Financial Management

FINANCIAL
MANAGEMENT
Semester Two
Ms. Sarika
PREFACE
Financial Management study material has been designed to meet the requirements of
MFC students. This study material provides technical instruction with illustrative
examples and exercises.
This study material seeks to:

Build understanding of the central ideas and theories of modern finance.
Develop familiarity with the analytical techniques helpful in financial decision making.
Furnish institutional material relevant for understanding the environment in which
financial decisions are taken.
Discuss the practice of financial management.
The primary thrust of the book is to show how financial theory can be applied to solve
real and day-to-day problems. An attempt has been made to relate theory to practice.
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INDEX Page no.
1. Financial Management 4
2. Time Value of Money 12
3. Cost of Capital 23
4. Leverage 32
5. Capital Structure 40
6. Capital Budgeting 49
7. Risk Analysis in Capital Budgeting 72
8. Working capital Management 82
9. Cash Management 92
10 Inventory Management 105
11 Receivables Management 118
12. Dividend Decision 128
13. Key to end chapter quizzes 142
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Chapter-1 Financial Management
Structure:
1.1 Introduction
Objectives
1.2 Meaning and Definitions
1.3 Goal of Financial Management
1.3.1 Profit Maximization
1.3.2 Wealth Maximization
1.4 Finance Functions
1.4.1 Investment Decisions
1.4.2 Financing Decisions
1.4.3 Divided Decisions
1.4.4 Liquidity Decision
1.4.5 Organization of Finance Function
1.5 Interface Between Finance and Other Business Function
1.5.1 Finance and Accounting
1.5.2 Finance and Marketing
1.5.3 Finance and Production (Operations)
1.5.4 Finance and HR
1.6 Summary
1.7 End chapter quiz
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1.1 Introduction
To establish any business, a person must find answers to the following questions:
a) Capital investments are required to be made. Capital investments are made to
acquire the real assets, required for establishing and running the business
smoothly. Real assets are land and building, plant and equipments etc.
b) Decision to be taken on the sources from which the funds required for the
capital investments mentioned above could be obtained.
c) Therefore, there are two sources of funds viz. debt and equity. In what
proportion the fund are to be obtained from these sources is to be decided for
formulating the financing plan.
d) Decision on the routing aspects of day to day management of collecting
money due from the firms customers and making payments to the suppliers
of various resources to the firm.
These are the core elements of financial management of a firm.
Financial Management of a firm is concerned with procurement and effective

utilization of fund for the benefit of its stakeholders. The most admired Indian
companies are Reliance, Infosys. They have been rated well by the financial analyst
on many crucial aspects that enabled them to create value for its share holders. They
employ the best technology, produce quality goods or render services at the least cost
and continuously contributed to the share holders wealth.
All corporate decision have financial implication. Therefore, financial management

embraces all those managerial activities that are required to procure funds at the least
cost and their effective deployment. Finance is the life blood of all organizations. It
occupies a pivotal role in corporate management. Any business which ignores the role
of finance in its functioning cannot grow competitively in todays complex business
world. Value maximization is the cardinal rule of efficient financial managers today.
1.2 Meaning and Definitions

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.
The modern approach transformed the field of study from the traditional narrow approach
to the most analytical nature. The core of modern approach evolved around, is
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procurement of the least cost funds and its effective utilization for maximization of share
holders wealth. Globalization of business and impact of information technology on
financial management have added new dimensions to the scope of financial management.
1.3 Goal of financial management

1.3.1Profit Maximization
Investors perception of companys performance can be traced to the goal of
maximization. But, the goal of profit maximization has been criticized on many accounts:
1. The concept of profit lacks clarity. What does the profit mean?
a) Is it profit after tax or before tax?
b) Is it operating profit or net profit available to share holders?
Difference in interpretation on the concept of profit expose the weakness of

the goal of profit maximization
2. Profit maximization ignores time value of money because it does not

differentiate between profit of current year with the profit to be earned in the
later years.
1.3.2Wealth Maximization
Wealth Maximization has been accepted by the finance managers, because it overcomes
the limitations of profit maximization means maximizing the net wealth of the
Companys share holders. Wealth maximization is possible only when the company
pursues policies that would increase the market value of shares of the company.
1.4 Finance Functions

Finance functions are closely related to financial decisions. The functions performed by a
finance manager are known as finance functions. In this course of performing these
functions finance manager takes the following decisions:-
1. Financing decision
2. Investment decision
3. Dividend decision
4. Liquidity decision
1.4.1 Investment Decisions

To survive and grow, all organizations must be innovative. It could be expansion through
entering into new markets, adding new products to its product mix, performing value
added activities to enhance the customer satisfaction, or adopting new technology that
would drastically reduce the cost of production.
If the management errs in any phase of taking these decisions and executing them, the
firm may become bankrupt. Therefore, such decisions will have to be taken after into
account all facts affecting the decisions and their execution.
Two critical issues to be considered in decision are:-
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1. Evaluation of expected profitability of the new investments.
2. Rate of return required on the project.
The rate of return required by investor is normally known by hurdle rate or cut-off rate or
opportunity cost of capital.
After a firm takes a decision to enter into any business or expand its exiting business,
plans to invest in buildings, machineries etc. are conceived and executed. The process
involved is called Capital Budgeting. Capital Budgeting decision demand considerable
time, attention and energy of the management.
1.4.2 Financing Decisions

Financing decisions relate to the acquisition of funds at the least cost. Here cost has two
dimension viz explicit cost implicit cost.
Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the
securities etc.
Implicit cost is not a visible cost but it may seriously affect the companys operation
especially when it is exposed to business and financial risk. For example, implicit cost is
the failure of the organization to pay to its lenders or debenture holders loan installment
on due date on account of fluctuations in cash flow attributable to the firms business risk.
In all financing decisions a firm has to determine the proportion of equity and debt. The
composition of dept and equity is called the capital structure of the firm.
Dept is cheap because interest payable on loan is allowed as deductions in computing

taxable income on which the company is liable to pay income tax to the Government of
India. For example, if the interest rate on loan taken is 12%, tax rate applicable to the
company is 50%, then when the company pays Rs.12 as interest to the lender, taxable
income of the company will be reduced by Rs.12.
In other words when actual cost is 12% with the tax rate of 50% the effective cost
becomes 6% therefore, dept is cheap.
Another thing notable in this connection is that the firm cannot avoid its obligation to pay
interest and loan installments to its lenders.
1.4.3 Dividend Decisions

Dividend yield is an important determinant of an investors attitude towards the security
(stock) in his portfolio management decisions. But dividend yield is the result of dividend
decision. Dividend decision is a major decision made by a finance manager. It is the
decision on formulation of dividend policy. Since the goal of financial management is
maximization of wealth of shareholders, dividend policy formulation demands the
managerial attention on the impact of its policy on dividend on the market value of the
shares.
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Optimum dividend policy requires decision on dividend payment rates so as to maximize
the market value of shares. The payout ratio means what portion of earning per share is
given to the shareholders in the form of cash dividend. In the formulation of dividend
policy, management of a company must consider the relevance of its policy on bonus
shares.
Dividend policy influences the dividend yield on shares. Since companys rating in the
Capital market have a major impact on its ability to procure funds by issuing securities in
the capital markets, dividend policy, a determinant of dividend yield has to be formulated
having regard to all the crucial element in building up the corporate image. The following
need adequate consideration in deciding on dividend policy:
1. Preference of share holders - Do they want cash dividend or Capital gains?
2. Current financial requirements of the company.
3. Legal constraints on paying dividends.
4. Striking an optimum balance between desires of share holders and the companys
funds requirements.
1.4.4 Liquidity Decision

Liquidity decisions are concerned with Working Capital Management. It is Concerned
with the day to day financial operation that involve current assets and current
liabilities.
The important element of liquidity decisions are:

1. Formulation of inventory policy
2. Policies on receivable management.
3. Formulation of cash management strategies
4. Policies on utilization of spontaneous finance effectively.
1.4.5 Organization of Finance Function

Financial decision are strategic in character and therefore, an efficient organization
structure is required to administer the same. Finance is like blood that flows through out
the organization. In all organization CFOs play an important role in ensuring proper
reporting based on substance to the stake holders of the company. Because of the crucial
role these functions play, finance function are organized directly under the control of
Board of Directors. For the survival of the firm, there is a need to ensure both long term
and short term financial solvency. Failure to achieve this will have its impact on all other
activities of the firm.
Week function performance by financial department will weaken production, marketing
and HR activities of the company. The result would be the organization becoming
anemic. Once anemic, unless crucial and effective remedial measures are taken up, it will
pave way for corporate bankruptcy.
CFO reports to the Board of Directors. Under CFO, normally two senior officers manage
the treasurer and controller functions.
A Treasurer performance the following function:

1. Obtaining finance.
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2. Liasoning with term lending and other financial institutions.
3. Managing working capital.
4. Managing investment in real assets.
A Controller performs:
1. Accounting and Auditing
2. Management control systems
3. Taxation and insurance
4. Budgeting and performance evaluation
5. Maintaining assets intact to ensure higher productivity of operating capital employed
in the organization.
1.5 Interface between Finance and Other Business Functions

1.5.1 Finance and Accounting
Looking at the hierarchy of the finance function of an organization, the controller reports
to CFO. Accounting is one of the functions that a controller discharges. Accounting and
finance are closely related. For computation of Return on Investment, earnings per share
and of various ratio for financial analysis the data base will be accounting information.
1.5.2 Finance and Marketing

Many marketing decisions have financial implication. Selections of channels of
distribution, deciding on advertisement policy, remunerating the salesmen etc have
financial implications.
1.5.3 Finance and Production (Operations)

Finance and operation are closely related. Decisions on plant layout, technology
selection, productions / operations, process plant size, removing imbalance in the flow of
input material in the production / operation process and batch size are all operations
management decisions but their formulation and execution cannot be done unless
evaluated from the finance angle.
1.5.4 Finance and HR

