Assessment set 2 Mb0045 Q4. Examine the importance of capital budgeting? Ans.

Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. Many formal methods are used in capital budgeting, including the techniques such as Accounting rate of return Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

Net present value

Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all the incremental cash flows from the project. (These future cash highest NPV(GE).) The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the Minimum acceptable rate of return on an investment. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV. In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV although they should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

Equivalent annuity method

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan. It is often used when comparing investment projects of unequal life spans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated. The use of the EAC method implies that the project will be replaced by an identical project. Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent answers. The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.

Real options
Real options analysis has become important since the 1970s as option pricing models have gotten more sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis try to value the choices - the option value - that the managers will have in the future and adds these values to the NPV.

Ranked Projects
The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended.

Funding Sources
When a corporation determines its capital budget, it must acquire said funds. Three methods are generally available to publicly traded corporations: corporate bonds, preferred stock, and common stock. The ideal mix of those funding sources is determined by the financial managers of the firm and is related to the amount of financial risk that corporation is willing to undertake. Corporate bonds entail the lowest financial risk and therefore generally have the lowest interest rate. Preferred stock have no financial risk but dividends, including all in arrears, must be paid to the preferred stockholders before any cash disbursements can be made to common stockholders; they generally have interest rates higher than those of corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way to finance capital projects. The Internal Rate of Return is very important. IMPORTANCE OF CAPITAL BUDGETING 1. Long-term Implications: A capital budgeting decision has its effect over a long time span and inevitably affects the companys future cost structure and growth. A wrong decision can prove disastrous for the long-term survival of firm. On the other hand, lack of investment in asset would influence the competitive position of the firm. So the capital budgeting decisions determine the future destiny of the company. 2. Involvement of large amount of funds: Capital budgeting decisions need substantial amount of capital outlay. This underlines the need for thoughtful, wise and correct decisions as an incorrect decision would not only result in losses but also prevent the firm from earning profit from other investments which could not be undertaken. 3. Irreversible decisions: Capital budgeting decisions in most of the cases are irreversible because it is difficult to find a market for such assets. The only way out will be scrap the capital assets so acquired and incur heavy losses. 4. Risk and uncertainty: Capital budgeting decision is surrounded by great number of uncertainties. Investment is present and investment is future. The future is uncertain and full of risks. Longer the period of project, greater may be the risk and uncertainty. The estimates about cost, revenues and profits may not come true. 5. Difficult to make: Capital budgeting decision making is a difficult and complicated exercise for the management. These decisions require an overall assessment of future events which are uncertain. It is really a marathon job to estimate the future benefits and cost correctly in quantitative terms subject to the uncertainties caused by economic-political social and technological factors. Kinds of capital budgeting decisions: Generally the business firms are confronted with three types of capital budgeting decisions. (i) The accept-reject decisions; (ii) Mutually exclusive decisions; (iii) Capital rationing decisions.

1. Accept-reject decisions: Business firm is confronted with alternative investment proposals. If the proposal is accepted, the firm incur the investment and not otherwise. Broadly, all those investment proposals which yield a rate of return greater than cost of capital are accepted and the others are rejected. Under this criterion, all the independent proposals are accepted. 2. Mutually exclusive decisions: It includes all those projects which compete with each other in a way that acceptance of one precludes the acceptance of other or others. Thus, some technique has to be used for selecting the best among all and eliminates other alternatives. 3. Capital rationing decisions: Capital budgeting decision is a simple process in those firms where fund is not the constraint, but in majority of the cases, firms have fixed capital budget. So large amount of projects compete for these limited budgets. So the firm rations them in a manner so as to maximize the long run returns. Thus, capital rationing refers to the situations where the firm has more acceptable investment requiring greater amount of finance than is available with the firm. It is concerned with the selection of a group of investment out of many investment proposals ranked in the descending order of the rate or return.

Q. no.5 CAPITAL RATIONING Generally, firms fix up maximum amount that can be invested in capital projects, during a given period of time, say a year. The firm then attempts to select a combination of investment proposals that will be within the specific limits providing maximum profitability and ranks them in descending order according to their rate of return; such a situation is of capital rationing. A firm should accept all investment projects with positive NPV, with an objective to maximize the wealth of shareholders. However, there may be resource constraints due to which a firm may have to select from among various projects. Thus there may arise a situation of capital rationing where there may be internal or external constraints on procurement of necessary funds to invest in all investment proposals with positive NPVs. Capital rationing can be experienced due to external factors, mainly imperfections in capital markets which can be attributed to non-availability of market information, investor attitude etc. Internal capital rationing is due to the self-imposed restrictions imposed by management like not to raise additional debt or laying down a specified minimum rate of return on each project. There are various ways of resorting to capital rationing. For instance, a firm may affect capital rationing through budgets. It may also put up a ceiling when it has been financing investment proposals only by way of retained earnings (sloughing back of profits). Since the amount of capital expenditure in that situation cannot exceed the amount of retained

earnings, it is said to be an example of capital rationing. Capital rationing may also be introduced by following the concept of Responsibility Accounting, whereby management may introduce capital rationing by authorising a particular department to make investment only up to a specified limit, beyond which the investment decisions are to be taken by higher-ups. The selection of project under capital rationing involves two steps: a. To identify the projects which can be accepted by using the technique of evaluation discussed above. b. To select the combination of projects.

