classified on the basis of composition. Thus we have gross working
capital comprising current assets and net working capital, which is the difference between
current assets and current liabilities. Another classification of working capital is the
permanent and variable working capital. The types of working capital are discussed in detail
in the following sections.
a. Gross Working Capital
Gross working capital is the amount of funds invested in the various components of current
assets. Current assets are the assets which can be converted into cash within an accounting
238
year and include cash, short-term securities, debtors (accounts receivables) and stock
(inventory). This concept has the following advantages.
(i) Financial managers are profoundly concerned with current assets.
(ii) Gross working capital provides the correct amount of working capital at the right
time.
(iii) It enables a firm to realize the greatest return on its investment.
(iv) It helps in the fixation of various areas of financial responsibility
(v) It enables a firm to plan and control funds and to maximize the returns on
investment.
For these advantages, gross working capital has become a more acceptable concept in
financial management.
b. Net Working Capital
The net working capital is the difference between current assets and current liabilities.
Current liabilities are those claims of outsiders which are expected to mature for payment
within an accounting year and include creditors (accounts payable), bills payable and
outstanding expenses. The concept of net working capital enables a firm to determine how
much amount is left for operational requirements.
c. Permanent Working Capital
Permanent working capital is the minimum amount of current assets which is needed to
conduct a business even during the dullest season of the year. This amount varies from year
to year, depending upon the growth of a company and the stage of the business cycle in
which it operates. It is the amount of funds required to produce the goods and services which
are necessary to satisfy demand at a particular point. It represents the current assets which
are required on a continuing basis over the entire year. It is maintained as the medium to
carry on operations at any time. Permanent working capital has the following characteristics:
(i) It is classified on the basis of the time factor
(b) It constantly changes from one asset to another and continues to remain in the
business process.
(ii) Its size increases with the growth of business operations.
d. Temporary or Variable Working Capital
It represents the additional assets which are required at different times during the operating
year, additional inventory, extra cash etc., Seasonal working capital is the additional amount
of current assets-particularly cash, receivables and inventory which are required during the
more active business seasons of the year. It is temporarily invested in current assets and
possesses the following characteristics:
(i) It is not always gainfully employed, though it may change from one asset to
another, as permanent working capital does and
(ii) It is particularly suited to business of a seasonal or cyclical nature.

239
e. Balance Sheet Working Capital
The balance sheet working capital is one which is calculated from the items appearing in the
balance sheet. Gross working capital, which is represented by the excess of current assets,
and net working capital, which is represented by the excess of current assets over current
liabilities are examples of the balance sheet working capital.
f. Cash Working Capital
Cash working capital is one which is calculated from the items appearing in the profit and
loss account. It shows the real flow of money or value at a particular time and is considered
to be the most realistic approach in working capital management. It is the basis of the
operation cycle concept which has assumed a great importance in financial management in
recent years. The reason is that the cash working capital indicates the adequacy of the cash
flow, which is an essential pre-requisite of a business.
g. Negative Working Capital
Negative working capital emerges when current liabilities exceed current assets. Such a
situation is not absolutely theoretical, and occurs when a firm is nearing a crisis of some
magnitude.

TRADE-OFF BETWEEN PROFITABILITY AND RISK

In evaluating a firm’s NWC position, an important consideration is the trade-off between
profitability and risk. In other words, the level of NWC has a bearing on profitability as well
as risk. The term profitability used in this context is measured by profits after expenses. The
term risk is defined as the probability that a firm will become technically insolvent so that it
will not be able to meet its obligations when they become due for payment.
The risk of becoming technically insolvent is measured using NWC. It is assumed that
the greater the amount of NWC, the less risk-prone the firm is. Or, the greater the NWC, the
more liquid is the firm and, therefore, the less likely it is to become technically insolvent.
Conversely, lower levels of NWC and liquidity are associated with increasing levels of risk.
The relationship between liquidity, NWC and risk is such that if either NWC or liquidity
increases, the firm’s risk decreases.

ADEQUACY OF WORKING CAPITAL

Working capital should be adequate for the following reasons:
(a) It protects a business from the adverse effects of shrinkage in the values of current
assets.
(b) It is possible to pay all the current obligations promptly and to take advantage of cash
discounts.
(c) It ensures to a greater extent the maintenance of a company’s credit standing and
provides for such emergencies as strikes, floods, fires etc.
(d) It permits the carrying of inventories at a level that would enable a business to serve
satisfactorily the needs of its customers.
(e) It enables a company to extend favorable credit terms to customers.

240
 (f) It enables a company to operate its business more efficiently because there is no delay
in obtaining materials etc. because of credit difficulties.
(g) It enables a business to withstand periods of depression smoothly.
(h) There may be operating losses or decreased retained earnings.
(i) There may be excessive non-operating or extraordinary losses.
(j) The management may fail to obtain funds from other sources for purposes of
expansion.
(k) There may be an unwise dividend policy.
(l) Current funds may be invested in non-current assets.
(m) The management may fail to accumulate funds necessary for meeting debentures on
maturity.
(n) There may be increasing price necessitating bigger investments in inventories and
fixed assets.
When working capital is inadequate, a company faces the following problems
(a) It is not possible for it to utilize production facilities fully for the want of working
capital.
(b) A company may not be able to take advantage of cash discount facilities.
(c) The credit-worthiness of the company is likely to be jeopardized because of the lack
of liquidity.
(d) A company may not be able to take advantage of profitable business opportunities.
(e) The modernization of equipment and even routine repairs and maintenance facilities
may be difficult to administer.
(f) A company will not be able to pay its dividends because of the non-availability of
funds.
(g) A company cannot afford to increase its cash sales and may have to restrict its
activities to credit sales only.
(h) A company may have to borrow funds at exorbitant rates of interest.
(i) Its low liquidity may lead to low profitability in the same way as low profitability
results in low liquidity.
(j) Low liquidity would positively threaten the solvency of the business. A company is
considered illiquid when it is not able to pay its debt on maturity. It must be wound
up under section 433 of the companies’ act, 1956, upon its inability to pay its debts.

DANGERS OF EXCESSIVE WORKING CAPITAL

Too much working capital is as dangerous as too little of it. Excessive working
capital raises the following problems
(a) A company may be tempted to overtrade and lose heavily.
(b) A company may keep very big inventories and tie up its funds unnecessarily.
241
 (c) There may be an imbalance between liquidity and profitability.
(d) A company may enjoy high liquidity and, at the same time, suffer from low
profitability.
(a) High liquidity may induce a company to undertake greater production which may not
have a matching demand. It may find itself in an embarrassing position unless its
marketing policies are properly adjusted to boost up the market for its goods.
(b) A company may invest heavily in its fixed equipment which may not be justified by
actual sales or production. This may provide a fertile ground for later over-
capitalization.
Excessive working capital may be as unfavorable as inadequacy of working capital
because of the large volume of funds not being used productively. Ralph Kennedy and
McMullen have observed that the availability of excess working capital may lead to
carelessness about costs, and therefore, to inefficiency of operations.

DETERMINANTS OF WORKING CAPITAL

A host of factors influencing working capital requirements for a firm can be divided into two
groups i.e. internal and external factors.
(a) Internal Factors
Nature of Business
Different industries may have varying levels of working capital because of different nature of
business and technology of the industry in which the company operates. Concerns engaged
in rendering public utility services require less amount of working capital and huge amount of
fixed assets. Trading concerns need little fixed assets and huge amount of funds in working
capital. Manufacturing concerns lie between the above two extremes. They require large
amount of working capital depending upon the total asset structure and other variables.
Size of Business
The firm’s size in terms of assets or sales has an important impact on its working capital
needs. Small firms may employ additional current assets as a cushion against cash flow
interruptions. Larger firms with many sources of funds may require less working capital in
relation to total assets or sales.

Production Policy
A firm following uniform production policy will have to pile stocks of materials during off
season. Thus, they incur greater inventory costs. The effect of seasonal fluctuations upon
working capital can be offset by pursuing the policy of adjusting production plan to seasonal
changes. Working capital needs of a firm with a level production plan will be higher than the
one with varying production plan.

Working Capital Cycle

In a manufacturing concern, the working capital cycle starts with the purchase of raw
material and ends with the realization of cash from the sale of finished products. This cycle
involves purchase of raw materials and stores, its conversion into stocks of finished goods

242
through work-in-progress with progressive increment of labour and service costs, conversion
of finished stock into sales, debtors and receivables and ultimately realization of cash and this
cycle continues again from cash to purchase of raw material and so on. The speed with which
the working capital completes one cycle determines the requirements of working capital.
Longer the period of the cycle larger is the requirement of working capital.
Credit Policy
The credit policy of a firm also influences the magnitude of working capital. Firms adopting
strict credit policy and granting credit facilities to firms will require less amount of working
capital as funds locked in receivables will be released soon for further uses.
Access to Money Market
Firms with readily available credit from banks and trade credit facilities at liberal terms will
be able to get by with less working capital than firms without such facilities.
Growth and Expansion of Business
Working capital requirements of an enterprise increase in correspondence with growth in
volume of sales. Growing firms require additional funds to acquire additional fixed assets in
order to sustain its growing production and sales. Besides, additional current assets are
required to support increased scale of operations. A growing enterprise requires additional
funds continuously to fulfill the increasing needs of business.
Profit Margin and Dividend Policy
A high net profit margin reduces the working capital requirements of a firm as it contributes
towards the working capital pool. However, the whole profit earned is not available for
working capital purposes as it essentially depends upon the dividend policy of the company.
Distribution of high proportion of profits in the form of cash dividend results in a drain on
cash resources thus reducing company’s working capital. Where the management follows a
conservative dividend policy and retains larger portion of net profit, the company’s working
capital position is strengthened.
Depreciation Policy
It influences the level of working capital by affecting tax liability and retained earnings of the
enterprise. Depreciation is a tax deductible expense. Higher depreciation results in lower tax
liability and greater profits. Similarly, net profits will be less if higher amount of depreciation
is charged. If the dividend policy is linked with net profits, the firm can pay less dividend by
providing more depreciation thus resulting in increased retained earnings and strong working
capital position.
Operating Efficiency of a Firm
If a firm successfully controls operating costs it will be able to improve net profit margin
resulting in release of greater funds for working capital. Operating efficiency results in
optimum utilization of resources at minimum costs.
B. External Factors
Business Fluctuation
Business enterprises experience fluctuations and demands for their products and services
because of changes in economic conditions. Thus, working capital requirements of these
243
enterprises are affected. In the event of economic prosperity, general demand of goods and
services tense to shoot up. To coup up with the increased demand and increased production
the firm will require additional working capital. If the economy is in recession business
enterprises experience decline in sales and production requirements will decrease with the
result that working capital needs of these enterprises will tend to decline. But, the firm will
require additional cash to meet operating expenses because the operating funds are locked in
inventories and will not be available for further uses. Thus, business depression may give
misleading appearance of the financial position of an enterprise. With recovery the cash
position may decline and the shortage of working capital may develop.
Technological Developments
Technological Developments in production can have sharp effects on working capital. If a
firm switches over to new manufacturing process and installs new equipments with which it
is able to cut the period involved in converting raw materials in to finished goods, permanent
working capital requirement will decrease. If the new machine can utilize less expensive raw
materials then the inventory needs will be reduced.
Transport and Communication Developments
Where the means of the transport and communication in a country are not well developed
industries require additional funds to maintain big inventory of raw materials and other
accessories which would not be needed where transport and communication systems are
highly developed.
Import Policy
Import policy of the government also has a impact on working capital of enterprises as they
have to arrange funds for importing goods at specific times.
Taxation Policy
Pressure on working capital is minimized when liberal taxation policy is followed. In case of
regressive taxation policy, heavy tax burden is imposed on companies leaving very little
profits for distribution and retention polices, thus increasing their working capital needs.
SUMMARY
Working Capital is regarded as life blood of business. Gross Working Capital refers to the
firms investment in current assets. Net Working Capital means the difference between current
assets and current liabilities, and therefore represents position of current assets which the firm
has to finance either from long term funds or bank borrowings. The level of Net Working
Capital has a bearing on the profitability as well as the risk in the sense inability of the firm to
meet obligations as and when they become due. Therefore, the trade-off between profitability
and risk is an important element in the evaluation of the level of NWC of a firm. The
determinants of Working Capital are classified into internal and external factors. The internal
factors are nature of business, size of business, production policy, manufacturing cycle,
growth and expansion of business etc. The external factors are business fluctuations,
technological developments, import policy and taxation policy etc.

244
MODEL QUESTIONS
1. Explain the concept of Working Capital.
2. Distinguish between the following.
(a) Gross working capital and Net working capital.
(b) Permanent and Temporary working capital.
(c) Production cycle and Operation cycle.
3. Explain the factors that determine the Working Capital needs of a firm.
4. Explain the adequacy and dangers of excess Working Capital.

FURTHER READINGS
1. Srivastava, R. M. 1998. Financial Management and Policy. Mumbai: Himalaya
Publishing House.
2. Kulkarni, P. V. and Satyaprased, B. G. 2002. Financial Management A Conceptual
Approach (with problems, Cases & Review Questions). Mumbai: Himalaya
Publishing House.
3. Pandey, I..M., 2004, Financial Management, Vikas Publishing House,
4. Khan, M. Y. and Jain, P. K., 2003, Financial Management, Tata Mcgraw-Hill
Company Ltd.

245
GUIDELINE 26 : PLANNING OF WORKING CAPITAL

OBJECTIVES
After studying this guideline, you will learn
• the need for Working Capital
• the estimation of Working Capital
• the approaches to determine an appropriate financing mix

NEED FOR WORKING CAPITAL

Given the objective of financial decision making to maximize the shareholders’ wealth, it is
necessary to generate sufficient profits. The extent to which profits can be earned will
naturally depend, among other things, upon the magnitude of the sales. A successful sales
programme is, in other words, necessary for earning profits by any business enterprise.
However, sales do not convert into cash instantly; there is invariably a time-lag between the
sale of goods and the receipt of cash. There is, therefore, a need for working capital in the
form of current assets to deal with the problem arising out of the lack of immediate
realization of cash against goods sold. Therefore, sufficient working capital is necessary to
sustain sales activity. Technically, this is referred to as the operating or cash cycle. The
operating cycle can be said to be at the heart of need for working capital. ‘The continuing
flow from cash to suppliers, to inventory, to accounts receivable and back into cash is what is
called the operating cycle’. In other words, the term cash cycle refers to the length of time
necessary to complete the following cycle of events.
The operating cycle, which is a continuous process, is shown in fig.1.
Phase 3
Receivables

Cash Phase 2

Inventory
Phase 1
Fig. 1

The operating cycle consists of three phases. In phase 1, cash gets converted into
inventory. This includes purchase of raw materials, conversion of raw materials into work-in-
progress, finished goods and finally the transfer of goods to stock at the end of the
manufacturing process. In the case of trading organizations, this phase is shorter as there
would be no manufacturing activity and cash is directly converted into inventory. The phase
is, of course, totally absent in the case of service organizations.
In phase II of the cycle, the inventory is converted into receivables as credit sales are
made to customers. Firms which do not sell on credit obviously not have phase II of the
operating cycle.

246
 The last phase, phase III, represents the stage when receivables are collected. This
phase completes the operating cycle. Thus, the firm has moved from cash to inventory, to
receivables and to cash again.