Attracting and retaining the best man power in the industry cannot be done unless they
are paid salary at competitive rates. If an organization formulates & implements a policy
for attracting the competent man power it has to pay the most competitive salary
packages to them. But it improves organizational capital and productivity.
1.6 Summary
Financial Management is concerned with the procurement of the least cost funds and its
effective utilization for maximization of the net wealth of the firm. There exists a close
relation between the maximization of net wealth of shareholders and the maximization of
the net wealth of the company. The broad areas of decision are capital budgeting,
financing, dividend and working capital. Dividend decision demands the managerial
attention to strike a balance between the investors expectation and the organizations
growth.
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1.7End chapter Quiz
1. Financial Management deals with procurement and ____________of funds for the
benefit of its stakeholders.
a) Short use
b) Effective utilization
c) Repayment
d) Least cost
2. _____________ is based on cash flows.
a) Wealth maximization
b) Profit maximization
c) Wealth Minimization
d) Profit Minimization
3. _____________ lead to investment in real assets.
a) Investment Decisions
b) Liquidity Decision
c) Operating Decision
d) Financing Decision
4. ___________ relate to the acquisition of funds at the least cost.
a) Investment Decisions
b) Liquidity Decision
c) Operating Decision
d) Financing Decision
5. Formulation of inventory policy is an important element of ____________.
a) Financing
b) Liquidity
c) Dividend
d) Taxation
6. Obtaining Finance is an important function of _____________.
a) Treasurers
b) Controller
c) CFO
d) Accountant
7. Taxation and Insurance is an important function of ______________.
a) Treasurers
b) Controller
c) CFO
d) Accountant
8. All corporate decisions have ______________ implications.
a) Production
b) Operational
c)Financial
d) Secondary
9. Two approaches to financial management are ____________ and ___________
approaches.
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a) Traditional, operational
b) Balanced, unbalanced
c) Traditional, modern
d) Current, future
10. Value __________ is the cardinal rule of efficient financial managers today.
a) Minimization
b) Maintenance
c) Maximization
d) Alteration
Chapter-2 Time Value of Money
Structure:
2.1 Introduction
Objectives
2.2 Time Preference Rate and Required Rate of Return
2.2.1 Compounding Technique
2.2.2 Discounting Technique
2.2.3 Future Value of a Single Flow (Lump sum)
2.2.4 Future Value of series of Cash Flows
2.2.5 Future Value of an Annuity
2.3 Present Value
2.3.1 Discounting or Present Value of a Single Flow
2.3.2 Present Value of a Series of Cash Flows
2.3.2.1 Present Value of Perpetuity
2.3.2.2 Capital Recovery Factor
2.4 Summary
2.5 End chapter Quiz
2.1 Introduction
The main objective of this unit is to enable you to learn the time value of money. In the
previous unit, we have learnt that wealth maximization is the primary objective of
financial management and that is more important than profit maximization for its
superiority in the sense that it is future-oriented. A decision taken today will have far-
fetching implication. For example, a firm investing in fixed assets will reap the benefits
of such investment for a number of years. If such assets are procured through bank
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borrowings or term loans from financial institutions, these involve an obligation to pay
interest and return and of principal. Decisions are made by comparing the cash inflows
(benefits / return) and cash outflows (outlays). Since these two components occur at
different time periods, there should be a comparison. In order to have a logical and
meaningful comparison between cash flows that accrue over different intervals of time. it
is necessary to convert the amounts to a common point of time. This unit is devoted for a
discussion of the techniques of doing so.
Learning Objectives:
After studying this unit, you should be able to understand the following.
1. Explain the time value of money.
2. Understand the valuation concepts.
3. Calculate the present and future values of lump sum and annuity flows.
Rationale: Time Value of Money is the value of a unit of money at different time
intervals. The value of money received today is more than its value received at a later
date. In other words, the value of money changes over a period of time. Since a rupee
received today has value, rational investors would prefer current receipts to future
receipts. That is why this phenomenon is also referred to as Time Preference of money.
Some important factors contributing to this are:
Investment opportunities:
Preference for consumption
Risk
These factors remind us of the famous English saying A bird in hand is worth two in
the bush.
Why should money have time value?
Some of the reasons are:

Money can be employed productively to generate real returns. For example, if we spend
Rs.500 on materials and Rs.300 on labour and Rs.200 on other expenses and the finished
product is sold for Rs.1100, we can say that the investment of Rs.1000 has fetched us a
return of 10%.
Secondly, during periods of inflation, a rupee has a higher purchasing power than a rupee
in future.
Thirdly, we all live under conditions of risk and uncertainty. As future is characterized
by uncertainty, individuals prefer current consumption to future consumption. Most
people have subjective preference for present consumption either because of their current
preference or because of inflationary pressures.
2.2 Future Value
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Time Preference Rate and Required Rate of Return
The time preference for money is generally expressed by an interest rate. This rate will be
positive even in the absence of any risk. It is called the risk-free rate. For example, if an
individuals time preference is 8%, it implies that he is willing to forego Rs.100 today to
receive Rs.108 after a period of one year. Thus he considers Rs.100 and Rs.108 are
equivalent in value. But in reality this is not the only factor he considers. There is an
amount of risk involved in such investment. He therefore requires another rate for
compensating him with this which is called the risk premium.
Required rate of return=Risk free rate + Risk Premium

There are two methods by which time value of money can be calculated- compounding
and discounting.
2.2.1 Compounding Technique

Under this method, the future values of all cash inflows at the end of the time horizon at a
particular rate of interest are found. Interest is compounded when the amount earned on
an initial deposit becomes part of the principal at the end of the first compounding period.
If Mr. A invests Rs.1000 in a bank which offers him 5% interest compounded annually,
he has Rs.1050 in his account at the end of the first year. The total of the interest and
Principal Rs.1050 constitutes the principal for the next year. He thus earns Rs.1102.50 for
the second year. This becomes the principal for the third year. This compounding
procedure will continue for an indefinite number of years. The compounding of interest
can be calculated by the following equation:
A=P(1+i)n
Where A = Amount at the end of the period

P = Principal at the end of the period
i = rate of interest
n = number of years
The amount of money in the account at the end of various years is calculated as under,
using the equation:
Amount at the end of year 1 = Rs.1000(1+0.05) = = Rs.1050
Amount at the end of year 2 = Rs.1050(1+0.05) = = Rs.1102.50
Amount at the end of year 3 = Rs.1102.50(1+0.05) = = Rs.1157.63
Year 1 2 3
Beginning amount Rs.1000 Rs.1050 Rs.1102.50
Interest Rate 5% 5% 5%
Amount of interest 50 52.50 55.13
Beginning principal 1000 Rs.1050 Rs.1102.50
Ending principal Rs.1050 Rs.1102.50 Rs.1157.63
The amount at the end of year 2 can be ascertained by substituting Rs.1000(1+0.05) for
Rs.1050, that is, Rs.1000(1+0.05)(1+0.05) = Rs.1102.50.
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Similarly, the amount at the end of year 3 can be ascertained by substituting
Rs.1000(1+0.05)(1+0.05)(1+0.05) = Rs.1157.63.
Thus by substituting the actual figures for the investment or Rs.1000 in the formula
A=P(1+i)n, we arrive at the result shown above in Table.
2.2.2 Discounting Technique

Under the method of discounting, we find the time value of money now, that is, at time 0
on the time line. It is concerned with determining the present value of a future amount.
This is in contrast to the compounding approach where we convert present amounts into
future amounts; in discounting approach we convert the future value to present sums. For
example, if Mr. A requires to have Rs.1050 at the end of year 1, given the rate of interest
as 5%, he would like to know how much he should invest today to earn this amount. If P
is the unknown amount and using the equation we get P(1+0.5) = 1050. Solving the
equation, we get P = Rs.1050/1.05 = Rs.1000.
Thus Rs.1000 would be required principal investment to have Rs.1050 at the end of the
year 1 at 5% interest rate. In other words, the present value of Rs.1050 received one year
from now, rate of interest 5%, if Rs.1000. The present value of money is the reciprocal of
the compounding value. Mathematically, we have P = A {1/(1+i)n} in which P is the
present value for the future sum to be received, A is the sum to be received in future, i is
the interest rate and n is the number of years.
2.2.3 Future Value of a Single Flow (lump sum)

The process of calculating future value will become very cumbersome if they have to be
calculated over long maturity periods of 10 or 20 years. A generalized procedure for
calculating the future value of a single cash flow compounded annually is as follows:
FVn = PV(1+i)n
Where FVn = Future Value of the initial flow in n years hence

PV = Initial cash flow
i = Annual rate of interest
N = Life of investment
The expression (1+i)n represents the future value of the initial investment of Re.1 at the
end of n number of years at the interest rate i, referred to as the Future Value Interest
Factor (FVIF). To help ease in calculations, the various combinations of I and n can
be referred to in the table. To calculate the future value of any investment, the
corresponding value of (1+i)n from the table is multiplied with the initial investment.
Example: The fixed deposit scheme of a bank offers the following interest rates:
Period of deposit Rate per annum

< 45 days 9%
46 days to 179 days 10%
180 days to 365 days 10.5%
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365 days and above 11%
How much does an investment of Rs.10000 invested today grow to in 3 years?
Solution: FVn = PV(1+i)n or PV*FVIF(11%, 3y)

= 10000*1.368 (from the tables)
= Rs.13680
Doubling period: A very common question arising in the minds of an investor is how
long will it take for the amount invested to double for a given rate of interest. There are
2 ways of answering this question. One is called rule of 72. This rule states that the
period within which the amount doubles is obtained by dividing 72 by the rate of interest.
For instance, if the given rate of interest is 10%, the doubling period is 72/10, that is, 7.2
years.
A much accurate way of calculating doubling period is the rule of 69, which is
expressed as 0.35+69/interest rate. Going by the same example given above, we get the
number of years as 7.25 years {0.35+69/10(0.35+6.9)}.
Increased frequency of compounding

It has been assumed that the compounding is done annually. If a scheme is offered where
compounding is done more frequently, let us see its effect on interest earned. For
example, if we have deposited Rs.10000 in a bank which offers 10% interest per annum
compounded semi-annually, the interest earned will be as follows:
Amount invested Rs.10000
Interest earned for first 6 months
10000*10%1/2(for 6 months) Rs.500
Amount at the end of 6 months Rs.10500
Interest earned for second 6 months
10500*10%*1/2 Rs.525
Amount at the end of the year Rs.11025
If in the above case compounding is done only once a year the interest earned will be
10000*10% which is equal to Rs.1000 and we will have Rs.11000 at the end of first year.
We find that we get more interest if compounding is done on a more frequent basis. The
generalized formula for shorter compounding periods is:
FVn = PV (1+i/m)m*n
Where, FVn = Future value after n years

