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INTRODUCTION

The branch of knowledge that deals with the art and science of managing money
is called financial management. With liberalization and globalization of Indian
economy, regulatory and economic environments have undergone drastic
changes. This has changed the profile of Indian finance managers today. Indian
financial managers have transformed themselves from licensed raj managers to
well informed dynamic proactive managers capable of taking decisions of
complex nature in the present global scenario.
Traditionally, financial management was considered a branch of knowledge with
focus on the procurement of funds. Instruments of financing, formation, merger &
restructuring of firms, legal
and institutional frame work involved therein occupied the prime place in this
traditional approach.
Two Basic Functions of Financial Management
Procurement of Funds:
Funds can be obtained from different sources having different characteristics in
terms of risk, cost and control. The funds raised from the issue of equity shares
are the best from the risk point of view since repayment is required only at the
time of liquidation.

However, it is also the most costly source of finance due to dividend


expectations of shareholders. On the other hand, debentures are cheaper than
equity shares due to their tax advantage. However, they are usually riskier than
equity shares. There are thus risk, cost and control considerations which a
finance manager must consider while procuring funds. The cost of funds should
be at the minimum level for that a proper balancing of risk and control factors
must be carried out.
Effective Utilization of Funds:
The Finance Manager has to ensure that funds are not kept idle or there is no
improper use of funds. The funds are to be invested in a manner such that they
generate returns higher than the cost of capital to the firm. Besides this,
decisions to invest in fixed assets are to be taken only after sound analysis using
capital budgeting techniques.

Similarly, adequate working capital should be

maintained so as to avoid the risk of insolvency


MEANING OF FINANCE
Finance may be defined as the art and science of managing money. It includes
financial service and financial instruments. Finance also is referred as the
provision of money at the time when it is needed. Finance function is the
procurement of funds and their effective utilization in business concerns.
The concept of finance includes capital, funds, money, and amount. But each
word is having unique meaning. Studying and understanding the concept of
finance become an important part of the business concern.
MEANING OF FINANCIAL MANAGEMENT
Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise.
It means applying general management principles to financial resources of the
enterprise

DEFINITION OF FINANCE
According to Khan and Jain, Finance is the art and science of managing
money.
Financial Management:
According to Oxford dictionary, the word finance connotes management of
money. Websters Ninth New Collegiate Dictionary defines finance as the
Science on study of the management of funds and the management of fund as
the system that includes the circulation of money, the granting of credit, the
making of investments, and the provision of banking facilities.
DEFINITION OF FINANCIAL MANAGEMENT
According to the Wheeler, Business finance is that business activity which
concerns with the acquisition and conversation of capital funds in meeting
financial needs and overall objectives of a business enterprise.
According to the Guthumann and Dougall, Business finance can broadly be
defined as the activity concerned with planning, raising, controlling, administering
of the funds used in the business.
In the words of Parhter and Wert, Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating
in nonfinancial fields of industry.
According to Howard & Upton, Financial management is the application of the
planning & control functions of the finance function.
According to J. F. Bradley, Financial management is the area of business
management devoted to the judicious use of capital & careful selection of

sources of capital in order to enable a spending unit to move in the direction of


reaching its goals.
Corporate finance is concerned with budgeting, financial forecasting, cash
management, credit administration, investment analysis and fund procurement of
the business concern and the business concern needs to adopt modern
technology and application suitable to the global environment.
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.
Thus, Financial Management is mainly concerned with the effective funds
management in the business. In simple words, Financial Management as
practiced by business firms can be called as Corporation Finance or Business
Finance.
Financial Management
SCOPE OF FINANCIAL MANAGEMENT
Financial management is one of the important parts of overall management,
which is directly related with various functional departments like personnel,
marketing and production. Financial management covers wide area with
multidimensional approaches. The following are the important scope of financial
management.

1. Financial Management and Economics


Economic concepts like micro and macroeconomics are directly applied with the
financial management approaches. Investment decisions, micro and macro
environmental factors are closely associated with the functions of financial
manager. Financial management also uses the economic equations like money
value discount factor, economic order quantity etc. Financial economics is one of
the emerging area, which provides immense opportunities to finance, and
economical areas.
2. Financial Management and Accounting
Accounting records includes the financial information of the business concern.
Hence, we can easily understand the relationship between the financial
management and accounting. In the olden periods, both financial management
and accounting are treated as a same discipline and then it has been merged as
Management Accounting because this part is very much helpful to finance
manager to take decisions. But nowadays financial management and accounting
discipline are separate and interrelated.

3. Financial Management or Mathematics


Modern approaches of the financial management applied large number of
mathematical and statistical tools and techniques. They are also called as
econometrics. Economic order quantity, discount factor, time value of money,
present value of money, cost of capital, capital structure theories, dividend
theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.

4. Financial Management and Production Management


Production management is the operational part of the business concern, which
helps to multiple the money into profit. Profit of the concern depends upon the
production performance. Production performance needs finance, because
production department requires raw material, machinery, wages, operating
expenses etc. These expenditures are decided and estimated by the financial
department and the finance manager allocates the appropriate finance to
production department.
The financial manager must be aware of the operational process and finance
required for each process of production activities.
5. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches.
For this, the marketing department needs finance to meet their requirements.
6. Financial Management and Human Resource
Financial management is also related with human resource department, which
provides manpower to all the functional areas of the management. Financial
manager should carefully evaluate the requirement of manpower to each
department and allocate the finance to the human resource department as
wages, salary, remuneration, commission, bonus, pension and other monetary
benefits to the human resource department. Hence, financial management is
directly related with human resource management.
OBJECTIVES OF FINANCIAL MANAGEMENT
Effective procurement and efficient use of finance lead to proper utilization of the
finance by the business concern. It is the essential part of the financial manager.
Hence, the financial manager must determine the basic objectives of the financial
management. Objectives of Financial Management may be broadly divided into
two parts such as:
1. Profit maximization
2. Wealth maximization

Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is
also functioning mainly for the purpose of earning profit. Profit is the measuring
techniques to understand the business efficiency of the concern. Profit
maximization is also the traditional and narrow approach, which aims at,
maximizes the profit of the concern. Profit maximization consists of the following
important features.
1. Profit maximization is also called as cashing per share maximization. It leads
to maximize the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all
the possible ways to increase the profitability of the concern.

3. Profit is the parameter of measuring the efficiency of the business concern. So


it shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favourable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives
of the business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.

Unfavourable Arguments for Profit Maximization


The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair
trade practice, etc.
(iii) Profit maximization objectives leads to inequalities among the sake holders
such as customers, suppliers, public shareholders, etc

Drawbacks of Profit Maximization


Profit maximization objective consists of certain drawback also:
(i) It is vague: In this objective, profit is not defined precisely or correctly. It
creates some unnecessary opinion regarding earning habits of the business
concern.
(ii) It ignores the time value of money: Profit maximization does not consider
the
time value of money or the net present value of the cash inflow. It leads certain
differences between the actual cash inflow and net present cash flow during a
particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business
concern. Risks may be internal or external which will affect the overall operation
of the business concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest
innovations and improvements in the field of the business concern. The term
wealth means shareholder wealth or the wealth of the persons those who are

involved in the business concern. Wealth maximization is also known as value


maximization or net present worth maximization. This objective is an universally
accepted concept in the field of business.
Favourable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the main
aim
of the business concern under this concept is to improve the value or wealth of
the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost
associated with the business concern. Total value detected from the total cost
incurred for the business operation. It provides extract value of the business
concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavourable Arguments for Wealth Maximization

Wealth maximization leads to prescriptive idea of the business concern


but it may

not be suitable to present day business activities.

Wealth maximization is nothing, it is also profit maximization, it is the


indirect name of the profit maximization.

Wealth maximization creates ownership-management controversy.

Management alone enjoy certain benefits.

The ultimate aim of the wealth maximization objectives is to maximize the


profit.

Wealth maximization can be activated only with the help of the profitable
position of the business concern.

APPROACHES TO FINANCIAL MANAGEMENT

Financial management approach measures the scope of the financial


management in
various fields, which include the essential part of the finance. Financial
management is not a revolutionary concept but an evolutionary. The definition
and scope of financial management has been changed from one period to
another period and applied various innovations. Theoretical points of view,
financial management approach may be broadly divided into two major parts
approach.
Traditional Approach
Traditional approach is the initial stage of financial management, which was
followed, in the early part of during the year 1920 to 1950. This approach is
based on the past experience and the traditionally accepted methods. Main part
of the traditional approach is rising of funds for the business concern. Traditional
approach consists of the following important area.

Arrangement of funds from lending body.

Arrangement of funds through various financial instruments.

Finding out the various sources of funds.

FUNCTIONS OF FINANCE MANAGER


Finance function is one of the major parts of business organization, which
involves the permanent, and continuous process of the business concern.
Finance is one of the interrelated functions which deal with personal function,
marketing function, production function and research and development activities
of the business concern. At present, every business concern concentrates more

on the field of finance because, it is a very emerging part which reflects the entire
operational and profit ability position of the concern. Deciding the proper financial
function is the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance
function.
He must have entire knowledge in the area of accounting, finance, economics
and management. His position is highly critical and analytical to solve various
problems related to finance. A person who deals finance related activities may be
called finance manager.
Finance manager performs the following major functions:
1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate
the financial requirement of the business concern. He should estimate, how
much finances required to acquire fixed assets and forecast the amount needed
to meet the working capital requirements in future.
2. Acquiring Necessary Capital
After deciding the financial requirement, the finance manager should concentrate
how the finance is mobilized and where it will be available. It is also highly critical
in nature.
3. Investment Decision
The finance manager must carefully select best investment alternatives and
consider the reasonable and stable return from the investment. He must be well
versed in the field of capital budgeting techniques to determine the effective
utilization of investment. The finance manager must concentrate to principles of
safety, liquidity and profitability while investing capital.

4. Cash Management
Present days cash management plays a major role in the area of finance
because proper cash management is not only essential for effective utilization of
cash but it also helps to meet the short-term liquidity position of the concern.
5. Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing,
production, personel, system, research, development, etc. Finance manager
should have sound knowledge not only in finance related area but also well
versed in other areas. He must maintain a good relationship with all the
functional departments of the business organization.
Department-I
Department-II
Department-III
Department-IV
Forecasting Funds
Managing Funds
Investing Funds
Finance
Manager
Acquiring Funds

Functions of Financial Manager


IMPORTANCE OF FINANCIAL MANAGEMENTFinance is the lifeblood of
business organization. It needs to meet the requirement of the business concern.
Each and every business concern must maintain adequate amount of finance for
their smooth running of the business concern and also maintain the business
carefully to achieve the goal of the business concern. The business goal can be
achieved only with the help of effective management of finance. We cant neglect
the importance of finance at any time at and at any situation. Some of the
importance of the financial management is as follows:
Financial Planning
Financial management helps to determine the financial requirement of the
business concern and leads to take financial planning of the concern. Financial
planning is an important part of the business concern, which helps to promotion
of an enterprise.
Acquisition of Funds
Financial management involves the acquisition of required finance to the
business concern. Acquiring needed funds play a major part of the financial
management, which involve possible source of finance at minimum cost.
Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of
the business concern. When the finance manager uses the funds properly, they
can reduce the cost of capital and increase the value of the firm.
Financial Decision
Financial management helps to take sound financial decision in the business
concern.
Financial decision will affect the entire business operation of the concern.
Because there is a direct relationship with various department functions such as
marketing, production personnel, etc.

Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper
utilization of funds by the business concern. Financial management helps to
improve the profitability position of the concern with the help of strong financial
control devices such as budgetary control, ratio analysis and cost volume profit
analysis.
Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of
the investors and the business concern. Ultimate aim of any business concern
will achieve the maximum profit and higher profitability leads to maximize the
wealth of the investors as well as the nation.
Promoting Savings
Savings are possible only when the business concern earns higher profitability
and maximizing wealth. Effective financial management helps to promoting and
mobilizing individual and corporate savings.
Nowadays financial management is also popularly known as business finance or
corporate finances. The business concern or corporate sectors cannot function
without the importance of the financial management.

Cost Of Capital
INTRODUCTION:
It has been discussed in lesson -4 that for evaluating capital investment
proposals according to the sophisticated techniques like Net Present Value and
Internal Rate of Return, the criterion used to accept or reject a proposal is the
cost of capital. The cost of capital plays a significant role in capital budgeting
decisions. In the present lesson the concept of cost of capital and the methods
for its computation are explained.
COST OF CAPITAL-KEY CONCEPTS:
The term cost of capital refers to the minimum rate of return a firm must earn on
its investments. This is in consonance with the firms overall object of wealth
maximization. Cost of capital is a complex, controversial but significant concept
in financial management.
The following definitions give clarity management.
Hamption J.: The cost of capital may be defined as the rate of return the firm
requires from investment in order to increase the value of the firm in the market
place.
James C. Van Horne: The cost of capital is a cut-off rate for the allocation of
capital to investments of projects. It is the rate of return on a project that will
leave unchanged the market price of the stock.
Soloman Ezra:Cost of Capital is the minimum required rate of earnings or the
cut-off rate of capital expenditure.