ESTIMATION OF WORKING CAPITAL REQUIREMENTS

The term working capital means the excess of current assets over current liabilities. Assessing
the requirements of working capital to be employed during immediate future period of
operations can be done by the following three techniques.
1. Percentage of sales method.
2. Operating cycle approach or cash working capital method.
3. Estimation of components of working capital method.
Percentage of sales method
This method is simple and traditional. The requirement of working capital can be determined
on the basis of sales. In this method, the working capital is expressed as a percentage to the
sales. This method is very useful in planning for short-term working capital requirements.
Operating cycle approach or cash working capital method
This method is otherwise known as cash working capital method. In order to estimate the
requirements of working capital required for business, the volume of cash required to finance
the entire process of the cycle is to be taken into consideration. This method suggest the
actual working capital required by a firm in a particular period, which can be determined with
reference to the length of the net operating cycle and the volume of cash needed to meet the
operating expenses for the period. The following formula may be used to express the duration
of the operating cycle;
O=R+W+F+D-C where,
O = period of the operating cycle
R = stock holding period for raw materials
W = no. of days required for holding stock of work-in-progress with regard to the cost of
production
F = no. of days required for holding stock of finished goods ready for sale
D = debtors collection period
C = creditors collection period
R = average stock of raw materials and stores/average consumption of raw materials and
stores per day
W = average stock of work-in-progress/average production cost per day
F = average inventory of finished goods/average cost of sales per day
D = average accounts receivable/average credit sales per day
C = average trade creditors/average credit purchases

After computing the period of one operating cycle, the total number of operating cycles
during one particular year can be calculated as follows:
Total number of operating cycles = 365/operating cycle period.
247
Once the number of operating cycles per year has been determined, the actual working capital
requirement can be calculated as follows:
Actual working capital requirement = total operating cost/number of operating cycles in a
year.
Estimation of components of working capital
The two components of working capital (WC) are current assets (CA) and current liabilities
(CL). They have a bearing on the cash operating cycle. In order to calculate the working
capital needs, what is required is the holding period of various types of inventories, the credit
collection period and the credit payment period. Working capital also depends on the
budgeted level of activity in terms of production/sales. The calculation of WC is based on
the assumption that the production/sales is carried on evenly throughout the year and all costs
accrue similarly. As the working capital requirements are related to the cost excluding
depreciation and not to the sale price, WC is computed with reference to cash cost. The cash
cost approach is comprehensive and superior to the operating cycle approach based on
holding period of debtors and inventories and payment period of creditors. The steps
involved in estimating the different items of CA and CL are as follows:
Estimation of Current Assets
Raw Materials Inventory: The investment in raw materials inventory is estimated on the
basis of :
Budgeted Cost of raw Average inventory
Production X material (s) X holding period
(in units) per unit (months/days)
12 months/365 days
Work-in-Process (W/P) Inventory
The relevant costs to determine work-in-process inventory are the proportionate share of cost
of raw materials and conversion costs (labour and manufacturing overhead costs excluding
depreciation). In case, full unit of raw material is required in the beginning, the unit cost of
work-in-process would be higher, that is, cost of full unit plus 50 per cent of conversion cost,
compared to the raw material requirement throughout the production cycle; W/P is normally
equivalent to 50 per cent of total cost of production.
Budgeted Estimated work- Average time span
Production X in-process cost X of work-in-progress
(in units) per unit inventory(months/days)
12 months/365 days
Finished Goods Inventory
Working capital required to finance the finished goods inventory is given by factors summed
up in Eq.
Budgeted Cost of goods produced Finished goods
Production X per unit (excluding X holding period
(in units) depreciation) (months/days)
12 months/365 days
248
Debtors: The WC tied up in debtors should be estimated in relation to total cost price
(excluding depreciation) Symbolically,
Budgeted Cost of sales per Average debt
Credit sales X unit excluding X collection period
(in units) depreciation (months/days)
12 months/365 days
Cash and Bank Balances
Apart from WC needs for financing inventories and debtors, firms also find it useful to have
some minimum cash balances with them. This would primarily be based on the motives for
holding cash balances of the business firm, attitude of management toward risk, the access to
the borrowing sources in times of need and past experience, and so on.
Estimation of Current Liabilities
The estimation of current liabilities (CL), such as trade creditors, wages and overheads is as
follows.
Trade Creditors
Budgeted yearly Raw material Credit period
Production X requirement X allowed by creditors
(in units) per unit (months/days)
12 months/365 days
Note: Proportional adjustment should be made to cash purchases of raw materials.
Direct Wages
Budgeted yearly Direct labour Average time-lag in
Production X Cost per unit X payment of wages
(in units) (months/days)
12 months/365 days
Overheads (Other Than Depreciation and Amortisation)
Budgeted yearly Overhead cost Average time-lag in
Production X per unit X payment of overheads
(in units) (months/days)
12 months/365 days
The amount of overheads may be separately calculated for different types of overheads. In
the case of selling overheads, the relevant item would be sales volume instead of production
volume.

Format-1 Determination of Working Capital

(I) Estimation of Current Assets: Amount
(a) Minimum desired cash and bank balances
(b) Inventories

249
 Raw material
Work-in-process
Finished Goods
(c ) Debtors
Total Current Assets
(II) Estimation of Current Liabilities:
(a) Creditors
(b) Wages
(c) Overheads
Total Current Liabilities
(III) Net Working Capital (I-II)
Add margin for contingency
(IV) Net Working Capital Required
DETERMINING FINANCE MIX
One of the most important decisions, in other words, involved in the management of
working capital is how current assets will be financed. There are, broadly speaking, two
sources from which funds can be raised for current asset financing; (i) short-term sources
(current liabilities), and (ii) long-term sources, such as share capital, long-term borrowings,
internally generated resources like retained earnings and so on. What proportion of current
assets should be financed by current liabilities and how much by long-term resources.
Decisions on such questions will determine the financing mix.
There are three basic approaches to determine an appropriate financing mix: (a)
Hedging approach, also called the Matching approach; (b) Conservative approach, and (c)
Trade-off between these two.
Hedging Approach
The term ‘hedging’ is often used in the sense of a risk-reducing investment strategy
involving transactions of a simultaneous but opposing nature so that the effect of one is likely
to counterbalance the effect of the other. With reference to an appropriate financing-mix, the
term hedging can be said to refer to the process of matching maturities of debt with the
maturities of financial needs. This approach to the financing decision to determine an
appropriate financing mix is, therefore, also called as Matching approach.
According to this approach, the maturity of the source of funds should match the
nature of the assets to be financed. For the purpose of analysis, the current assets can be
broadly classified into two classes:
1. those which are required in a certain amount for a given level of operation and,
hence, do not vary over time.
2. those which fluctuate over time.
The hedging approach suggests that long-term funds should be used to finance the
fixed portion of current assets requirements The purely temporary requirements, that is, the
seasonal variations over and above the permanent financing needs should be appropriately
financed with short-term funds (current liabilities). This approach, therefore, divides the

250
requirements of total funds into permanent and seasonal components, each being financed by
a different source. This has been illustrated in the following table.

Estimated Total Funds Requirements of Hypothetical Ltd

Total funds Permanent Seasonal
Month required requirements requirement
Rs. Rs. Rs.
(1) (2) (3) (4)
January 8,500 6,900 1,600
February 8,000 6,900 1,100
March 7,500 6,900 600
April 7,000 6,900 100
May 6,900 6,900 0
June 7,150 6,900 250
July 8,000 6,900 1,100
August 8,350 6,900 1,450
September 8,500 6,900 1,600
October 9,000 6,900 2,100
November 8,000 6,900 1,100
December 7,500 6,900 600

According to the hedging approach, the permanent portion of funds required (Col.3)
should be financed with long-term funds and the seasonal portion (Col.4) with short-term
funds with this approach, the short-term financing requirements (current assets) would be
just equal to the short-term financing available (current liabilities). There would, therefore,
be no NWC.
We may graphically illustrate the hedging principle as shown in figure-2.
Hedging Financing Strategy
Temporary Current Short-term financing
Assets

Current assets Permanent CA

Rupee Amount

Long-term plus
Spontaneous financing
Fixed assets

Time Fig.2
251
 To put it very succinctly the hedging principle states that the firm’s assets not
financed by spontaneous sources should be financed in accordance with the rule: permanent
assets (including permanent working capital needs) financed with long-term sources and
temporary assets (viz. fluctuating working capital need) with short-term sources of finance to
ward of the liquidity risk.
Conservative Approach
This approach suggests that the estimated requirement of total funds should be met from
long-term sources; the use of short-term funds should be restricted to only emergency
situations or when there is an unexpected outflow of funds. In the case of the Hypothetical
Ltd in table 2.1, the total requirements, including the entire Rs.9,000 needed in October, will
be financed by long-run sources. The short-term funds will be used only to meet
contingencies. The amounts given in column 4 of table 2.1 represent the extent to which
short-term financial needs are being financed by long-term funds, that is, the NWC. The
NWC reaches the highest level (Rs, 2,100) in October (Rs. 9,0000 - Rs. 6,900). Any long-
term financing in excess of Rs. 6,900 in permanent financing the needs of the company
represents NWC. We may graphically illustrate the conservative approach as depicted in
figure-3.
Conservative Financing Strategy

Marketable Short-term
Securities financing

Permanent
Rupee amount

current assets
Current Assets
Long-term plus
Spontaneous financing

Fixed Assets

Time Period
Fig.3
Aggressive Approach
Figure - 4 depicts that a firm that continually finances a part of its permanent asset needs
with short-term funds and thus follows a more aggressive strategy in managing its working
capital. It can be seen that even when its investment in asset needs is lowest the firm must
still rely on short-term financing. Such a firm would be subjected to increased risk of a cash
short-fall in that it must depend on a continual rollover or replacement of its short-term debt
with more short-term debt. The benefit derived from following such a policy relates to the
possible savings resulting from the use of lower-cost short-term debt as opposed to long-term
debt.

252
 Aggressive Financing Strategy
Short-term
Permanent dependence financing
on short-term financing

Permanent
current assets
Rupee amount

Current Assets
Long-term plus
Spontaneous financing

Fixed Assets

Time
Fig.4

It has been observed that the hedging approach is associated with high profits as well
as high risk, while the conservative approach provides low profits and low risk. So neither
approach by itself would serve the purpose of efficient working capital management. A trade-
off between these two extremes would give an acceptable financing strategy.

SUMMARY
The need for Working Capital arises from the operating or cash cycle of the firm. The
operating cycle refers to the length of time to convert the non-cash current assets into cash. In
other words, cash cycle refers to the time involved in completing the following sequence of
events: conversion of cash into inventory, conversion of inventory into receivables and
conversion of receivables into cash. A free requisite of efficient working capital management
is its correct computation. The two components which have a bearing on the cash operating
cycle of the firm and, therefore, the quantum of working capital requirements are the current
assets and current liabilities. In this computation, therefore, the relevant factors are the
holding periods of the various types of inventories, collection period and the payment period
and minimum cash balances.
Apart from the profitability-risk trade-off, the determination of the financing-mix is
the second ingredient of the theory of working capital management. The financing-mix refers
to the proportion of current assets to be financed by current liabilities and long-term sources.
One approach to determine the financing mix is the hedging approach, according to which the
long-term funds should be used to finance the fixed/core portion of the current assets and the
purely temporary/seasonal requirements should be met out of short-term funds. This approach
is a high-profit, high-risk financing mix. According to the second approach, namely, the
conservative approach, the estimated total requirements of the current assets should be
financed from long-term sources and the short-term funds should be used only in emergency
situations. In effect, the conservative approach is a low-profit, low-risk combination. Neither
of these two approaches is suitable for efficient working capital management. A trade-off
between these two extremes provides a financing plan between these two approaches, and

253
therefore, an acceptable financing strategy from the viewpoint of the management of working
capital.

PRACTICAL PROBLEMS
Problem No.1
ABC Ltd. Sells its products on a gross profit of 20% on sales. The following information is
extracted from its annual accounts for the year ended 31st March 2005:
Rs.
Sales (3 months credit) 40,00,000
Raw materials 12,00,000
Wages (15 days in arrears) 9,60,000
Manufacturing expenses (one month in arrears) 12,00,000
Administration expenses (one month in arrears) 4,80,000
Sales promotion expenses (payable half yearly in advance) 2,00,000
The company enjoys one month’s credit from suppliers of raw materials and maintains 2
months stock of raw materials and one and a half months finished goods. Cash balance is
maintained at Rs. 1,00,000 as a precautionary balance. Assuming a 10% margin, find out the
working capital requirements of ABC Ltd.
Solution
Statement of Working Capital Requirements
Current Assets Rs.
Stock of Raw materials (12,00,000x2/12) 2,00,000
Stock of finished goods at cost
(40,00,000x80/100x3/2x1/12) 4,00,000
(as gross profit is 20% on sales, so cost is 80% of sales)
Debtors at cost (40,00,000x80/100x3/12) 8,00,000
Advance payment of sales promotion expenses
(2,00,000x6/12) 1,00,000
Cash balance 1,00,000
16,00,000
less: Current Liabilities: Rs.
Creditors for raw materials
(12,00,000x1/12) 1,00,000
Wages outstanding (15days
Taken for ½ months in arrears,
9,60,000x1/24) 40,000

254
Manufacturing expenses
Outstanding (12,00,000x1/12) 1,00,000
Administration expenses
Outstanding (4,80,000x1/12) 40,000
2,80,000
Net-Working-Capital 13,20,000
Add: 10% Margin for contingencies 1,32,000
Working Capital Required 14,52,000
Problem No.2
While preparing a project report on behalf of a client you have collected the following facts.
Estimate the net working capital required for that project. Add 10 per cent to your computed
figure to allow contingencies:
Amount
Estimated cost per unit of production is:
Raw material 80
Direct labour 30
Overheads
(exclusive of depreciation, Rs 10 per unit) 60
Total cash cost 170
Additional Information:
Selling price Rs.200 per unit
Level of activity, 1,04,000 units of production per annum
Raw materials in stock, average 4 weeks
Work in progress (assume 50 per cent completion stage in respect of conversion costs and
100 per cent completion in respect of materials), average 2 weeks
Finished goods in stock, average 4 weeks
Credit allowed by suppliers, average 4 weeks
Credit allowed to debtors, average 8 weeks
Lag in payment of wages, average 1.5 weeks
Cash at bank is expected to be, Rs.25,000.
You may assume that production is carries on evenly through the year (52 weeks) and wages
and overheads accrue similarly. All sales are on credit basis only.

255
Solution
Net Working Capital Estimate of a Project
(A) Current assets:
(i) Raw materials in stock, (1,04,000xRs80x4/52) Rs 6,40,000
(ii) Work-in-progress
(a) Raw material (1,04,000 x Rs 80 x 2/52) 3,20,000
(b) Direct Labour (1,04,000 x Rs 15 x 2/52) 60,000
(c ) Overheads (1,04,000 x Rs 30 x 2/52) 1,20,000
(iii) Finished goods stock: (1,04,000 x Rs 170 x 4/52) 13,60,000
(iv) Debtors : (1,04,000 x Rs 170 x 8/52) 27,20,000
(v) Cash at bank 25,000
Total investment in current assets 52,45,000
B. Current liabilities
(i) Creditors, average 4 weeks:(1,04,000 Rs 80 x 4/52) 6,40,000
(ii) Lag in payment of wages (1,04,000 x rs 30 x 3/104) 90,000
Total current liabilities 7,30,000
C. Net working Capital:(Current – Current liabilities) 45,15,000
Add 10 per cent contingencies 4,51,500
49,66,500
Working note
A full unit of raw material is required at the beginning of the manufacturing process and,
there fore, total cost of the material, that is Rs 80 per unit has been taken into consideration,
while in the case of expenses, viz. direct labour and overheads, the unit has been finished
only to the extent of 50 per cent. Accordingly, Rs 15 and Rs 30 have been charged for direct
labour and overheads respectively in valuing work-in-proess.
Problem .No. 3 From the following g projections of XYZ & Ltd for the next year, you are
required to determine the working capital required by the company.
Annual sales, Rs. 14,40,000
Cost of production (including depreciation of Rs.1,20,000), Rs. 12,000,000
Raw Material purchases, Rs.7,05,000
Monthly expenditure, Rs 30,000
Estimated opening stock of raw materials, Rs 1,40,000
Estimated closing stock of raw materials, Rs 1,25,000

256
Inventory norms:
Raw materials, 2 months
Work-in-process, ½ month
Finished goods, 1 month
The firm enjoys a credit of half-a-month on its purchases and allows one month credit on its
supplies. On sales orders, the company receives an advance of Rs 15,000.
You may assume that production is carried out evenly throughout the year and minimum
cash balance desired to be maintained is Rs 35,000.
Solution
Statement showing determination of net working capital
(A) Current assets:
Cash balance Rs 35,000
Inventories:
Raw materials:
Opening stock 1,40,000
Add Purchases 7,05,000
Less closing stock 1,25,000
Annual consumption 7,20,000
Two months requirement: (Rs 7,20,000 x 2/12) 1,20,000
Work-in-process: (Rs 10,80,000 x 1/12) 45,000
Finished goods (Rs 10,80,000 x 1/12) 90,000
Debtors: (Rs 10,80,000 x 1/12) 90,000@
Total current assets 3,80,000
(B) Current liabilities:
Trade Creditors: (Rs 7,05,000 x 1/24) 29,375
Advance received from debtors 15,000
Total current liabilities 44,375
(C) Net working capital (A-B) 3,35,625
@ It is assumed that there is neither opening nor closing stock of finished stock and
therefore, cost of sales is Rs 10,80,000 excluding depreciation.
Monthly expenditure is excluded as the cost of production includes it (Rs.7.2 lakh, raw
materials + Rs3.6 lakh, other expenses @ Rs 30,000 per month).