PV = Cash flow today
I = Nominal interest rate per annum
M = No. of times compounding is done during a year
N = No. of years for which compounding is done.
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Example: Under the Andhra Banks Cash Multiplier Scheme, deposits can be made for
periods ranging from 3 months to 5 years. Every quarter, interest is added to the
principal. The applicable rate of interest is 9% for deposits less than 23 months and 10%
for periods more than 24 months. What will the amount of Rs.1000 today be after 2
years?
Solution:
FVn = PV (1+i/m)m*n
1000(1+0.10/4)4*2
1000(1+0.10/4)8
Rs.1218
Effective vs. nominal rate of interest: We have just learnt that interest accumulation by
frequent compounding is much more than the annual compounding. This means that the
rate of interest given to us, that is, 10% is the nominal rate of interest per annum. If the
compounding is done more frequently, say semi-annually, the principal amount grows at
10.25% per annum. 1.025% is known as the Effective Rate of Interest. The general
relationship between the effective and nominal rates of interest is as follows:
r = {(1+i/m)m}-1
Where,
r = Effective rate of interest
i = Nominal rate of interest
m = Frequency of compounding per year.
Example: Calculate the effective rate of interest if the nominal rate of interest is 12% and
interest is compounded quarterly.
Solution:
r = {(1+i/m)m}-1
r = {(1+0.12/4)4}-1
r = 0.126 or 12.6% p.a.
2.2.4 Future Value of Series of Cash Flows

We have considered only single payment made once and its accumulation effect. An
investor may be interested in investing money in installments and wish to know the value
of his savings after n years. For example, Mr. Madan invests Rs.500, Rs.1000, Rs.1500,
Rs.2000 and Rs.2500 at the end of each year for 5 years. Calculate the value at the end of
5 years compounded annually if the rate of interest is 5% p.a.
Solution:
End of Amount Number of Compounded FV in Rs.
year invested years interest factor
compounded from tables
1 Rs.500 4 1.216 608
2 Rs.1000 3 1.158 1158
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3 Rs.1500 2 1.103 1654
4 Rs.2000 1 1.050 2100
5 Rs.2500 0 1.000 2500
Amount at the end of 5th year Rs.8020
2.2.5 Future Value of An Annuity

Annuity refers to the periodic flows of equal amounts. These flows can be either termed
as receipts or payments. For example, if you have subscribed to the Recurring Deposit
Scheme of a bank requiring you to pay Rs.5000 annually for 10 years, this stream of pay-
outs can be called Annuities. Annuities require calculations based on regular periodic
contribution of a fixed sum of money.
The future value of a regular annuity for a period of n years at i rate of interest can be
summed up as under:
FVAn = A{(1+i)n-1}/i
Where
FVAn = Accumulation at the end of n years
i = Rate of interest
n = Time horizon or no. of years
A = Amount deposit/invested at the end of every year for n years.
The expression {(1+i)n-1}/i is called the Future Value of Interest Factor for Annuity
(FVIFA). This represents the accumulation of Re.1 invested at the end of every year for
n years at i rate of interest. The tables at the end of this book give us the calculations for
different combinations of i and n. We just have to multiply the relevant value with A and
get the accumulation in the formula given above.
Example: M.Ram Kumar deposits Rs.2000 at the end of every year for 5 years into his
account for 5 years, interest being 5% compounded annually. Determine the amount of
money he will have at the end of the 5th year.
End of Amount Number of Compounded FV in Rs.

year invested years interest factor
compounded from tables
1 Rs.2000 4 1.216 2432
2 Rs.2000 3 1.158 2316
3 Rs.2000 2 1.103 2206
4 Rs.2000 1 1.050 2100
5 Rs.2000 0 1.000 2000
Amount at the end of 5th year Rs.11054
OR Using formula and the tables we can find that:

= 2000 FVIF(5%, 5y)
= 2000*5.526
= Rs.11052
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We notice that we can get the accumulations at the end of n period using the tables.
Calculations for a long time horizon are easily done with the help of reference tables.
Annuity tables are widely used in the field of investment banking as ready reckoners.
2.3 Present Value

We have so far seen how the compounding technique can be used. They can be used to
compare the cash flows separated by more than one time period, given the interest rate.
With this technique, the amount of present cash can be converted into an amount of cash
of equivalent value in future. Likewise, we may be interested in converting the future
cash flows into their present values. The Present Value PV of a future cash flow is the
amount of the current cash that is equivalent to the investor. The process of determining
present value of a future payment or a series of future payments is known as discounting.
2.3.1 Discounting or Present Value of a Single Flow

We can determine the PV of a future cash flow or a stream of future cash flows using the
formula:
PV = FVn/(1+i)n
Where, PV = Present Value

FVn = Amount
Cash flow today
i = Interest rate
n = Number of years
2.3.2 Present Value of a Series of Cash Flows

In a business scenario, the businessman will receive periodic amounts (annuity) for a
certain number of years. An investment done today will fetch him returns spread over a
period of time. He would like to know if it is worthwhile to invest a certain sum now in
anticipation of returns he expects over a certain number of years. He should therefore
equate the anticipated future returns to the present sum he is willing to forego. The PV of
a series of cash flow can be represented by the following formula:
PV=CT/(1=i)1 + CT/(1=i)2 + CT/(1=i)3 + CT/(1=i)4 +..+ CT/(1=i)n
Which reduces to:

PVAn=A{1+i)n-1/i(1+i)n}
The expression {1+i)n-1/i(1+i)n} is known as Present Value Interest Factor Annuity

(PVIFA). It represents the PVIFA of Re.1 for the given values of i and n. The values of
PVIFA(I, n) can be found out using the tables. It should be noted that these values are
true only if the cash flows are equal and the flows occur at the end of every year.
Example: Find out the present value of an annuity of Rs.10000 over 3 years when
discounted at 5%.
Solution:
18
= 10000*PVIFA(5%, 3y)
= 10000*2.773
= Rs.27730
2.3.2.1 Present Value of Perpetuity

An annuity for an infinite time period is perpetuity. It occurs indefinitely. A person may
like to find out the present value of his investment assuming he will receive a constant
return year after year. The PV of perpetuity is calculated as P-A/i.
Example: If the principal of a college wants to institute a scholarship of Rs.5000 to a

meritorious student in finance every year, find out the PV of investment which would
yield Rs.5000 in perpetuity, discounted at 10%.
Solution:
P=A/i
= 5000/0.10
= Rs.50000
This means he should invest Rs.50000 to get an annual return of Rs.5000.

Present Value of an uneven periodic sum: In some investment decisions of a firm, the
returns may not be constant. In such cases, the PV calculated as follows:
P = A1/(1+i) + A2/(1+i)2 + A3/(1+i)3 + A4/(1+i)4 +.+ An/(1+i)n
OR
PV = A1 PVIF(i, 1) + A2 PVIF(i, 2) + A3 PVIF(i, 3) + A4 PVIF(i, 4) +.+ An
PVIF(i, n)
Example: An investor will receive Rs.10000, Rs.15000, Rs.8000, Rs.11000 and Rs.4000
respectively at the end of each of 5 years. Find out the present value of this stream of
uneven cash flows, if the investors interest rate is 8%.
PV = 10000/(1+0.08)+ 15000/(1+0.08)2+ 8000/(1+0.08)3+ 11000/(1+0.08)4+

4000/(1+0.08)5
= Rs.39276
2.3.2.2 Capital Recovery Factor

Capital recovery is the annuity of an investment for a specified time at a given rate of
interest. The reciprocal of the present value annuity factor is called Capital Recovery
Factor.
A=PVAn{i(1+i)n}/(1+i)n-1}
{i(1+i)n}/(1+i)n-1} is known as the Capital Recovery Factor.
Example: A loan of Rs.100000 is to be repaid in 5 equal annual installments. If the loan

carries a rate of 14% p.a., what is the amount of each installment?
Solution:
19
Installment*PVIFA(14%,5) = 100000
Installment=100000/3.433 = Rs.29129
2.4 Summary
Money has time preference. A rupee in hand today is more valuable than a rupee a year
later. Individuals prefer possession of cash now rater than at a future point of time.
Therefore cash flows occurring at different points in time cannot be compared. Interest
rate gives money its value and facilitates comparison of cash flows occurring at different
periods of time. Compounding and discounting are two methods used to calculate the
time value of money.
2.5 End Chapter Quiz
1. The important factors contributing to time value of money are ___________,

_________ and _____________.
a) Investment opportunities, preference for consumption, risk
b) Purchasing power, compounding, discounting
c) Investment opportunities, preference for consumption, discounting
d) Purchasing power, preference for consumption, risk
2. During periods of inflation, a rupee has a ___________ than a rupee in future.
a) Higher purchasing power
b) Lower purchasing power
c) Equal purchasing power
d) Different purchasing power
3. As future is characterized by uncertainty, individuals prefer ____________
Consumption to _____________ consumption.
a) Current, future
b) Future, current
c) Daily, annual
d) Past, future
4. There are two methods by which time value of money can be calculated by
__________ and __________ techniques.
a) Compounding, annuity
b) Compounding, discounting
c) Annuity, present value
d) Present value, discounting
5. __________ is created out of fixed payments each period to accumulate to a
future sum after a specified period.
a) Annual Sum
b) Fixed fund
c) Sinking fund
d) Fixed sum
20
6. The __________ of a future cash flow is the amount of the current cash that is
equivalent to the investor.
a) Present value
b) Current value
c) Compounding
d) Annuity
7. An annuity for an infinite time period is called ________________.
a) Discounting
b) Capacity
c) Perpetuity
d) Capital
8. The reciprocal of the present value annuity factor is called _____________.
a) Capital Recovery Factor
b) Annual Recovery factor
c) Time recovery factor
d) Preference recovery factor
9. Doubling period rules are, rule of _____ and rule of _________.
a) 71, 96
b) 72, 96
c) 71, 69
d) 72, 69
10. A person deposits Rs.25000 in a bank that pays 6% interest half yearly. Calculate
the amount at the end of 3 years.
a) 26850
b) 27850
c) 28850
d) 29850
21
Chapter 3 Cost of Capital
Structure:
3.1 Introduction
Objectives
3.2 Design of an Ideal Capital Structure
3.3 Cost of Different Sources of Finance
3.3.1 Cost of Debentures
3.3.2 Cost of Term Loans
3.3.3 Cost of preference Capital
3.3.4 Cost of Equity capital
3.3.5 Cost of Retained Earnings
3.3.5.1 Capital Asset Pricing Model Approach
3.3.5.2 Earning Prince Ratio Approach
3.4 Weighted Average Cost of Capital
3.5 Summary
3.1 Introduction
Capital structure is the mix of long-term source of funds like debentures, loans,
preference shares, equity shares and retained earning in different ratios. It is always
advisable for companies to plan their capital structure. Decisions takes by not assessing
things in a correct manner may jeopardize the very existence of the company. Firms may
prosper in the short-run by not indulging in proper planning but ultimately may face
problems in future. With unplanned capital structure, they may also fail to economize the
use of their funds and adapt to the changing conditions.
1. Define cost of capital.
2. Bring out the important of cost of capital.
3. Explain how to design an ideal capital structure.
4. Compute Weighted Average Cost of Capital.
3.2 Designing an Ideal Capital structure