In capital rationing it may also be more desirable to accept several small investment proposals than a few large investment proposals so that there may be full utilization of budgeted amount. This may result in accepting relatively less profitable investment proposals if full utilization of budget is a primary consideration. Similarly, capital rationing may also mean that the firm foregoes the next most profitable investment following after the budget ceiling even though it is estimated to yield a rate of return much higher than the required rate of return. Thus capital rationing does not always lead to optimum results. Steps of Calculation: Step 1: Calculation of cash outflow Cost of project/asset Transportation/installation charges Working capital Cash outflow Step 2: Calculation of cash inflow Sales Less: Cash expenses PBDT Less: Depreciation PBT Less: Tax PAT Add: Depreciation Cash inflow p.a Note:

xxxx xxxx xxxx xxxx

xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx

Depreciation = Straight Line method PBDT Tax is Cash inflow ( if the tax amount is given) PATBD = Cash inflow Cash inflow- Scrap and working capital must be added.

Step 3: Apply the different techniques Payback period= No. of years + Amt to recover/ total cash of next years. ARR = Average Profits after tax/ Net investment x 100 NPV= PV of cash inflows PV of cash outflows Profitability index = PV of cash inflows/ PV of cash outflows IRR : Pay back factor: Cash outflow/ Avg cash inflow p.a. Find IRR range PV of Cash inflows for IRR range and then calculate IRR

Module-5: Dividend Decision Meaning: The tern dividend refers to that part to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company. Dividend policy and significance of dividend policy It refers to the policy that the management formulates in regard to earnings for distribution as dividends among shareholders. It determines the division of earnings between payments to shareholders and retained earnings. Significance of dividend policy The firm has to balance between the growth of the company and the distribution to the shareholders It has a critical influence on the value of the firm It has to also to strike a balance between the long term financing decision( company distributing dividend in the absence of any investment opportunity) and the wealth maximisation The market price gets affected if dividends paid are less. Retained earnings helps the firm to concentrate on the growth, expansion and modernization of the firm To sum up, it to a large extent affects the financial structure, flow of funds, corporate liquidity, stock prices, and growth of the company and investors satisfaction. Factors influencing the dividend decision Stability of earnings Financing policy of the firm Liquidity of funds Dividend policy of competitive firms Past dividend rates Debt obligation

Ability to borrow Growth needs of the company Profit rates Legal requirements Policy of control Corporate taxation policy Tax position of shareholders Effect of trade policy Attitude of the investor group

Stability of dividends/ regularity It is the desirable policy of the management to distribute the shareholders a certain percentage of earnings as a reward for their investment. It may not always relate to the earnings of the company. Dividend practices: Constant dividend per share Constant percentage of net earnings Small constant dividend per share plus extra earnings Dividend as a fixed percentage of market value Significance of stability of dividend: Confidence among shareholders Investors desire for current income Institutional investors requirement Stability in market prices of shares Raising additional finances Spreading of ownership of outstanding shares Reduces the chances of loss of control Market for debentures and preference shares. Forms of Dividend Scrip Dividend Bond Dividend Property Dividend Cash Dividend Debenture Dividend Bonus share or Stock dividends Optional Dividend Objectives of stock dividend Conservation of cash Lower rate of dividend

Financing expansion programmes Transferring the formal ownership of surplus and reserves to the shareholders Enhanced prestige Widening share market True presentation of earning capacity

Merits of Stock dividend To the company 1. Maintenance of liquidity position 2. Satisfaction of shareholders 3. Economical issue of capitalisation 4. Remedy for under capitalisation 5. Enhance prestige 6. Widening the share for market 7. Finance for expansion programmes 8. Conservation of control To the shareholders 1. Increase in their equity 2. Marketability of shares increases 3. Increase in income 4. Increase demand for shares