257
Problem No. 4 You are supplied with the following information in respect of XYZ Ltd for
the ensuing year:
Production of the year, 69,000 units
Finished goods in store, 3 months
Raw material in store, 2 months’ consumption
Production process, 1 month
Credit allowed by creditors, 2 months
Credit given to debtors, 3 months
Selling price per unit, Rs 50
Raw material, 50 per cent of selling price
Direct wages, 10 per cent of selling price
Manufacturing and administrative overheads, 16 per cent of selling price
Selling over heads, 4 per cent of selling price
There is a regular production and sales cycle and wages overheads accrue evenly.
Wages are paid in the next month of accrual. Material is introduction in the beginning of the
production cycle. You are required to ascertain its working capital requirement.
Solution
Statement showing working capital requirement
(A) Current assets:
(i) Raw material in store (69,000 x Rs25 x 2/12) 2,87,500
(ii) Work-in-process (69,000 x Rs 31.5 x 1/12) 1,81,125
(Material, Rs 25 + 0.50 x (Rs 5, Direct wages + Rs 8,
Manufacturing and other administrative overheads)
(iii) Finished goods in store (69,000 x Rs 38 x 3/12) 6,55,500
(iv) Debtors (69,000 x Rs 38 x 3/12) 6,90,000
Total current liabilities 18,14,125
(B) Current liabilities:
(i) Creditors (69,000 x Rs 25 x 2/12) 2,87,500
(ii) Wages (69,000 x Rs 5 x 2/12) 28,750
Total current liabilities 3,16,250
(C) Net working capital (A-B) 14,97,875
___________________________________________________________

258
Model Questions
1. What is the concept of working capital cycle? what is meant by cash conversion
cycle? Why are these concepts important in working capital management?
2. What methods do you suggest for estimating working capital needs? Illustrate yours
answer.
3. Explain the risk-return trade-off of current assets financing.

Further Readings
1. Van Horne C.F., 2004, Financial Management and Policy, Prentice – Hall, New
Delhi.
2. Bringham E.F., 1977, Financial Management, Drydon Press.
3. Pandey I.M., 2004, Financial Management, Vikas Publishing House Pvt. Ltd., New
Delhi.

259
GUIDELINE 27 : MANAGEMENT OF CASH AND
MARKETABLE SECURITIES

OBJECTIVES
After studying this guideline, you will learn
• the importance of cash management
• the motives for holding cash
• the cash forecasting and budgeting
• the techniques of cash management
• the management of marketable securities

INTRODUCTION
Cash is the basic input needed to keep the business running on a continuous basis, it is also
the ultimate output expected to be realized by selling the service or product manufactured by
the firm. The term cash includes coins, currency and cheques held by the firm, and balances
in its bank accounts. Sometimes near-cash items, such as marketable securities or bank time
deposits are also included in cash. Cash management is one of the key areas of working
capital management. The aim of cash management is to maintain adequate control over cash
position to keep the firm sufficiently liquid and to use excess cash in some profitable way.
Cash management is also important because it is difficult to predict cash flows accurately,
particularly the inflows, and there is no perfect coincidence between the inflows and outflow
of cash. Inorder to resolve the uncertainty about cash flow prediction and lack of
synchronization between cash receipts and payments, the organization should evolve
appropriate strategies for cash management. The ideal cash management system will depend
on firm’s products, organization structure, competition, culture and options available.
MOTIVES FOR HOLDING CASH
The term cash with reference to cash management is used in two senses. In a narrow sense, it
is used broadly to cover currency and generally accepted equivalents of cash, such as
cheques, drafts and demand deposits in banks. The broad view of cash also includes near-
cash assets, such as marketable securities and time deposits in banks. The main
characteristics of these is that they can be readily sold and converted into cash. They serve as
a reserve pool of liquidity that provides cash quickly when needed. Here the term cash
management is employed in the broader sense that is cash does not earn any return, why is it
held? There are four primary motives for maintaining cash balances: (i) Transaction motive;
(ii) Precautionary motive; (iii) Speculative motive; and (iv) Compensating motive.
Transaction Motive
An important reason for maintaining cash balances is the transaction motive. This refers to
the holding of cash to meet routine cash requirements to finance the transactions which a firm
carries on in the ordinary course of business. A firm enters into a variety of transactions to
accomplish its objectives which have to be paid for in the form of cash.

260
 The requirement of cash balances to meet routine cash needs is known as the
transaction motive and such motive refers to the holding of cash to meet anticipated
obligations whose timing is not perfectly synchronized with cash receipts. If the receipts of
cash and its disbursements could exactly coincide in the normal course of operations, a firm
would not need cash for transaction purposes.
Precautionary Motive
The Precautionary motive is the need to hold cash to meet contingencies in the future. The
cash balances held in reserve for such random and unforeseen fluctuations in cash flows are
called as precautionary balances. In other words, precautionary motive of holding cash
implies the need to hold cash to meet unpredictable obligations. Thus, precautionary cash
balance serves to provide a cushion to meet unexpected contingencies. The more
unpredictable are the cash flows, the larger is the need for such balances.
Speculative Motive
The Speculative motive relates to the holding of cash for investing in profit-making
opportunities as and when they arise. Firms aim to exploit profitable opportunities and keep
cash in reserve to do so. Thus the speculative motive helps to take advantage of :

An opportunity to purchase raw materials at a reduced price on payment of immediate
cash;

A chance to speculate on interest rate movements by buying securities when interest
rates are expected to decline;

Delay purchases of raw materials on the anticipation of decline in prices; and

Make purchase at favourable prices.
Compensation Motive
Compensating balances are also required by some loan agreements between a bank and its
customers. During periods when the supply of credit is restricted and interest rates are rising,
banks require a borrower to maintain a minimum balance in his account as a condition
precedent to the grant of loan. This is presumably to ‘compensate’ the bank for a rise in the
interest rate during the period when the loan will be pending. The compensating cash
balances can take either of two forms: (i) an absolute minimum, say Rs 5 lakh, below which
the actual bank balance will never fall; (ii) a minimum average balance, say Rs 5 lakh over
the month. The first alternative is more restrictive as the average amount of cash held during
the month must be above Rs 5 lakh by the amount of the transaction balance.
Hence among the four primary motives of holding cash balances, the two most
important are the transactions motive and the compensation motive. Business firms normally
do not speculate and need not have speculative balances. The requirement of precautionary
balances can be met out of short-term borrowings.
CASH FORECASTING AND BUDGETING
In managing working capital efficiently and effectively, the primary concern of management
remains to provide adequate amount of liquidity to the firm. Liquidity is represented by net
working capital in the fund flow analysis and by cash and cash equivalents in the case of cash
flow analysis, and both of these measures are based on balance sheet that reports items as on
a particular date. In this unit, we shall discuss the dynamics of business liquidity and the

261
nature and role of cash flow forecasting and budgeting in man aging liquidity facet of
working capital management in a firm.
Cash Forecasting
Cash forecasts are needed to prepare cash budgets. Cash forecasting may be done on short or
long-term basis. Forecasts converting periods of one year or less are considered short-term,
those extending beyond one year are considered long-term.
The short-term forecast helps in determining the cash requirements for a
predetermined period to run a business. If the cash requirements are not determined, it would
not be possible for the management to know-how much cash balance is to be kept in hand, to
what extent bank financing be depended upon and whether surplus funds would be available
to invest in marketable securities. To know the operating cash requirements, cash flow
projections have to be made by a firm. Two most commonly used methods of short-term cash
forecasting are:
(i) The receipt and disbursements method.
(ii) The adjusted net income method.
The receipts and disbursements method is generally employed to forecast for limited
periods, such as a week or a month. The adjusted net income method, on the other hand,
is preferred for longer durations ranging between a few months to a year.
Long-term cash forecasts are prepared to give an idea of the company’s financial
requirements in the distant future. Long-term cash forecasting reflects the impact of growth,
expansion or acquisitions, it also indicates financing problems arising from these
developments. Long-term cash forecasts may be made for two, three or five years.
Cash Budget
A firm is well advised to hold adequate cash balances but should avoid excessive balances.
The firm has, therefore, to assess its need for cash properly. The cash budget is probably the
most important tool in cash management. This is a device to help a firm to plan and control
the use of cash. It is a statement showing the estimated cash inflows and cash outflows over
the planning horizon. In other words, the net cash position (surplus or deficiency) of a firm
as it moves from one budgeting sub-period to another is highlighted by the cash budget.
The various purposes of cash budgets are: (i) to coordinate the timings of cash needs.
It identifies the period(s) when there might either be a shortage of cash or an abnormally
large cash requirement;(ii) it pinpoints the period(s) when there is likely to be excess cash;
(iii) it enables a firm which has sufficient cash to take advantage of cash discounts on its
accounts payable, to pay obligations when due, to formulate dividend policy, to plan
financing of capital expansion and to help unify the production schedule during the year so
that the firm can smooth out costly seasonal fluctuations; finally, (iv) it helps to arrange
needed funds on the most favourable terms and prevents the accumulation of excess funds.
Elements of Cash Budget
The principal aim of the cash budget, as a tool to predict cash flows over a given period of
time, is to ascertain whether at any point of time there is likely to be an excess or shortage of
cash. The preparation of a cash budget involves various steps.

262
 The first element of a cash budget is the selection of the period of time to be covered
by the budget. It is referred to as to planning horizon. The planning horizon means the time
span and the sub periods within that time span over which the cash flows are to be projected.
There is no fixed rule. The coverage of a cash budget will differ from firm to firm depending
upon its nature and the degree of accuracy with which the estimates can be made.
The planning horizon of a cash budget should be determined in the light of the
circumstances and requirements of a particular case. For instance, if the flows are expected
to be stable and dependable, such a firm may prepare a cash budget covering a long period,
say, a year and divide it into quarterly intervals. In the case of a firm whose flows are
uncertain, a quarterly budget, divided into monthly intervals, may be appropriate. Where
flows are affected by seasonal variations, monthly budgets, subdivided on a weekly or even a
daily basis, may be necessary. If the flows are subject to extreme fluctuations, even a daily
budget may be called for.
The second element of the cash budget is the selection of the factors that have a
bearing on cash flows. The items included in the cash budget are only cash items; non-cash
items such as depreciation and amortization are excluded. The factors that generate cash
flows are generally divided, for purposes of the construction of cash budget, into two broad
categories: (a) operating, and (b) financial. While the former category includes cash flows
generated by the operations of the firms and are known as operating cash flows, the latter
consists financial cash flows.
Operating Cash Flows The operating factors which generate cash outflows and inflows
over the time horizon of a cash budget are given in table (27.1).
Operating Cash Flow Items:
Inflows/Cash Receipts Outflows/Disbursements
1. Cash Sales 1. Accounts payable/Payable payments
2. Collection of accounts receivable 2. Purchase of raw materials
3. Disposal of fixed assets 3. Wages and Salary (payroll)
4. Factory expenses
5. Administrative and selling expenses
6. Maintenance expenses
7. Purchase of fixed assets
Financial Cash Flows The major financial factors affecting the generation of cash flows are
depicted in table (27.2).
Financial Cash Flow Items:
Cash Inflows/Receipts Cash Outflows/Payments
1. Loans/Borrowings 1. Income-tax/Tax payments
2. Sales of securities 2. Redemption of loan
3. Interest received 3. Repurchase of shares

263
4. Dividend received 4. Interest paid
5. Rent received 5. Dividends paid
6. Refund of tax
7. Issue of new shares and securities
Preparation of Cash Budget
After the time span of the cash budget has been decided and pertinent operating and financial
factors have been identified, the final step is the construction of the cash budget.
Illustration No.1.
A firm adopts a sox-monthly time span, subdivided into monthly intervals for its cash budget.
(A) the following information is available in respect of its operations: (Rs. Lakh)
Months
1 2 3 4 5 6
1. Sales 40 50 60 60 60 60
2. Purchases 1 1.50 2 2 2 1
3. Direct labour 6 7 8 8 8 6
4.Manufacturing overheads 13 13.50 14 14 14 13
5.Administrative expenses 2 2 2 2 2 2
6.distribution expenses 2 3 4 4 4 2
7.Raw materials (30 days credit) 14 15 16 16 16 15
(B) Assume the following financial flows during the period:
(a) Inflows: 1. Interest received in months 1 and month 6, Rs 1 lakh each;
2. Dividend received during months 3 and 6, Rs 2 lakh each;
3. Sales of shares in month 6, Rs 160 lakh.
(b) Outflows: 1. Interest paid during month 1, rs 0.4 lakh;
2. Dividends paid during months 1 and 4, Rs 2 lakh each;
3. Instalment payment on machine in month 6, Rs 20 lakh;
4. Repayment of loan in month 6, Rs. 80 lakhs.
(c) Assume that 10 per cent of each month’s sales are for cash; the balance 90 per cent are on
credit. The terms and credit experience of the firm are:
1. No cash discount;
2. 1 per cent of credit sales is returned by the customers;
3. 1 per cent of total accounts receivable is bad debt;
4. 50 per cent of all accounts that are going to pay, do so within 30 days;
5. 100 per cent of all accounts that are going to pay, do so within 60 days.
264
Using the above information prepare a cash budget
Solution (Rs Lakh)
Months
1 2 3 4 5 6

(A) Cash Inflows:

1. Cash sales (10% of total) 4.00 5.00 6.00 6.00 6.00 6.00
2. Receivables collection - 17.64 39.68 48.50 52.92 52.92
3. Interest received 1.00 - - - - 1.00
4. Dividends received - - 2.00 - - 2.00
5. sale of shares - - - - - 160.00
Total (A) 5.00 22.64 47.68 54.50 58.92 221.92
(B) Cash outflows:
1. Purchases 1.00 1.50 2.00 2.00 2.00 1.00
2. Labour 6.00 7.00 8.00 8.00 8.00 6.00
3. Manufacturing overheads 13.00 13.50 14.00 14.00 14.00 13.00
4. Admin istrative expenses 2.00 2.00 2.00 2.00 2.00 2.00
5. Distribution charges 2.00 3.00 4.00 4.00 4.00 2.00
6. Raw materials (30 days credit) - 14.00 15.00 16.00 16.00 16.00
7. Interest paid 0.40 - - - - -
8. Dividend paid 2.00 - - 2.00 - -
9. Instalment of machine - - - - - 20.00
10. Repayment of loan - - - - - 80.00
Total (B) 26.40 41.00 45.00 48.00 46.00 140.00

(C) Net Receipt or (Payment (A-B)(21.40) (18.36) 2.68 6.50 12.92 81.92
The above cash budget helps to reconcile the need for cash with the financing
arrangement. For instance, in the first two months, the cash receipts fall below the
disbursements and the firm obviously needs temporary financing which it will be able to pay
in the subsequent months. In month 6, it has, in fact, excess cash for which temporary
investment will have to be made until the funds can be employed in business.
CASH MANAGEMENT TECHNIQUES
The strategic aspects of efficient cash management are (i) efficient inventory management,
(ii) speedy collection of accounts receivable, and (iii) delaying payments on accounts
payable. There are some specific techniques and process for speedy collection of receivables
from customers and slowing disbursements. We discuss them in the present section.