It requires a number of factors to be considered such as:
22
Return: The capital structure of a company should be most advantageous. It
should generate maximum returns to the shareholders for a considerable period of
time and such return should keep increasing.
Risk: As already discussed in the previous chapter on leverage, use of excessive
debt funds may threaten the companys survival. Debt does increase equity
holders returns and this can be done till such time that no risk is involved.
Flexibility: The company should be able to adapt itself to situations warranting
changed circumstances with minimum cost and delay.
Capacity: The capital structure of the company should be within the debt
capacity. Debt capacity depends on the ability for funds to be generated.
Revenues earned should be sufficient enough to pay creditors interests, principal
and also to shareholders to some extent.
Control: An ideal capital structure should involve minimum risk of loss of
control to the company. Dilution of control by indulging in excessive debt
financing is undesirable.
With the above points on ideal capital structure, raising funds at the appropriate time to
finance firms investment activities is an important activity of the finance Manager.
Golden opportunities may be lost for delaying decisions to this effect. A combination of
debt and equity is used to fund the activities. What should be the proportion of debt and
equity? This depends on the costs associated with raising various sources of funds. The
cost of capital is the minimum rate of return a company must earn to meet the expenses
of the various categories of investors who have made investment in the form of loans,
debentures, equity and preference shares. A company no being able to meet these
demands may face the risk of investors taking back their investments thus leading to
bankruptcy. Loans and debentures come with a pre-determined interest rate, preference
shares also have a fixed rate of dividend while equity holders expect a minimum return of
dividend based on their risk perception and the companys past performance in terms of
pay-out of dividend.
3.3 Cost of Different Sources of finance

The various sources of finance and their costs are explained below:
3.3.1 Cost of debentures

The cost of debenture is the discount rate which equates the net proceeds from issue of
debenture to the expected cash outflow interest and principal repayments.
Kd = 1(1-T) + {(F P) / n}
(F+P) / 2
Where Kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture,
T is the corporate tax rate,
F is the redemption price per debenture,
P is the net amount realized per debenture,
n is maturity period.
23
Example:
Lakshmi Enterprise wants to have an issue of non-convertible debenture for Rs.10 Cr.
Each debenture is of par value of Rs.100 having an interest rate of 15%. Interest is
payable annually and they are redeemable after 8 years at a premium of 5%. The
company is planning to issue the NCD at a discount of 3% to help in quick subscription.
If the corporate tax rate is 50% what is the cost of debenture to the company?
Solution:
Kd = 1(1 T) + {(F P) / n}
(F + P) / 2
= 15(1 - 0.5) + (105 97) / 8

(105 + 97) / 2
= 7.5 + 1
101
= 0.084 or 8.4%
3.3.2 Cost of Term Loans

Term loans are loans taken from banks or financial institution for a specified number of
years at a pre-determined interest rate. The cost of term loans is equal to the interest rate
multiplied by 1-tax rate. The interest is multiple by 1-tax rate as interest on term loans is
also taxed.
Kt = I(1 - T)
Where I is interest,
T is tax rate.
Example:
Yes Ltd: has taken a loan of Rs.5000000 from Citi Bank at 9% interest.
What is the cost of term loan?
Solution:
Kt = I(1- T) = 9(1 0.4) = 5.4%
3.3.3 Cost of preference Capital

The cost of preference share Kp is the discount rate which equates the proceeds from
preference capital issue to the dividend and principal repayments which is expressed as:
Kp = D + {(F P) / n}
(F+P) / 2
24
Where Kp is the cost of preference capital,
D is the preference dividend per share payable,
F is the redemption price,
P is the net proceeds per share,
n is the maturity period.
Example:
C2C Ltd. Has recently come out with a preference share issue to the tune of Rs.100 lakhs.
Each preference share has a face value of 100 and a dividend of 12% payable. The shares
are redeemable after 10 yrs. at a premium of Rs.4 per share. The company hopes to
realize Rs.98 per share now. Calculate the cost of preference capital.
Solution:
Kp = D + {(F P ) / n}
(F + P) / 2
= 12 + (104 98) / 10
(104 +98) / 2
= 12.6
101
Kp = 0.1247 or 12.47%
3.3.4 Cost of Equity Capital

Equity shareholders do not have a fixed rate of return on their investment. There is no
legal requirement (unlike in the case of loans or debentures where the rates are governed
by the deed) to pay regular dividends to them. Measuring the rate of return to equity
holders is a difficult and complex exercise. There are many approaches for estimating
return the dividend forecast approach, capital asset pricing approach, realized yield
approach, etc. Accounting to dividend forecast approach, the intrinsic value of an equity
share is the sum of present values of dividend associated with it.
Ke = (D1/Pe) + g
This equation is modified from the equation Pe={D1/Ke-g}. Dividend cannot be

accurately forecast as they may sometimes be nil or have a constant growth or sometime
supernormal growth periods.
Is Equity Capital free of cost?

Some people are of the opinion that equity capital is free of cost for the reason that a
company is not legally bound to pay dividend and also the rate of equity dividend is not
fixed like preference dividends. This is not a correct view as equity shareholders buy
shares with the expectation of dividend and capital is not free of cost.
25
Example:
Suraj Metals are expected to declare a dividend of Rs.5 per share and the growth rate in
dividends is expected to grow @ 10% p.a. The price of one share is currently at Rs.110 in
the market. What is the cost of equity capital to the company?
Solution:
Ke = (D1/Pe) + g
= (5/110) + 010
= 0.1454 or 14.54%
3.3.5 Cost of Retained Earnings

A companys earning can be reinvested in full to fuel the ever-increasing demand of
companys fund requirements or they may be paid off to equity holders in full or they
may be partly held back and invested and partly paid off. These decisions are taken
keeping in mind the companys growth stages. High growth companies may reinvest the
entire earnings to grow more, companies with no growth opportunities return the fund
earned to their owners and companies with constant growth invest a little and return the
rest. Shareholders of companies with high growth prospects utilizing funds for
reinvestment activities have to be compensated for parting with their earnings. Therefore
the cost of retained earning is the same as the cost of shareholders expected return from
the firms ordinary shares. That is, Kr = Ke.
3.3.5.1 Capital Asset Pricing Model Approach

This model establishes a relationship between the required rate of return of a security and
its systematic risks expressed as . According to this model,
Ke = Rf + (Rm - Rf)
Where Ke is the rate of return on share,

Rf is the risk free rate of return,
is the beta of security,
Rm is return on market portfolio.
The CAPM model is based on some assumptions, some of which are:

Investors are risk- averse.
Investors make their investment decisions on a single-period horizon.
Transaction costs are low and therefore can be ignored. This translates to assets
being bought and sold in any quality desired. The only considerations mattering
are the price and amount of money at the investors disposal.
All investors agree on the nature of return and risk associated with each
investment.
Example:
What is the rate of return for a company if its is 1.5, risk free rate of return is 8% and
the market rate or return is 20%?
26
Solution:
Ke = Rf + (Rm - Rf)
= 0.08 + 1.5(0.2-0.08)
= 0.08 + 0.18
= 0.26 or 26%
3.3.5.2 Earnings Price Ratio approach

According to this approach, the cost of equity can be calculated as:
Ke = E1/P where E1 is expected EPS one year hence and P is the current market price
per share.
E1 is calculated by multiplying the present EPS with (1 + Growth rate).
Cost of Retained Earning and cost of External Equity

As we have just learnt that if retained earning are reinvested in business for growth
activities the shareholders expect the same amount of returns and therefore Ke =Kr. But it
should be borne in mind by the policy makers that floating a new issue and people
subscribing to it will involve huge amount of money towards floatation costs which need
not be incurred if retained earnings are utilized towards funding activities. Using the
dividend capitalization model, the following model can be used for calculating cost of
external equity.
Ke = {D1/P0(1 f)} + g
Where Ke is the cost of external equity,

D1 is the dividend external at the end of year 1,
P0 is the current market price per share,
g is the constant growth rate of dividends,
f is the floatation costs as a % of current market price.
The following formula can be used as an approximation:
Ke = Ke/(1-f)
Where Ke is the cost of external equity,
Ke is the rate of return required by equity holders,
F is the floatation cost.
Example:
Alpha Ltd. Requires Rs.400 Cr to expand its activities in the southern zone. The
Companys CFO is planning to get Rs.250 Cr through a fresh issue of equity shares to the
general public and for the balance amount he proposes to use of the reserves which are
currently to the tune of Rs.300 Cr. The equity investors expectations of return are 16%.
The cost of procuring external equity is 4%. What is the cost of external equity?
Solution:
27
We know that Ke=Kr, that is Kr is 16%
Cost of external equity is Ke =Ke/(1-f)
0.16/(1-0.04) = 0.1667 or 16.67%
3.4 Weighted Average cost of Capital