Demerits of stock dividend To the company 1. Increase in the capitalisation of the company 2. It results in more liability 3. Denies other investors to shareholders 4. Management control not diluted it may lead to fraud To the shareholder 1. It lowers the market value 2. Shareholders prefers cash dividend 3. EPS also falls
Q. no 6. WORKING CAPITAL MANAGEMENT Concept of Working Capital Like the broader concept of capital, there is no universally accepted definition of working capital. As Gilbert Harold puts this problem, Unfortunately there is so much disagreement among financiers, accountants, businessmen and economists as to the exact meaning of the term working capital. it is quite true. Various financial theorists have used this term in a number of ways. Some explain it in a narrow sense while some others in a very wide sense. In narrow sense, some authorities define the term as the difference between current assets and current liabilities. Other writers think of working capital as being equal to the total of the current assets. On the other hand, some writers like Gerstenberg are not ready to call it as working capital. They prefer to all it as Circulating Capital so we shall have to go through the various concepts of working

capital before reaching at any conclusion. Definitions of working Capital In the broad sense, the term working capital is used to denote the total current assets. The following are some definitions of this group. (1) Working Capital means current assets. (2) The sum of the current assets is the working capital of a business. - J.S. Mill. (3) Any acquisition of funds which increases the current assets increase working capital also, for they are one and the same. - Bonneville (4) Working capital refers to a firms investment in short-term assets cash, short-term securities, accounts receivable and inventories. - Weston & Brigham In the narrow sense, the working capital is regarded as the excess of current assets over current liabilities. This is the definition used by most financial experts and authors emphasizing the accounting phase of finance. They include the name of E.E. Lincoln, E.A. Saliers, and C.W. Gerstenberg etc. Gerstenberg defines it as follows : It has ordinarily been defined as the excess of current assets over current liabilities. Thus we see there is no difference in authorities over the true concept of working capital. the true difference is on it quantity. The total current assets minus current liabilities approach refers to net working capital. the total current assets approach has a broader application and it is more inviting to the financial management. It takes into consideration all the current resources of the enterprise, from whatever source derived and their application to the current and future activities of the enterprise. In the words of Walker and Bauglin. A good current ratio may mean a good umbrella for creditors against rainy day, but to the management it reflects and financial planning or presence of ideal assets or over capitalisation. Actually speaking, a successful financial executive is interested not in maintaining a good current ratio but in maintaining an adjustable account assets so that the business may operate smoothly. Thats if the term working capital is used without future qualification, it generally refers to the gross working capital. Kinds of Working Capital Working capital can be classified on the basis of its composition. Thus, we can have gross working capital comprising current assets and net working capital representing current assets minus current liabilities. From the viewpoint of the finance manager this basis of classification is helpful since it categories the various areas of financial responsibility. For instance, funds invested in cash, inventories and receivable require careful planning and control if the firm is to maximize its return on investment. While the above classification is very significant to the financial management, it is not completely adequate as it does not mention about time. Time is an important variable which influences pattern of financing working capital requirements. Using times as a basis, working capital may be categorized as permanent and variable working capital. Permanent working capital represents current assets required on a continuous basis over the entire year. A manufacturing enterprise has to carry irreducible minimum amount of inventories necessary to ensure continued production and sales. Likewise, some amount of funds lie tied in receivables where the firm sells goods on credit terms. Some amount of cash has also to be held by the firm so as a to exploit business fluctuations. Thus, minimum amount of current assets which firm has to hold for all the time to come to carry on operations at any time is termed as permanent or regular working capital. It represents hare core of the working capital. permanent working capital changes constantly its form from one asset to another whereas fixed assets retain their form over a long period of time. Further, fund of value representing permanent working capital never leaves the business process and therefore, the suppliers should not expect its return until the business ceases to exit. Finally, permanent working capital will tend to expand so long as the firm experiences growth in its operation. Over and above permanent working capital, the firm may need additional current assets temporarily to satisfy seasonal/cyclical demands. Thus, for example, added inventory must be held to support the peak Mead Baker Malott.