265
Efficient Inventory-Production Management
The strategy is to increase the inventory turnover, avoiding stock-outs, that is,
shortage of stock. This can be done in the following ways:
1. Increasing the raw materials turnover by using more efficient inventory control
techniques.
2. Decreasing the production cycle through better production planning, scheduling and
control techniques: it will lead to an increase in the work-in-progress inventory
turnover.
3. Increasing the finished goods turnover through better forecasting of demand and a
better planning of production.
Speedy Cash Collections
In managing cash efficiently, the cash inflow process can be accelerated through
systematic planning and refined techniques. There are two board approaches to do this. In
the first place, the customers should be encouraged to pay as quickly as possible. Secondly,
the payment from customers should be converted into cash without any delay.
Prompt Payment by Customers
One way to ensure prompt payment by customers is prompt billing. What the customers has
to pay and the period of payment should be notified accurately and in advance. The use of
mechanical devices for billing along with the enclosure of a self-addressed return envelope
will speed up payment by customers.
Early Conversion of Payments into Cash
Once the customer makes the payment by writing a cheque in favour of the firm, the
collection can be expedited by prompt encashment of the cheque. There is a lag between the
time a cheque is prepared and mailed by the customer and the time the funds are included in
the cash reservoir of the firm. The early conversion of payment into cash, as a technique to
speed up collection of accounts receivable, is done to reduce the time lag between posting of
the cheque by the customer and the realization of money by the firm.
The collection of accounts receivable can be considerably accelerated, by reducing transit,
processing and collection time. An important cash management technique is reduction in
deposit float. This is possible if a firm adopts a policy of decentralized collections. We
discuss below some of the important processes that ensure decentralized collection so as to
reduce (i) the amount of time that elapses between the mailing of a payment by a customer,
and (ii) the point the funds become available to the firm for use. The principal methods of
establishing a decentralized collection network are (a) Concentration Banking, and (b) Lock-
box System.
Concentration Banking
In this system of decentralized collection of accounts receivable, large firms which have a
large number of branches at different places, select some of the strategically located branches
as collection centers for receiving payment from customers. A concentration bank is one with
which the firm has a major account-usually a disbursement account. Hence, this arrangement
is referred to as concentration banking.

266
 Concentration banking, as a system of decentralized billing and multiple collection
points, is a useful technique to expedite the collection of accounts receivable. It reduces the
time needed in the collection process by reducing the mailing time. Since the collection
centers are near the customers, the time involved in sending the bill to the customer is
reduced. Moreover, the time-lag between the dispatch of the cheque by the customer and its
receipt by the firm is also reduce. Thus, the arrangement of multiple collection centers with
concentration banking results in a saving of time in both mailing and clearance of customer
payments and leads to a reduction in the operating cash requirements.
Lock-Box System
The concentration banking arrangement is instrumental in reducing the time involved in
mailing and collection. But with this system of collection of accounts receivable, processing
for purpose of internal accounting is involved, that is, some time elapses before a cheque is
deposited by the local collection center in its account. The lock-box system takes care of this
kind of problem, apart from effecting economy in mailing and clearance times.
Thus, the lock-box system is like concentration banking in that the collection is
decentralized and is done at the branch level. But they differ in one very important respect.
While the customer sends the cheques, under the concentration banking arrangement, to the
collection centers, he sends them to a post office box under the lock-box system. In a way,
the lock-box arrangement is an improvement over the concentration banking system. Its
superiority arises from the fact that one step in the collection process is eliminated with the
use of lock-box
Thus, the lock-box system, as a method of collection of receivables, has a two-fold
advantage: (i) the bank performs the clerical task of handling the remittances prior to
deposits, services which the bank may be able to perform at lower cost; (ii) the process of
collection through the banking system begins immediately upon the receipt of the
cheque/remittance and does not have to wait until the firm completes its processing for
internal accounting purpose. Although the use of concentration banking and lock-box
systems accelerate the collection of receivables, they involve a cost.
Slowing Disbursements
Apart from speedy collection of accounts receivable, the operating cash requirement can be
reduced by slow disbursements of accounts payable. In fact, slow disbursements represent a
source of funds requiring no interest payments. There are several techniques to delay
payment of accounts payable, namely, (i) avoidance of early payments; (ii) centralized
disbursements; (iii) floats; and (iv) accruals.
Avoidance of Early Payments
One way to delay payments is to avoid early payments. According to the terms of credit, a
firm is required to make a payment within a stipulated period. It entitles a firm to cash
discounts.
Centralised Disbursements
Another method to slow down disbursements is to have centralized disbursements. All the
payments should be made by the head office from a centralized disbursement account. Such
an arrangement would enable a firm to delay payments and conserve cash.

267
Float
A very important technique of slow disbursements is float. The term float refers to the
amount of money tied up in cheques that have been written, but have yet to be collected and
encashed. Alternatively, float represents the difference between the bank balance and book
balance of cash of a firm. Float used in this sense is called as cheque kiting. There are two
ways of doing it: (a) Paying from a distant bank (b) scientific cheque-cashing analysis.
Paying from a Distant Bank
The firm may issue a cheque on banks away from the creditor’s bank. This would involve
relatively longer transit time for the creditor’s bank to get payment and, thus enable the firm
to use its funds longer.
Cheque-encashment Analysis
Another way to make use of float is to analyse, on the basis of past experience, the time-lag
in the issue of cheques and their encashment. For instance, cheques issued to pay wages and
salary may not be encashed immediately; it may be spread over a few days, say, 25 per cent
on one day, 50 per cent on the second day and the balance on the third day. It would mean
that the firm should keep in the bank not the entire amount of a payroll but only a fraction
represented by the actual withdrawal each day. This strategy would enable the firm to solve
the operating cash.
Accruals
Finally, a potential tool for stretching accounts payable is accruals which are defined as
current liabilities that represent a service or goods received by a firm but not yet paid for. For
instance, payroll, that is, remuneration to employees who render service in advance and
receive payments later. In a way, they extend credit to the firm for a period at the end of
which they are paid, say, a week or a month the longer the period after which payment is
made, the greater is the amount of free financing consequently and the smaller is the amount
of cash balances required. Thus, less frequent payrolls, that is, weekly as compared to
monthly, are an important source of accrual. They can be manipulated to slow down
disbursements. Other examples of accrual are rent to lessors and taxes to government. But
these can be utilized only to a limited extent as there are legal constraints beyond which such
payments cannot be extended.
CASH MANAGEMENT MODELS
while it is true that financial managers need not necessarily follow cash management models
exactly but a familiarity with them provides an insight into the normative framework as to
how cash management should be con ducted. This section, therefore, attempts to outline
following analytical models for cash management: (i) Baumol Model, (ii) Miller-Orr Model.
Baumol Model
The purpose of this model is to determine the minimum cost amount of cash that a financial
manager can obtain by converting securities to cash, considering the cost of conversion and
the counter-balancing cost of keeping idle cash balances which otherwise could have been
invested in marketable securities. The total cost associated with cash management, according
to this model, has two elements: (i) cost of converting marketable securities into cash and (ii)
the lost opportunity cost.

268
 The conversion costs are incurred each time marketable securities are converted into
cash. symbolically, total conversion cost per period.
Tb
=
C
Where
b = cost per conversion assumed to be independent of the size of the transaction
T = Total transaction cash needs for the period
C = Value of marketable securities sold at each conversion.

The opportunity cost is derived from the lost/forfeited interest rate (i) that could have
been earned on the investment of cash balances. The total opportunity cost is the interest rate
times the average cash balance kept by the firm. The model assumes a constant and a certain
pattern of cash outflows.
C 
= i 
2
Where
i= interest rate that could have been earned.
C/2 = the average cash balance that is, the beginning cash (C) plus the ending cash balance
of the period (zero) divided by 2.
The total cost associated with cash management comprising total conversion cost plus
opportunity cost of not investing of not investing cash until needed in interest-bearing
instruments can be symbolically expressed as
 C   Tb 
= i + 
2 C 
To minimize the cost, therefore, the model attempts to determine the optimal
conversion amount, that is, the cash withdrawal which costs the least. The reason is that a
firm should not keep the total beginning cash balance during the entire period as it is not
needed at the beginning of the period. For example, if the period were one thirty day month,
only one-thirtieth of the opening cash balance each day will be required. This means if only
one-thirtieth of the entire amount is withdrawn, the rest could be left invested in interest
earning marketable securities. As a result, on the one-thirtieth of cash not needed to the last
day of the month, twenty-nine day’s interest could be earned by the firm and so on.
Symbolically, the optimal conversion amount (C),
2bt
Ce =
I
In sum, the Baumol Model of cash management is very simplistic. Further, its
assumptions of certainty and regularity of withdrawal of cash do not realistically reflect the
actual situation in any firm. Also, the model is concerned only with transaction balances and

269
not with precautionary balances. In addition, the assumed fixed nature of the cash
withdrawals is also not realistic.
Nevertheless, the model does clearly and concisely demonstrate the economies of
scale and the counteracting nature of the conversion and opportunity costs which are
undoubtedly major considerations in any financial manager’s cash management strategy.
Miller-Orr Model
The objective of cash management, according to Miller-Orr (MO), is to determining the
optimum cash balance level which minimizes the cost of cash management. Symbolically,
bE ( N )
= + E(M )
t
Where
b = the fixed cost per conversion
E(M) = the expected average daily cash balance
E(N) = the expected number of conversions
t= the number of days in the period
i = the lost opportunity costs
C = total cash management costs
The MO Model is, in fact, an attempt to make the Baumol Model more realistic as
regards the pattern of cash flows. As against the assumption of uniform and certain levels of
cash balances in the Baumol Model, the MO Model assumes that cash balances randomly
fluctuate between an upper bound (h) and a lower bound (o). When the cash balances hit the
upper bound, the firm has too much cash and should buy enough marketable securities to
bring the cash balances back to the optimal bound (z). When the cash balances hit zero, the
financial manager must return them to the optimum bound (z) by selling/converting securities
into cash. According to the MO Model, as in Baumol model, the optimal cash balance (z) can
be expressed symbolically as
3
2br 2
Z=
4i
where r2 = variance of the daily changes in cash balances.
Thus, as in Baumol Model, there are economies of scale in cash management and the two
basic costs of conversion and lost interest that have to be minimized.
Mo Model also specifies the optimum, upper boundary (h) as three times the optimal cash
balance level such that
h=3z
Further, the financial manager could consider the use of less liquid, potentially more
profitable securities as investments for the cash balances in excess of h.

270
MARKETABLE SECURITIES
Once the optimum level of cash level of cash balance of a firm has been determined, the
residual of its liquid assets is invested in marketable securities. Marketable securities are
short-term investment instruments to obtain a return on temporarily idle funds. In other
words, they are securities which can be converted into cash in a short period of time, typically
a few days. The basic characteristics of marketable securities affect the degree of their
marketability/liquidity. To be liquid, a security must have two basic characteristics: a ready
market and safety of principal. Ready marketability minimizes the amount of time
required to convert a security into cash. The second determinant of liquidity is that there
should be little or no loss in the value of a marketable security over time. Only those
securities that can be easily converted into cash without any reduction in the principal amount
qualify for short-term investments.
There are three motives for maintaining liquidity (cash as well as marketable
securities) and, therefore, for holding marketable securities: transaction motive,
safety/precautionary motive and speculative motive. Each motive is based on the premise
that a firm should attempt to earn a return on temporarily idle funds. The type of marketable
security purchased will depend on the motive for the purchase.
Marketable Security Alternatives
We describe briefly the more prominent marketable/near-cash securities available for
investment. Our concern is with money market instruments.
Treasury Bills
There are obligations of the government. They are sold on a discount basis. The
investor does not receive an actual interest payment. The return is the difference between the
purchase price and the face (par) value of the bill.
The treasury bills are issued only in bearer form. They are purchased, therefore,
without the investors’ name upon them. This attribute makes them easily transferable from
one investor to another. A very active secondary market exists for these bills. Due to their
virtually risk free nature and because of active secondary market for them, treasury bills are
one of the most popular marketable securities even though the yield on them is lower.
Negotiable Certificates of Deposit (CDs)
These are marketable receipts for funds that have been deposited in a bank for a fixed
period of time. The deposited funds earn a fixed rate of interest. The denomination and
maturities are tailored to the investors’ need. The CDs are offered by banks on a basis
different from treasury bills, that is, they are not sold at a discount. CDs may be issued in
either registered or bearer form, the latter facilitates transactions in the secondary market and,
thus, is the most common.
Commercial Paper
It refers to short-term unsecured promissory note sold by large business firms to raise cash.
As they are unsecured, the issuing side of the market is dominated by large companies which
typically maintain sound credit ratings. Commercial papers (CPs) can be sold either directly
or through dealers. For all practical purposes, there is no active trading in secondary market
for commercial paper although direct sellers of CPs often repurchase it on request. This
feature distinguishes CPs from all of the previously discussed short-term investment vehicles
271
Bankers’ Acceptances
These are drafts (order to pay) drawn on a specific bank by an exporter in order to obtain
payment for goods he has shipped to a customer who maintains an account with that specific
bank. They can also be used in financing domestic trade. The draft guarantees payment by
the accepting bank at a specific point of time. The seller who holds such acceptance may sell
it at a discount to get immediate funds thus; the acceptance becomes a marketable security.
In fact, the acceptances of major banks are a very safe investment, making the yield
advantage over treasury bills worth looking for marketable securities portfolio.
Repurchase Agreements
These are legal contracts that involve the actual sale of securities by a borrower to the lender
with a commitment on the part of the former to repurchase the securities at the current price
plus a stated interest charge. There are two major reasons why a firm with excess cash
prefers to buy repurchase agreements rather than a marketable security. First, the original
maturities of the instruments being sold can, in effect, be adjusted to suit the particular needs
of the investment firm. Therefore, funds available for a very short period, that is, one/two
days can be employed to earn a return. Closely related to the first is the second reason,
namely, since the contract price of the securities that make up the arrangement is fixed for the
duration of the transaction, the firm buying the repurchase agreement is protected against
market fluctuations throughout the contract period. This makes it a sound alternative
investment for funds that are surplus for only short periods.
Units
The units of the Unit Trust of India (UTI) offer a reasonably convenient alternative avenue
for investing surplus liquidity as (i) there is a very active secondary market for them, (ii) the
income from units is tax-exempt up to a specified amount and, (iii) the units appreciate in a
fairly predicatable manner.
Inter-corporate Deposits
Inter-corporate deposits, that is, short-term deposits with other companies is a fairly attractive
form of investment of short-term funds in terms of rate of return which currently ranges
between 12 and 15 per cent. However, apart from the fact that one month’s time is required
to convert them into cash, Inter-corporate deposits suffer from high degree of risk.
Bills Discounting
Surplus funds may be deployed to purchase/discount bills. Bills of exchange are drawn by
seller (drawer) on the buyer (drawee) for the value of goods delivered to him. During the
pendency of the bill, if the seller is in need of funds, he may get it discounted. Bill
discounting is superior to Inter-corporate deposits for investing surplus funds.
Call Market
It deals with funds borrowed/lent overnight/one-day (call) money and notice money for
periods up to 14 days. It enables corporates to utilize their float money gainfully. However,
the returns (call rates) are highly volatile. The stipulations pertaining to the maintenance of
cash reserve ratio (CRR) by banks is the major determinant of the demand of funds and is
responsible for volatility in the call rates.

272
SUMMARY
Cash management is one of the key areas of working capital management. There are four
motives for holding cash (i) transaction motive (ii) precautionary motive (iii) speculative
motive and (iv) compensating motive. The basic objectives of cash management are to
reconcile two contradictory and conflicting task, to meet the payment schedule and to
minimize funds committed to cash balances.
Cash budget is the most important tool in cash management. It is a device to help a
firm to plan and control the use of cash. The cash position of a firm as it moves from one
period to another period is highlighted by the cash budget. A cash budget has normally three
parts, namely, cash collections, cash payments and cash balances. The major sources of cash
receipts and payments are operating and financial. There are two approaches to derive
optimal cash balance. The important models are (i) Baumol model and (ii) Miller-orr model.
Marketable securities are an outlet for surplus cash as liquid security. To be liquid a
security must have two basic characteristics, that is, a ready market and safety of principal.
The prominent marketable securities available for investment are: treasury bills, commercial
paper, interbank call money, commercial bills under the bill market scheme and short-term
deposits.