It is clear from the above definitions that the cast of capital is that minimum rate
of return which a firm is expected to earn on its investments so that the market
value of its share is maintained. We can also conclude from the above definitions
that there are three basic aspects of the concept of cost of capital:
i) Not a cost as such: In fast the cost of capital is not a cost as such, it is the
rate of return that a firm requires to earn from its projects.
ii) It is the minimum rate of return: A firms cost of capital is that minimum rate
of return which will at least maintain the market value of the share.
iii) It comprises three components:
K=ro+b+f
Where, k=cost of capital;
ro= return at zero risk level:
b = premium for business risk, which refers to the variability in operating profit
(EBIT) due to change in sales.
f = premium for financial risk which is related to the pattern of capital structure.

IMPORTANCE OF COST OF CAPITAL:


The cost of capital is very important in financial management and plays a crucial
role in the following areas:
i) Capital budgeting decisions: The cost of capital is used for discounting cash
flows under Net Present Value method for investment proposals. So, it is very
useful in capital budgeting decisions.

ii) Capital structure decisions: An optimal capital is that structure at which the
value of the firm is Value of the firm is maximum and cost of capital is the lowest.
So, cost of capital is crucial in designing optimal capital structure.
iii) Evaluation of final Performance: Cost of capital is used to evaluate the
financial performance of top management. The actual profitabily is compared to
the expected and actual cost of capital of funds and if profit is greater than the
cast of
capital the performance nay be said to be satisfactory.
iv) Other financial decisions: Cost of capital is also useful in making such other
financial decisions as dividend policy, capitalization of profits, making the rights
issue, etc.
CLASSIFICATION OF COST OF CAPITAL :
Cost of capital can be classified as follows:
i) Historical Cost and future Cost: Historical costs are book costs relating to
the past, while future costs are estimated costs act as guide for estimation of
future costs.
ii) Specific Costs and Composite Costs: Specific accost is the cost if a specific
source of capital, while composite cost is combined cost of various sources of
capital. Composite cost, also known as the weighted average cost of capital,
should be considered in capital and capital budgeting decisions.
iii) Explicit and Implicit Cost: Explicit cost of any source of finance is the
discount
rate which equates the present value of cash inflows with the present value of
cash

outflows. It is the internal rate of return and is calculated with the following
formula;
iv) Average Cost and Marginal Cost: An average cost is the combined cost or
weighted average cost of various sources of capital. Marginal cost of refers to the
average cost of capital of new or additional funds required by a firm. It is the
marginal cost which should be taken into consideration in investment decisions.
DETERMINATION OF CAST OF CAPITAL:
As stated already, cost of capital plays a very important role in making decisions
relating to financial management. It involves the following problems.
Problems in determination of cost of capital:
i) Conceptual controversy regarding the relationship between cost of capital and
capital structure is a big problem.
ii) Controversy regarding the relevance or otherwise of historic costs pr future
costs in decision making process.
iii) ReComputation of cost of equity capital depends upon the excepted rate of
return by its investors. But the quantification of expectations of equity
shareholders is a very difficult task.
iv) Retained earnings has the opportunity cost of dividends forgone by the
shareholders. Since different shareholders may have different opportunities for
reinvesting dividends, it is very difficult to compute cost of retained earnings.
v) Whether to use book value or market value weights in determining weighted
average cost of capital poses another problem.

COMPUTATION OF COST OF CAPITAL:


Computation of cost capital of a firm involves the following steps:
i) Computation of cost of specific sources of a capital, viz., debt, preference
capital,
equity and retained earnings, and ii) Computation of weighted average cost of
capital.
Cost of Debt (kd)
Debt may be perpetual or redeemable debt. Moreover, it may be issued at par,at
premium or discount. The computation of cost debt in each is explained below.

Perpetual / irredeemable debt:


i) At par:
Kd = Cost of debt before tax =I/Po
Kd = Cost of debt; I= interest; Po = net proceeds
kd(after-tax) = i/P(I-t)
Where T = tax rate
Example
Y Ltd issued Rs. 2,00,000, 9% debentures at a premium of 10%. The costs of
floatation are 2% .
The tax rate is 50%. Compute the after tax cost of debt.
I Rs. 18,000
Answer: kd(after-tax)= (i-t) (I-5)=4.17%

NP Rs. 2,15,600
[net proceeds = Rs. 2,00,000 + 20,000 (2/100x2,20,000)]

Redeemable debt
The debt repayable after a certain period is known ad redeemable debt. Its cost
computed by using the following formula:
I+1/n (P-NP)
i) Before tax cost of debt =
(P+NP)
I = interest: P= proceeds at par;
NP = net proceeds; n = No. of years in which debt is to be redeemed
ii) After tax of debt = Before tax cost of debt x(1-t)
Example
A company issued Rs. 1,00,000 10% redeemble debentures at a discount of
50%. The cost of floatation amount to Rs. 3,000. The debentures are redeemable
after 5 years. Compute before
TAx and after tax Cost of debt. The rate is 50%.
Solution :
I+1/n (P-NP)
i) Before tax cost of debt = (P+NP)
10,000+1/5(1,00,000-92,000) = (1,00,000+92,000)
10,000-16000 11,000 = = =12.08% 96,000 96,000
[NP=1,00,000 5,000 3,000=92,000]
After tax cost of debt = Before tax cost x (1-t)=12.08X(1-.5)=6.04%

Cost of preference Capital(kP)


In case of preference share dividend are payable at a fixed rate. However, the
dividends are not allowed to be deducted for computation of tax. So no
adjustment for tax is required just like debentures, preference share may be
perpetual or redeemable. Future, they may be issued at par, premium or
discount.
Perpetual preference Capital
i) If issued at par ; Kp = D/P
Kp = Cost of preference capital
D = Annual preference dividend
P = Proceeds at par value
ii) If issued at premium or discount
Kp = D/NP Where NP = net proceeds.
Example:
A company issued 10,000, 10% preference share of Rs. 10 each, Cost of issue is
Rs. 2 per share. Calculate cost of capital, of these shares are not issued (a) at
par , (b) at 10% premium, and (c) at 5% discount.

Solutions :
Cost of preference capital, (Kp) = D/NP
a) When issued at par:
Rs. 10,000 10,000

Kp = x100 = x100 =12.5%


1,00,000-20,000 80,000
[ Cost of issued = 10,000xRs. 2= Rs. 20,000]
b) When issued at 10% premium:
Rs. 10,000 10,000
Kp = x100 = x100 =11.11%
1,00,000 + 10,000-20,000 90,000
c) When issued at 5% discount:
Rs. 10,000 10,000
Kp = x100 = x100 =13.33%
1,00,000- 5,000-20,000 75,000
Redeemable preference shares
It is calculated with the following formula:
D+ MV- NP/n
KP = (MV+NP)
Where, Kp = Cost of preference capital
D = Annual preference dividend
MV = Maturity value of preference shares
NP = Net proceeds of preference shares
Example:
A company issues 1,00,000 10% preference share of Es. 10 each. Calculate the
cost of preference capital if it is redeemable after 10 years.
a) At par b) at 5% premium

Solution
D + 1/n MV- NP
KP = 100
(MV+NP)
a) Cost of preference capital , if redeemable at par:
Rs. 1,00,000 +1/10 (10,00,000 10,00,00) Rs. 1,00,000
KP = x100 x100 = 10%
(10,00,000 +10,00,000) Rs. 10,00,000
b) If redeemable at a premium of 5% Kp =
Rs. 1,00,000 +1/10 (10,50,000 10,00,00)
KP = x100
(10,50,000 +10,00,000)
Rs. 1,00,000 + 5,000 Rs. 1,05,000
= X100 x100 = 10.24%
Rs. 10,25,000 Rs. 10,25,000

Cost of Equity capital


Cost of Equity is the expected rate of return by the equity shareholders. Some
argue that, as there is no legal for payment, equity capital does not involve any
cost. But it is not correct. Equity shareholders normally expect some dividend
from the company while making investment in shares. Thus, the rate of return
expected by them becomes the cost of equity. Conceptually, cost of equity share
capital may be defined as the minimum rate of return that a firm must earn on the
equity part of total investment in a project in order to leave unchanged the market
price of such shares. For the determination of cost equity capital it may be
divided into two categories:
i) External equity or new issue of equity shares.

ii) Retained earnings.


The cost of external equity can be computed as per the following approaches:
Dividend Yield / Dividend Price Approach
According to this approach, the cost of equity will be that rate of expected
dividends which will maintain the present market price of equity shares. It is
calculated with the following formula:
Ke = D/NP (for new equity shares)
Or
Ke = D/MP (for existing shares)
Where,
Ke = Cost of equity
D = Expected dividend per share
NP = Net proceeds per share
Mp = Market price per share
This approach rightly recognizes the importance of dividends. However, it ignores
the
importance of retained earnings on the market price of equity shares. This
method is suitable only when the company has stable earnings and stable
dividend policy over a period of time.
Example
A company issues, 10,000 equity shares of Rs. 100 each at a premium of 10%.
The company has been paying 20% dividend to equity shareholders for the past
five years and expected to maintain the same in the future also. Compute cost of
equity capital. Will it make any difference if the market price of equity share is Rs.
150 ?

Dividend yield plus Growth in dividend methods


According to this method, the cost of equity is determined on the basis if the
expected dividend rate plus the rate of growth in dividend. This method is used
when dividends are expected to grow at a constant rate.
Cost of equity is calculated as:
Ke = D1 /NP +g (for new equity issue)
Where,
D1 = expected dividend per share at the end of the year. [D1 = Do(1+g)]
Np = net proceeds per share
g = growth in dividend for existing share is calculated as:
D1 / MP + g
Where,
MP = market price per share.

Example:
ABC Ltd plans to issued 1,00,000 new equity share of Rs. 10 each at par. The
floatation costs are expected to be 5% of the share price. The company pays a
dividend of Rs. 1 per share and the growth rate in dividend is expected to be 5%.
Compute the cost of new issue share.
If the current the cost of new issue of shares.
Solution :
Cost of new equity shares = (Ke) = D/NP +g
Ke = 1 / (10-5-) + 0.05 = 1 / 9.5 + 0.05
= 0.01053 + 0.05
= 0.1553 or 15.53%

Cost of existing equity share: ke = D / MP + g


Ke = 1/ Rs. 15 = 0.05 = 0.0667 or 11.67%
Earnings Yield Method
According to this approach, the cost of equity is the discount rate that capitalizes
a stream of future earnings to evaluate the shareholdings. It is called by taking
earnings per share (EPS) into consideration. It is calculated as:
i) Ke = Earnings per share / Net proceeds = EPS / NP [For new share]
ii) Ke = EPS / MP [ For existing equity]
Example
XYZ Ltd is planning for an expenditure of Rs. 120 lakhs for its expansion
programme. Number of existing equity shares are 20 lakhs and the market value
of equity shares is Rs. 60. It has net earnings of Rs. 180 lakhs.
Compute the cost of existing equity share and the cost of equity capital assuming
that new share will be issued at a price of Rs. 52 per share and the costs of new
issue will be Rs. 2 per share.
Cost of Retained Earnings (Kr)
Retained earnings refer to undistributed profits of a firm. Out of the total earnings,
firms generally distribute only past of them in the form of dividends and the rest
will be retained within the firms. Since no dividend is required to paid on retained
earnings, it is stated that retained earnings carry no cost. But this approach is
not appropriate. Retained earnings has the opportunity cost of dividends in
alternative investment becomes cost if retained earnings.
Hence, shareholders expect a return on retained earnings at least equity.

Kr = Ke = D/NP+g
However, while calculating cost of retained earnings, two adjustments should be
made:
a) Income-tax adjustment as the shareholders are to pay some income tax out of
dividends, and
b) adjustment for brokerage cost as the shareholders should incur some
brokerage cost while investment dividend income. Therefore, after these
adjustments, cost of retained earnings is calculated as:
Kr = Ke (1-t)(1-b)
Where, Kr = cost of retained earnings
Ke = Cost of equity
t = rate of tax
b = cost of purchasing new securities or brokerage cost.
Example
A firm s cost of equity (Ke) is 18%, the average income tax rate of shareholders
is 30% and brokerage cost of 2% is excepted to be incurred while investing their
dividends in alternative securities. Compute the cost of retained earnings.
Solution : Cost of retained earnings = (Kr) = Ke (1-t)(1-b)=18(1-.30)(1-.02)
=18x.7x.98=12.35%
WEIGHTED AVERAGE COST OF CAPITAL:
It is the average of the costs of various sources of financing. It is also known as
composite or overall or average cost of capital. After computing the cost of
individual sources of finance, the weighted average cost of capital is calculated
by putting weights in the proportion of the various sources of funds to the total
funds.