selling periods. Receivable increase following periods of high sale. Extra cash may be need to pay for additional supplies following expansion in business activity. Similarly, in periods of dull business conditions when most of the produce remains held in stock due to precipitate fall in demand, the company would require additional cash to tide over the crises. Excess amount of working capital may be carried to face cut-throat competition or any other contingencies like strikes and lockouts. This additional amount of working capital represents variable or temporary working capital, size of which depends upon changes in levels of production and sales resulting from changes in market conditions. Funds requirements for this purpose are of short duration. Importance of Working Capital Working Capital is just like the heart of business. If it becomes weak, the business can hardly prosper and survive. It is an index of the solvency of a concern. Its proper circulation provides to the business the right account of cash to maintain regular flow of its operations. The following are the some worth mentioning advantages of maintaining an ample working capital fund in the business.(1) Cash Discount If proper cash balance is maintained, the business can avail of the cash discounts facilities offered to it by the suppliers. (2) Liquidity and Solvency The proper administration of working Capital enhances the liquidity in funds and solvency and credit worthiness of the concern. (3) Meeting unseen Contingencies It Provides Funds for unseen emergencies so that a business can successfully said through the periods of crisis. (4) High Morale The provision of adequate working capital improves the morale of the executive and their efficiency reaches it highest climax. (5) Good Bank Relations Good relations with banks can also be maintained. The enterprise by maintaining an adequate amount of working capital is able to maintain a sound bank credit, trade credit and can escape insolvency. (6) Fixed Assets Efficiency Incurred Fixed assets of the firm also can not work without proper amount of working capital. without it, fixed assets are like guns which can not shoot as there are no cartridges. (7) Research and Innovation Programmes No research programme, innovation and technical developments are possible to undertake without sufficient among of working capital. (8) Expansion Facilitated The expansion programme of a firm is highly successful, if it is financed through own working capital. (9) Profitability Increased The profitability of a concern also depends, in no small measure, on the right proportion of fixed assets and current assets. Every activity of the business directly or indirectly affects the current position of the enterprise hence its needs should be properly estimated and calculated. Thus the need for maintain an adequate working capital can hardly be questioned. Just as circulation of blood is very necessary in the human body to maintain life, smooth flow of funds is very necessary to maintain the health of the enterprise. The importance of working capital can be very well explained in the words of Husband and Dockery : The price object of management is to make a profit. Whether or not this accomplished in most business depends largely on the manner in which the working capital is administered. Determinants of Working Capital (The amount of working capital) There are numerous factors which affect the working capital of a concern, the appraisal of which assets management in formulating its policies and estimating its prospective requirements. The important factors are as follows: (1) Nature of Business The effect of the general nature of the business on the working capital requirements can not be exaggerated. Rail roads, and other, public utility services have large fixed investment, so they have the lower requirements for current assets. Industrial and manufacturing enterprises on the other hand, generally required a large amount of working capital. A rapid turnover of capital (sales divided by total assets) will inevitably meant a larger proportion of current assets. (2) Production Policies The nature of production policy also exercises its impact on capital needs. Strong seasonal movement have special workings capital problems and requirements. A high level production plan also involves higher investment in working capital. (3) The proportion of the cost of Raw Materials to Total Costs In those industries where cost of

materials is a large proportion of the total cost of the goods produced or where costly raw material is used, requirements of working capital will be rather large. But if the importance of raw materials is small, the requirements of working capital will naturally be small. (4) Length of period of manufacture The time which elapses between the commencement and end of the manufacturing process has an important being upon the requirements of working capital. if it takes long to manufacture the finished project, naturally a large sum of money will have to be kept invested in the form of working capital. (5) Rapidity of Turnover Turnover represents the speed with which the working capital is recovered by the sale of goods. In certain business, sales are made quickly so that stocks are soon exhausted and new purchases have to be made. In this manner, a small sum of money invested in stocks will result in sales of a much large amount. It will reduce the requirements of more working capital. (6) Terms of Purchases If continuous credit is allowed by supplier, payment can be postponed for some time and can be made out of the sale proceeds of the goods produced. In such a case the requirements of working capital will be reduced. The period of credit received and allowed also determines the working capital requirements of the enterprise. (7) Growth with Expansion of Business As a company gross, it is logical to except the larger amount of working capital will be required. Growing concerns require more working capital than those that are static. The requirement of working capital also varies with economic circumstances and corporate practices. (8) Business Cycles Requirements of working capital also very with the business cycles. When the price level is up due to boom conditions, he inflationary conditions create demand for more working capital. During depression also a heavy amount of working capital is needed due to the inventories being locked unsold and book debts uncollected. (9) Requirements of Cash The working capital requirements of a company is also influenced by the amount of cash required by it for various purposes. The greater the requirements of cash, the higher will be the working capital costs of the company. (10) Dividend Policy of the Concern If conservative divided policy is followed by the management the needs of working capital can be met with the retained earnings. Often variations in need, of working capital bring about an adjustment of dividend policy. The relationship between divided policy and working capital is well established and mostly companies declare divided after careful study of cash requirements. (11) Other Factors In addition to the above considerations there are a number of other factors affecting the requirements of working capital, for example, lack of co-ordination in production and distribution policies, the fiscal and tariff policies of the government etc. A prudent financial manager is always manger is always interested in obtaining the correct amount of the working capital at the right time, at a reasonable cost at the best possible favourable terms. To adopt the right sources it is very necessary for him to have a through understanding of the firms short-term funds needs, market for short-term funds, required level of liquidity in funds and risk assumption. A firm interested to obtain short-term funds has a choice of securing finance from alternative sources internal as well as external. In making any final choice as regards to sources of working capital the relative cost of financing, dependability upon the source and flexibility in financial planning must be given due weightgae.