PRACTICAL PROBLEMS
Problem No.1
The following information is available in respect of a trading firm:
(i) On an average, debtors are collected after 45 days; inventories have an average
holding period of 75 days and creditors payment period on an average is 30 days.
(ii) The firm spends a total of Rs. 120 lakh annually at a constant rate.
(iii) It can earn 10 per cent on investments.
From the above information, compute: (a) the cash cycle and cash turnover, (b)
minimum amounts of cash to be maintained to meet payments as they become due, (c)
savings by reducing the average inventory holding period by 30 days.
Solution:
(a) Cash cycle = 45 days + 75 days – 30 days = 90 days (3 months) Cash turnover =
12 months (360 days)/3 months (90 days) = 4
(b) Minimum operating cash = Total operating annual outlay/cash turnover, that is, Rs.
120 lakh/4 = Rs 30 lakh.
(c) Cash cycle = 45 days + 45 days – 30 days = 60 days (2 months)
Cash turnover = 12 months (360 days)/2 months (60 days) = 6.
Minimum operating cash = Rs. 120 lakh/6 = Rs. 20 lakh
Reduction in investments = Rs. 30 lakh – Rs. 20 lakh = Rs. 10 lakh
Savings = 0.10 x Rs. 10 lakh = Rs. 1 lakh.

273
Problem No.2
Royal Industries feels a lock-box system can shorten its accounts receivable collection period
by 3 days. Credit sales are estimated at Rs. 365 lakh per year, billed on a continuous basis.
The firm’s opportunity cost of funds is 15 percent. The cost of lock box system is Rs. 50,000.
(a) Will you advise ‘Royal’ to go for lock-box system?
(b) Will your answer be different if accounts receivable collection period is reduced by 5
days ?

Solution:
(a) Cash released by lock-box system (Rs. 365 lakh/365 days
=Rs. 1 lakh x 3 days) Rs 3,00,000
Savings (Rs. 3 lakh x 0.15) 45,000
Less cost of loci-box system 50,000
Net loss (5,000)

The firm is advised not to go for the lock-box system.

(b) Cash released: Rs. 1 lakh x 5 days Rs. 5,00,000
Savings (Rs. 5 lakh x 0.15) 75,000
Less cost of lock-box system 50,000
Net savings 25,000
________________________________________________________
Yes, the firm should go for the lock box system.
MODEL QUESTIONS:
1. Explain the three principal motives for holding cash.
2. Illustrate with example the modus operandi of preparing a cash budget.
3. Explain the techniques that can be used to accelerate the firm’s collections.
4. What is lock-box system? How does it help to reduce the cash balances.
5. Explain the criteria that a firm should use in choosing the short-term investment
alternatives inorder to invest surplus cash.

FURTHER READINGS:
1. Van Horne C.F., 2004, Financial Management and Policy, Prentice – Hall, New Delhi.
2. Bringham E.F., 1977, Financial Management, Drydon Press.
3. Pandey I.M., 2004, Financial Management, Vikas Publishing House Pvt. Ltd., New Delhi.
274
GUIDELINE 28 : INVENTORY MANAGEMENT

OBJECTIVES
After studying this guideline, you are able to learn
• the types of inventories.
• the objectives of inventory management.
• the inventory management techniques.

INTRODUCTION
Inventories constitute the most significant part of current assets of a large majority of
companies in India. On an average inventories are approximately sixty percent of current
assets in public limited companies in India. Proper inventory management is important to the
financial health of the organization. Excessive level of inventory results in large inventory
carrying costs, including the cost of capital tied up in inventory. Out of stock forces
customers to turn to competitors or results in a loss of sales. Thus inventory management,
like the management of the other current assets should be related to the overall objective of
the firm. Efficient management of inventory should ultimately result in the maximization of
owner’s wealth.
TYPES OF INVENTORIES
Inventories are stock of the product a company is manufacturing for sale and
components that make up the product. The various forms in which inventories exist in a
manufacturing company are raw materials, work-in-progress and finished goods.
Raw materials are those basic inputs that are converted into finished products through the
manufacturing process. Raw material inventories are those units which have been purchased
and stored for future production.
Work-in-process inventories are semi-manufactured products. They represent products that
need more work before they become finished products for sale.
Finished goods inventories are those completely manufactured products which are ready for
sale. Stocks of raw materials and work-in-progress facilitate production, while stock of
finished goods is required smooth marketing operations. Thus, inventories serve as a link
between the production and consumption of goods.
The levels of three kinds of inventories for a firm depend on the nature of its business.
A manufacturing firm will have substantially high levels of all three kinds of inventories,
while a retail or wholesale firm will have a very high level of finished goods inventories and
no raw materials and work-in-process inventories.
MOTIVES OF HOLDING INVENTORIES
The question of managing inventories arises only when the company holds
inventories. Maintaining inventories involves tying up of the company’s funds and incurrence
of storage and holding costs. These are the three general motives for holding inventories:

275
Transaction motive emphasizes the need to maintain inventories to facilitate smooth
production and sales operations.
Precautionary motive necessitates holding of inventories to guard against the risk of
unpredictable changes in demand and supply forces and other factors.
Speculative motive influences the decision to increase or reduce inventory levels to take
advantage of price fluctuations.
A company should maintain adequate stock of materials for a continuous supply to
the factory for an uninterrupted production. Other factors which may necessitate purchasing
and holding of raw materials inventories are quantity discounts and anticipated price increase.
Work-in-process inventory builds up because of the production cycle. Production cycle is the
time span between introduction of raw materials into production and emergence of finished
product at the completion of production cycle, till production cycle completes stock of work-
in-process has to be maintained. Efficient firms constantly try to make production cycle
smaller by improving their production techniques. Stock of finished goods has to be
maintained for sudden demands from customers. Failure to supply products to customers,
when demanded would mean loss of the firm’s sales to competitors.
OBJECTIVE OF INVENTORY MANAGEMENT
The objective of inventory management should be to determine and maintain
optimum level of inventory investment. The optimum level of inventory will lie between the
two danger points of excessive and inadequate inventories. The firm should always avoid a
situation of over investment or under- investment in inventories. The major dangers of over
investment are:
(a) Unnecessary tie-up of the firm’s funds and loss of profit
(b) Excessive carrying cost
(C) Risk of liquidity.
The excessive level of inventories consumes funds of the firm, which cannot be used
for any other purpose, and thus, it involves an opportunity cost. The Carrying costs, such as
the storage, handling, insurance, recording and inspection, also increase in proportion to the
volume of inventory. Maintaining an inadequate level of inventories is also dangerous. The
consequences of under-investment in inventories are:
(a) Production hold-ups and
(b) Failure to meet delivery commitments.
Inadequate raw materials and work-in-process inventories will result in frequent
production interruptions. Similarly, if finished goods inventories are not sufficient to meet the
demand of customers regularly, they may shift to competitors, which will amount a
permanent loss to the firm.
The aim of inventory management, thus, should be to avoid excessive and inadequate
levels of inventories and to maintain sufficient inventory for the smooth production and sales
operations. Efforts should be made to place an order at the right time with the right source to
acquire the quantity at the right price and quality.

276
INVENTORY MANAGEMENT TECHNIQUES
In managing inventories, the firm’s objective should be in consonance with the
shareholder wealth maximization principle. To achieve this firm should determine the
optimum level of inventory. To manage inventories efficiently, answer should be sought to
the following two questions:
How much should be ordered?
When should it be ordered?
Economic Order Quantity (EOQ)
The first question relates to the problem of determining economic order quantity (EOQ).
One of the major inventory management problems to be resolved is how much inventory
should be added when inventory is replenished. Determining an optimum inventory level
involves two types of costs:
Ordering costs
Carrying costs
Ordering costs is used incase of raw materials (or supplies) and includes the entire costs of
acquiring raw materials. These are the costs incurred on requisitioning, purchase ordering,
transporting, receiving and storing of raw materials. Ordering costs increase in proportion to
the number of orders placed, thus the more frequently inventory is acquired the higher the
firm’s ordering costs. On the other hand, if the firm maintains large inventory levels there
will be few orders placed and ordering costs will be relatively small. Thus, ordering costs
decrease with increasing size of inventory.
Carrying costs are the costs incurred for maintaining a given level of inventory. They
include storage, insurance, taxes, deterioration and obsolescence. Carrying costs vary with
inventory size. The economic size of inventory would depend on trade off between carrying
costs and ordering costs. The optimum inventory size is commonly referred to as economic
ordered quantity. To determine the economic ordered quantity there are three approaches:
The trial and error approach
The formula approach
Graphic approach
Order Formula Approach
The total order costs will be number of orders during the year multiplied by ordering
costs per order. The ordering costs per order O are fixed. If A represents total annual
requirements and Q the order size, the number of orders will be A/Q and total order cost will
be:
Total ordering cost= (annual requirement x per order cost)/order size
TOC= AO/Q
The total carrying cost will be the product of the average inventory units and the
carrying costs per unit.
Average inventory= order size/2= Q/2
Total carrying cost will be:
Total carrying cost= average inventory x per unit carrying cost
TCC = QC/2
Total cost = total carrying cost+ total order cost

277
 TC = QC/2 + AO/Q
Economic order quantity
2 × quantity required × ordering cost
=
carrying cost

2AO
EOQ =
c
Illustration
The usage of an inventory item during the year is estimated at 2000 units. The
ordering cost works out to Rs. 100 per order and the holding cost is estimated at Rs. 10 per
unit per year. The cost of the item, i.e., the purchase price is Rs. 1 per unit.
By applying the EOQ model we can directly arrive at the economic order quantity
as follows:
Q = ( 2x100x2000 ) /10 = 200 units.

Graphic approach
The economic order quantity can also be found out graphically. Figure 28.1
Illustrates the EOQ function. In the figure carrying cost, ordering cost and total cost are
plotted on vertical axis and horizontal axis is used to represent the order size.

0 X

Figure 28.1 : Economic Order Quantity

Quantity discount
There are occasions when a firm is able to take advantage of quantity discounts
provided the order size reaches a certain level. It is possible to analyze and decide on such
cases.

278
 For instance, in the preceding example we found that the usage per year is 2000 units,
the holding cost per unit per year is Rs. 10 and the ordering cost is Rs. 100; let us now
consider what would be the solution if it was known that a quantity discount of 10% in price
is available if the order size is raised to 250 units.
Whether or not the quantity discount should be availed of depends on an assessment
of the costs and benefits involved.
The savings resulting from the quantity discount = (Re.1) (0.10) (2000) = Rs. 200.
The cost is the additional holding cost minus savings in ordering cost stemming from
fewer orders being placed while the cost was
CQ x /2 = 10 (200) /2 = Rs. 1000.
The cost would now be, cQ#/2 = 10 (250)/2 = Rs. 1250;
Where, Q# = new order size
As there would be a difference of Rs. 250
The savings in ordering cost can be arrived at as follows:
Total ordering cost when 200 units are ordered each time
= 2000 (100)/200 = Rs. 1000.
Total ordering cost when 250 units are ordered each time
= 2000 (100) /250 = Rs. 800
Therefore, the saving in ordering cost would be Rs. 200.
Thus while the saving in ordering cost would be Rs. 200, the escalation in holding cost would
be Rs. 250, that is to say that the net increase in cost would be Rs. 50.
In this particular instance it would be advisable to avail of the quantity discount option
because the saving of Rs. 200 exceeds the net increase in cost of Rs.50.
Reorder Point
The reorder point is that inventory level at which an order should be placed to replenish the
inventory. To determine the reorder point under certainty, we should know:
Lead time
Average usage
Economic order quantity
Lead time is the time normally taken in replenishing inventory after the order has been
placed. By certainty we mean that usage and lead time do not fluctuate. Under such a
situation, reorder point is simply that inventory level which will be maintained for
consumption during the lead time.
Reorder point = lead time × average usage
Safety Stock
The reorder point is computed under the assumption of certainty. It is difficult to
predict usage and lead time accurately. The demand for material may fluctuate from day-
today to week. Similarly, the actual delivery time may be different from the normal lead time.
If the actual usage increases or the delivery of the inventory is delayed the firm can face a
problem of stock out which can be proving to be costly for the firm. Therefore, in order to
guard against stock out the firm has to maintain a minimum or buffer inventory as cushion

279
against expected increase use and / or delay in delivery time. Thus the formula to determine
the reorder point when safety stock is maintained is as follows:
Reorder point = lead ×average usage + safety stock
To decide on the level of the safety stock to be carried a firm must balance the cost of
stock out with the cost of carrying additional inventory.

DETERMINATION OF STOCK LEVELS

Carrying of too much and too little of inventories is detrimental to the firm. If the inventory
level is too little, the firm will faces frequent stock-outs involving heavy ordering cost and if
the inventory level is too high it will be unnecessary tie-up of capital. Therefore, an efficient
inventory management requires that a firm should maintain an optimum level of inventory
where inventory costs are the minimum and at the same time there is no stock-out which may
result in loss of sale or stoppage of production. Various stock levels are discussed as such.
(a) Minimum Level
This represents the quantity which must be maintained in hand at all times. If stocks are less
than the minimum level then the work will stop due to shortage of materials. Following
factors are taken into account while fixing minimum stock level.
Lead Time A purchasing firm requires some time to process the order and time is also
required by the supplying firm to execute the order. The time taken in processing the order
and then executing it is known as lead time. It is essential to maintain some inventory during
this period.
Rate of Consumption It is the average consumption of materials in the factory. The rate of
consumption will be decided on the basis of past experience and production plans.
Nature of Material The nature of material also affects the minimum level. If a material is
required only against special orders of the customer then minimum stock will not be required
for such materials. Minimum stock level can be calculated with the help of following
formula:
Minimum stock level = Re-ordering level - (Normal consumption × Normal
Re-order period).
(b) Re-ordering Level When the quantity of materials reaches at a certain figure then fresh
order is sent to get materials again. The order is sent before the materials reach minimum
stock level. Re-ordering level or ordering level is fixed between minimum level and
maximum level. The rate of consumption, number of days required to replenish the stocks,
and maximum quantity of materials required on any day are taken into account while fixing
re-ordering level. Re-ordering level is fixed with the following formula:
Re-ordering Level = Maximum Consumption × Maximum Re-order period
(c) Maximum Level It is the quantity of materials beyond which a firm should not exceed
its stocks. If the quantity exceeds maximum level limit then it will be overstocking. A firm
should avoid overstocking because it will result in high material costs. Overstocking will
mean blocking of more working capital, more space for storing the materials, more wastage
of materials and more chances of losses from obsolescence.

280
Maximum Stock Level = Re-ordering Level + Re-ordering Quantity – (Minimum
Consumption × Minimum Re-ordering period).
(d) Danger Level
It is the level beyond which materials should not fall in any case. If danger level arises then
immediate steps should be taken to replenish the stocks even if more cost is incurred in
arranging the materials. If materials are not arranged immediately there is a possibility of
stoppage of work. Danger level is determined with the following formula:
Danger Level = Average Consumption × Maximum re-order period for
emergency purchases.
(e) Average Stock Level
The average stock level is calculated as such:
Average Stock Level = Minimum Stock Level + ½ of re-order quantity.

INVENTORY CONTROL SYSTEM

A firm needs an inventory control system to effectively manage its inventory. There
are several inventory control systems in vogue in practice. They range from simple systems
to very complicated systems. The nature of business and size dictate the choice of an
inventory control system.
ABC Control System
Large number of firms has to maintain several types of inventories. It is not desirable
to keep the same degree of control on all the items. The firm should pay maximum attention
to those items whose value is the highest. The firm should be selective in its approach to
control investment in various types of inventories. This analytical approach is called the ABC
analysis and tends to measure the significance of each item of inventories in terms of its
value. The high value items are classified as ‘A items’ and would be under the strict control.
‘C items’ represent relatively least value and would under the simple control and ‘B items’
fall in between these two categories and require reasonable attention of management. This
approach is also known as proportional value analysis (PVA).
The following steps are involved in implementing the ABC analysis:
Classify the items of inventories, determining the expected use in units and price per unit for
each item.
Determine the total of each item by multiplying the expected units by its unit price.
Rank the items in accordance with the total value, giving first rank to the item with highest
total value and so on.
Compute the ratios (percentage) of number of units of each item to total units of all items and
ratio of total value of each item to total value of all items.
Combine items on the basis of their relative value to form three categories- A, B, C.
Just-in-Time (JIT) System
Japanese firms popularized the Just-in-Time (JIT) inventory system in the world. In
the JIT system material or the manufactured components and parts arrive to the

281
manufacturing sites or stores just few hours before they are put to use. The delivery of
material is synchronized with the manufacturing cycle and the speed. JIT system eliminates
the necessity of carrying large inventories, and thus saves carrying and other related costs to
the manufacturer. The JIT inventory system complements the total quality management
(TQM).
Outsourcing
A few years ago there was a tendency on the parts of many companies to manufacture
all components in-house. Now more and more companies are adopting the practice of out-
sourcing. Out-sourcing is a system of buying parts and components rather than manufacturing
them internally. For example, Tata motors have developed number of ancillary units around
its manufacturing sites that supply parts and components to its manufacturing plants. The car
manufacturing company Maruthi which is now controlled by Suzuki of Japan has the similar
system of supply.
Computerised Inventory Control System
More and more companies small or large size, are adopting the computerized system
of controlling inventories. A computerized inventory control system enables a company to
easily track large items of inventories. It is an automatic system of counting inventories,
recording withdrawals and revising the balance. There is an inbuilt system of placing order as
the computer notices that a reorder point has been reached. The computer information
systems of the buyers and suppliers are linked to each other. As soon as the supplier’s
computer receives an order from the buyer’s system, the supply process is activated.