Weighted average cost of capital is computed by using either of the following two
types of weights:
1) Market value 2) Book Value
Market value weights are sometimes preferred to the book value weights as the
market value represents the true value of the investors. However, market value
weights suffer from the following limitations:
i) Market value are subject to frequent fluctuations.
ii) Equity capital gets more importance, with the use of market value weights.
Moreover, book values are readily available.
Average cost of capital is computed as followings:
Kw = KW
W
Where, Kw = weighted average cost of capital
X = cost of specific sources of finance
W = weights (proportions of specific sources of finance in the total)
The following steps are involved in the computation of weighted average cost of
capital:
i) Multiply the cost of each sources with the corresponding weight.
ii) Add all these weighted costs so that weighted average cost of capital is
obtained.
The weighted average cost of capital
(WACC) is a common topic in the financial management examination. This rate,
also called the discount rate, is used in evaluating whether a project is feasible or
not in the net present value (NPV) analysis, or in assessing the value of an asset.

Previous examinations have revealed that many students fail to understand how
to calculate or understand WACC.

WACC is calculated as follows:


WACC = E/V x Re + D/V x Rd x (1-tax rate)
WACC is the proportional average of each category of capital inside a firm
common shares, preferred shares, bonds and any other long-term debt where:
Re = cost of equity
Rd = cost of debt
E = market value of the firms equity
D = market value of the firms debt
V = E + D = firm value
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
WACC is simply a replica of the basic accounting equation: Asset = Debt
+ Equity. WACC focuses on the items on the right hand side of this
equation.
(Most companies do not have preferred shares. For simplicity, we only use
common shares and bonds in our illustrations.)
A firm derives its assets by either raising debt or equity (or both). There are costs
associated with raising capital and WACC is an average figure used to indicate
the cost of financing a companys asset base. In determining WACC, the firms
equity value, debt value and hence firm value needs to be derived. This part is
definitely not too difficult. You also need to find the cost of the equity and the cost
of the debt.

Basically there are two approaches in finding the cost of equity: the dividend
growth approach and the capital asset pricing model (CAPM) approach. Using
the dividend approach,
Po = D1 / (Re - g)
where
Po is the current stock price or price of the stock in period 0.
D1 is the dividend in period 1
Re is the cost of equity
g is the dividend growth rate
Re = D1 / Po + g
This approach only applies to dividend-paying stock as we need to determine the
dividend growth rate. The other approach is the CAPM, which was developed by
Sharpe, a Nobel Prize winner in economics in 1990.
Re = Rf + Bex (Rm - Rf )
Using CAPM, the risk free rate (Rf ) and market return (Rm) have to be found, as
does the stocks beta. There are many arguments about how best to determine
the risk free rate, market return and the beta. However, CAPM is relatively more
commonly used than the dividend growth model since most stocks do not have a
stable dividend history. When calculating the cost of debt, we do not use the
coupon rate of the bond as reference. Rather, we use the yield rate. For
example, if a bond has coupon rate of 3% and a market price of 103, this implies
that the actual yield is less than 3%. Let me use an example to illustrate. On the
equity side, a company has 50 million shares with market price of $80 per share.
The beta of the stock is 1.15 and market risk premium is 9%. The risk-free rate is

5%. On the debt side, the company has $1 billion outstanding debt (face value).
The current price of the debt
is 110 and the coupon rate is 9%: the company pays semi-annual coupons with
15 years to maturity. Assume the tax rate is 15%.
To find the cost of equity,
Re = 5 + 1.15(9) = 15.35%
Remember the market risk premium is Rm-Rf. Since this is given, we need not
deduct 5% from 9%. To find cost of debt, we turn to the bond pricing equation
and find r.
P = C x [1 - 1/(1 + r )t]/r + F x 1/(1 + r )t
We may assume the face value of individual bond = $1,000. Since C = $45
remember its a semiannual payment), t = 30, P = $1,100,
F=$1,000, we find that r = 3.9268%.
(You may need to use a computer or estimation method to find r.)
Since the cost of debt is given on an annual basis, Rd = 2 x 3.9268% =
7.854%. In calculating WACC, we use the after-tax cost of debt. (This is
because interest payments are eligible for tax deductions.) If the interest rate is
7.854%, taking into account the tax deduction, the actual interest rate must be
lower. Thus the after tax
cost of debt is 7.854% x (1-15%) = 6.6759%.
A useful way of checking your answer is to remember that, for most companies,
the cost of debt (before tax) is usually lower than the cost of equity. If you
calculate Re to be less than Rd, you have probably made a mistake. We have
the cost of debt and cost of equity; now we need to find the firms value. The
values are as follows:

Equity market value E = 50 million ($80) = $4 billion


Debt market value D = $1 billion (1+110%) = $1.1 billion
Firm market value V = E + D = $5.1 billion
Weight of E = E/V = $4 /$5.1 = 0.7843
Weight of D = D/V = $1.1 /$ 5.1 = 0.2157
So, what is the WACC?
WACC = 0.7843(15.35%) + 0.2157(6.6759%) = 13.48%
This rate is used in the evaluation of a project NPV or in determining the value of
an asset. Why is WACC important? For a project to be feasible, not just
profitable, it must generate a return higher than the cost of raising debt (Rd) and
the cost of raising equity (Re). Students must bear in mind that WACC is affected
not only by Re
and Rd, but it also varies with capital structure. Since Rd is usually lower than
Re, then the higher the debt level, the lower the WACC. This partly explains why
firms usually prefer issuing debt first before they raise more equity. As part of
their risk management processes, some companies add a risk factor, say 1.5%,
to the WACC
in order to include a risk cushion in their project evaluation. The logic behind this
is simple as the process of finding WACC involves a large degree of estimation:
you need to estimate the risk free rate, the beta and the market return. So next
time you tackle a WACC question, remember this process. In real life the process
is similar, just more complicated as a company may have different debts with
different interest rates.
As investors desire to obtain the best/highest return on their investments in
securities such as shares (Equity) and loans to companies such as debentures
(Debt), these returns are costs to the companies paying these Dividends (on
equity) and Interest (on Debts)!

Companies MUST consider the cost of financing they receive in the form of
equity or debt if they are to manage their finances better; cheaper finance cost to
the company means higher profitability and in most cases, superior cash flow.
Generally, the cost of EQUITY has no tax effect but the cost of DEBT finance to
companies are technically SUBSUDISED by tax since INTEREST (cost of Debt)
can be claimed for tax purposes in so far as it is wholly, exclusively and
necessarily incurred for business purposes.
The Cost of Equity
Assumptions of the Dividend Valuation Model (DVM) Investors only buy shares to
acquire a future dividend stream. All investors have homogeneous (i.e. identical)
expectations of this future dividend stream. The stock market is extremely
efficient at pricing securities. Present Value (PV) of dividend stream = current
share price
(current market price of share).

An Example:
Assuming CONSTANT dividend streams of income (Investors perspective) A plc
has paid a dividend of 50p per share for many years. This is expected to
continue for the foreseeable future. A plcs current share price is 2.50 ex div.
You are required to calculate the cost of equity of X plc, Ke.

Solution:
Present value (PV) of dividend stream = current share price (see
assumption 4 above please)
50p
Ke
= 250p _ Ke =
250 p
50 p = 20% per annum
Note:
Current share price used is Ex. Div. (i.e. without the next dividend
payment).
Constant dividend divided by Cost of Equity equals Current share Price
Assuming INCREASING dividend streams of income (Investors
perspective)
To deal with an increasing perpetuity we need a formula.
PV of dividends = current share price
K g D e 1 = P0 or K e = 0 1 P D + g

An Example
D plc has just paid a dividend of 30p per share. Shareholders
expect dividends to grow at 5% pa. The current share price is 1.80
ex div.
D1 = 30p x 1.05 = 31 p
P0 = 180 p
Ke = 0 1 P D + g = 180p
31 + 5 = 22%

Note: If the market capitalisation is given in cum div terms it will need to be
converted to the ex div equivalent for use in the formula
If given profit and loss and balance sheet information growth can be estimated as
follows:
First we calculate the retention or plough back rate from the profit and loss
account. (If 100% profit is retained = 100% retention rate)
Retention rate = profit after tax
retained profit 100%
Secondly we calculate the return on capital employed (ROCE)
from the profit and loss account and balance sheet (as normally
done in Ratio analysis or Interpretation of Accounts)
ROCE = opening net assets
profit after tax 100%

Redeemable debentures
A redeemable debenture will pay the holder interest for a number of years, then
will be redeemed for a capital sum by the company (i.e. company will BUY BACK
debt Debentures). Here an IRR computation is appropriate.
An Example
N plc has some 10 per cent coupon debentures in issue redeemable in five years
at par. They are currently trading at 90 ex int. Interest is paid annually. Tax is at
30%.
Solution
The cost of debt would be the IRR of the following debt flows (as they affect the
company) estimated by interpolation in the usual way:

Cash flow
t0 90.00 Benefit to company of retaining debentures
t1 t5 (7.0) Net of tax interest cost
t5 (100.0) Redemption cost

Cost of Retained Earnings


1.Cost of Retained Earnings

Cost of retained earnings (ks) is the return stockholders require on the companys
common stock.
There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach

a)CAPM Approach

To calculate the cost of capital using the CAPM approach, you must first estimate
the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day
Treasury-bill rate as well as the expected rate of return on the market (r m).
The next step is to estimate the companys beta (b i), which is an estimate of the
stocks risk. Inputting these assumptions into the CAPM equation, you can then
calculate the cost of retained earnings.

Formula

Example: CAPM approach

For Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of retained
earnings for Newco using the CAPM approach?
Answer:

ks = rf + bi (rm rf) = 4% + 1.1(15%-4%) = 16.1%


b) Bond-Yield-Plus-Premium Approach

This is a simple, ad hoc approach to estimating the cost of retained earnings.


Simply take the interest rate of the firms long-term debt and add a risk premium
(typically three to five percentage points):

Formula
ks = long-term bond yield + risk premium

Example: bond-yield-plus-premium approach


The interest rate on Newcos long-term debt is 7% and our risk premium is 4%.
What is the cost of retained earnings for Newco using the bond-yield-pluspremium approach?
Answer:
ks = 7% + 4% = 11%
c) Discounted Cash Flow ApproachAlso known as the dividend yield plus
growth approach. Using the dividend-growth model, you can rearrange the
terms as follows to determine ks.
Formula
ks = D1 + g;
P0
where:
D1 = next years dividend
g = firms constant growth rate
P0 = price
Typically, you must also estimate g, which can be calculated as follows:

Formula
g = (retention rate)(ROE) = (1-payout rate)
(ROE)
Example: discounted cash flow approach

Assume Newcos stock is selling for $40; its expected return on equity (ROE) is
10%, next years dividend is $2 and the company expects to pay out 30% of its
earnings. What is the cost of retained earnings for Newco using the discounted
cash flow approach?
Answer:

g must first be calculated:


g = (1-0.3)(0.10) = 7.0%
ks = 2/40 + 0.07 = 0.12 or 12%
Concept And Determination Of Cost Of Retained Earning
Concept Of Cost Of Retained Earning
The portion of net profit distributed to shareholders is called dividend and the
remaining portion of the profit is called retained earning. In other word, the
amount of undistributed profit which is available for investment is called retained
earning. Retained earning is considered as internal source of long-term financing
and it is a part of shareholders equity.
Generally, retained earning is considered as cost free source of financing. It is
because neither dividend nor interest is payable on retained profit. However, this
statement is not true. Shareholders of the company that retains more profit
expect more income in future than the shareholders of the company that pay
more dividend and retains less profit. Therefore, there is an opportunity cost of
retained earning. In other words, retained earning is not a cost free source of
financing. The cost of retained earning must be at least equal to shareholders
rate of return on re-investment of dividend paid by the company.

Determination Of Cost Of Retained Earning


In the absence of any information relating to addition of cost of re-investment and
extra burden of personal tax, the cost of retained earning is considered to be
equal to the cost of equity. However, the cost of retained earnings differs from the
cost of equity when there is flotation cost to be paid by the shareholders on reinvestment and personal tax rate of shareholders exists.
i)Cost of retained earnings when there is no flotation cost and personal tax
rate applicable for shareholders:
Cost of retained earnings(kr) = Cost of equity(ke) = (D1/NP)+g
where,
D1= expected dividend per share
NP= current selling price or net proceed
ii)Cost of retained earnings when there is flotation cost and personal tax
rate applicable for shareholders:
Cost of retained earnings(kr) = Cost of equity(ke) x 1-fp) (1-tp)
where,
fp = flotation cost on re-investment(in fraction) by shareholders
tp = Shareholders' personal tax rate.
Illustration
A company's share are currently selling for $ 120. The expected dividend and the
growth rate are $5.20 and 6% respectively. Then calculate the cost of retained
earning.