1. Trade Credit Sources of Working Capital : The following chart gives a snapshot view of various sources of working capital available for a firm: 2. Credit papers 3. Bank credit 4. Public deposits Working Capital Sources Long term Sources Short term sources 5. Customers credit 6. Govt. Assistance Sale of shares 7. Loans from Directors etc. Sale of debentures 8. Security of Employees Internal 1. Depreciation funds 9. Factoring Ploughing back of 2. Provision for taxation profits 3. Accrued expenses Sale of idle fixed Long-term loans

1. 2. 3. 4. 5.

Financing of Long-tem working Capital The long-term working capital requirements include the initial working capital and the regular working capital. along with it, the minimum level of investment in various current assets also determines the requirement of long-term working capital. This capital can be conveniently financed by the following sources (1) Share Capital A part of long-term working capital can be financed with the share capital. (2) Sale of Debentures Debentures are also an important source of long-tern working capital because they are fixed cost sources. Rights Debentures have also been very popular in India since 1978. (3) Ploughing back of profits A part of the earned profits may be ploughed back by the firm in meeting their working capital requirements. It is regular and cheapest sources of working capital as it does not involve any explicit cost of capital. (4) Sale of Fixed Assets Any idle fixed asset can be sold out and sale proceeds can be utilized for financing the working capital requirements. (5) Term Loans - The loans raised for a period varying from 3 to 5-7 years are also important sources for working capital. this type of finance is ordinarily repayable in installments. Such loan usually increases the working capital of the enterprises. Financing of short-term Working Capital This category of funds covers the need of working capital for financing day-to-day business requirements. Normally, the duration of such requirements does not exceed beyond a year. The sources of short-term working capital may be internal as well as external. (a) Internal Sources (1) Depreciation Funds The depreciation funds constitute important source for working capital. some authors of business finance do not accept them as a source of funds but it is not reasonable. (2) Provision for Taxation The provisions for taxation can also be used by the companies as a source of working capital during the intermitant periods. (3) Accrued Expenses The firm can postpone the payment of expanses for short periods. Hence these accrued expenses also constitute an important source of working capital. (b) External Sources (1) Trade Credit One of the most important forms of short term finance is the trade credit extended by one business enterprise to another on the purchase and sale of goods and equipment. The use of trade credit has increased in recent years due mainly perhaps to the credit squeeze. The trade credit may also assume three forms :purchase on open account, purchasing on furnishing a pronote for specified period and purchase on trade acceptance (i.e. bills payable) (2) Bank Credit Commercial banks are also principal source of working capital. they provided working capital in a number of ways such as overdrafts, cash credits, line of credit, short term loans etc. Compared with other methods of borrowing this is the most flexible source because when the debt is no longer required it can be quickly and early reduced. It is also comparatively cheap. (3) Credit Papers In the category of credit papers, bills of exchange and promissory notes of shorter duration varying between a month and six months are used. These papers are discounted with a bank and capital can be arranged. Accommodation bills is an important method of such finance. (4) Public Deposit Public deposits are also an important source of shot-term and medium term finance. Due to shortages of bank credit in recent past, the importance of public deposits has increased. They have been very popular among Indian companies during last three years. (5) Customers Credit Advances may also be obtained on contracts entered into by the enterprise. The customers are often asked to make some advance payment in cash in lieu of a contract to purchase. Such advance can be utilized in purchasing raw material paying wages and so on. (6) Governmental Assistance Sometimes, central and state governments also provide short-term finance on easy terms.