SUMMARY
Inventories constitute about 60 percent of current assets of Public limited companies
in India. The manufacturing companies hold inventories in the form of raw materials, work-
in-process and finished goods. Inventories represent investment of a firm’s funds. The
objective of inventory management should be the maximization of the value of the firm. The
Economic Order Quantity of inventory will occur at a point where the total cost is minimum.
A firm which carries a number of items in inventory that differ in value, can follow a
selective control system. A selective control system, such as the ABC analysis, classifies
inventories into three categories according to the value of items. Large number of companies
these days follow the total quality management (TQM) system which requires companies to
adapt JIT and computerized system of inventory management.

PRACTICAL PROBLEMS

Problem. No.1
A manufacturing company has an expected usage of 50,000 units of certain product
during the next year. The cost of processing an order is Rs. 20 and the carrying cost per unit
is Re. 0.50 for one year. Lead time on an order is five days and the company will keep a
reserve supply of two days’ usage. You are required to calculate (a) the economic order
quantity and (b) the reorder point. (Assume 250-day year).
Solution
(a) The economic order quantity is:
282
 2 AO 2 × 50, 000 × 20
EOQ = = = 40, 00, 000 = 2, 000 units
C 0.50
(b) The reorder point is:
Daily usage = 50,000/250 = 200 units
Reorder point = Safety stock + Lead time x Usage
= 2(200) + 5(200) = 400 + 1,000 = 1,400
Problem. No.2
From the following information, calculate minimum stock level, maximum stock level
and re-ordering level:
(i) Minimum Consumption 200 units per day
(ii) Minimum Consumption 150 units per day
(iii) Normal Consumption 160 units per day
(iv) Re-order period 10-15 days
(v) Re-order quantity 1,600 units
(vi) Normal re-order period 12 days
Solution
Re-ordering level = Maximum Consumption x Maximum Re-order Period
= 200 units × 15 = 3,000 units
Minimum Stock Level= Re-ordering level - (Normal Consumption x Normal
Re-ordering Period)
= 3,000 - (160 × 12)
= 3,000 - 1,920 = 1,080 units
Maximum Stock Level = Re-ordering Level + Re-order Quantity - (Minimum
Consumption × Minimum Re-order Period)
= 3,000 + 1,600 - (150 x 10)
= 3,000 + 1.600 - 1,500
= 3,100 units.
MODEL QUESTIONS
1. What is meant by inventory management? Why is it essential to a business concern?
2. Discuss in detail the motives of holding inventory.
3. Explain various tools and techniques used for inventory management.
4. What is ABC analysis? How is it useful as a tool of inventory management?
FURTHER READINGS
1. Van Horne C.F., 2004, Financial Management and Policy, Prentice – Hall, New Delhi.
2. Bringham E.F., 1977, Financial Management, Drydon Press.
3. Pandey I.M., 2004, Financial Management, Vikas Publishing House Pvt. Ltd., New Delhi.
283
GUIDELINE 29 : MANAGEMENT OF RECEIVABLES

OBJECTIVES
After studying this guideline, you will learn
• the dimensions of efficient management of receivables.
• the credit policy variables like credit standards, credit analysis, credit terms and
collection policies.
• the concept of cost of marginal investment in the accounts receivable.

INTRODUCTION
Investment in accounts receivables forms the second most important segment of working
capital next to inventory. Receivables form about one-third of current assets in India. The
term receivables is defined as debt owed to the firm by customers arising from sale of goods
or services in the ordinary course of business. Accounts receivables represent the amount due
from its customers to whom the company has extended the credit. The sale of goods on credit
is an essential part of the modern competitive economic systems. Credit sales and receivables
are marketing tool to aid the sale of goods. As a marketing tool they are intended to promote
sales and thereby profits. The period of credit and extent of receivables depends upon the
credit policy followed by the firm. However extension of credit involves risk and cost. The
firm should weigh the benefits as well as costs to determine the goal of receivables
management. In the words of Bolton the objective of receivables management is ‘to promote
sales and profits until that point is reached where the return on investments in further funding
receivables is less than the cost of funds raised to finance the additional credit (cost of
capital)’.

FACTORS INFLUENCING THE SIZE OF RECEIVABLES

Besides sales, a number of other factors also influence the size of receivables. The following
factors directly and indirectly affect the size of receivables.
Size of credit sale The volume of credit sales is the first factor, which increases or decreases
the size of receivables. If a concern sells only on cash basis as in the case Bata Shoe
Company, then these will be no receivables. The higher the part of credit sales out of total
sales, figures of receivables will also be more or vice versa.
Credit policies A firm with conservative credit policy will have low size of receivables
while a firm with liberal credit policy will be increasing this figure. The vigor with which the
concern collects receivables also affects its receivables. If collections are prompt then even if
credit is liberally extended, there is always a possibility of bad debts.
Terms of trade The size of receivables also depends upon the terms trade. The period of
credit allowed and rates of discount given are linked with receivables. If credit period
allowed is more than receivables will also be more. Sometimes trade policies of competitors
have to be followed otherwise it becomes difficult to expand the sales. The trade terms once
followed cannot be changed without adversely affecting sales opportunities.

284
Expansion plans When a concern wants to expand the activities, it will have to enter new
markets. To attract customers, it will give incentives in the form of credit facilities. The
periods of credit can be reduced when the firm is able to get permanent customers. In the
early stages of expansion more credit becomes essential and size of receivables will be more.
Relation with profits The credit policy is followed with a view to increase sales. When
sales beyond a certain level the additional costs incurred are less than the increase in
revenues. It will be beneficial to increase sales beyond a point because it will bring more
profits. The increase in profits will be followed by an increase in the size of receivables or
vice-versa.
Credit collection efforts The collection of credit should be streamlined. The customers
should be sent periodical reminders if they fail to pay in time. On the other hand, if adequate
attention is not paid towards credit collection then the concern can land itself in serious
financial problem. Efficient credit collection machinery will reduce the size of receivables. If
these efforts are slower then outstanding amounts will be more.
Habits of customers The paying habits of customers also have a bearing on the size of
receivables. The customers may be in the habit of delaying payments even though they are
financially sound. The concern should remain in touch with such customers and should make
them realize the urgency of their needs.
The specific benefits and costs which are relevant to the determination of the
objectives of receivables management are explained below:

BENEFITS
The benefits are the increased sales and anticipated profits because of a more liberal policy.
When firms extend trade credit, that is, invest in receivables, they intend to increase the sales.
The impact of a liberal trade credit policy is likely to take two forms. First, it is oriented to
sales expansion. In other words, a firm may grant trade credit either to increase sales to
existing customers or attract new customers. This motive for investment in receivables is
growth-oriented. Secondly, the firm may extend credit to protect its current sales against
emerging competition. Here, the motive is sales-retention. As a result of increased sales, the
profits of the firm will increase.
Other things being equal, a relatively liberal policy and, therefore, higher investments
in receivables, will produce larger sales. However, costs will be higher with liberal policies
than with more stringent measures. Therefore, accounts receivable management should aim at
a trade-off between profit (benefit) and risk (cost). That is to say, the decision to commit
funds to receivables (or the decision to grant credit) will be based on a comparison of the
benefits and costs involved, while determining the optimum level of receivables. The costs
and benefits to be compared are marginal costs and benefits. The firm should only consider
the incremental (additional) benefits and costs that result from a change in the receivables or
trade credit policy.

COSTS
The major categories of costs associated with the extension of credit and accounts
receivables are:
1. Collection cost
285
 2. Capital cost
3. Delinquency cost and
4. Default cost
Collection cost
Collection costs are administrative costs incurred in collecting the receivable from the
customers to whom credit sales have been made. Included in this category of costs are:
1. additional expenses on the creation and maintenance of a credit department with staff,
accounting records, stationery, postage and other elated items.
2. expenses involved in acquiring credit information either through outside specialists
agencies or by the staff of the firm itself. These expenses would not be incurred with
the firm does not sell on credit.
Capital cost
The increased level of accounts receivable is an investment in assets. They have to be
financed thereby involving a cost. There is a time lag between the sale of goods to, and
payment by the customers. Meanwhile the firm has to pay employees and suppliers of raw
materials, thereby implying that the firm should arrange for additional funds to meet its own
obligations while waiting for payment from its customers. The cost on the use of additional
capital to support credit sales, which alternatively could profitably employed elsewhere, is,
therefore, a part of cost of extending credit or receivables.
Delinquency cost
This cost arises out of the failure of the customers to meet their obligations when payment on
credit sales become due after the expiry of the credit period. Such costs are called
delinquency cost. The important components of these costs are:
1. Blocking-up of funds for an extended period.
2. Cost associated with steps that have to be initiated to collect the overdues such as,
reminders and other collection efforts, legal charges, where necessary and so on.
Default cost
Finally the firm may not be able to recover the overdues because of the inability of the
customers. Such debts are treated as bad debts and have to be written off as they cannot be
realized. Such costs are known as default costs associated with credit sales and accounts
receivables.

CREDIT POLICIES
A firm’s investment in accounts receivable depends on; (a) the volume of credit sales, and (b)
the collection period. For example, if a firm’s credit sales are Rs. 30 lakh per day and
customers, on an average, take 45 days to make payment, then the firm’s average investment
in accounts receivable is:
Daily credit sales x Average collection period
Rs. 30 lakh x 45 = Rs. 1, 350 lakh

286
 The investment in receivable may be expressed in terms of costs of sales instead of
sales value.
The volume of credit sales is a function of the firm’s total sales and the percentage of
credit sales to total sales. Total sales depend on market size, firm’s market share, product
quality, intensity of competition, economic conditions etc. The financial manager hardly has
any control over these variables. The percentage of credit sales to total sales is mostly
influenced by the nature of business and industry norms.
There is one way in which the financial manager can affect the volume of credit sales
and collection period and consequently, investment in accounts receivable. That is through
the changes in credit policy. The term credit policy is used to refer to the combination of
three decision variables: (i) credit standards, (ii) credit terms, and (iii) collection efforts, on
which the financial manager has influence.
The credit policy of a firm provides the framework to determine
• Whether or not to extend credit to a customer and
• How much credit to extend.
The credit policy decision of a firm has two broad dimensions.
1. Credit standards and
2. Credit analysis.
A firm has to establish and use standards in making decisions, develop appropriate
sources of credit information and methods of credit analysis. We illustrate below how these
two aspects are relevant to the accounts receivable management of a firm.
Credit Standards
The term credit standards represent the basic criteria for the extension of credit to customers.
The quantitative basis of establishing credit standards are factors such as credit ratings, credit
references, average payments period and certain financial ratios. To illustrate the effect, we
have divided overall standards into (a) tight or restrictive, and (b) liberal or non-restrictive.
The aim is to show what happens to the trade off when standards are relaxed or alternatively
tightened. The trade off with reference to credit standards covers.
• The collection cost
• The average collection period/cost of investment in accounts receivables
• Level of bad debt losses, and
• Level of sales
The implications of the four factors are elaborated below.
Collection Cost
The implications of relaxed credit standards are
• More credit
• A large credit department to service accounts receivables and related matters

287
 • Increase in collection costs. The effect of tightening of credit standards will be exactly
the opposite.
These costs are likely to be semi-variable. This is because up to a certain point the existing
staff will be able to carry on the increased workload, but beyond that additional staff should
be required. These are assumed to be included in the variable cost per unit and need not be
separately identified.
Investments in receivables or the average collection period
The investments in accounts receivable involves a capital cost as funds have to be arranged
by the firm to finance them till customers make payments. Moreover, the higher the average
accounts receivable, the higher is the capital or carrying cost. A change in the credit
standards-relaxation of tightening-leads to a change in the level of accounts receivable either
through a change in (a) sales or (b) collections.
A relaxation in credit standards, as already stated, implies an increase in sales which,
inturn, would lead to higher averages accounts receivables. Further, relaxed standards would
mean that credit is extended liberally so that it is available to even less credit worthy
customers who will take a longer period to pay overdues. The extension of trade credit to
slow-paying customers would result in a higher level of accounts receivables.
In contrast, a tightening of credit standards would signify
• A decrease in sales and lower average accounts receivable, and
• An extension of credit limited to more creditworthy customers who can promptly pay
their bills and thus a lower average level of accounts receivables.
Thus a change in sales and change in collection period together with a relaxation in
standards would produce a higher carrying cost, while changes in sales and collection period
result in lower costs when credit standards are tightened. These basic reactions also occur
when changes in credit terms or collection procedures are made.
Bad Debt Expenses
Another factor which is expected to be affected by changes in the credit standards is bad debt
(Default) Expenses. They can be expected to increase with relaxation in credit standards and
decrease if credit standards become more restrictive.
Sales Volume
Changing credit standards can also be expected to changes the volume of sales. As standards
are relaxed, sales are expected to increase; conversely, a tightening is expected to cause a
decline in sales.
Example
A firm is currently selling a product @ Rs 10 per unit. The most recent annual sales (all
credit) were 30,000 units. The variable cost per unit is Rs 6 and the average cost per unit,
given a sales volumes of 30,000 units, is Rs 8. the total fixed cost is Rs 60,000. The average
collection period may be assumed to be 30 days.
The firm is contemplating a relaxation of credit standards that is expected to result in
a 15 per cent increase in units sales; the average collection period would increase to 45 days
288
with no change in bad debt expenses. It is also expected that increased sales will result in
additional net working capital to the extent of Rs 10,000. The increase in collection expenses
may be assumed to be negligible. The required return on investment is 15 per cent.
Should the firm relax the credit standard?
Solution
The decision to put the proposed relaxation in the credit standards into effect should
be based on a comparison of (i) additional profits on sales and (ii) cost of the incremental
investments in receivables. If the former exceeds the latter, the proposal should be
implemented, otherwise not.
Profit on Incremental Sales
The profits on sales will increase by an amount equal to the product of the additional
units sold and additional profit per unit. Since the 30,000 units representing the current level
of sales absorb all the fixed costs, any additional units sold will cost only the variable cost per
unit. The marginal profit per unit will be equal to the difference between the sales price per
unit (Rs 10) and the variable cost per unit (Rs 6). The marginal profit/contribution margin per
unit would, therefore, be Rs 4. The total additional (marginal) profits from incremental sales
will be Rs 18,000 (Rs 4,500xRs 4).
Cost of Marginal/Incremental Investment in Receivables
The second variable relevant to the decision to relax credit standards is the cost of marginal
investment in accounts receivable. This cost can be computed by finding the difference
between the cost of carrying receivables before and after the proposed relaxation in credit
standards. It can be calculated as follows:
(i) Turnover of accounts receivable:
Number of days in the year 360
Proposed plan = =
Average Collection period 45
360
Preset plan = = 12
30
(ii) Total cost of sales :
Present plan = Number of units x cost per unit = 30,000 x Rs.8 = Rs.2,40,000
Proposed plan = (30,000 x Rs.8) + (4,500 x Rs.6) = Rs.2,67,000
(iii) Average investment in accounts receivable :
Present plan = Rs. 2,40,000/12 = Rs.20,000
Proposed plan = Rs.2,67,000/8 = Rs.33,375
(iv) The cost of marginal investment in accounts receivable: This is the different
between the average investments in accounts receivable under (i) the proposed
plan and (ii) under the present plan. It is calculated as follows:
Average Investments with proposed plan Rs.33,375
Less average investment with present plan 20,000
289
 Marginal investments 13,375
Marginal investments represent the amount of additional funds required to finance
incremental accounts receivable if the proposal to relax the credit standards is implemented.
The additional cost of Rs.13,375 is the cost of marginal investment in accounts receivable.
Rs.13,375 x 15
Given 15 per cent as required return on the investments, the cost =
100