Solution,

Cost of retained earning(kr) = (D1/NP)+ g


= (5.20/120) +0.60 = 0.1033 or 10.33%
Cost of Preference Capital
Preference shares represent a special type of ownership interest in the firm.
They are entitled to a fixed dividend, but subject to availability of profit for
distribution. The preference share holders have to be paid their fixed dividends
before any distribution of dividends to the equity shareholders. Their dividends
are not allowed as an expense for the purpose of taxation. In fact, the preference
dividend is a distribution of profits of the business. Because dividends are paid
out of profits after taxes, the question of after tax or before tax cost of preference
shares does not arise as in case of cost of debentures.
Preference shares can be divided into:
1. Irredeemable preference shares
2. Redeemable preference shares

(1) Cost of Irredeemable preference shares


Irredeemable preference shares are those shares issuing by which the company
has no obligation to pay back the principal amount of the shares during its
lifetime. The only liability of the company is to pay the annual dividends. The cost
of irredeemable preference shares is:
Kp (cost of pref. share) = Annual dividend of preference shares
Market price of the preference stock
Example: Let us calculate the cost of 10% preference capital of 10,000
preference shares whose face value is $100. The market price of the share is
currently $115.

Annual dividend = 10% of $100 = $10 per share


Kp = $10/$115 = 8.7%
Cumulative preference shares:
In case of cumulative preference shares, the market price of the preference stock
will be increased by such amount of dividend in arrears. Cumulative preference
shares are those shares whose dividends will get accumulated if they are not
paid periodically. All the arrears of cumulative preference shares must be paid
before paying anything to the equity share holders.
Non-cumulative preference shares:
These are preference shares whose dividends do not get carried forward to the
next year if they are not paid during a year.

If the company issues new preference shares, the cost of preference capital
would be:
Kp = Annual dividend / Net proceeds after floatation costs, if any.
Example: A limited company issues 8% preference shares which are
irredeemable. The face value of share is $100 but they are issued at $105. The
floatation cost is $3 per share.
Kp = $8/($105-$3) = 7.84%
If the floatation costs are expressed as percentage, the formula will take the
following shape:

Kp = Annual dividend/Net proceeds(1-floatation costs)

(2) Cost of Redeemable preference shares


Redeemable preference shares are those shares which have a fixed maturity
date at which they would be redeemed.
Cost of Redeemable preference shares = Annual Dividend + (Redeemable Value
- Sale value) / Number of years for redemption
(Redeemable Value + Sale value) / 2
Or
Kp = D +(RV - SV) / N
(RV + SV) / 2
Example:
A company issues 10000, 8% preference shares of $100 each redeemable after
20 years at face value. The floatation costs are $3 per share.
Redeemable value = $100;
Sale value = $100-$3 = $97
Annual dividend = $8 per share.
Kp = 8 + (100 - 97) / 20

= 8.27%

(100 + 97) / 2
An Example irredeemable debentures

M plc has some 8 per cent coupon irredeemable debentures in issue trading at
90 ex int. Corporation tax is 30 per cent with no lag in payment. Interest is paid
annually.
Solution
PV of aftertax interest = current debenture price
8(1 0.30) Kd = 90
Kd =90
5.60 = 6.2% per annum
Note: The calculation is made Ex. Int. (meaning Exclusive of the next Interest to
be received)
Redeemable debentures
A redeemable debenture will pay the holder interest for a number of years, then
will be redeemed for a capital sum by the company (i.e. company will BUY BACK
debt Debentures). Here an IRR computation is appropriate.
An Example
N plc has some 10 per cent coupon debentures in issue redeemable in five years
at par. They are currently trading at 90 ex int. Interest is paid annually. Tax is at
30%.
Solution
The cost of debt would be the IRR of the following debt flows (as they affect the
company) estimated by interpolation in the usual way:
Cash flow
t0 90.00 Benefit to company of retaining debentures
t1 t5 (7.0) Net of tax interest cost
t5 (100.0) Redemption cost

The cost of debt is sometimes known as the gross redemption yield


in exam questions.

DEBENTURES

A debenture is a document which either creates a debt or acknowledges it.


Debenture issued by a company is in the form of a certificate acknowledging
indebtedness. The debentures are issued under the Company's Common Seal.
Debentures are one of a series issued to a number of lenders. The date of
repayment is specified in the debentures. Debentures are issued against a
charge on the assets of the Company. Debentures holders have no right to vote
at the meetings of the companies.

KINDS OF DEBENTURES

(a)Bearer Debentures:
They are registered and are payable to the bearer. They are negotiable
instruments and are transferable by delivery.
(b) Registered Debentures:
They are payable to the registered holder whose name appears both on the
debentures and in the Register of Debenture Holders maintained by the
company. Registered Debentures can be transferred but have to be registered
again. Registered Debentures are not negotiable instruments. A registered
debenture contains a commitment to pay the principal sum and interest. It also
has a description of the charge and a statement that it is Issued subject to the
conditions endorsed therein.

(c) Secured Debentures:


Debentures which create a change on the assets of the company which may be
fixed or floating are known as secured Debentures. The term "bonds" and
"debentures"(secured) are used interchangeably in common parlance. In USA,
BOND is a long term contract which is secured, whereas a debentures is an
unsecured one.
(d) Unsecured or Naked Debentures:
Debentures which are issued without any charge on assets are insecured or
naked debentures. The holders are like unsecured creditors and may see the
company for the recovery of debt.
(e) Redeemable Debentures:
Normally debentures are issued on the condition that they shall be redeemed
after a certain period. They can however, be reissued after redemption.
(f) Perpetual Debentures:
When debentures are irredeemable they are called perpetual. Perpetual
Debentures cannot be issued in India at present.
(g) Convertible Debentures:
If an option is given to convert debentures into equity shares at the stated rate of
exchange after a specified period, they are called convertible debentures.
Convertible Debentures have become very popular in India. On conversion the
holders cease to be lenders and become owners.
Debentures are usually issued in a series with a pari passu (at the same rate)
clause which entitles them to be discharged rateably though issued at different
times. New series of debentures cannot rank pari passu with the old series
unless the old series provides so.
New debt instruments issued by public limited companies are participating
debentures, convertible debentures with options, third party convertible

debentures convertible debentures redeemable at premiums, debt equity swaps


and zero coupon convertible notes. These are discussed below:
(h) Participating Debentures:
They are unsecured corporate debt securities which participate in the profits of
the company. They might find investors if issued by existing dividend paying
companies.
(i) Convertible Debentures with options:
They are a derivative of convertible debentures with an embedded option,
providing flexibility to the issuer as well as the investor to exit from the terms of
the issue. The coupon rate is specified at the time of issue.
(j) Third Party Convertible Debentures:
They are debt with a warrant allowing the investor to subscribe to the equity of
third firm at a preferential price visa vis the market price. Interest rate on third
party convertible debentures is lower than pure debt on account of the
conversion option.
(k) Convertible-Debentures Redeemable at a Premium:
Convertible Debentures are issued at face value with 'a put option entitling
investors to sell the bond to the issuer at a premium. They are basically similar to
convertible debentures but embody less risk.
(I) Debt-Equity Swaps:
Debt-Equity Swaps are an offer from an issuer of debt to swap it for equity. The
instrument is quite risky for the investor because the anticipated capital
appreciation may not materialise.
(m) Deep discount Bonds:
They are designed to meet the long term funds requirements of the issuer and
investors who are not looking for immediate return and can be sold with a long
maturity of 25-30 years at a deep discount on the face value of debentures. IDBI

deep discount bonds for Rs 1 lakh repayable after 25 years were sold at a
discount price of Rs. 2,700.
(n) Zero-Coupon Convertible Note:
A zero-coupon convertible note can be converted into shares. If choice is
exercised investors forego all accured and unpaid interest. The zero-coupon
convertible notes are quite sensitive to changes in interest rates.
(o) Secured Premium Notes (SPN) with Detachable Warrants:
SPN which is issued along with a detachable warrant, is redeemable after a
notice period, say four to seven years. The warrants attached to it ensures the
holder the right to apply and get allotted equity shares; provided the SPN is fully
paid.
There is a lock-in period for SPN during which no interest will be paid for an
invested amount. The SPN holder has an option to sell back the SPN to the
company at par value after the lock in period. If the holder exercises this option,
no interest/ premium will be paid on redemption. In case the SPN holder holds its
further, the holder wili be repaid the principal amount along with the additional
amount of interest/ premium on redemption in instalments as decided by the
company. The conversion of detachable warrants into equity shares will have to
be done within the time limit notified by the company.
(p) Floating Rate Bonds:

The rate on the floating Rate Bond is linked to a benchmark interest rate like the
prime rate in USA or LIBOR in eurocurrency market. The State Bank of India's
floating rate bond was linked to maximum interest on term deposits which was 10
percent. Floating rate is quoted in terms of a margin above or below the bench
mark rate. The-floor rate in the State Bank of India case was 12 per cent. Interest
rates linked to the bench mark ensure that neither the borrower nor the lender
suffer from the changes in interest rates. When rates are fixed, they are likely to

be inequitable to the borrower when interest rates fall subsequently, and the
same bonds are likely to be inequitable to the lender when interest rates rise
subsequently.

Chapter-2

MEANING OF CAPITAL BUDGETING


The term capital budgeting means planning for capital assets. The capital
budgeting decision means decision as to whether or not money should be
invested in long-term projects. Such projects may include the setting up of a
factory or installing machinery or creating additional capacities to manufacture a
part which at present may be purchased from out side. It includes a financial
analysis of the various proposals regarding capital expenditure to evaluate their
impact on the financial condition of the company for the purpose to choose the
best out of the various alternatives. The finance manager has various tools and
techniques by means of which he assists the management in taking a proper
capital budgeting decisions.
The capital budgeting decisions therefore evaluate expenditure decisions which
involve current outlays but are likely to produce benefits over a period of time
longer then one year. The benefit which may arise from capital budgeting
decisions may be either in the form of increased revenues or reduction in costs. A
capital budgeting decision requires evaluation of a proposed project to forecast
the likely or expected return from the project and determine whether return from
the project is adequate. Further, since business is a part of society, it is therefore
also the moral responsibility of a finance manager to undertake only those
projects which are socially desirable.
Businesses look for opportunities that increase their share holders value. In
capital budgeting, the managers try to figure out investment opportunities that are
worth more to the business than they cost to acquire. Ideally, firms should peruse
all such projects that have good potential to increase the business worth. Since
the available amount of capital at any given time is limited; therefore, it restricts
the management to pick out only certain projects by using capital budgeting

techniques in order to determine which project has potential to yield the most
return over an applicable period of time.
Capital budgeting is the process which enables the management to decide
which, when and where to make long-term investments. With the help of Capital
Budgeting Techniques, management decide whether to accept or reject a
particular project by making analysis of the cash flows generated by the project
over a period of time and its cost. Management decides in favor of project if the
value of cash flows generated by the project exceeds the cost of undertaking that
project.

A Capital Budgeting Decision rules likely to satisfy the following criteria:

Must give consideration to all cash flows generated by the project.

Must take into account Time Value of Money concept.

Must always lead to the correct decision when choosing among mutually
exclusive projects.

Regardless of the specific nature of an investment opportunity under


consideration, management must be concerned not only with how much cash
they are expecting to receive, but also when they expect to receive it and how
likely they are to receive it.
Evaluating the size of investment, timing; when to take that investment, and the
risk involve in taking particular investment is the essence of capital budgeting.
. CAPITAL BUDGETING OR INVESTMENT DECISION
Meaning:It is the process of making investment decision in capital expenditure. The main
characteristics of capital expenditure is that the expenditure which is incurred at one point

of time where as the benefits of the expenditure are realized at all points of time in future.
The following are some of the elements of capital expenditure.
1) Cost of acquisition or purchase in permanent assets such as land and building
plant and machinery etc.
2) Cost of addition, expansion, improvement or alteration in the fixed asset.
3) Research and development product cost etc.
Definition:According to CHARLES-T-HORANGREEN Capital budgeting is long term
planning for making and financing a proposed capital outlay.
According to RICHARD & GREENLAW Capital Budgeting is acquiring inputs
with long run return.
According to LYNCH Capital Budgeting consist in planning & development of
available capital for the purpose of maximizing the long term profitability of the
concern.
NEED & IMPORTANCE OF Capital Budgeting:1) It involves large investment of funds.
2) The large funds are invested more or less on permanent basis.
3) This decision is irreversible in nature.
4) It has long term effect on profitability.
PROCESS OF CAPITAL BUDGETING OR STEPS IN C.B.:1) Identification of investment proposal.
2) Screening the proposal.
3) Evaluation of various proposals.

4) Fixing priorities.
5) Preparation of budget.
6) Implementing proposals.
7) Performance review.
METHODS OR TECHNIQUES OF CAPITAL BUDGETING:Traditional Method:a) Pay Back period
b) Average rate of return method (ARR)
A. PAYBACK PERIOD (PBP)
The term payback period refers to the period in which the product will generate the
necessary cash to recover the initial investment.
Accept or Reject criteria:The selection of the project is based on the earning capacity of the project. A cut off
period for the project is fixed if the payback period is lower than the cut off period such
projects are accepted.
CALCULATIONS OF PAYBACK PERIOD:I.

When cash inflows are uniform.