(7) Loans from Directors etc. An enterprise can also obtain loans from it officers, directors,
managing directors etc. These loans are often obtained at almost negligible rates of interest. Some times, no interest is charges on them. Loans an also to obtained from other fellow companies working within the same group. (8) Security of Employee - If employees are required to make deposits with their employer companies, such companies can utilize those amounts in meeting their working capital needs. (9) Factoring Factoring involves raising funds on the security of the companys debts, so that cash is received earlier than it the company waited of the debtors to pay. Thus the factors help in improving the companys liquidity position. But this finance is not cheap in comparison to bank credit etc. The forecast of working capital requirements of a concern is not an easy job. The concept of working capital is closely related to that current assets. So, some experts of finance suggest that in estimations the working capital requirements, the total current assets requirement should be forecasted. But, however, is contention is not justified on logic as the short term needs of the funds are equally vitally affected by the nature and composition of fixed assets. Hence, the problem of working capital forecast should be dealt within the overall financial requirements of the concern. Forecasting Techniques of Working Capital If the working capital is to be estimated for the ensuring year, then the current requirements of the assets and cash flow for that period are to be estimated. The study of cash flow will reveal how much cash is available to meet the current assets requirements. The basic object of forecasting working capital needs is either to measure the cash position of the enterprise or to exercise control over the liquidity position of the concern. But, the circular flow of working capital does not occur automatically and it is the essential responsibility of management to guide it in proper proportions through the production machine. There are three popular methods available for forecasting working capital requirements: (a) Cash Forecasting Method In this method the position of cash at the end of the period is shown after considering the receipts and payments to be made during that period. Its form assuring more or less a summary of cashbook. This shows the deficiency or surplus of cash at the definite point of time. (b) The Balance Sheet Method In the balance sheet method of forecasting, a forecast it made of the various assets and liabilities of the business. Afterwards, the difference between the two is taken which will indicate either cash surplus or cash deficiency. (c) Profit and Loss Adjustment Method Under this method the forecasted profits are adjusted after adding the cash inflow and deducting the cash outflows. The basic idea under method is to adjust the estimated profits on cash basis. A forecast of working capital requirements can also be called a working capital budget. The main object of preparing a working capital budget is to source an effective utilization of the investment in current assets. It shows the behaviour of working capital with the volume of output or estimated sales. Estimating Working Capital Requirements In order to determine the amount of working capital needed by a firm, a number of factors viz. Production policies, nature of business, length of manufacturing process, credit policy, rapidity of turn-over, seasonal fluctuation, etc. are to be considered by the Financial Manager. Besides this a Finance Manager can apply any of the following techniques for assessing the working capital requirement of a firm. Techniques for assessment of Working Capital Requirements. Following is a brief explanation for the various techniques for assessment of a firms working Capital requirements.

1. Estimation of Components of Working Method : Since Working capital is the excess of current assets
over current liabilities, an assessment of the working capital requirements can be made by estimating the amounts of different constituents of working capital e.g., inventories, accounts receivable, cash, accounts payable etc. 2. Percent of Sales Method: This is a traditional and simple method of estimating working capital requirements. According to this method, on the basis of pas experience between sales and working capital requirements, a ratio can be determined for estimating the working capital requirements in future. For example, if the past experience show that working capital has been 30% of sales and its is estimated that the sales for the next year would amount to Rs. One lack, the amount of working capital requirement can be assessed as Rs. 30,00 The basic criticism of this method that it presumes a linear relationship between sales and working

capital. This is not true in all cases san method is nto universally accepted. 3. Operating Cycle Approach : According to this approach, the requirements of working capital depends upon the operating cycle of the business. The operating cycle begins with the acquisition of raw materials and ends with the collection of receivables. It may be broadly classified into the following four stages viz. (i) Raw materials and stores stage; (ii) Work-in progress stage; (iii) Finished goods inventory stage; and (iv) Receivable collection stage; The duration of the operating cycle for the purpose of estimating working capital requirements is equivalent to the sums of the duration of each of these stages less the credit period allowed by the suppliers of the firms. Symbolically, the duration of the working capital cycle can be put as follows: O=R+W+F +DC Where, O = Duration of opening cycle R = Raw materials and stores storage period; W = Work in process period; F = Finished stock storage period; D = Debtors collection period; C = Creditors payment period. Each of the component of the operating cycle can be calculated as follows: Average stock of raw materials and stores R = --------------------------------------------------------------------------------Average Raw Materials and stores consumption per day Average work in process inventory W = -------------------------------------------------------------------------------Average cost of production per day Average finished stock inventory F = --------------------------------------------------------------------------------Average cost of goods sold per day Average book debts D = ---------------------------------------------------Average credit sales per day Average trade creditors C = ---------------------------------------------------Average credit purchases per day After computing the period of one operating cycle, total number of operating cycles that can be completed during a year can be computed by dividing 365 days with the number of operating days in a cycle. The total operating expenditure in the year when divided by the number of operating cycles in a year will give the average amount of the working capital requirements. Approaches for Determining the Finance Mix There are three approaches for determining the working capital financing mix. (i) The hedging approach According to this approach, the maturity of sources of funds should match the nature of assets to be financed. The approach is therefore also termed as Matching Approach. It divides the requirements of total working capital funds into two categories. a. Permanent Working Capital, i.e. funds required for purchase of core current assets. Such funds do not vary over time. b. Temporary or Seasonal Working Capital, i.e. funds which fluctuate over time.

The permanent working capital requirements should be financed by long-term funds while the seasonal working capital requirements should be financed out of short-term funds.