In the previous section we have calculated the cost of each component in the overall
capital of the company. The term cost of capital refers to the overall composite cost of
capital or the weighted average cost of each specific type of fund. The purpose of using
weighted average is to consider each component in proportion of their contribution to the
total fund available. Use of weighted average is preferable to simple average method for
the reason that firms do not procure funds equity from various sources and therefore
simple average method is not used. The following steps are involved to calculate the
WACC.
Step I: Calculate the cost of each specific source of fund, that of debt, equity, preference
capital and term loans.
Step II: Determine the weight associated with each source.
Step III: Multiply the weight associated with each source.
Step IV: WACC = WeKe + WrKr +WpKp + WdKd +WtKt
Assignment of weights
Weight can be assigned based on any of the below mentioned methods:
1) The book values of the sources of funds in the capital structure, 2) Present market
value of the funds in the capital structure and 3) in the proportion of financing planned
for the capital budget to be adopted for the next period.
As per the book value approach, weight assigned would be equal to each sources
proportion in the overall funds. The book value method is preferable. The market value
approach uses the market of each source and the disadvantage in this method is that these
values change very frequently.
3.5 Summary:
Any organization requires funds to run its business. These funds may be acquired from
short-term or long-term sources. Long-term funds are raised from two important sources-
capital (owners fund) and debt. Each of these two has a cost factor, merits and demerits.
Having excess debt is not desirable as debt-holders attach many conditions which may
not be possible for the companies to adhere to. It is therefore desirable to have a
combination of both debt and equity which is called the optimum capital structure.
Optimum capital structure refers to the mix of different source of long term funds in the
total capital of the company.
Cost of capital is the minimum required rate of return needed to justify the use of capital.
A company obtains resources from various sources issue of debentures, availing term
loans from banks and financial institution, issue of preference and equity shares or it may
even withhold a portion or complete profit earned to be utilized for further activities.
Retained earnings are the only internal source to fund the companys future plans.
28
Weighted Average Cost of Capital is the overall cost of all sources of finance.
The debenture carry a fixed rate of interest. Interest qualifies for tax deduction in
determining tax liability. Therefore the effective cost of debt is less than the actual
interest payment made by the firm.
The cost of term loan is computed keeping in mind the tax liability.
The cost of preference share is similar to debenture interest. Unlike debenture interest,
dividends do not qualify for tax deductions.
The calculation of cost of equity is slightly different as the return to equity are not
constant.
The cost of retained earning is the same as the cost of equity funds.

1. _____________ is the mix of long term sources of funds like debentures, loans,
preference shares, equity shares and retained earnings in different ratios.
a) Working capital
b) Cost of capital
c) Leverage
d) Capital structure
2. The capital structure of a company should generate ______________ to the

shareholders.
a) Working capital
b) Cost of capital
c) Maximum Return
d) Leverage
3. The capital structure of the company should be within the ______________.

a) Earning capacity
b) Maximum limit
c) Debt capacity
d) Minimum Limit
4.An ideal capital structure should involve minimum risk of _____________ to the
company.
a) loss of control
b) loss of finance
c) loss of capital
d) loss of equity
5. ______________ do not have a fixed rate of return on their investment.
a) Preference shareholders
29
b) Equity shareholders
c) Debentureholders
d) Banker
6. According to Dividend forecast approach, the intrinsic value of an equity share is the
sum of present value of ___________ associated with it.
a) Share
b) Money
c) Dividend
d) Capital
7. Capital asset pricing model approach is:

a) Ke= Rf - b(Rm+Rf)
b) Ke= Rf + b(Rm-Rf)
c) Ke= Rf + b(Rm+Rf)
d) Ke= Rf - b(Rm-Rf)
8. Earnings price ratio approach: Ke =E1/P, Where E1 is-

a) Expected EPS one Yr. hence
b) Earning price per share
c) Earning Ratio per share
d) Earning capacity per share
9.Supersonic industries has entered into an agreement with Indian Overseas Bank for a
loan of Rs. 10Cr. With an interest rate of 10%. What is the cost of the loan if the tax rate
is 45%.
a) 7.5%
b) 6.5%
c) 5.5%
d) 4.5%
10.According to dividend forecast approach, the intrinsic value of an equity share is the
sum of the present values of ___________ associated with it.
a) Share
b) Money
c) Dividend
d) Capital
30
Chapter 4 Leverage
Structure:
4.1 Introduction
Objectives
4.2 Operating Leverage
4.2.1 Application of Operating Leverage
4.3 Finance Leverage
4.3.1 Uses of Financial Leverage
4.4 Combined Leverage
4.4.1 Uses of DTL
4.5 Summary
4.1 Introduction
A company uses different sources of financing to fund its activities. These sources can be
classified as those which carry a fixed rate of return and those whose returns vary. The
fixed sources of finance have a bearing on the return of shareholders. Borrowing funds as
loans have an impact on the return on shareholders and this is greatly affected by the
magnitude of borrowing in the capital structure of a firm. Leverage is the influence of
power to achieve something. The use of an asset or source of funds for which the
company has to pay a fixed cost or fixed return is termed as leverage. Leverage is the
influence of an independent finance variable on a dependent variable. It studies how the
dependent variable responds to a particular change in independent variable.
There are two types of leverage operating leverage and financial leverage. Leverage
associated with the asset purchase activities is known as operating leverage, while those
associated with financing activities is called as financial leverage.
After studying this unit, you should able to understand the following.
1. Explain the meaning of leverage.
2. Mention the different types of leverage.
3. Discuss the advantages of leverage.
4.2 Operating Leverage:

Operating leverage arises due to the presence of fixed operating expenses in the firms
income flows. A companys operating costs can be categorized into three main sections:
31
Fixed costs are those which do not vary with an increase in production or sales
activities for a particular period of time. These are incurred irrespective of the
income and volume of sales and generally cannot be reduced.
Variable costs are those which vary in direct proportion to output and sales. An
increase or decrease in production or sales activity will have a direct effect on
such types of costs incurred.
Semi-variable costs are those which are partly fixed and partly variable in nature.
These costs are typically of fixed nature up to a certain level beyond which they
vary with the firms activities.
The operating leverage is the firms ability to use fixed operating costs to increase the
effects of changes in sales on its earning before interest and taxes. Operating leverage
occurs any time a firm has fixed costs. The percentage change in profits with a change in
volume of sales is more than the percentage change in volume.
Example:
A firm sells a product for Rs.10 per unit, its variable costs are Rs.5 per unit and fixed
expenses amount to Rs.5000 p.a. Show the various levels of EBIT that result from sale of
1000 units, 2000 units and 3000 units.
Solution:
Sales in units 1000 2000 3000
Sales revenue Rs. 10000 20000 30000
Variable cost 5000 10000 15000
Contribution C 5000 10000 15000
Fixed cost 5000 5000 5000
EBIT 000 5000 10000
If we take 2000 units as the normal course of sales, the results can be summed as under:
A 50% increase in sales from 2000 units to 3000 units results in a 100% increase
in EBIT.
A 50% decrease in sales from 2000 units to 1000 units results in a 100% decrease
in EBIT.
The illustration clearly tells us that when a firm has fixed operating expenses, an increase
in sales results in a more proportionate increase in EBIT and vice versa. The former is a
favorable operating leverage and the letter is unfavorable.
Another way of explaining this phenomenon is examining the effect of the degree of
operating leverage DOL. The DOL is a more precise measurement. It examines the effect
of the change in the quantity produced on EBIT.
DOL = % change in EBIT / % change in output
32
To put in a different way, (EBIT/EBIT) / (Q/Q)
EBIT is Q (S-V)-F Where Q is quantity, S is sales, V is variable cost and F is fixed cost.
Substituting this we get, {Q(S-V)} / {Q(S-V)-F}
Example:
Calculate the DOL of Gupta enterprises.
Quantity produced and sold 1000 units
Variable cost - Rs.200 per unit
Selling price per unit - Rs.300 per unit
Fixed expenses - Rs.20000
Solution:
DOL = {Q(S-V)} / {Q(S-V)-F}
= 1000(300-200)
1000(300-200)-2000
=100000/80000
DOL = 1.25
If the company does not incur any fixed operating costs, there is no operating leverage.
Example:
Sales in units 1000
Sales revenue Rs. 10000
Variable cost 5000
Contribution 5000
Fixed cost 0
EBIT 5000
Solution:
DOL = {Q(S-V)} / {Q(S-V)-F}
{1000(5000)} / {1000(5000)-0}
=5000000/5000000
=DOL =1
As operating leverage can be favorable or unfavorable, high risks are attached to higher
degrees of leverage. As DOL considers fixed expenses increases the operating risks of the
company and hence a higher degree of operating leverage. Higher operating risks can be
taken when income levels of companies are rising and should not be ventured into
revenues move southwards.
4.2.1 Application of Operating Leverage

Measurement of business risk: Risk refers to the uncertain conditions in which a
company performs. Greater the DOL, more sensitive is the EBIT to a given change in
unit sales. A high DOL is a measure of high business risk and vice versa.
33
Production planning: A change in production method increases or decreases DOL. A
firm can change its cost structure by mechanizing its operations, thereby reducing its
variable costs and increasing its fixed costs. This will have a positive impact on DOL.
This situation can be justified only if the company is confident of achieving a higher
amount of sales thereby increasing its earnings.
4.3 Financial Leverage