Cash inflows = Earnings after tax but before depreciation.
Payback period = Cash outflow (original investment)
Cash inflow

MERITS OF PAYBACK PERIOD:1) It is traditional and old method


2) It involves simple calculations
3) Selection or Rejection of the project can be made easily
4) The results attain under this method are more reliable
5) It is the best method for evaluating high risky projects.
DEMERITS OF PAYBACK PERIOD:-

1) It is based on the principle of rule of thum method


2) It does not recognize the importance of time value of money
3) It does not consider the profitability and economic life of the project
4) It does not recognize the pattern of cash flows and its timings
5) Payback period concept does not reflects all the relevant dimensions of
profitability.
PROBLEMS:1) A project cost Rs. 1,00,000-00 and gives annual cash flow of Rs. 20,000-00 for 8
years. Calculate payback period.
PBP= Cash outflow = 1,00,000-00 = 5 years
Cash inflow

20,000-00

2) The project cost Rs. 5,00,000-00 gives annually a profit of Rs. 80,000-00 after
depreciation at 12% p.a. But before tax of Rs. 50%, calculate the PBP.
Calculation of cash inflow
Earnings Rs.
Before (-) tax at 50%

80,000-00
40,000-00
40,000-00

After (+) depreciation


5,00,000 x 12 =
100

60000
100000

PBP = CO = 500000 = 5 years


CI
II.

100000

When cash inflows are not uniform


PBP = 1st year + investment cumulative C.I. of 1st year
Cumulative C.I. 2nd year CCI 1st year

1) A project requires an initial cash outlay of Rs. 1,00,000-00 and generates cash inflows
as under.
Year

Cash inflows

1
2
3
4
5
6
7
8

10000
20000
25000
40000
10000
10000
10000
5000

Calculations of PBP when CI are not uniform


Cumulative cash inflows
1
2
3
4
5
6
7
8

10000
20000
25000
40000
10000
10000
10000
5000

10000
30000
55000
95000 1st year
105000 2nd year
115000
125000
130000

PBP = 1st year + investment CCI of 1st year


CCI of 2nd year CCI of 1st year
= 4 + 100000 95000
105000 95000
= 4 + 5000
10000
= 4 + 0.5 = 4.5
That means 4 years 6 months.
2) MOHAN & Co, is considering the purchase of a machine. 2 machines x and y each
costing Rs. 50,000-00 are available. Cash inflows are expected to be as under.
Calculate PBP.
Year Machine X Rs. Machine Y Rs.
1
15000
5000
2
20000
15000
3
25000
20000
4
15000
30000
5
10000
20000

Calculation of PBP
Machine X
CI
CCI
15000
15000
20000
35000
25000
60000
15000
75000
10000
85000

Year
1
2
3
4
5
PBP =

Machine Y
CI
CCI
5000
5000
15000
20000
20000
40000
30000
70000
20000
90000

1yr + Invt - CCI 1yr

1st year
2nd year

PBP = 1yr + Invt - CCI 1yr

CCI 2yr CCI 1yr


= 2 + 50000 - 35000

CCI 2yr CCI 1yr


= 3 + 50000 - 40000

60000 - 35000
= 2 + 15000

70000 - 40000
= 3 + 10000

25000
30000
= 2 + 0.6 = 2.6
= 3 + 0.33 = 3.33
2 years 7 months
3 years 4 months
Since machine X PBP is less compare to machine Y that means machine X takes 2
years and seven months to payback 50,000-00 and machine Y takes 3 years and 4
months to payback 50000-00. Therefore as finance the investment on X to be accepted
and machine Y should be rejected.
3) From the following information suggest which project should be selected.
Particulars
Cost of project
Net cash flows
1
2
3
4
5
6

Project A Project B
180000
180000
80000
64000
40000
20000
15000

40000
42000
60000
80000
32000
5000

Calculation of PBP
Year
1
2

Project A
CI
CCI
80000 80000
64000 144000 1st year

Year
1
2

Project B
CI
CCI
40000 40000
42000 82000

3
4
5
6
PBP =

40000
2000
15000

184000 2nd year


184000
204000
219000

1yr + Invt - CCI 1yr

3
4
5
6

60000
80000
32000
5000

142000
222000
254000
259000

1st year
2nd year

PBP = 1yr + Invt - CCI 1yr

CCI 2yr CCI 1yr


= 2 + 180000 - 144000

CCI 2yr CCI 1yr


= 3 + 180000 142000

184000 - 144000
= 2 + 36000

222000 - 142000
= 3 + 38000

40000
= 2 + 0.9 = 2.9
2 years 11 months

80000
= 3 + 0.475 = 3.475
3 years 6 months

According to the PBP method project A should be accepted for investment because it
takes less time (2.0) when compare to project B which takes 3.475.
4) Determine PBP for the following project which requires cash outflow of Rs. 10000/-&
generates the cash inflow of Rs. 2000/-, Rs.4000/-, Rs.3000/- & Rs. 2000/- in the 1st, 2nd,
3rd, & 4th, years respectively.
Year
1
2
3
4

Cash inflows
2,000
4,000
3,000
2,000

PBP =

CCI
2,000
6,000
9,000- 1st year
11,000-II year

1yr + Invt CCI 1yr

CCI 2yr CCI 1yr


= 3 + 10000 - 9000
17000 - 9000
= 3 + 1000
2000
= 3 + 0.5 or 3.5
3 years 6 months

5) The following information relating to the machines are available for consideration.
Advice the management which of the 2 machines is preferable.
Particulars
Cost of investment
Estimated life

Machine A
25000
7 years

Machine B
40000
9 years

Net cash benefits or profits


I year
II year
III year
IV year
V year
VI year
VII year
VIII year
IX year

3,000
4,000
5,000
6,000
7,000
7,200
7,500
7,500
7,500

2,000
5,000
6,000
7,000
8,000
12,000
13,000
13,200
13,400

Calculate PBP
Year
1
2
3
4
5
6
7
8
9
PBP =

CI
3000
4000
5000
6000
7000
7200
7500

Machine A
Year
CCI
3000
1
7000
2
12000
3
18000
4
25000 III year
5
32200
6
39700
7
39700
8
39700
9

1yr + Invt - CCI 1yr

CCI 2yr CCI 1yr


= 4 + 25000 16000
25000 - 18000
= 4+1
= 5 years

Machine B
CI
CCI
2000
2000
5000
7000
6000 13000
7000 20000
8000 28000
12000 40000
13000 53000
13200 66200
13400 79600

I year
II year

PBP = 1yr + Invt - CCI 1yr


CCI 2yr CCI 1yr
= 5 + 40000 28000
40000 - 28000
= 5+1
= 6 years

According to this method project A should be selected because if takes less time
to PB the investment compare to machine B
II AVERAGE RATE OF RETURN or ACCOUNTING RATE OF RETURN:This method takes into A/c the earnings expected from the investment over there
whole life. If is known as a/c ing rate of return.
ACCEPT OR REJECT CRITERIA:The expected return is determined & the project which has a higher rate of return
than the minimum rate of return called the cut-off rate is accepted & the project which
gives a lower expected rate of return than the minimum rate is rejected.
NOTE
Cash inflow or profit here means profit after fax & after dep
METHODS OF ARR:- or RETURN ON INVESTMENT
1) Average rate of return method :ARR= Average annual profit (after dep & after fax) x100
Net investment
a) Where average annual profit= Total profit
No. years
b) Net investment = original investment-scrap value
2) Return per unit of invt method:
RPU= Total profit (AT & D) x100
Net investment
Return on average investment method:RAI = Total profits (AT & D)
Average investment
Where a) Average investment =Total (original) investment
2
3) Average return or average investment method:Average annual profits x100
Average investment
a) Average investment = original investment-scrap value
2

b) Average investment = original investment


2
(DCF=Discounted Cash Flow)
c) Average investment = original investment scrap value + additional WC + SC
2
1) A project requires an investment of Rs. 5,00,000-00 and has a scrap value of
20,000-00 after 5 years it is expected the yield profit after depreciation and after
tax during the 5 years amounting to Rs. 40,000-00, Rs. 60,000-00, Rs. 70,000-00,
Rs. 50,000-00 and Rs. 20,000-00 respectively. Calculate ARR on investment.
I.

ARR = Annual average profit x 100


Average investment

Average Annual profit = Total profit


No. of year
= 40000+60000+70000+50000+20000 = 240000 = 48000
5

Net investment = original investment SV


= 500000 20000 = 480000
ARR = 48000 x 100 = 0.1 x 100
480000
= 10
II.

ARR = Total profit x 100 = 240000 x 100 = 50%


Net investment

III.

ARR = Total profits

480000
x 100

Average investment
T.P. = 240000
Average investment = original investment scrap value
2
= 240000 20000 = 480000 = 240000
2
= 240000 = 100%
240000

IV.

ARR = Average profit

x 100 = 480000 x 100 = 20%

Average investment

240000

2) Calculate ARR from the data given below cost of the investment Rs. 630000/-,
scrap value at the end of 5 years Rs. 30,000-00. It is expected to yield profit after
depreciation and taxes during the 5 years.
Year
Profit
I.

1
50000

2
70000

3
80000

4
60000

5
40000

ARR = Annual average profit x 100


Average investment

Where Average Annual profit = Total profit


No. of year
= 50000+70000+80000+60000+40000 = 300000 = 60000
5

Where Net investment = original investment SV


= 630000 30000 = 600000
ARR = 60000 x 100 = 10%
600000
II.

ARR = Total profit x 100 = 300000 x 100 = 50%


Net investment

III.

ARR = Total profits

600000
x 100 = 300000 x 100 = 100%

Average investment

300000

Average investment = original investment scrap value


2
= 630000 30000 = 300000
2
IV.

ARR = Average profit

x 100 = 60000 x 100 = 20%

Average investment

300000

3) Calculate ARR from the following information cost of the project 10,00,000-00,
scrap value 4,00,000-00, it is expected to generate the cash inflows as under.
Year

Profit
I.

50000

70000

80000

60000

40000

ARR = Annual average profit x 100 = 70000 x 100 = 11.66%


Average investment

600000

Average Annual profit = Total profit


No. of year
= 350000 = 70000
5
Net investment = original investment SV
= 1000000 400000 = 600000
II.

ARR = Total profit x 100 = 350000 x 100 = 58.33%


Net investment

III.

600000

ARR = Total profits

x 100 = 350000 x 100 = 116.66%

Average investment

300000

Average investment = original investment scrap value


2
= 1000000 400000 = 600000 = 300000
2
IV.

ARR = Average profit

x 100 = 70000 x 100 = 23%

Average investment

300000

4) Calculate average rate of return for projects A and B from the following
information.
Investment
Expected life

Project A
30000
5 years

Project B
40000
6 years

Projected net income after depreciation and taxes


Years
1
2
3
4
5

Project A
3000
3000
3000
2000
1000

Project B
6000
6000
5000
3000
2000

12000

1000
23000

If the required rate of return is 10% which project should be undertaken.


Project A & Project B
AP= Total Profit
No. years
1) ARR= Average of Profit x100

=1200

Net Investment

A=2400 x100

=2400

30000
=8%
B= 3833 x100

=23000

40000

=9.58%
2) ARR= Total Profit x100
Net Investment
A= 12000x100
30000
= 40%
= 23000x100
4000
= 57.5%
3) ARR= Total Profit x100

Average = Original Investment-scarp value

Average Investment
A= 12000 x100

2
= 30000

15000
=80%
B= 23000 x100

2
= 15000
= 40000

20000
=11.5%
3) ARR= Average annual Profit x100

Average investment
A= 2400 x100
15000
=16%
B= 3833 x100
20000
=19.165%
4) Calculate ARR from the following information cost of the project
1000000/-, scrap value 4.00.000/- . It is expected to generate the cash
inflows as under additional 1.00.000/year
C. I

1
50000

2
60000

3
70000

4
80000

5
90000

ARR = Annual Average Profit x100


Average investment
Where Average Profits = Total Profits
No. years
= 350000 = 70000
5
Average Investment = Original Investment Scrap value
2
= 1000000 400000
2

= 600000
2

= 300000
ARR = 70000 x100
300000
= 23.33%
ARR = Average Annual Profit

x100

Average Investment
Average Investment = Original Investment scarper value+ additional

2
= 1000000 400000 + 100000+ 400000
2
= 600000 + 500000
2
= 300000 + 500000
= 800000
ARR = 70000 x 100
800000
8.75%
MODERN OR DISCOUNTED CASH FLOW
III

NET PRESENT VALUE METHOD

[IRR] 2) Internal rate of return method


2) Profitability index
Net present value method:Net present value value means the disblw the present value of cash outflows & the
present value cash inflows occurring in the future period over the entire life of the
project.
1) The following information is available pertaining to project A
u.r. require to calculate NPV
Cost of the investment Rs. 100000/The cash inflows
1
40000

2
30000

3
50000

4
20000

The discount factors at 10% are


Year
Discount factor
at 10%
Calculation of NPV

.909

.826

0.75

0.683

Year C.I.
1
40000
2
30000
3
50000
4
20000

Discount factor at 10%


0.909
0.826
0.751
0.683

Total pre value of C.I.

1,12,350

Less: original investment

1,00,000

N.P.V.