(ii)

The Conservative Approach According to this approach all requirements of funds should be meet from long-term sources. The short-term sources should be used only for emergency requirements. The conservative approach is less risky, but mote costly as compared to the hedging approach. In other words conservative approach is low profit low risk (or high cost, high net working capital) while hedging approach results in high profit-high risk (for low cost, low net working capital). Trade-off between hedging and conservative approached. The hedging and conservative approach are both on two extremes. Neither of them can therefore help in efficient working capital measurement. A trade-off between these two can give satisfactory results. The level of such trade-off will differ from case to case depending upon perception of the risky by the persons involved in financial decision- making. However, one way of determining the level of trade-off is by finding the average working capital so obtained may be financed by long-term funds and the balance by short-term funds. For example, if during the quarter ending 31st March, the minimum working capital required is estimated at Rs. 10,000 while the maximum at Rs. 15,000, the average level comes to Rs. 12,500 [i.e. (10,000 + 15,000) 2]. The firm should therefore finance Rs. 12,000 from long-term sources while any extra capital required any time during the period, from short-term sources while any extra capital required any time during the period, from short-term sources (i.e., current liabilities)

(iii)

Q. no.1

WEIGHTED AVERAGE COST OF CAPITAL (WACC) The firms WACC is the cost of Capital for the firms mixture of debt and stock in their capital structure.
WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. stock)

So now we need to calculate these to find the WACC!

wd = weight of debt (i.e. fraction of debt in the firms capital structure) ws = weight of stock wp = weight of prefered stock
THE FIRMS CAPITAL STRUCTURE IS THE MIX OF DEBT AND EQUITY USED TO FINANCE THE BUSINESS. Think of the firms capital structure as a pie, that you can slice into different shaped pieces. The firm strives to pick the weights of debt and equity (i.e. slice the pie) to minimize the cost of capital.

wd

ws

wp

COST OF DEBT (Kd) We use the after tax cost of debt because interest payments are tax deductible for the firm.

Kd after taxes = Kd (1 tax rate)

EXAMPLE

If the cost of debt for Cowboy Energy Services is 10% (effective rate) and its tax rate is 40% then: Kd after taxes = Kd (1 tax rate) = 10 (1 0.4) = 6.0 %

We use the effective annual rate of debt based on current market conditions (i.e. yield to maturity on debt). We do not use historical rates (i.e. interest rate when issued; the stated rate).

Cost of Preferred Stock (Kp) Preferred Stock has a higher return than bonds, but is less costly than common stock. WHY? In case of default, preferred stockholders get paid before common stock holders. However, in the case of bankruptcy, the holders of preferred stock get paid only after short and long-term debt holder claims are satisfied. Preferred stock holders receive a fixed dividend and usually cannot vote on the firms affairs. preferred stock dividend Kp = market price of preferred stock <OR if issuing new preferred stock>

preferred stock dividend Kp = market price of preferred stock (1 flotation cost)

Unlike the situation with bonds, no adjustment is made for taxes, because preferred stock dividends are paid after a corporation pays income taxes. Consequently, a firm assumes the full market cost of financing by issuing preferred stock. In other words, the firm cannot deduct dividends paid as an expense, like they can for interest expenses. Example If Cowboy Energy Services is issuing preferred stock at $100 per share, with a stated dividend of $12, and a flotation cost of 3%, then: preferred stock dividend Kp = market price of preferred stock (1 flotation cost) $12 = $100 (1-0.03) = 12.4 %

Cost of Equity (i.e. Common Stock & Retained Earnings) The cost of equity is the rate of return that investors require to make an equity investment in a firm. Common stock does not generate a tax benefit as debt does because dividends are paid after taxes. The cost of common stock is the highest. Why? Retained earnings are considered to have the same cost of capital as new common stock. Their cost is calculated in the same way, EXCEPT that no

adjustment is made for flotation costs.

3 Ways to Calculate 1. 2. 3. Use CAPM (GORDON MODEL) The constant dividend growth model same as DCF method Bond yield plus risk premium

1. Ks using CAPM (capital asset pricing model)

The CAPM is one of the most commonly used ways to determine the cost of common stock. This cost is the discount rate for valuing common stocks, and provides an estimate of the cost of issuing common stocks. Ks = Krf + (Km - Krf) Where: Krf Km EXAMPLE: Cowboy Energy Services has a B = 1.6. The risk free rate on T-bills is currently 4% and the market return has averaged 15%. Ks = Krf + (Km - Krf) = 4 + 1.6 (15 4) = 21.6 % For information on estimating the cost of equity based on the dividend growth model, or the bond-yield plus risk premium, refer to the background readings textbook. is the risk free rate is the firms beta is the return on the market

WACC: PUTTING IT ALL TOGETHER RECALL:

WACC = wd (cost of debt after tax) + ws (cost of stock/RE) + wp(cost of PS)

EXAMPLE Cowboy Energy Services maintains a mix of 40% debt, 10% preferred stock, and 50% common stock in its capital structure. The WACC is: WACC = 0.4(6%) + 0.1 (12.4) + 0.5(21.6) = 2.4 + 1.24 + 10.8 = 14.4 %

Reminder: Read the article: Best Practices in Estimating the Cost of Capital: Survey and Synthesis. It provides excellent information on how some of the most financially sophisticated companies and financial advisers estimate capital costs.