Financial leverage as opposed to operating leverage relates to the financing activities of a
firm and measures the effect of EBIT on EPS of the company. A companys sources of
funds fall under two categories those which carry a fixed financial charge debentures,
bonds and preference shares and those which do not carry any fixed charge equity
shares. Debentures and bonds carry a fixed rate of interest and have to be paid off
irrespective of the firms revenues. Though dividends are not contractual obligations,
dividend on preference shares is a fixed charge and should be paid off before equity
shareholders are paid any. The equity holders are entitled to only the residual income of
the firm after all prior obligations are met.
Financial leverage refers to the mix of debt and equity in the capital structure of the firm.
This results from the presence of fixed financial charges in the companys income stream.
Such expenses have nothing to do with the firms performance and earnings and should
be paid off regardless of the amount of EBIT. It is the firms ability to use fixed financial
charges to increase the effects of changes the returns to shareholders. A company earning
more by the use of assets funded by fixed sources is said to be having a favorable or
positive leverage. Unfavorable leverage occurs when the firm is not earning sufficiently
to cover the cost of funds. Finance leverage is also referred to as Trading on Equity.
Example:
The EBIT of a firm is expected to be Rs.10000. The firm has to pay interest @ 5% on
debenture worth Rs.25000. It also has preference shares worth Rs.15000 carrying a
dividend of 8%. How does EPS change if EBIT is Rs.5000 and Rs.15000? Tax rate may
be taken as 40% and number of outstanding shares as 1000.
Solution:
EBIT 10000 5000 15000
Interest on deb. 1250 1250 1250
EBT 8750 3750 13750
Tax 40% 3500 1500 5500
EAT 5250 2250 8250
Preference div 1200 1200 1200
Earnings available 4050 1050 7050
to equity holders
EPS 4.05 1.05 7.05
34
Interpretation:
A 50% increase in EBIT from Rs.10000 to Rs.15000 results in 74% increase in
EPS.
A 50% decrease in EBIT from Rs.10000 to Rs.5000 results in 74% decrease in
EPS.
This example shows that the presence of fixed interest source funds leads to a more than
proportional change in EPS. The presence of such fixed sources implies the presence of
financial leverage. This can be expressed in a different way. The degree of finance
leverage DFL is a more precise measurement. It examines the effect of the fixed sources
of funds on EPS.
DFL =%change in EPS

%change in EBIT
DFL= {EPS/EPS} {EBIT/EBIT}
Or DFL =EBIT {EBIT-I-{Dp/1-T)}}
I is Interest, Dp is dividend on preference shares, T is tax rate.
Example:
Kusuma Cements Ltd. has an EBIT of Rs.500000 at 5000 units production and sales. The
capital structure is as follows:
Capital structure Amount Rs.
Paid up capital 500000 equity shares of Rs.10 each 5000000
12% Debentures 400000
10% Preference shares of Rs.100 each 400000
Total 5800000
Corporate tax rate may be taken at 40%
Solution:
EBIT 500000
Less Interest on debentures 48000
EBT 452000
DFL= EBIT {EBIT-I-{Dp/(1-T)}}

500000
(500000-48000-{40000/(1-0.40)}
DFL=1.30
4.3.1 Use of Financial Leverage

Studying DFL at various levels makes financial decision-making on the use of fixed
sources of funds for funding activities easy. One can assess the impact of change in EBIT
on EPS.
Like operating leverage, the risks are high at high degrees of financial leverage. High
financial costs are associated with high DFL. An increase in financial costs implies
higher level of EBIT to meet the necessary financial commitments. A firm not capable of
35
honoring its financial commitments may be forced to go into liquidation by the lenders of
funds. The existence of the firm is shaky under these circumstances. On the one hand
trading on equity improves considerably by the use of borrowed funds and on the other
hand, the firm has to constantly work towards higher EBIT to stay alive in the business.
All these factors should be considered while formulating the firms mix of sources of
funds. One main goal of financial planning is devise a capital structure in order to provide
a high return to equity holders. But at the same time, this should not be done with heavy
debt financing which drives the company on to the brink of winding up.
4.4 Total or Combined Leverage

The combination of operating and financial leverage is called combined leverage.
Operating leverage affects the firms operating profit EBIT and financial leverage affects
PAT or the EPS. These cause wide fluctuation in EPS. A company having a high level of
operating or financial leverage will find a drastic change in its EPS even for a small
change in sales volume. Companies whose products are seasonal in nature have
fluctuating EPS, but the amount of change in EPS due to leverage is more pronounced.
The combined effect is quite significant for the earning available to ordinary
shareholders. Combined leverage is the product of DOL and DFL.
Q(S-V)
DTL=
Q(S-V) F I {Dp/(1 - T)}
Example:
Calculate the DTL of M/s Pooja Enterprises Ltd. given the following information.
Quantity sold 10000 units
Variable cost per unit Rs.100 per unit
Selling price per unit Rs.500 per unit
Fixed expenses Rs.1000000
Number of equity shares 100000
Debt Rs.1000000 @ 20% interest
Preference shares 10000 shares of Rs.100 each @ 10%
Dividend
Tax rate 50%
Q(S-V)
DTL=
Q(S-V) F I {Dp/(1 - T)}
10000(500 100)
10000(500 100) 1000000 200000 {100000/0.5}
DTL= 1.54
36
Cross verification:
{Q(S V)}
DOL =
{Q(S V) F}
10000(500 100)
=
10000(500 100) 1000000
DOL=1.33
EBIT
DFL =
EBIT I {Dp/(1-T)}
3000000
=
3000000 200000 {100000/0.5}
DFL = 1.15
DTL=DOL*DFL
1.33*1.15=1.54
4.4.1 Uses of DTL(Degree of total Leverage)

DTL measures the total risk of the company as it is a combined measure of both
operating and financial risk.
4.5 Summary
Leverage is the use of influence to attain something else. The advantage a company has
with its current status is used to gain some other benefit. There are three measures of
leverage operating leverage, financial leverage and total or combined leverage.
Operating leverage examines the effect of change in quantity produced upon EBIT and is
useful to measure business risk and production planning. Financial leverage measures the
effect of change in EBIT on the EPS of the company. It also refers to the debt-equity mix
of a firm. Total leverage is the combination of operating and financial leverages.

1. _____________ arises due to the presence of fixed operating expenses in the
firms income flows.
a) Financial Leverage
b) Operating Leverage
c) Operating Cycle
d) Financial Ratio
2. EBIT is calculated as __________.

a)Q(S-V)-F
b)F(S-V)-Q
c)Q(V-S)-F
d)S(Q-V)-F
37
3. Higher operating risks can be taken when ___________ of companies are rising.
a) Expense level
b) Capital Structure
c) Income Level
d) Working Capital
4. Dividend on _____________ is a fixed charge.

a) Small value shares
b) Preference Shares
c) Equity Shares
d) All the shares
5. Financial Leverage is also referred to as trading on _______________.

a) Preference
b) Shares
c) Equity
d) Gold
6.There are three measures of leverage __________leverage, _______ leverage and
_________ leverage.
a) Primary, secondary, total
b) Combined, current, future
c) Financial, Investment, Dividend
d) Financial, operating, combined
7. A firm's degree of total leverage (DTL) is equal to its degree of operating leverage
________ its degree of financial leverage (DFL).
a) Plus
b) Minus
c) Divided by
e) Multiplied by
8. Financial leverage refers to the mix of debt and equity in the _______ of the
firm.
a) Capital structure
b) Assets
c) Net profit
d) EBIT
9.High financial costs are associated with _________ DFL.

a) Low
b) High
c) Medium
d) None of the above
10. A high DOL is a measure of _________ business risk and vice versa.
a) Low
38
b) High
c) Medium
39
Chapter - 5 Capital Structure
Structure:
5.1 Introduction
Objectives
5.2 Features of an Ideal Capital Structure
5.3 Factors Affecting Capital Structure
5.4 Theories of Capital Structure
5.4.1 Net Income Approach
5.4.2 Net Operating Income Approach
5.4.3 Traditional Approach
5.4.4 Miller and Modigliani Approach
5.4.4.1 Criticisms of MM proposition
5.5 Summary
5.1 Introduction
The capital structure of a company refers to the mix of long-term finances used by the
firm. In short, it is the financing plan of the company. With the objective of maximizing
the value of the equity shares, the choice should be that pattern of using debt and equity
in a proportion that will lead towards achievement of the firm's objective. The Capital
structure should add value to the firm. Financing mix decisions are investment decisions
and have no impact on the operating earnings of the firm. Such decisions influence the
firm's value through the earnings available to the shareholders.
The value of a firm is dependent on its expected future earnings and the required rate of
return. The objective of any company is to have an ideal mix of permanent sources of
funds in a manner that will maximize the company's market price. The proper mix of
funds is referred to as Optimal Capital Structure.
The capital structure decisions include debt-equity mix and dividend decisions. Both
these have an effect on the EPS.
1. Explain the features of ideal capital structure.
2. Name the factors affecting the capital structure.
3. Mention the various theories of capital structure.
40
5.2 Features of an Ideal Capital Structure
Profitability: The firm should make maximum use of leverage at minimum cost.
Flexibility: It should be flexible enough to adapt to, changing conditions. It

should be in a position to raise funds at the shortest possible time and also repay
the moneys it borrowed, if they appear to be expensive. This is possible only if
the company's lenders have not put forth any conditions like restricting the
company from taking further loans, no restrictions placed on the assets usage or
laying a restriction on early repayments. In other words, the finance authorities
should have the power to take decisions on the basis of the circumstances warrant.
Control: The structure should have minimum dilution of control.
Solvency: Use of excessive debt threatens the very existence of the company.
Additional debt involves huge repayments. Loans with high interest rates are to be
avoided however attractive some investment proposals look. Some companies
resort to issue of equity shares to repay their debt for equity holders do not have a
fixed rate of dividend.
5.3 Factors Affecting Capital Structure

Leverage: The use of fixed charges sources of funds such as preference shares, loans
from banks and financial institutions and debentures in the capital structure is known as
"trading on equity" or "financial leverage". Creditors insist on a debt equity ratio of 2:1
for medium sized "and large sized companies, while they insist on 3:1 ratio for SSI. Debt
equity ratio is an indicator of the relative contribution of creditors and owners. The debt
component includes both long term and short term debt and this is represented as
Debt/Equity. A debt equity ratio of 2:1 indicates that .for every 1 unit of equity, the
company can raise 2 units of debt. By normal standards, 2:1 is considered a healthy ratio,
but it is not always a hard and fast rule that this standard is insisted upon. A ratio of 1.5:1
is considered good for a manufacturing company while a ratio of 3: 1 is good for heavy
engineering companies. It is generally perceived that lower the ratio, higher is the
element of uncertainty in the minds of lenders.
Increased use of leverage increases commitments of the company, the outflows being in
the nature of higher interest and principal repayments, thereby increasing the risk of the
equity shareholders. The other factors to be considered before deciding on an ideal capital
structure are:
Cost of capital- High cost funds should be avoided however attractive an
investment proposition may look like, for the profits earned may be eaten away by
interest repayments.
Cash flow projections of the company- Decisions should be taken in the light of
cash flows projected for the next 3-5 years. The company officials should not get
carried away at the immediate results expected. Consistent lesser profits are any
way preferable than high profits in the beginning and not being able to get any
after 2 years.
41
Size of the company
Dilution of control - The top management should have the entire flexibility to
take appropriate decisions at the right time. The capital structure planned should
be one in this direction.
Floatation costs - A company desiring to increase its capital by way of debt or

equity will definitely incur floatation costs. Effectively, the amount of money
raised by any issue will be lower than the amount expected because of the
presence of floatation costs. Such costs should be compared with the profits and
right decisions taken.
5.4 Theories of Capital Structure