Pre. Value of CI (AxB)


36360
24780
37550
13660

12350

A firm where cost of capital is 10% is considering to mutually exclusive project X and Y.
The details of which are
Particulars
Capital outlay
Cash inflows

-1
2
3
4
5

Project X
70000
10000
20000
30000
45000
60000

Project Y
70000
50000
40000
20000
10000
10000

Compute NPV at 10%. The present value factors are given below.
Year
P.V. 10%

1
0.909

2
0.826

3
0.751

4
0.683

5
0.621

Calculation of Net Present Value of project X & Y


Year
1
2
3
4
5

CI
10000
20000
30000
45000
60000

PV 10%
0.909
0.826
0.751
0.683
0.621

Less:

Investment
NPV

PV of CI
9090
16520
22530
30735
37260
116135
70000
45135

Year
1
2
3
4
5

CI
50000
40000
20000
10000
10000

PV 10%
0.909
0.826
0.751
0.683
0.621

Less:

Investment
NPV

PV of CI
45450
33040
15020
6830
6210
106550
70000
36550

Since the NPV of project X is greater than (45135) project Y (36550) it is advisable to
accept project X and reject project Y.

3) From the following information suggest which project should be accepted under
project A PBP

NPV project B

Particulars
Cost of project

Project A
180000

Project B
180000

Dis F
10%

Net C.I.
Year
1
2
3
4
5
6

Project A
8000
64000
40000
20000
15000

Project B
40000
42000
60000
80000
32000
5000

PV
0.564
0.909
0.826
0.751
0.683
0.621

Compute NPV of Project A and Project B


Year
1
2
3
4
5
6

CI
80000
64000
40000
20000
15000

PV 10%
0.909
0.826
0.751
0.683
0.621
0.564

Less:

Investment
NPV

PV of CI
72720
52864
30040
12420
8460
176504
180000
-3496

Year
1
2
3
4
5
6

CI
40000
42000
60000
80000
32000
5000

PV 10%
0.909
0.826
0.751
0.683
0.621
0.564

Less:

Investment
NPV

PV of CI
36360
34692
45060
54640
19872
2820
193444
180000
13444

Calculation of PBP
Year
1
2
3
4
5
6
PBP =

CI
80000
64000
40000
20000
15000

Project A
CCI
80000
144000 I year
184000 II year
184000
204000
219000

1yr + Invt - CCI 1yr

Year
1
2
3
4
5
6

Project B
CI
CCI
40000 40000
42000 82000
60000 142000
80000 222000
32000 254000
5000 259000

PBP = 1yr + Invt - CCI 1yr

I year
II year

CCI 2yr CCI 1yr


= 2 + 180000 - 144000

CCI 2yr CCI 1yr


= 3 + 180000 - 142000

184000 - 144000
= 2 + 36000

222000 - 142000
= 3 + 38000

40000
= 2 + 0.9 = 2.9
2 years 11 months

80000
= 3 + 0.475 = 3.48
3 years 6 months

4) From the following information calculate NPV.


Particulars
Investment
Life of the project

Project X
20000
5 years

Project Y
30000
5 years

Cash inflows:
Project X
Project Y

1
5000
20000

2
10000
10000

3
10000
5000

4
3000
3000

5
2000
2000

Discount factor 10% should be taken


Present value at the rate of PV = (1/1+r)n
Here the discount factors are not provided therefore below calculation is advisable to
calculate discount factor.
I-year = (1/1+r)n = (1/1+10)1 = 0.909
II-year = (1/1+10)2 = 0.909 x 0.909 = 0.826
III-year = (1/1+10)3 = 0.826 x 0.909 = 0.751
IV-year = (1/1+10)4 = 0.751 x 0.909 = 0.683
V-year = (1/1+10)5 = 0.683 x 0.909 = 0.621
Calculation of NPV
Year
1
2
3
4
5

Project X
CI
PV 10%
5000
0.909
10000
0.826
10000
0.751
3000
0.683
2000
0.621
Less:

Investment

PV of CI
4545
8260
7510
2049
1242
23606
20000

Year
1
2
3
4
5

CI
20000
10000
5000
3000
2000
Less:

Project Y
PV 10%
0.909
0.826
0.751
0.683
0.621
Investment

PV of CI
18180
8260
3755
2049
1242
33486
30000

NPV

3606

NPV

3486

5) Raja Ltd. wants to replace its existing plant. It has 3 proposals 1,2,3. The plants under
the 3 proposals are expected to cost Rs. 2,50,000-00 each and has an estimated life of
5 years, 4 years and 3 years respectively. The companies required rate of return is
10%. The anticipated net cash inflows after taxes for the 3 plants are as follows.
Years
1
2
3
4
5

Plant 1
80000
60000
60000
60000
180000

Plant 2
110000
90000
85000
35000
-

Plant 3
130000
110000
20000
-

Which of the above proposals would you recommend to the management for acceptance?
Use NPV technique for evaluation. The present value of Re.1 at 10% for each of the 5
years is given below.
Capital Budgeting Tools
Payback Period
Accounting Rate of Return
Net Present Value
Internal Rate of Return
Profitability Index

Payback Period
Payback period is the time duration required to recoup the investment committed
to a project. Business enterprises following payback period use "stipulated
payback period", which acts as a standard for screening the project.

Management ScienceComputation of Payback Period


When the cash inflows are uniform the formula for payback period is cash outflow
divided by annual cash inflow
Computation of Payback Period
When the cash inflows are uneven, the cumulative cash inflows are to be
arrived at and then the payback period has to be calculated through
interpolation.
Here payback period is the time when cumulative cash inflows are equal to the
outflows. i.e.,
Payback Reciprocal Rate
The payback period is stated in terms of years. This can be stated in terms of
percentage also. This is the payback reciprocal rate.
Reciprocal of payback period = [1/payback period] x 100
Management Science-II
Indian Institute of Technology
Decision Rules
A. Capital Rationing Situation
Select the projects which have payback periods lower than or
equivalent to the stipulated payback period.
Arrange these selected projects in increasing order of their
respective payback periods.
Select those projects from the top of the list till the capital
Budget is exhausted.

Decision Rules
C. Mutually Exclusive Projects
In the case of two mutually exclusive projects, the one with a lower payback
period is accepted, when the respective payback periods are less than or
equivalent to the stipulated payback period.

Determination Of Stipulated Payback Period

Stipulated payback period, broadly, depends on the nature of the


business/industry with respect to the product, technology used and speed
at which technological changes occur, rate of product obsolescence etc.

Stipulated payback period is, thus, determined by the management's


capacity to evaluate the environment vis--vis the enterprise's products,
markets and distribution channels and identify the ideal-business design
and specify the time target.

Management Science-II of Technology Madras

Advantages Of Payback Period

It is easy to understand and apply. The concept of recovery is familiar to


every decision-maker.

Business enterprises facing uncertainty - both of product and technology


- will benefit by the use of payback period method since the stress in this
technique is on early recovery of investment. So enterprises facing
technological obsolescence and product obsolescence - as in
electronics/computer industry - prefer payback period method.

Liquidity requirement requires earlier cash flows. Hence, enterprises


having high liquidity requirement prefer this tool since it involves minimal
waiting time for recovery of cash outflows as the emphasis is on early
recoupment of investment.

Disadvantages Of Payback Period


The time value of money is ignored. For example, in the case of project
A Rs.500 received at the end of 2nd and 3rd years are given same weight age.
Broadly a rupee received in the first year and during any other year within the
payback period is given same weight. But it is common knowledge that a rupee
received today has higher value than a rupee to be received in future.
But this drawback can be set right by using the discounted payback period
method. The discounted payback period method looks at recovery of initial
investment after considering the time value of inflows.
Another important drawback of the payback period method is that it ignores the
cash inflows received beyond the payback period. In its emphasis on early
recovery, it often rejects projects offering higher total cash inflow.

Disadvantages of Payback Period (Cont...)

Investment decision is essentially concerned with a comparison of rate of return


promised by a project with the cost of acquiring funds required by that project.
Payback period is essentially a time concept; it does not consider the rate of
return.
Example
There ARE TWO PROJECTS (Project A AND B) AVAILABLE FOR A COMPANY,
WITH A LIFE OF 6 YEARS EACH AND REQUIRING A CAPITAL OUTLAY OF
Rs.9,000/- EACH; AND ADDITIONAL WORKING CAPITAL OF Rs.1000/- EACH.
The cash inflows comprise of profit after tax + Depreciation + INTEREST (Tax
adjusted) for five years and salvage value of Rs.500/- for each project plus
working capital released in the 6th year. This company has prescribed a hurdle
payback period of 3 years. Which of the two projects should be selected?
Indian Institute of Technology
Example Data

Project A

Project B

Investment

10,000

10,000

Cash inflow

6-years

6-years

Year -1

3,000

2,000

Year -2

3,500

2,500

Year -3

3,500

2,500

Year -4

1,500

2,500

Year -5

1,500

3,000

Year -6

3,000

5,500

Payback period

16,000
3 years

18,000
4 years & 2 months

Example
Project A

Cumulative

Project B

Cumulative

cash inflows

cash inflows

of Project A

of Project B

Year -1

3,000

3,000

2,000

2,000

Year -2

3,500

6,500

2,500

4,500

Year -3

3,500

10,000

2,500

7,000

Year -4

1,500

11,000

2,500

9,500

Year -5

1,500

13,000

3,000

12,500

Year -6

3,000

16,000

5,500

18,000

Example
Payback period for Project A = 3 years (cumulative cash inflows = outflows)
Payback period for Project B = 4 years + 500/3000 = 4 years and 2 months.
(Note: Interpolation technique is used here to identify the exact period at which
cumulative cash inflows will be equal to outflows. The amount required to equate
is Rs.500, while the returns from the 5th year is 3,000. Hence the addition time
duration required to compute the payback period is (500/3000) x 12 which is 2

months. The interpolation technique is used based on the assumption that cash
inflows accrue uniformly throughout the year.)
Management Science-II Pro
The investment decision will be to choose Project A with a payback period of 3
years and reject Project B with a payback period of 4 years and 2 months.
Accounting Rate Of Return
Accounting rate of return is the rate arrived at by expressing the average annual
net profit (after tax) as given in the income statement as a percentage of the total
investment or average investment. The accounting rate of return is based on
accounting profits. Accounting profits are different from the cash flows from a
project and hence, in many instances, accounting rate of return might not be
used as a project evaluation decision. Accounting rate of return does find a place
in business decision making when the returns expected are accounting profits
and not merely the cash flows
Computation Of Accounting Rate Of Return
The accounting rate of return using total investment.
or
Sometimes average rate of return is calculated by using the following
formula:
Where average investment = total investment divided ment Science-II
Indian Institute of
Decision Rules
A. Capital Rationing Situation
Select the projects whose rates of return are higher than the cut-off rate
Arrange them in the declining order of their rate of return and
Select projects starting from the top of the list till the capital available
is exhausted.

B. No Capital Rationing Situation


Select all projects whose rate of return are higher than the cut-off rate.
C. Mutually Exclusive Projects
Select the one that offers highest rate of return.
Accounting Rate Of Return Advantages
It Is Easy To Calculate.
The Percentage Return Is More Familiar To The Executives.
Accounting Rate Of Return Disadvantages
The definition of cash inflows is erroneous; it takes into account profit after tax
only. It, therefore, fails to present the true return.
Definition of investment is ambiguous and fluctuating. The decision could be
biased towards a specific project, could use average investment to double the
rate of return and thereby multiply the chances of its acceptances.
Management Science-II Prof
Time value of money is not considered here.
Example
There are two projects (Project A and B) available for a business enterprise,
with a life of 6 years each and requiring a capital outlay of Rs.9,000/- each and
additional working capital of Rs.1000/ each. The cash inflows comprise of profit
after tax + depreciation + interest (Tax adjusted) for five years and salvage value
of Rs.500/- for each project at year 6 plus working capital released also in the 6th
year.

The Profit (after tax) component of the cash inflows for each project are given in
the next slide.
Example
Net Profit After Tax

Year
1

Project A
1,580

Project B
280

2
3
4
5
6
Total Net Profit After Tax
Average Annual Net

2,080
2,080
80
80
80
5,980
5,980/6=996.6

1,080
1,080
1,080
2,580
1,880
7,980
7,980/6=1330

Profit
-II

Example
Taking into account the working capital released in the 6th year and salvage
value of the investment, the total investment will be (10,000-1,500) Rs.8500 and
the average investment will be (8500/2) Rs.4250 for each project.
The rate of return calculations are:
Net profit after tax as a percentage of total investment

Project A

Project B

1130 X 100 = 15.6%


8500

The investment decision will be to select Project B since its rate of return is
higher than that of Project A if they are mutually exclusive. If they are
independent projects both can be accepted if the minimum required rate of return
is 11.7% or less.
Management Science-II Prof
Net Present Value (Npv)
Net present value of an investment/project is the difference between present
value of cash inflows and cash outflows. The present values of cash flows are
obtained at a discount rate equivalent to the cost of capital.
Computation Of Net Present Value (Npv)
When the cash outflow is required for only one year i.e., in the present year,
then the Net present value is calculated as follows:
"I" is the initial investment (cash outflow) required by the project

Decision Rules
A. "Capital Rationing" situation
Select projects whose NPV is positive or equivalent to zero.