Determining the Weights to be Used: My example above gives you the weights to use in calculating the WACC. How do you calculate the weights yourself? The firms balance sheet shows the book values of the common stock, preferred stock, and long-term bonds. You can use the balance sheet figures to calculate book value weights, though it is more practicable to work with market weights. Basically, market value weights represent

current conditions and take into account the effects of changing market conditions and the current prices of each security. Book value weights, however, are based on accounting procedures that employ the par values of the securities to calculate balance sheet values and represent past conditions. The table on the next page illustrates the difference between book value and market value weights and demonstrates how they are calculated.
VALUE DOLLAR AMOUNT WEIGHTS OR % OF TOTAL VALUE 40.4 9.1 50.5 ASSUMED COST OF CAPITAL (%)

Book Value Debt 2,000 bonds at par, or $1000 Preferred stock 4,500 shares at $100 par value Common equity 500,000 shares outstanding at $5.00 par value Total book value of capital Market Value Debt 2,000 bonds at $900 current market price Preferred stock 4,500 shares at $90 current market price Common equity 500,000 shares outstanding at $75 current market price Total market value of capital 5,955,000 100 What is the WACC? 3,750,000 63.0 13.5 405,000 6.8 12 1,800,000 30.2 10 4,950,000 100 11.24 is the WACC 2,500,000 13.5 450,000 12 2,000,000 10

Note that the book values that appear on the balance sheet are usually

different from the market values. Also, the price of common stock is normally substantially higher than its book value. This increases the weight of this capital component over other capital structure components (such as preferred stock and long-term debt). The desirable practice is to employ market weights to compute the firms cost of capital. This rationale rests on the fact that the cost of capital measures the cost of issuing securities stocks as well as bonds to finance projects, and that these securities are issued at market value, not at book value. Target weights can also be used. These weights indicate the distribution of external financing that the firm believes will produce optimal results. Some corporate managers establish these weights subjectively; others will use the best companies in their industry as guidelines; and still others will look at the financing mix of companies with characteristics comparable to those of their own firms. Generally speaking, target weights will approximate market weights. If they dont, the firm will attempt to finance in such a way as to make the market weights move closer to target weights. Hurdle rates: Hurdle rates are the required rate of return used in capital budgeting. Simply put, hurdle rates are based on the firms WACC. To understand the concept of hurdle rates, I like to think of it this way. A runner in track jumps over a hurdle. Projects the firm is considering must jump the hurdle or in other words exceed the firms borrowing costs (i.e. WACC). If the project does not clear the hurdle, the firm will lose money on the project if they invest in it and decrease the value of the firm. The hurdle rate is used by firms in capital budgeting analysis (one of the next topics we will be studying). Large companies, with divisions that have different levels of risk, may choose to have divisional hurdle rates.

Divisional hurdle rates are sometimes used because firms are not internally homogeneous in terms of risk. Finance theory and practice tells us that investors require higher returns as risk increases. For example, do the following investment projects have the same level of risks? Engineering projects such as highway construction, market-expansion projects into

foreign markets, new-product introductions, E-commerce startups, etc. Breakpoints (BP) in the WACC: Breakpoints are defined as the total financing that can be done before the firm is forced to sell new debt or equity capital. Once the firm reaches this breakpoint, if they choose to raise additional capital their WACC increases. For example, the formula for the retained earnings breakpoint below demonstrates how to calculate the point at which the firms cost of equity financing will increase because they must sell new common stock. (Note: The formula for the BP for debt or preferred stock is basically the same, by replacing retained earnings for debt and using the weight of debt.) BPRE = Retained earnings Weight of equity Example: Cowboy Energy Services expects to have total earnings of $840,000 for the year, and it has a policy of paying out half of its earnings as dividends. Thus, the addition to retained earnings will be $420,000 during the year. We now want to know how much total new capital debt, preferred and retained earnings can be raised before the $420,000 of retained earnings is exhausted and the company is forced to sell new common stock. We are seeking the amount of capital which represents the total financing that can be done before Cowboy Energy Services is forced to sell new common stock to maintain their target weights in their WACC. Lets assume that Cowboy Energy Services maintains a capital structure of 60% equity, 40% debt. Using the formula above: BPRE = Retained earnings Weight of equity = $420,000/0.60 = $700,000

Thus, Cowboy Energy Services can raise a total of $700,000 in new financing, consisting of 0.6($700,000) = $420,000 of retained earnings and 0.40($700,000) = $280,000 of debt, without altering its capital structure. The BPRE = $700,000 is defined as the retained earnings break point, or the amount of total capital at which a break, or jump, occurs in the marginal cost of capital. Can there be other breaks? Yes, there can depending on if there is some point at which the firm must raise additional capital at a higher cost.