= Rs.2,006.25

this is an opportunity cost in that the firm would earn this amount from alternative uses if the
funds are not tied up in additional accounts receivable.
(v) Cost of working capital : Rs.10,000 x 0.15 = Rs.1,500
In the above illustration, since the additional profits on increased sales as a result of relaxed
credit standards (Rs.18,000) is considerably more than the cost of incremental investments in
accounts receivable (Rs.2,006.25) and working capital (Rs.1,500), the firm should relax its
credit standards. Such an action would lead to an overall increase in the profits of the firm by
Rs.14,493.75 (Rs.18,000 – Rs.2,006.25 – Rs.1,500).
The effect of tightening credit standards would be just the opposite.
Credit analysis:
Besides establishing credit standards a firm should develop procedures for evaluating credit
applicants. The second aspect of credit policies of firm is credit analysis and investigation.
The financial or credit manager should consider three C’s: (a) character, (b) capacity, and (c)
condition.
• Character refers to the customer’s willingness to pay. The financial or credit manager
should judge whether the customers will make honest efforts to honour their credit
obligations. The moral factor is of considerable importance in credit evaluation in
practice.
• Capacity refers to the customer’s ability to pay. Ability to pay can be judged by
assessing the customer’s capital and assets which he may offer as security. Capacity
is evaluated by the financial position of the firm as indicated by analysis of ratios and
trends in firm’s cash and working capital position. The financial or credit manager
should determine the real worth of assets offered as collateral (security).
• Conditions refers to the prevailing economic and other conditions which may affect
the customers’ ability to pay. Adverse economic conditions can affect the ability or
willingness of a customer to pay. An experienced financial or credit manager will be
able to judge the extent and genuineness to which the customer’s ability to pay is
affected by the economic conditions.
Information on these variable may be collected from the outside agencies which may
be keeping credit information about customers. A firm should use this information in
preparing categories of customers according to their creditworthiness and default risk. This

290
would be an important input for the financial or credit manager in formulating its credit
standards.

Credit terms
The second decision area in accounts receivable management is the credit terms.
After the credit standards have been established and the credit worthiness of the customers
has been assessed, the management of the firm must determine the terms and conditions on
which trade credit will be made available. The stipulations under which goods are sold on
credit or referred to as credit terms. These relate to the payment of the amount under the
credit sale. Thus, credit terms specify the repayment terms of receivable.
Credit terms have three components,
1. Credit period, in terms of the duration of time for which trade credit is extended-during
this period the overdue amount must be paid by the customer.
2. Cash discount, if any, which the customer can take advantage of, i.e., the overdue amount
will be reduced by this amount;
3. Cash discount period, which refers to the duration during which the discount can be
availed of. These terms are usually written in abbreviations, for instance “2/10 net 30”.
The credit term, like the credit standards, affect the profitability as well as the cost of
a firm. A firm should determine the credit terms on the basis of cost benefit trade – off.
Collection Policies
The third area involved in the accounts receivables management is collection policies. They
refer to the procedures followed to collect accounts receivable when, after the expiry of the
credit period, they become due. These policies cover two aspects.
1. Degree of effort to collect the over dues.
2. Type of collection efforts.
Degree of collection effort:
To illustrate the effect of the collection effect, the credit policies of a firm may be categorized
into
• Strict/light
• Lenient
The collection policy would be tight if very rigorous procedures are followed. A tight
collection policy has implications, which involve benefits as well costs. The management
has to consider a trade off between them. Likewise a lenient collection effort also affects the
cost benefit trade-off.
In the first place, the bad debts expenses (default cost) would decline. Moreover, the
average collection period will be reduced. As a result of these two effects the firm will
benefit and its profits will increase but there would be a negative effects also. A very rigorous
collection strategy would involve increased collection costs. Yet another negative effect may
be in the form a decline in the volume of sales. This may be because some customers may
291
not like the pressure and intense efforts initiated by the firm, and may be switched to other
firms.

Type of Collection efforts

The second aspect of the collection policies relates to the steps that should be taken to collect
over dues from the customers. A well-established collection policy should have clear cut
guidelines as to the sequence of collection efforts. After the credit period is over and
payment remains due, the firm should initiate measures to collect them. The effort should in
the beginning be polite, but, with passage of time, it should gradually become strict. The
steps usually taken are
• Letter, including reminders, to expedite payment
• Telephone calls for personal contact
• Personal visits
• Help of collection agencies and
• Finally legal action
The firm should take recourse to very stringent measures like legal actions; only after
all other avenues have been fully exhausted. They not only involve a cost but also effect the
relationship with the customers. The aim should be to collect as early as possible; Genuine
difficulties of the customers should be given due consideration.

SUMMARY
When a firm makes an ordinary sale of goods and services and does not receive
payment, the firm grants trade credit and creates accounts receivable which would be
collected in future. Thus, accounts receivable represent an extension of credit to customers,
allowing them a reasonable period to time, in which to pay for the goods/services which they
have received.
The objective of receivables management is to have a trade-off between the benefits
and costs associated with the extension of credit. The benefits are increased sales and
associated increased profits/marginal contribution. The major categories of cost of accounts
receivables are collection costs, capital costs, delinquency costs and default costs.
The management of receivables involves crucial decision in three areas: (i) credit
policies, (ii) credit terms, and (iii) collection policies.

ILLUSTRATIONS:
Illustration 1
Bharat Ltd. decides to liberalise credit to increase its sales. The liberalized credit policy will
bring additional sales of Rs.3,00,000. The variable costs will be 60% of sales and there will
be 10% risk for non-payment and 5% collection costs. Will the company benefit from the
new credit policy?

292
Solution
Rs.
Additional Sales Revenue 3,00,000
Less: Variable Cost (60%) 1,80,000
Incremental Revenue 1,20,000
Less: 10% for non-payment risk 30,000
90,000
Less: 5% for costs of collection 15,000
Additional Revenue from increased sales due to liberal 75,000
credit policy
The company will be benefited from the new credit policy because the increase in
revenue is more than the costs of providing additional credit. If fact, the profit of the
company will increase by Rs. 75,000.
Illustration 2
The following are the details regarding the operation of a firm during a period of 12 months:
Sales Rs. 12,00,000
Selling price per unit 10
Variable cost per unit 7
Total cost per unit 9
Credit period allowed to customers One month
The firm is considering a proposal for a more liberal credit by increasing the average
collection period from one month to two months. This relaxation is expected to increase sales
by 25%.
You are required to advise the firm regarding adopting of the new credit policy,
presuming that the firm’s return on investment is 25 per cent.
Solution
(i) Calculation of new average cost per unit after adopting new credit policy
Current sales Rs. 12,00,000
Selling price per unit Rs.10
Number of units sold at present (12,00,000/10) 1,20,000
Current cost of sales (1,20,000 X 9) Rs. 10,80,000
Add: Cost of additional sales (30,000 X 7) Rs. 2,10,000
Total cost for 1,50,000 units = Rs. 12,90,000
New average cost per unit (12,90,000/1,50,000) Rs. 8.60
293
 (iii) Calculation of average additional investment in debtors
Current cost of sales = Rs. 10,80,000
Current credit period = 1 month
(a) Current investment in debtors (10,80,000 X 1/12) = Rs. 90,000
Proposed cost of sales for 1,50,000 units = Rs. 12,90,000
Proposed credit period = 2 months
(b) Proposed investment in debtors (12,90,000 X 2/12) = Rs. 2,15,000
(c) Additional investment in debtors (b - a) = Rs. 1,25,000
(iv) Calculation of profit on additional sales
Additional units sold X Contribution per unit = 30,000 X 3 = Rs. 90,000
(v) Calculation of return on additional investment
Additional Profit 90,000
x 100 = x 100 = 72%
Additional Investment 1,25,000
As the required rate of return (25%) is much lower than the expected return on
additional investment (72%), the proposal should be accepted.

MODEL QUESTIONS:
1. What do you understand by Receivable Management? Discuss the factors which
influence the size of receivables.
2. Discuss the various aspects of receivable management.
3. What are Credit Standards? What key variables should be considered in evaluating
possible changes in Credit Standards?
4. What are Collection Policies? How can they be evaluated?

FURTHER READINGS:
1. Pandey I.M., 2005, Financial Management, Vikas Publishing House, New Delhi.
2. Shashi K. Gupta and R.K. Sharma., 2006, Financial Management – Theory and
Practice, Kalyani Publishers , Hyderabad.
3. Khan M.Y. and Jain P.K., 2005, Financial Management, Tata Mcgraw-Hill
Publishing Company Ltd, New Delhi.

294
GUIDELINE 30 : FINANCING OF WORKING CAPITAL

OBJECTIVES
After studying this guideline, you will learn
• the short-term sources of finance for working capital like trade credit, accrued
expenses, bank finance, commercial paper and factoring.
• the forms of bank finance and the security required
• the regulation of bank finance and the recommendations of committees

INTRODUCTION
External funds available for a period of one year or less are called short-term finance. In
India, short-term funds are used to finance working capital. Two most significant short-term
sources of finance for working capital are: trade credit and bank borrowing. Two other short-
term sources of working capital finance which have recently developed in India are: factoring
of receivables and commercial paper.

TRADE CREDIT
Trade credit refers to the credit that a customer gets from suppliers of goods in the normal
course of business. In practice the buying forms do not have to pay cash immediately for the
purchases made. This deferral of payments is a short term financing called trade credit. It is a
major source of financing for firms. In India, it contributes to about one-third of short-term
financing. It is a spontaneous source of financing. The major advantages of trade credit are as
follows:
Easy availability: Unlike other sources of finance, trade credit is relatively easy to obtain.
Except in the case of financially very unsound firms, it is almost automatic and does not
require any negotiations. The easy availability is particularly important to small firms which
generally faces difficulty in raising funds from the capital markets.
Flexibility: Flexibility is another advantage of trade credit. Trade credit grows with the
growth in firm’s sales. The expansion in the firm’s sales causes its purchases of goods and
services to increase which is automatically financed by trade credit. In contrast, if the firm’s
sales contract, purchases will decline and consequently trade credit will also decline.
Informality: Trade credit is an informal, spontaneous source of finances. It does not require
any negotiations and formal agreement. It does not have the restrictions which are usually
parts of negotiated sources of finances.

ACCRUED EXPENSES AND DIFFERED INCOME

In addition to trade credit, accrued expenses and differed income are other
spontaneous sources of short term financing. Accrued expenses represent a liability that a
firm has to pay for the services which it has already received. The most important component
of accruals are wages and salaries, taxes and interest.

295
 Differed income represents funds received by the firm for goods and services which it
has agreed to supply in future. These receipts increase the firm’s liquidity in the form of cash,
therefore, they constitute an important source of financing. Advance payments made by
customers constitute the main item of differed income.

BANKS FINANCE FOR WORKING CAPITAL

Banks are the main institutional source of working capital finance in India. A bank
considers a firm’s sales and production plans and the desirable levels of current assets in
determining its working capital requirements. The amount approved by the bank for the
firm’s working capital is called credit limit. Credit limit is the maximum funds which a firm
can obtain from the banking system. It can draw funds in the following forms: (a) overdraft,
(b) cash credit (c) bills purchasing or discounting, and (d) working capital loan.
Overdraft
Under the overdraft facility, the borrower is allowed to withdraw funds in excess of
the balance in his current account upto a certain specified limit during a stipulated period. It
is a very flexible arrangement from the borrower’s point of view since he can withdraw and
repay funds whenever he desires within the overall stipulations.
Cash credit
The cash credit facility is similar to the overdraft arrangement. It is the most popular
method of bank finance for working capital in India. Under the cash credit a borrower is
allowed to withdraw funds from the bank upto the sanctioned credit limit. He is required to
borrow the entire sanctioned credit once, rather, he can draw periodically to the extent of his
requirements and repay by depositing surplus funds in his cash credit account. Cash credit is
a most flexible arrangement from the borrower’s point of view. Cash credit limits are
sanctioned against the security of current assets.
Discounting of Bills
Under the discounting of bills, a borrower can obtain credit from a bank against its
bills. The bank discounts the borrower’s bills. The amount provided under this agreement is
covered within the overall cash credit or overdraft limit. Before discounting the bills the bank
satisfies itself as to the credit worthiness of the drawer. To encourage bills as instruments of
credit, the Reserve Bank of India introduced the new bill market scheme in 1970. The scheme
was intended to reduce the borrowers’ reliance on the cash credit system which is susceptible
to misuse.
Letter of Credit
Unlike cash credit or overdraft facility, the letter of credit arrangement is an indirect
financing, the bank will make payment to the supplier on behalf of the customer only when
he fails to meet the obligation.
Working Capital Loan
A borrower may sometimes require ad hoc or temporary accommodation in excess of
sanctioned credit limit to meet unforeseen contingencies. Banks provide such accommodation
through a demand loan account or a separate non-operable cash credit account. The borrower

296
is required to pay a higher rate of interest above the normal rate of interest on such additional
credit.

SECURITY REQUIRED IN BANK FINANCE

Banks generally do not provide working capital finance without adequate security. The
modes of security which a bank may require are hypothecation, pledge, mortgage and lien.
Hypothecation
Under hypothecation, the borrower is provided with working capital fiancé by the bank
against the security of movable property, generally inventories. The borrower does not
transfer the property to the bank; he remains in the possession of property made available as
security for the debt. Thus hypothecation is a charge against property for an amount of debt
where neither ownership nor possession is passed to the creditor. Banks generally grant credit
hypothecation only to first class customers with highest integrity. They do not usually grant
hypothecation facility to new borrowers.
Pledge
Under this arrangement, the borrower is required to transfer the physical possession of the
property offered as a security to the bank to obtain credit. The bank has a right of lien and can
retain possession of the goods pledged unless payment of the principal, interest and any other
expenses is made.
Mortgage
Mortgage is the transfer of a legal or equitable interest in a specific immovable property for
the payment of a debt. In case of mortgage, the possession of the property may remain with
the borrower, with the lender getting the full legal title. The transferor of interest (borrower)
is called the mortgagor, the transferee (bank) is called the mortgagee, and the instrument of
transfer is called the mortgage deed.
Lien
It means right of the lender to retain property belonging to the borrower until he repays
credit. It can be either a particular lien or general lien. Particular lien is a right to retain
property until the claim associated with the property is fully paid. General lien, on the other
hand, is applicable till all dues of the lender are paid. Banks usually enjoy general lien.

COMMERCIAL PAPER (CP)

It is an important money market instrument in advanced countries like USA to raise
short-term funds. In India, on the recommendation of the Vaghul Working Group, the
Reserve Bank of India (RBI) introduced the commercial paper scheme in the Indian money
market in 1989.Commercial paper is a form of unsecured promissory note issued by firms to
raise short-term funds. The companies are allowed to issue commercial papers which have a
networth of Rs. 10 crores, maximum permissible bank finance of not less than Rs. 25 crores,
and are listed on the stock exchange. The RBI has provided for the minimum issue of Rs. 25
lakhs. Only the large, highly rated companies are able to operate in the commercial paper
market in India.