Arrange in the descending order of NPVs.


Select Projects starting from the list till the capital budget allows.

B. "No capital Rationing" Situation


Select every project whose NPV >= 0
C. Mutually Exclusive Projects
Select the one with a higher NPV.
Net Present Value (Npv) Example
Assuming that the cost of capital is 6% for a project involving a lumpsum cash
outflow of Rs.8,200 and cash inflow of Rs.2,000 per annum for 5 years, the Net
Present Value calculations are as follows:
a) Present value of cash outflows Rs.8200Management Science-II Prof.
b) Present value of cash inflows
Present value of an annuity of Rs.1 at 6% for 5 years=4.212
= Rs.8424
) Net present value = present value of cash inflows - present value of cash
Since the net present value of the project is positive (Rs.224), the
he internal rate of return method is also known as the yield method.

Internal Rate Of Return (Irr) Example


The IRR can be restated as the rate of discount, at which the present value

project corresponds to a discount rest factor of 4.100 indicates that the present
value of one Rupee annuity for 5 years at 7%
2000 = 8200.
ue

Trial And Error Method:


Through the trial and error method, we
(2000 x 3.7908) - 8200 = 7581.6 - 8200 = -618.4.
arrive at a positive NPV. H
(2000 x 4.3295) - 8200 = 8659 - 8200 = 459.
Now, we have to interpolate the IRR which lies positive and negative NPV i.e.,
the discount rate
NPV.
The IRR rule will be 5% +[(618.4/1077.4) x 5%] = 5% + 2% = 7%.
Management Science-II

Profitability Index (Pi)


Profitability ratio is otherwise referred to as Benefit / Cost ratio. This is an
extention of Net Present valueMethod. This is a relative valuation index and
hence is comparable
across different types of projects requiring different quantum of initial
investments.
Profitability Index (PI) is the ratio of cash inflows to the present value of cash
outflows. The present value of cash flows are obtained at a discount rate
equivalent to the cost of capital.

PI = Present Value of Cash inflows


Present Value of Cash outflows

LEVERAGES

Defining Financial Leverage


Financial leverage can be defined as the degree to which a company uses fixedincome securities, such as debt and preferred equity. With a high degree of
financial leverage come high interest payments. As a result, the bottomline
earnings per share is negatively affected by interest payments. As interest
payments increase as a result of increased financial leverage, EPS is driven
lower.
As mentioned previously, financial risk is the risk to the stockholders that is
caused by an increase in debt and preferred equities in a company's capital
structure. As a company increases debt and preferred equities, interest payments
increase, reducing EPS. As a result, risk to stockholder return is increased. A
company should keep its optimal capital structure in mind when making financing
decisions to ensure any increases in debt and preferred equity increase the value
of the company.
Degree of Financial Leverage
This measures the percentage change in earnings per share over the percentage
change in EBIT. This is known as "degree of financial leverage" (DFL). It is the

measure of the sensitivity of EPS to changes in EBIT as a result of changes in


debt.
Formula

DFL = percentage change in EPS or EBIT


percentage change in EBIT EBIT-interest

A shortcut to keep in mind with DFL is that, if interest is 0, then the DLF will be
equal to 1.
Example: Degree of Financial Leverage
With Newco's current production, its sales are $7 million annually. The company's
variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The
company's annual interest expense amounts to $100,000 annually. If we increase
Newco's EBIT by 20%, how much will the company's EPS increase?

Answer:
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000$100,000)
DFL = $1,800,000/$1,700,000 = 1.058
Given the company's 20% increase in EBIT, the DFL indicates EPS will increase
21.2%.

Financial and Operating Leverage

Introduction
The capital budgeting of a firm, it has to decide the way in which the capital
projects will be financed. Every time the firm makes an investment decision, it is
the same time making a financing decision also. For example, a decision to build
a new plant or to buy a new machine implies specific way of financing that
project. Should a firm employ equity or debt or credit? What are implies of the
debt-equity mix? What is an appropriate mix of debt and equity?

Capital Structure Defined


The assets of a company can be financed either by increasing the owners' claims
or the creditors claims. The owners' claims increase when the firm raises funds
by issuing ordinary shares or by retaining the earnings; the creditors' claims
increase by borrowing. The various means of financing represent the financial
structure of an enterprise. The left-hand side of the balance sheet represents the
financial structure of a company. Traditionally, short-term borrowings are
excluded from the list of methods of financing the firms capital expenditure, and
therefore, the long-term claims are said to from the capital structure of the
enterprise. The term capital structure is used to represent the proportionate
relationship between debt and equity. Equity includes paid up share capital,
share premium and reserves and surplus.

The financing or capital structure decisions is a significant managerial decision. It


influences the shareholder's return and risk. Consequently, the market value of

the share may be affected by the capital structure initially at the time of its
promotion. Subsequently, whenever funds have to be raised to finance
investments, a capital structure decision is involved. A demand for raising funds
generates a new capital structure since a decision has to be made as to the
quantity and forms of financing. This decision will involve an analysis of the
existing capital structure and the factors, which will govern the decision at
present. The dividend decision, is, in a way, a financing decision. The company's
policy to retain or distribute earnings affects the owners' claims. Shareholders'
equity position is strengthened by retention of earnings. Thus, the dividend
decision has a financing decision of the company may affect its debt-equity mix.
The debt-equity mix has implications for the shareholders' earnings and risk,
which in turn, will affect the cost of capital and the market value of the firm.

The management of a company should seek answers to the following questions


while making the financing decision:

How should the investment project be financed?

Does the way in which the investment projects are financed matters?

How does financing affect the shareholders' risk, return and value?

Does there exist an optimum financing mix in terms of the maximum value
of the firms shareholders?

Can be optimum financing mix be determined in practice for a company?

What fact ores in practice should a company consider in designing its


financing policy

Working Capital Management

Cash and Marketable Securities Management

Are the most liquid of a firms assets


Cash consists of currency and deposits in checking accounts
Marketable securities consist of S-T investments made with idle cash
Investing Idle Cash: The Money Market
The securities normally used for temporary investments are usually purchased in
the money market where short-term, high quality, marketable securities are
traded. When cash needs are known, securities of specific short-term maturity
may be selected. If cash is needed, money market securities may be sold
quickly, and because there is little price variability if market interest rates change,
the cost of selling the securities is kept at a minimum. One choice of short-term is
Treasury bills, which mature less than 6 months and are the safest money market
securities.
Another choice is high quality investment is commercial paper, the short-term
notes (maturities usually less than 270 days) issued by industrial and financial
corporations. Certificates of deposits (CDs) are short-term notes issued by
commercial banks. Repurchase agreements (repos), the purchase of securities
under agreement to resell (at a higher price) are issued by commercial banks
when the checking account of the business is higher than desired. The money
stays in the bank and the business has a temporary earning investment.
Reasons for Holding Cash and Marketable Securities:
Transactions: Firms use cash to make transactions (pay bills) until they receive
cash from customers.
Precautionary: firms hold cash as a precaution to meet any unexpected demand
for cash.
Future requirements: firms hold cash to meet future planned needs (eg. capital

expenditure, tax payments, dividend payments, loan payments)


Speculative: firms hold cash to be more flexible ion case any good investment
opportunity comes up.
Optimal Cash and Marketable Securities Balance:
Weight the benefits and costs of holding various balances:
Holding cash and marketable Securities incur an opportunity cost. The cash
in the bank earn very low rate of return. The firm could have earn higher return
by investing this cash in the firms operation.
Running short of cash and marketable Securities also incurs shortage
costs:

Foregone cash discounts: Suppliers frequently offer trade discounts for


paying
bills early. From a financing standpoint, the cost of not taking these discounts is
very high, so firms should always have enough cash on hand to take advantage
of
them.
Deterioration of the firms credit rating: Credit rating take into account the
level of liquid assets in the firm (quick ratio and current ratio). An adequate
supply of cash helps keep the firms current and quick ratios high enough to
maintain a good credit rating.
High interest expense: if the firm is not able to pay bills on time, it will have to
pay high financing charges.

Possible financial insolvency: Bankruptcy


Collection and Disbursement of Cash
Managers always try to speed up the collection of cash from customers and to
slow down the
disbursements of cash to supplies and other parties.
Accounts Receivable Management
Credit Policy
Credit standards
Criteria used to screen credit applications: Evaluation of Credit
Applications.
Gathering information: financial statements, credit reports, banks, prior
experience.
Numerical scoring system (Altman Z score), see p. 547.
Five Cs of credit
Character : assess customer willingness to meet credit Terms
Capacity : customers liquidity position
Capital: customers financial strength and net worth
Collateral: customers assets than can be used as collateral
Conditions: the general conditions in the economy.

Controls the quality of accounts: quality of account means how long the
customer takes to repay the credit granted and the probability of default. The
probability of default is measured by the bad-debt loss ratio which is the
proportion of account receivable that is uncollected.
Credit should be extended if the expected profit from the credit sale is
greater than the expected profit from refusing credit. If paid as agreed, the
profit margin will be realized on the sale; if payment is not received, the firm loses
the cost of sales. Refusing credit makes no profit
Credit terms : Conditions under which credit extended must be repaid
Credit period :Time allowed for payment
Cash discount: allowed if payment is made within a specific period of time. It
specified as % of the invoiced amount. For example: credit terms of (2/10, net
30) mean that customer can deduct 2% of the invoice amount if payment is made
within 10 days from the invoice date. If payment is not made within the 10 days,
then full invoice amount is due in 30 days from invoice days. Cash discount is
used to speedup the collection of account receivable.
Collection efforts: Methods employed in an attempt to collect payment on past
due
Accounts
Balance between leniency and alienating customers
Sending notices
Telephoning
Collection agency
Legal action

Monitoring status: perform aging of accounts analysis. An aging


schedule is a report that actually breaks down a firms receivables by age

Inventory Management
Types of Inventory
Raw materials inventory
Stores of items used in production
Quantity discounts: by large quantity to get discount on price
Assure supply in times of scarcity
Work-in-process inventory
Items at some intermediate state of completion
Size related to length and complexity of production cycle
Finished goods inventory
Items ready and available for sale
Permits prompt filling of orders
Costs Associated with an Inventory Policy
Ordering costs: Costs of placing and receiving an order of goods, including
inspecting shipments, handling payment, follow up calls and letters.

Carrying costs: Costs of holding inventory for a given period of time, including
storage and handling cost, obsolescence and deterioration cost, and opportunity
cost of funds invested in inventory.
Stockout costs: Incurred when a firm is unable to fill an order, including losing
sales and the extra cost of placing special orders or work overtime to produce the
needed product.
Just-in-time inventory (JIT): The firm does not carry inventory. Once the order
is received from customers, the order for raw material is placed with the supplier
and the product is manufactured. JIT method is used to reduce inventory cost by
supplying Inventory at exactly the right time and in exactly the right quantities.
Example, Dell Computer Co.

Working capital: INTRODUCTION


Working capital in ordinary parlance is taken to be the fund available for
meeting the day-to-day requirements of an enterprise. A part of the fixed or
permanent capital is invested in Assets, which are kept in the business presently
or for a long period, for the purpose of earning profit. These are know as the fixed
assets viz, Land and Building, Plant and Machinery, Furniture and Fixtures and
intangible assets like Good will, Patent and Trade marks Another part of the
permanent capital left in the business for supporting day to day normal
operations is called working capital. They generates important elements of cost
namely, material wages and expenses. This cost usually leads to production and
sales in case of manufacturing concerns and sales in case of others.

One of his distinguish factors of fund employed in working capital is that


it constantly changes it is from to drive the Business Wheel. It is also know as
circulating capital which means current assets of the company that is changed
in the ordinary course of the business from one form to another. Further
continuous flow of cash to inventories, inventories to receivables and receivables
to cash is called operating cycle.

Working capital typically means the firms holding of current or short-term


assets such as cash, receivables, inventory and marketable securities. These
items are also referred to as circulating capital corporate executives devote a
considerable amount of attention to the management of working capital.

Definition of Working Capital:


Working Capital refers to that part of the firms capital, which is required
for financing short-term or current assets such a cash marketable
securities, debtors and inventories. Funds thus, invested in current assets
keep revolving fast and are constantly converted into cash and this cash
flow out again in exchange for other current assets. Working Capital is
also known as revolving or circulating capital or short-term capital.
Current assets of a company that are changed in the ordinary course of
business from one from to another, as for example, from cash to
inventories, inventories to receivable, receivables into cash.