As we are aware, equity and debt are the two important sources of long-term sources of
finance of a firm. The proportion of debt and equity in a firm's Capital structure has to be
independently decided case to case. A proposal though not being favourable to lenders
may be taken up if they are convinced with the earning potential and long-term benefits.
Many theories have been propounded to understand the relationship between financial
leverage and firm value.
Assumptions
The following are some common assumptions made:
The firm has only two sources of funds - debt and ordinary shares.
There are no taxes - both corporate and personal.
The firm's dividend pay-out ratio is 100%, that is, the firm pays off the entire
earnings to its equity holders and retained earnings are zero.
The investment decisions of a company are constant, that is, the firm does not
invest any further in its assets.
The operating profits EBIT are not expected to increase or decline.
All investors shall have identical subjective probability distribution of the future
expected EBIT.
A firm can change its capital structure at a short notice without the occurrence of
transaction costs.
The life of the firm is indefinite.
Based on the above, we derive the following:
1. Debt capital being constant, Kd is the cost of debt which is the discount rate at
which discounted future constant interest payments are equal to the market value
of debt, that is, Kd = I/B where, I refers to total interest payments and B is the
total market value of debt.
Therefore value of the debt B = I/Kd
2. Cost of equity capital Ke = (D1/P0) + g where D1 is dividend after one year, Po

is the current market price and g is the expected growth rate.
42
3. Retained earnings being zero, g = br where r is the rate of return on equity shares
and b is the retention rate, therefore g is zero. Now we know Ke = E1/PO + g and
g being zero, so Ke = NI/S where NI is the net income to equity holders and S is
market value of equity shares.
4. The net operating income being constant, overall cost of capital is represented as
K0 = W1K1 + W2K2.
That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the debt, S
market value of equity and V total market value of the firm (B+S). The above
equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, (K1 being the debt
component and Ke being the equity component) which can be expressed as K0 = I
+ NI/V or EBIT/V or in other words, net operating income/market value of
firm.
5.4.1 Net Income Approach

This theory is suggested by Durand and he is of the view that capital structure decision is
relevant to the valuation of the firm. Any change in the financial leverage will have a
corresponding change in the overall cost of capital and also the total value of the firm. As
the ratio of debt to equity Increases, the WACC declines and market value of firm
increases. The NI approach is based on 3 assumptions - no taxes, cost of debt less than
cost of equity and use of debt does not change the risk perception of investors.
We know that K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
Example:
Given below are two firms A and B, which are identical in all aspects except the degree
of leverage employed by them. What is the average cost of capital of both firms?
Firm A Firm B
Net operating income EBIT Rs. 100000 Rs. 100000
Interest on debentures I Nil Rs. 25000
Equity earnings E Rs. 100000 Rs. 75,000
Cost of equity Ke 15% 15%
Cost of debentures Kd 10% 10%
Market value of equity S = E/Ke RS.666667 Rs. 50,000
Market value of debt B Nil Rs.250000
Total value of firm V Rs.666667 Rs.7,50,000
Average Cost of capital of firm A is:

10% * 0/Rs. 666667 + 15% * 666667/666667 which is 15%
Average Cost of capital of firm B is:

10% * 25000/783333 + 15% * 533333/783333 which is 10.53%
43
Interpretation: The use of debt has caused the total value of the firm to increase and the
overall cost of capital to decrease.
5.4.2 Net Operating Income Approach

This theory is again propounded by Durand and is totally opposite of the Net Income
Approach. He says any change in leverage will not lead to any change in the total value
of the firm, market price of shares and overall cost of capital. The overall capitalization
rate is the same for all degrees of leverage. We know that:
K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
As per the NOI approach the overall capitalization rate remains constant for all degrees of
leverage. The market values the firm as a whole and the split in the capitalization rates
between debt and equity is not very significant.
The increase in the ratio of debt in the capital structure increases the financial risk of
equity shareholders and to compensate this, they expect a higher return on their
investments. Thus the cost of equity is
Ke = Ko +[(Ko - Kd)(B/S)]
Cost of debt: The cost of debt has two parts - explicit cost and implicit cost. Explicit cost
is the given rate of interest. The firm is assumed to borrow irrespective of the degree of
leverage. This can mean that the increasing proportion of debt does not affect the
financial risk of lenders and they do not charge higher interest. Implicit cost is increase in
Ke attributable to Kd. Thus the advantage of use of debt is completely neutralized by the
implicit cost resulting in Ke and Kd being the same.
Example:
Given below are two firms X and Y which are similar in all aspects except the degree of
leverage employed.
Firm A Firm B
Net operating income EBIT Rs. 10000 Rs. 10000
Overall capitalization rate Ko 18% 18%
Total market value V =
55555 55555
EBIT/Ko
Interest on debt I Rs. 1000 Rs.2000
Debt capitalization rate Kd 11% 11%
Market value of debt B= I/Kd RS.9091 Rs. 18181
Market value of equity S=V-B RS.46464 RS.37374
Leverage B/S 0.1956 0.2140
The equity capitalization rates are

Firm A = 9000/46464 which is 19.36%
44
Firm B = 8000/37374 which is 21.40%
The equity capitalization rates can also be calculated with the formula
Ke = Ko +[ (Ko - Kd)(B/S)]
Firm A = 0.18 + [(0.18 - 0.11)(0.1956)] = 19.36%
Firm B = 0.18 + [(0.18 - 0.11)(0.4865)] = 21.40%
5.4.3 Traditional Approach:

The Traditional Approach has the following propositions:
Kd remains constant until a certain degree of leverage and thereafter rises at an
increasing rate.
Ke remains constant or rises gradually until a certain degree of leverage and
thereafter rises very sharply.
As a sequence to the above 2 propositions, Ko decreases till a certain level,
remains constant for moderate increases in leverage and rises beyond a certain
point.
5.4.4 Miller and Modigliani Approach

Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up
to a reasonable limit and Ko being constant at all degrees of leverage. They state that the
relationship between leverage and cost of capital is elucidated as in NOI approach. The
assumptions for their analysis are:
Perfect capital markets: Securities can be freely traded, that is, investors are free
to buy and sell securities (both shares and debt instruments), there are no
hindrances on the borrowings, no presence of transaction costs, securities
infinitely divisible, availability of all required information at all times.
Investors behave rationa1ly, that is, they choose that combination of risk and
return that is most advantageous to them.
Homogeneity of investors risk perception, that is, all investors have the same
perception of business risk and returns.
Taxes: There is no corporate or personal income tax.
Dividend pay-out is 100%, that is, the firms do not retain earnings for future
activities.
Basic propositions: The following three propositions can be derived based on the above
assumptions:
Proposition I: The market value of the firm is equal to the total market value of equity
and total market value of debt and is independent of the degree of leverage. It can be
expressed as:
45
Expected NOI
Expected overall capitalization rate
V + (S+D) which is equal to O/Ko which is equal to NOI/Ko
V + (S+D) = O/Ko = NOI/Ko
Where V is the market value of the firm,
S is the market value of the firm's equity,
D is the market value of the debt,
O is the net operating income,
Ko is the capitalization rate of the risk class of the firm.
The basic argument for proposition I is that equilibrium is restored in the market by the
arbitrage mechanism. Arbitrage is the process of buying a security at lower price in one
market and selling it in another market at a higher price bringing about equilibrium. This
is a balancing act. Miller and Modigliani perceive that the investors of a firm whose value
is higher will sell their shares and in return buy shares of the firm whose value is lower.
They will earn the same return at lower outlay and lower perceived risk. Such behaviours
are expected to increase the share prices whose shares are being purchased and lowering
the share prices of those share which are being sold. This switching operation will
continue till the market prices of identical firms become identical.
Proposition II: The expected yield on equity is equal to discount rate (capitalization rate)
applicable plus a premium.
Ke = Ko +[(Ko-Kd)D/S]
Proposition III: The average cost of capital is not affected by the financing decisions as
investment and financing decisions are independent.
5.4.4.1 Criticisms of MM Proposition

Risk perception: The assumption that risks are similar is wrong and the risk perceptions
of investors are personal and corporate leverage is different. The presence of limited
liability of firms in contrast to unlimited liability of individuals puts firms and investors
on a different footing. All investors lose if a levered firm becomes bankrupt but an
investor loses not only his shares in a company but would also be liable to repay the
money he borrowed. Arbitrage process is one way of reducing risks. It is more risky to
create personal leverage and invest in unlevered firm than investing in levered firms.
Convenience: Investors find personal leverage inconvenient. This is so because it is the

firm's responsibility to observe corporate formalities and procedures whereas it is the
investor's responsibility to take care of personal leverage. Investors prefer the former
rather than taking on the responsibility and thus the perfect substitutability is subject to
question.
Transaction costs: Another cost that interferes in the system of balancing with arbitrage
process is the presence of transaction costs. Due to the presence of such costs in buying
46
and selling securities, it is necessary to invest a higher amount to earn the same amount
of return.
Taxes: When personal taxes are considered along with corporate taxes, the Miller and
Modigliani approach fails to explain the financing decision and firm's value.
Agency costs: A firm requiring loan approach creditors and creditors may sometimes
impose protective covenants to protect their positions. Such restriction may be in the
nature of obtaining prior approval of creditors for further loans, appointment of key
persons, restriction on dividend pay-outs, limiting further issue of capital, limiting new
investments or expansion schemes etc.
5.5 Summary
According to the NI Approach, overall cost of capital continuously decreases as and
when debt goes up in the capital structure. Optimal capital structure exists when the firm
borrows maximum.
NOI Approach believes that capital structure is not relevant. Ko is dependent business
risk which is assumed to be constant.
Traditional Approach tells us that Ko decreases with leverage in the beginning, reaches
its maximum point and further increases.
Miller and Modigliani Approach also believe that capital structure is not relevant.