297
FACTORING
Factoring provides resources to finance receivables as well as facilitates the collection
of receivables. Factoring can broadly be defined as an agreement in which receivables arising
out of sale of goods/services are sold by a firm (client) to the ‘factor’ (a financial
intermediary) as a result of which the title of the goods/services represented by the said
receivables passes on to the factor. Credit sales generate the factoring business in the ordinary
course of business dealings. Realisation of credit sales is the main function of factoring
service. Once a sale transaction is completed, the factor steps in to realize the sales. Thus, the
factor works between the seller and the buyer and sometimes with the seller’s banks together.
Factoring provides resources to finance receivables as well as facilitates the collection
of receivables. Although such services constitute a critical segment of the financial services
scenario in the developed countries, they appeared in the Indian financial scene only in the
early nineties as a result of RBI initiatives. The first two bank-sponsored organizations which
provide such services are: (i) SBI Factors and Commercial Services Ltd, and (ii) Canbank
Factors Ltd. The first private sector factoring company, Foremost Factors Ltd, started
operations since the beginning of 1997.

Functions of a Factor
Depending on the type/form of factoring, the main functions of a factor, in general terms, can
be classified into five categories:
• Financing facility/trade debts;
• Maintenance/administration of sales ledger;
• Collection facility/of accounts receivable;
• Assumption of credit risk/credit control and credit restriction; and
• Provision of advisory services.
Financing Trade Debts
The unique feature of factoring is that a factor purchases the book debts of his client at a price
and the debts are assigned in favour of the factor who is usually willing to grant advances to
the extent of, say, 80 per cent of the assigned debts. Where the debts are factored with
recourse, the finance provided would become refundable by the client in case of non-payment
of the buyer. However, where the debts are factored without recourse, the factor’s obligation
to the seller becomes absolute on the due date of the invoice whether or not the buyer makes
the payment.
Administration of Sales Ledger
The factor maintains the clients’ sales ledgers. On transacting a sales deal, an invoice is sent
by the client to the customer and a copy of the same is sent to the factor. The ledger is
generally maintained under the open-item method in which each receipt is matched against
the specific invoice. The customer’s account clearly reflects the various open invoices
outstanding on any given date. The factor also gives periodic (fortnightly/weekly depending
on the volume of transactions) reports to the client on the current status of his receivables,
receipts of payments from the customers and other useful information. In addition, he factor
298
also maintains a customer-wise record of payments spread over a period of time so that any
change in the payment pattern can be easily identified.
Provision of Collection Facility
The factor undertakes to collect the receivables on behalf of the client relieving him of the
problems involved in collection, and enables him to concentrate on other important functional
areas of the business. This also enables the client to reduce the cost of collection by way of
savings in manpower,; time and efforts.
Credit Control and Credit Restriction
Assumption of credit risk is one of the important functions of a factor. This service is
provided where debts are factored without recourse. The factor in consultation with the client
fixes credit limits for approved customers. Within these limits, the factor undertakes to
purchase all trade debts of the customer without recourse.
Advisory Services
These services are a spin-off of the close relationship between a factor and a client. By virtue
of their specialized knowledge and experience in finance and credit dealings and access to
extensive credit information, factors can provide a variety of incidental advisory services to
their clients:
• Customer’s perception of the client’s products, changes in the marketing strategies,
emerging trends and so on;
• Audit of the procedures followed for invoicing, delivery and dealing with sales
returns;
• Introduction to the credit department of a bank/subsidiaries of banks engaged in
leasing, hire-purchase and merchant banking.
Cost of Services
The factors provide various services at a charge. The charge for collection and sales ledger
administration is in the form of a commission expressed as a value of debt purchased. It is
collected up-front/in advance. The commission for short-term financing as advance part-
payment is in the form of interest charge for the period between the date of advance payment
and the date of collection/guaranteed payment date. It is also known as discount charge.

REGULATION OF BANK FINANCE

Banks have been following certain norms in granting working capital finance to
companies. These norms have been greatly influenced by the recommendations of various
committees appointed by the Reserve Bank of India from time to time. The norms of working
capital finance followed by banks since mid 70’s were mainly based on the recommendations
of the Tandon Committee. The Chore Committee made further recommendations to
strengthen the procedures and norms for working capital finance by banks. The norms based
on the recommendations of these committees are discussed below. In the deregulated
economic environment in India recently, banks have considerably relaxed their criteria of
lending. In fact, each bank can develop its own criteria for the working capital finance.

299
 In view of the growing demand on bank funds from all sectors, industrial companies
have no option but to use bank funds in the most efficient way. In the past, they misused or
mismanaged the bank funds. Bank credit primarily meant for working capital finance was
found to be used for long-term purposes and to finance subsidiaries and associated
companies. Not only this, cheap credit available from banks has been used to build-up
disproportionate stocks of materials to realize trading profits.
In fact, the misuse of bank funds was made possible by the existing system of bank
lending, based on cash credit system. The practice was to lend generally to the extent of 75
per cent of the value of inventory and receivables, the remaining 25 per cent being the
margin. The value of inventory included purchases of materials on credit. Thus, this
amounted to double financing-from creditors as well as banks. Bank lending, under the cash
credit system, was directly related to security in the form of inventory and receivable,
irrespective of borrower’s operations. So long as the borrower continued to provide the
required margin, the banker considered his advance to be safe and liquid, and did not bother
about the way in which advance was being utilized. The borrower’s limit was generally
increased, without much questioning about his operations, whenever inventory and receivable
levels went up. The banker never took a closer look into the affairs of the customer.

THE DEHEJIA COMMITTEE

The above-mentioned deficiencies of the existing system of bank lending, based on
cash credit system, were formally highlighted by the Dehejia Committee in 1968. The
committee concluded that the diversion of bank finance for the acquisition of fixed and other
non-current assets was made possible by the banker’s fixation on security under the cash
credit lending system. The committee felt that, while theoretically commercial bank lending
was for short-term purposes, in actual practice, it was not so. According to their report, a
large part of bank lending was really long-term in character, and was repayable on demand
only in name.
The major weaknesses in the existing system of working capital finance to industry,
as pointed out by the Dehejia Committee and again identified by the Tandon Committee, are
summarized below:
1. It is the borrower who decides how much he would borrow; the banker does not
decide how much he would lend and is, therefore, not in a position to do credit
planning.
2. The bank credit is treated as the first source of finance and not as supplementary to
other sources of finance.
3. The amount of credit extended is based on the amount of security available, not on the
level of operations of borrower.
4. Security does not by itself ensure safety of bank funds since all bad and sticky
advances are secured advances; safety essentially lies in the efficient follow-up of the
industrial operations of the borrower.
Although the monetary authorities were aware of this faulty system of bank lending,
yet it was only in 1973, when the demand for bank credit rose sharply in spite of stagnant
production and when a number of banks had to freeze credit limits abruptly, that a serious
300
consideration was given to the matter. Following this and the background of the
unprecedented price rise in 1974, the Reserve Bank constituted the Tandon Committee to
frame guidelines for follow-up of bank credit.
THE TANDON COMMITTEE RECOMMENDATIONS
A study group, popularly known as the Tandon Committee, was appointed by the Reserve
Bank of India in July 1974 to suggest guidelines for the rational allocation and optimum use
of bank credit. The recommendations of the Tandon Committee are based on the following
guidelines.
1. Operating Plan: The borrower should indicate the likely demand for credit. For this
purpose, he should draw operating plans for the ensuing year and supply them to the
banker. This procedure will facilitate credit planning at the banks’ level. It will also
help the bankers in evaluating the borrower’s credit needs in a realistic manner and in
the periodic follow-up during the ensuing year.
2. Production-based financing: The banker should finance only the genuine production
needs of the borrower. The borrower should maintain reasonable levels of inventory
and receivable; he should hold just enough to carry on his target production. Efficient
management of resources should, therefore, be ensured to eliminate slow moving and
flabby inventories.
3. Partial bank financing: The working capital needs of the borrower cannot be entirely
financed by the banker. The banker will finance only a reasonable part of it; for the
remaining the borrower should depend upon his own funds, generated internally and
externally.
The following are the major recommendations of the Tandon Committee:
Inventory and receivable norms
The Tandon Committee made a number of important recommendations regarding the bank
lending practices. But it is the recommendation regarding the inventory and receivable norms
which have been debated and criticized mostly.
The Committee pointed out that the borrower should be allowed to hold only a
reasonable level of current assets, particularly inventory and receivable. Only the normal
inventory, based on a production plan, lead time of supplies, economic ordering levels and
reasonable factor of safety, should be financed by the banker. Flabby, profit-making or
excessive inventory should not be permitted under any circumstance. Similarly, the banker
should finance only those receivables which are in tune with the practices of the borrower’s
firm and industry.
The norms for reasonable levels of inventory and receivable are needed to ensure
rational allocation of resources and to avoid the undesirable holding and financing of current
assets.
The Tandon Committee, in its final report, suggested norms for fifteen industries
excluding heavy engineering and highly seasonal industries, like, sugar. The norms were
applied to all industrial borrowers, including small-scale industries, with aggregate limits
from the banking system in excess of Rs. 10 lakh. The Committee expected that the norms
could be extended to smaller borrowers progressively as early as possible. Although the
Committee defined norms in the case of fifteen industries only, yet it emphasized, and rightly
301
so, that industries not covered should not be exempt from the discipline of norms. In such
cases, banks should keep in view the purpose and spirit behind the norms when considering
the extension of credit facilities.
Lending norms
Another important recommendation of the Committee related to the approach to be followed
by commercial banks in lending credit to borrowers. The Committee felt that the main
function of a banker as a lender was to supplement the borrower’s resources to carry an
acceptable level of current assets. This implied: (a) the level of current assets must be
reasonable and based on norms, (b) a part of the fund requirements for carrying current assets
must be financed from long-term funds comprising owned funds and term borrowing
including other non-current liabilities.
The banker was required to finance only a part of the working capital gap; the other
part was to be financed by the borrower from the long-term sources. Working capital gap is
defined as current assets minus current liabilities excluding bank borrowings. Current assets
will be taken at estimated values or values as per the Tandon Committee norms, whichever is
lower. Current assets will consist of inventory and receivables, referred as chargeable current
assets (CCA) and other current assets (OCA).
Maximum Permissible Bank Finance (MPBF)
In view of the above approach to bank lending, the Committee suggested the following three
methods of determining the permissible level of bank borrowings:
• First method: In the first method, the borrower will contribute 25 per cent of the
working capital gap; the remaining 75 per cent can be financed from bank
borrowings. This method will give a minimum current ratio of 1:1.
• Second method: In the second method, the borrower will contribute 25 per cent of the
total current assets. The remaining of the working capital gap (i.e. the working capital
gap less the borrower’s contribution) can be bridged from the bank borrowings. This
method will give a current ratio of 1.3:1.
• Third method: In the third method, borrower will contribute 100 per cent of core
assets, as defined and 25 per cent of the balance of current assets. The remaining of
the working capital gap can be met from the borrowings. This method will further
strengthen the current ratio.
The first two methods, immediately accepted for implementation by the Reserve
Bank.
Style of Credit
In view of the deficiencies of the cash credit system of lending, the Committee also suggested
a change in the style of bank lending. The Committee recommended the bifurcation of total
credit limit into fixed and fluctuating parts. The fixed component was to be treated as a
demand loan for the year representing the minimum level of borrowings which the borrower
expected to use throughout the year. The fluctuating component was to be taken care of by a
demand cash credit. The cash credit portion could be partly used by way of bills. It was also
suggested by the Committee that the new cash credit limit should be placed on a quarterly
budgeting – reporting system.
302
Information System
Yet another important recommendation of the Tandon Committee related to the flow of
information from the borrower to the bank. The Committee advocated for the greater flow of
information both for operational purposes and for the purpose of supervision and follow-up
credit. Information was sought to be provided in three forms-operating statement, quarterly
budget and funds flow statement. The statements prepared will give estimates and actuals.
Projected annual figures would facilitate a genuine credit appraisal, while quarterly figures,
furnished continuously, would enable a systematic and regular follow-up.
The Tandon Committee Report has been widely debated and criticized. But it must be
admitted that the Tandon Committee report has brought about a perceptible change in the
outlook and attitude of both the bankers and their customers. They have become quite aware
in the matter of making best use of a scarce resource like bank credit. The report has helped
in bringing a financial discipline through a balanced and integrated scheme for bank lending.
THE CHORE COMMITTEE RECOMMENDATIONS
In April 1979, the Reserves Bank of India constituted a working group to review the
system of cash credit under the chairmanship of Mr. K.B. Chore. The main terms of reference
for the group were to review the cash credit system and suggest modifications and/or
alternate types of credit facilities to promote greater credit discipline and relate credit limits
to production. The major recommendations having a bearing on bank credit to firms of the
Group are as follows:
Reduced Dependence on Bank Credit
Borrowers should contribute more funds to finance their working capital requirements, and
reduce dependence on bank credit. Therefore, the group recommended firms to be placed in
the second method of lending as explained by the Tandon Committee. In case the borrower
was unable to comply with this requirement immediately, he would be granted excess
borrowing in the form of working capital term loan (WCTL). WCTL should be repaid in
semi-annual instalments for a period not exceeding five years and a higher rate of interest
than under the cash credit system would be charged.
Credit Limit to be Separated into ‘Peak Level’ and ‘Normal Peak Level’ Limits
Banks should appraise and fix separate limits for the ‘peak level’ and ‘normal non-peak
level’ credit requirements for all borrowers in excess of Rs. 10 lakh, indicating the relevant
periods. Within the sanctioned limits for these two periods the borrower should indicate in
advance his need for funds during a quarter. Any deviation in utilization beyond 10 per cent
tolerance limit should be treated, as an irregularity and appropriate action should be taken.
Banks should discourage ad hoc or temporary credit limits. If sanctioned under exceptional
circumstances, additional interest of 1 per cent per annum should be charged for such limits.
Existing Lending System to Continue
The existing system of three types of lending: Cash credit, loans and bills should continue.
Cash credit system should, however, be replaced by loan and bills wherever possible. Cash
credit accounts in case of large borrowers should be scrutinized once in a year. Bifurcation of
cash credit account into demand loan and fluctuating cash credit component practiced as per
the Tandon Committee recommendation should discontinues. Advances against book debts
should be converted to bills wherever possible and atleast 50 per cent of cash credit limit
303
utilized for financing purchase of raw material inventory should also be changed to this bill
system.
Information System
The discipline relating to the submission of quarterly statements to be obtained form the
borrowers under the existing system should be strictly adhered to in respect of all borrowers
having working capital limits of Rs. 50 lakhs and over from the banking system.
SUMMARY
External funds available for a period of one year or less are called short-term finance.
The trade credit and deferred income and accrued expenses are available in the normal course
of business, and therefore, they are called spontaneous sources of working capital finance.
Bank finance have to be negotiated and involve explicit costs. The recently developed short-
term finance in India are factoring and commercial paper. Trade credit refers to the credit that
a buyer obtains from the supplier of goods and services. Payment is required to be made
within a specified period. Suppliers sometimes offer cash discount to buyers for making
prompt payment. Buyer should calculate the cost of foregoing cash discount to decide
whether or not cash discount should be availed. Accrued expenses and deferred income also
provide some funds for financing working capital.
Bank finance is the most commonly negotiated source of the working capital finance.
It can be availed in the forms of overdraft, cash credit, discount of bills and loan. Each
company’s working capital need is determined as per the norms. These norms are based on
the recommendation of the Tandon Committee and later on, the Chore Committee.
Commercial paper is an important money market instrument for raising short-term
finances. In India, commercial papers of 91 to 180 days maturity are being floated. The
interest rate will be determined in the market.
Factoring involves sale of accounts receivables to a factor who charges a commission,
bears the credit risk associated with the accounts receivable purchased by it and provides
funds in advance of collection and thus finances receivables.
MODEL QUESTIONS:
1. What are the features of trade credit as a short-term source of working capital finance.
2. Discuss the main forms of working capital advance by banks.
3. Discuss briefly commercial paper as source of working capital finance.0
4. What is factoring? Give a brief account of the major functions of a factor.
5. Explain the recommendations of Tandon Committee for the optimum use of bank
credit.
FURTHER READINGS:
1. Van Horne, James C., 2004, Financial Management, and Policy, Prentice Hall of India
Pvt. Ltd.: New Delhi.
2. Kuchhal, S.C., 2002, Financial Management, Chaitanya: Allahabad.
3. Pandey, I.M., 2005, Financial Management, Vikas: New Delhi.
4. Khan, M.Y., and Jain, P.K., 2003, Financial Management:Text and Problems, Tata
McGraw-Hill Publishing Company Limited: New Delhi.
*** ***
304