Concept of working capital:


There are two possible interpretations of working capital concept

Balance sheet concept

Operating cycle concept

Balance sheet concept:


There are two interpretations of working capital under the balance sheet concept.
a. Excess of current assets over current liabilities
b. Gross or total current assets.
Excess of current assets over current liabilities is called the net working
capital or net current assets. Working capital is really what a part of long term
finance is locked in and used for supporting current activities.
The balance sheet definition of working capital is meaningful only as an
indication of the firms current solvency in repaying its creditors. When firms
speak of shortage of working capital they in fact possibly imply scarcity of cash
resources. In fund flow analysis and increase in working capital, as
conventionally defined, represents employment or application of funds.
Operating cycle concept:
A companys operating cycle typically consists of three primary activities:

Purchasing resources

Producing the product and

Distributing (selling) the product.

These activities create funds flows that are both unsynchronized and uncertain.
Unsynchronized because cash disbursements (for example, payments for
resource purchases) usually take place before cash receipts (for example

collection of receivables). They are uncertain because future sales and costs,
which generate the respective receipts and disbursements, cannot be forecasted
with complete accuracy.

Diagrammatic Representation of operating


cycle

CASH

DEBTORS

INVENTORIES

Circulating nature of Current Assets


Principles of Working Capital Theory
Principle 1: PRINCIPLE OF RISK VARIATION
If the working capital is varied relative to fixed asset investment (also sales)
the amount of risks that a firm assumes is also varied and the opportunity for a
gain or loss is increased i.e., the more the risk assumed, and grater is
opportunity for gain or loss. In order that there should be maintained for the firm.

Holding the fixed assets constant varying the current assets bring about such
trade off. Current assets tend to fluctuate with output.
This relationship between the current assets and output levels is shown in the
figure given bellows:

ASSET
LEVEL

FIXED ASSETS

CURRENT ASSETS

25000

50000

OUTPUT (IN UNITS)

There are mainly three approaches to working capital management viz.


conservative approach and matching or hedging approach and aggressive
approach.
CONSERVATIVE APPROCH

In case of conservative approach, the ratio of current assets to fixed is


greater at every level of output, the firms level of liquidity is greatest and risk of
technical insolvency is lowest. But the profitability of the firm will be lower, on
account of increased cost of maintaining high liquidity. The firm finances its fixed
assets and permanent current assets and a part of temporary current assets are
financed. This is shown in the figure given below.

TIME
Sources: financial management I.M.Pandey

AGGRESSIVE APPROCH
In this case the profitability will be higher but the firm has lowest and
correspondingly the greatest risk. Therefore it should be the goal of the
management to select the level of current assets that optimizes the firms rate of
return.

In aggressive approach the firm losses more of short term financing. Under
this approach the firm finances its temporary current assets and also a part of
performance current assets through short-term sources. Some extremely
aggressive firms may even finance a part of their fixed assets with short term.
The relatively higher use of short term financing makes the firm more risky. This
is illustrated in the fig given below
TEMPORARY CURRENT ASSETS

TIME
Sources: Financial Management I.M.Panday

MATCHING OR HEDGING APPROACH


The expected life of the assets is matched with the life of the sources of
funds raised to finance them. Under this approach therefore the long term
financing will be based to finance fixed assets and permanent current assets.

And short term finance for temporary current assets. The term hedging refers the
process of matching the maturities of debts with maturity of financial needs.

TEMPORARY CURRENT ASETS

TIME
Sources: Financial Management I.M.Panday

PRINCIPLE: 2
PRINCIPLE OF COST OF CAPITAL
Capital should be invested in each component of working capital as long as
the equity position of the firm increases. This principle is based on the concept

that each rupee invested in fixed or working capital should contributed to the net
worth of the firm.
PRINCIPLE: 3
PRINCIPLE OF EQUITY POSITION
The type of capital used to finance working capital directly affects the amount
of risks that a firm assumes as well as the opportunities for gain or loss and cost
of capital. There are two approaches of financing, which a firm can adopt viz. the
hedging approach and margin of safety approach.
Margin of safety approach
Involves financing a portion of the firm expected seasonal funds
requirement on long-term basis as illustrated below.
Margin of safety approach

Sources: khan and Jain

Thus in this approach the firm reduces the risk of fund availability

Thus in this approach the firm reduces the risk of fund availability by
employing long term funds to finance a portion of the seasonal
requirements, but the profitability is also reduced on account of higher cost

associated with existences of idle funds (long-term) in terms of seasonal


through.
Ultimately the company should select an approach depending up on the
nature of business, economic condition; cost of capital etc. There is even the
possibility of shifting from one approach to another in the course of business.
PRINCIPLE: 4
PRINCIPLE OF MATURITY OF PAYMENT
The greater the disparity between the maturity of firms short-term debt
instruments and its flow of internally generated the greater the risk. Thus shorter
the maturity schedule of the debt, the greater is the risk that firm will be unable to
pay the debt and longer the maturity schedule of debt in relation of expected
cash flow, lesser the risk of inability to pay the debt. On the whole management
has to determine the liquidity of the firm on the basis of information about the risk
and opportunity cost holding liquidity. Management must behave in a manner
consistent with the maximization of shareholders net worth.
CONCEPTS OF WORKING CAPITAL
There are two types of working capital
1. Gross working capital.
2. Net working capital.

1. GROSS WORKING CAPITAL


The gross working capital or simply working capital refers to the firm total
investment in the current assets. This concept has broad application and takes
dividend and accounts the total current resources of the enterprises from
whatever sources derived and their application to the activities, both current and
future of enterprises.

2. NET WORKING CAPITAL


Net working capital refers to the difference between current assets and
current liabilities.Net working capital may be positive or negative. A positive net
working capital will arise when current asset exceeds current liability. A negative
Net working capital arises when current liabilities are exceeds current assets.
The two concepts of working capital have equal singnificance.The Gross
working capital is quantitative in character.
1. Permanent working capital
2. Temporary or variable working capital
1. Permanent working capital
This refers to the minimum amount of investments in all current assets
which is required at all times to carry out minimum level of business activities.
In other words, represent current assets required on a continuing basis over
the entire year.Tandon committee has referred to these types of working capital
as Core Current Assets.
Permanent working capital grows with the size of the business. In other words,
greater the size of the business, greater is the amount of such working capital
and vice versa. Permanent working capital is permanently needed for the
business and therefore it should be financed out of long-term funds.

The Permanent working capital is again sub divided into:


Regular Working Capital and
Reserve margin

Regular Working Capital is that part of capital, which is used, in regular


business for the purpose of manufacturing and purchase of raw materials etc.
Reserve margin is the excess over the need for regular working capital that
should be provided for contingencies that may arise at unstated periods. The
contingencies includes
1. Raising Prices
2. Business depressions
3. Strikes, fires and unexpected competition
4. Special operations
2. Temporary or Variable Working Capital
The amount of working capital keeps on fluctuating from time to time on
the basis of business activities. it represents the additional current assets
required at different times during the operating year.
Supplier of temporary working capital can expect its return during the offseason when the firm does not require it. Hence temporary working capital is
generally financed from short-term sources of finances, such as Bank credit. it
changes with volume of business. It may be sub divided into.
1. Seasonal working capital
2. Special working capital

In many lines at business (e.g., sugar and fur industry) operation are highly
seasonal and as a result working capital requirements vary greatly during the
year. The capital required to meet the seasonal needs of industry is termed as
seasonal working capital on Other hand special working capital, is that part of the
variable working capital is required for financing special operations, such as

Inauguration of extensive marketing experiments with new products or with new


methods of distribution carrying out special jobs and similar to the operations that
are outside the usual business of buying fabricating and selling.
WORKING CAPITAL CYCLE
Working capital required because of time gap between sales and their
actual realization in cash. The time gap is technically termed as Operating
Cycle of the business. During this time, certain, expenses are to be met such
as payment for few materials, cost of storing and protecting raw-material
semi-finished and finished goods held in inventory and various production
expenses. Hence a firm needs working capital until such time as goods as
produced, sold and cash is realized. And as this type of operating cycle
repeats it self the firm should continuously maintain certain level of working
capital and this involves the management of working capital.
The amount of working capital differs from time to time and from business
to business depending upon the operating cycle in each case. The shorter the
operating cycles the quicker in the realization of sales and hence lesser
amount of working capital needed. The typical operating cycle of
manufacturing or trading firms and a services or financial firm is showing
below.

1. Operating Cycle of a Manufacturing Firm

Conversion of Raw materials into work in progress


Conversion of work in progress into Finished goods
Conversion of Finished goods into Sales
Conversion of Sales into Debtors
Conversion of Debtors into Cash
2. Operating Cycle of a Trading Firms

3. Operating Cycle of a Services or Financial Firm


Cash -------------------- Debtors
i.e., operating cycle includes the length of the time taken to
1. Conversion of Cash into Debtors and
2. Conversion of Debtors into Cash
DETERMINANTS OF WORKING CAPITAL
There are no set rules or formulate to determine the working capital
requirements of the firm. A large number of factors the needs of the firms are
as follows.
Nature and size of the Business
Manufacturing Cycle

Seasonality of operations
Firms Credit Policy
Production Policy
Availability of Credit
Price Level Changes
Dividend Policy
Distribution Policy
Growth and Expansion Activities
Length of operation Cycle
Operating Efficiency
Proportion of Fixed Assets to Total Assets
Introduction of New Products
Hazards and Contingencies inherent in a Particular type of Business
Explanation for the some of the above factors is as follows:
1. Nature and size of the Business
A firm which sells predominantly on cash basis has modest working
capital, while the manufacturing concern like machine tools unit, which sells
largely on credit, has very substantial working capital management.
2. Seasonality of operations
In case of firm manufacturing ceiling fans, working capital needs increases
considerably during the summer months and decreases during the winter period.
3. Production Policy
In the case of manufacturers of ceiling fans are the pronounced seasonal
fluctuations in its sales. They maintain a steady production through out the year
rather than intensifying the production policy during the peak business season.
4. Credit Policy
If the concern has a strict credit policy then the working capital need will be low
and if the credit terms are liberal then working capital need will be high.
5. Availability of credit:-

If the credit is available at generous term working capital need will be low and
if the terms are not generous then working capital will be high.

Proportion of Fixed Assets and Current Assets:Industries


Hotel and Restaurant
Electricity and Distribution
Shipping
Iron and Steel
Tea Plantation
Sugar Industries
Tobacco Industries
Construction Company

Sources of working capital


Financing of Current Assets

Current Assets[%]
10-20
20-30
30-40
40-50
50-60
60-70
70-80
80-90

Fixed Assets[%]
80-90
70-80
60-70
50-60
40-50
30-40
20-30
10-20

On the basis of ownership of funds, the sources of working capital may be


brought under two groups.
Internal sources
1. Retained Earnings
2. Deprecation
External sources
1. Shares
2. Debentures
3. Loans
4. Deposits
5. Trade creditors etc
On the basis of their terms of repayment they can be classified as
Long Term Financing and
Short Term Financing
Regulations of Bank Finance for Working Capital
Regulations of Bank Finance for Working Capital in India have been shaped
significantly by the important finding and recommendations of the following
committees namely;
1. Tandon committee in 1974
2. Chore committee in 1979
3. Marathe committee in 1982

SOURCES OF FINANCE
INTRODUCTION:
Finance is essential for all organisations in order to carryout its activities and to achieve the target
of the enterprise.The business cannot run without adequate finance,that is why finance is called
"lifeblood of business".

MEANING:
It means the agencies or services from which the funds are obtained or collected .it includes
method of raising finance and period for which funds are required.
The financial requirements can be classified into two groups.
1.Fixed capital /longterm financial requirements:This capital is required to meet the capital
expenditure

for

purchase

of

fixed

assets

such

as

land&building,plant&machinery,furniture&fixture....etc.
2.Working capital/short term financial requirement :This capital is required to meet day to day
expences such as purchase of materials ,payment of salaries&wages...etc.

CLASSIFICATION OF SOURCES OF FINANCE:


1.On the basis of period:

a)Long term sources:more than one year eg:-equity and preference shares,debentures,retained
earnings,long term loans...etc.
b)Short term sources:minimum one year eg:-public deposit,trade credit,short term loans etc....
2.On the basis of ownership:
a)Own capital:eg :-share capital,reserves and surplus,retained earnings...etc
b)Borrowed capital:eg:-debenture ,public deposits,loans ...etc
3.On the basis of sources ofgenerations:
a).Internal source:eg:-retained earnings, depreciation....etc
b)External source:eg:-shares,debentures,loans ...etc.
However the most popular form to classify sources of finance is as follows:

SHORT TERM
MEDIUM TERM
LONG TERM
1.Indegeneous

bankers

1.issue

of

debentures

1.issue of shares
2.customers advaces

2.issue of preference shares

2.ploughingback of profits
3.trade credit

3.bank loans

3.loans from special fin.institutions


4.bank credit

4.public deposits

5.factoring

5.fixed deposits

6.accruals

6.loans from fin. institutions

7.deferred incomes

7.instalment credit

notes prepared by;


Mujeeb khan
Asstt.professor
REFERENCE;
1.FINANCIAL MANAGEMENT-SHARMA&GUPTA
2.FINANCIAL MANAGEMENT-KHAN&JAIN
3.FINANCIAL MANAGEMENT-I.M.PANDEY
4.FINANCIAL MANAGEMENT-Dr.SATYAPRASAD

gfgc-n.r.pura