1.Financing mix decisions have no impact on the ___________ of the firm.
a) Operating Earnings
b) Production
c) Operations
d) Finance
2. The value of a firm is dependent on its expected future _________ and the required
rate of ________.
a) Loss, return
b) Earnings, return
c) Projects, loss
d) Projects, earnings
3. __________ and ______________ are two important sources of long term sources of
finance of a firm.
a) Equity, debt
b) Fixed capital, working capital
c) Short term loan, long term loan
d) Income, profit
47
4. As the ratio of debt to equity increases, the _________ declines and ____________ of
firm increases.
a) Market value, WACC
b) WACC, Market value
c) Profit, WACC
d) WACC, loss
5. As per the NOI approach the overall __________ rate remains constant for all degrees
of leverage.
a) Net profit
b) Dividend
c) Market
d) Capitalization
6. ___________ is the process of buying a security at lower price in one market and
selling it in another market at a higher price bringing about ____________.
a) Arbitrage, equilibrium
b) Arbitrage, leverage
c) Leverage, Arbitrage
d) Capitalization, Arbitrage
48
Chapter 6 Capital Budgeting
Structure:
6.1 Introduction
Objective
6.2 Importance of Capital budgeting
6.3 Complexities involved in Capital Budgeting Decisions
6.4 Phases of Capital Expenditure Decisions
6.5 Identification of Investment Opportunities
6.6 Rationale of Capital Budgeting Proposals
6.7 Capital Budgeting Process
6.7.1 Technical Appraisal
6.7.2 Economic Appraisal
6.8 Investment Evaluation
6.9 Appraisal criteria
6.9.1 Traditional Techniques
6.9.2 Discounted pay back period
6.10 Summary
6.1 Introduction
HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over Bank of
Madurai. The motive behind all these mergers is to grow because in this era of
globalization the need of the hour is to grow as big as possible. In all these, one could
observe that the desire of the management to create value for shareholders is the
motivating force.
Another way of growing is through branch expansion, expanding the product mix and
reducing cost through improved technology for deeper penetration into the market for the
companys products. For example, a bank which is urban based, for expansion takes over
a bank with rural network. Here urban based bank can open more urban branches only
when it meets the Reserve Bank of India guidelines of having a minimum number of
rural branches. This is the motive for the merger of urban based bank of ICICI with the
rural based Bank of Madurai.
In this competitive arena pro-active organization makes attempts to convert challenges

into opportunities. Indian economy is growing at 9%. It has far reaching implications.
49
New lines of business such as retailing, investment advisory services and private banking
are emerging. All these involve investment decisions. These investment decisions that
corporates take to reap the benefits arising out of the emerging business opportunities are
evaluation of specific investment proposals. Here the word capital refers to the operating
assets used in production of goods or rendering of services. Budgeting involves
formulating a plan of the expected cash flows during the future period. When we
combine Capital with budget we get Capital budget. Capital budget is a blue print of
planned investments in operating assets. Therefore, Capital budgeting is the process of
evaluating the profitability of the projects under consideration and deciding on the
proposal to be included in the Capital budget for implementation. Capital budgeting
decisions involve investment of current funds in anticipation of cash flows occurring over
a series of years in future. All these decisions are Strategic because they change the
profile of the organizations. Successful organizations have created wealth for their
shareholders through Capital budgeting decisions. Investment of current funds in long-
term assets for generation of cash flow in future over a series of years characterizes the
nature of Capital Budgeting decisions.
1. Explain the concept of capital budgeting.
2. Bring out the importance of capital budgeting.
3. Examine the complexity of capital budgeting procedure.
4. Discuss the various techniques of appraisal methods.
5. Evaluate capital budgeting decision.
6.2 Importance of Capital budgeting

Capital budgeting decisions are the most important decisions in Corporate financial
management. These decisions make or mar a business organization. These decisions
commit a firm to invest its current funds in the operating assets (i.e. long-term assets)
with the hope of employing them most efficiently to generate a series of cash flows in
future.
These decisions could be grouped into

1. Replacement decisions: These decisions may be decision to replace the
equipments for maintenance of current level of business or decisions aiming at
cost reductions.
2. Decisions on expenditure for increasing the present operating level or expansion
through improved network of distribution.
3. Decisions for products of new goods or rendering of new services.
4. Decisions on penetrating into new geographical area.
5. Decisions to comply with the regulatory structure affecting the operations of the
company. Investments in assets to comply with the conditions imposed by
Environmental Protection Act come under this category.
6. Decisions on investment to build township for providing residential
accommodation to employees working in a manufacturing plant.
50
There are many reasons that make the Capital budgeting decisions the most crucial for
finance mangers
1. These decisions involve large outlay of funds now in anticipation of cash flows in
future. For example, investment in plant and machinery. The economic life of
such assets has long periods. The projections of cash flows anticipated involve
forecasts of many financial variables. The most crucial variable is the sales
forecast.
2. A long term investment of funds some times may change the risk profile of the
firm.
3. Most of the Capital budgeting decisions involve huge outlay.
4. Capital budgeting decisions involve assessment of market for companys products
and services, deciding on the scale of operations, selection of relevant technology
and finally procurement of costly equipment. If a firm were to realize after
committing itself considerable sums of money in the process of implementing the
Capital budgeting decisions taken that the decision to diversify or expand would
become a wealth destroyer to the company, then the firm would have experienced
a situation of inability to sell the equipments bought. Loss incurred by the firm on
account of this would be heavy if the firm were to scrap the equipments bought
specifically for implementing the decision taken. Sometimes these equipments
will be specialized costly equipments. Therefore, Capital budgeting decisions are
irreversible.
5. The most difficult aspect of Capital budgeting decisions is the influence of time.
6. All capital budgeting decisions have three strategic elements. These three
elements are cost, quality and timing. Decisions must be taken at the right time
which would enable the firm to procure the assets at the least cost for producing
the products of required quality for customer. Any lapse on the part of the firm in
understanding the effect of these elements on implementation of Capital
expenditure decision taken, will strategically affect the firms profitability.
7. Liberalization and globalization gave birth to economic institutions like World
Trade organization. General Electrical can expand its market into India snatching
the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric
Company. Ability of G E to sell its product in India at a rate less than the rate at
which Indian Companies sell cannot be ignored. Therefore, the growth and
survival of any firm in todays business environment demands a firm to be pro-
active. Pro-active firms cannot avoid the risk of taking challenging Capital
budgeting decisions for growth.
Therefore, Capital budgeting decisions for growth have become an essential
characteristics of successful firms today.
8. The social, political, economic and technological forces generate high level of
uncertainty in future cash flows streams associated with Capital budgeting
decisions. These factors make these decisions highly complex.
9. Capital expenditure decisions are very expensive. To implement these decisions,
firms will have to tap the Capital market for funds. The composition of debt and
equity must be optimal keeping in view the expectation of investors and risk
profile of the selected project.
51
6.3 Complexities involved in Capital Budgeting Decisions
Capital expenditure decision involves forecasting of future operating cash flows. Such
forecasting suffers from uncertainty because the future is highly uncertain. Forecasting
the future cash flows demands the necessity to make certain assumptions about the
behaviour of costs and revenues in future. Fast changing environment makes the
technology considered for implementation many times obsolete.
6.4 Phases of Capital Expenditure Decisions

The following steps are involved in Capital budgeting decisions:
1. Identification of investment opportunities.
2. Evaluation of each investment proposal.
3. Examine the investments required for each investment proposal.
4. Prepare the statements of Costs and benefits of investment proposals.
5. Estimate and compare the net present values of the investment proposals that have
been cleared by the management on the basis of screening criteria.
6. Examine the government policies and regulatory guidelines to be observed for
execution of each investment proposal screened and cleared based on the criteria
stipulated by the management.
7. Budgeting for capital expenditure for approval by the management.
8. Implementation.
9. Post completion audit.
6.5 Identification of investment opportunities

A firm is in a position to identify investment proposal only when it is responsive to the
ideas for capital projects emerging from various levels of the organization. The proposal
may be adding new products to the companys product line, expansion of capacity to
meet the emerging market demand for companys product or new technology based
process of manufactures that will reduce the cost of production.
6.6 Rationale of Capital Budgeting Proposals

The investors and stake holders expect a firm to function efficiently to satisfy their
expectations. Through the stake holders expectation of the performance of the company
may clash among themselves, the one that touches all these stakeholders expectation
could be visualized in terms of the firm obligation to reduce the operating costs on a
continuous basis and increasing its revenues. These twin obligations of a firm form the
basis of all Capital budgeting decisions. Therefore, Capital budgeting decisions could be
grouped into two categories:
1. Decisions on cost reduction programmes.
2. Decisions on revenue generation through expansion of installed capacity.
6.7 Capital Budgeting process

Once the screening of proposals for potential involvement is over, the company should
take up the following aspects of Capital Budgeting process.
1. Commercial: A proposal should be commercially viable. The following aspects are
examined to ascertain the commercial viability of any investment proposal.
52
a. Market for the product
b. Availability of raw materials
c. Sources of raw materials
d. The elements that influence the location of a plant i.e. the factors to be considered
in the site selection.
2. Infrastructural facilities such as roads, communications facilities, financial services

such as banking, public transport services etc.
Among the aspects mentioned above the crucial one is the need to ascertain the demand
for the product or services. It is done by market appraisal. In appraisal of market for the
new product, the following details are complied and analyzed.
a. Consumption trends
b. Competition and players in the market
c. Availability of substitutes
d. Purchasing power of consumers
e. Regulations stipulated by Government on pricing the proposed products or
services
f. Production constraints
Relevant forecasting technologies are employed to get a realistic picture of the potential
demand for the proposed product or service. Many projects fail to achieve the planned
targets on profitability and cash flows if the firm could not succeed in forecasting the
demand for the product on a realistic basis.
6.7.1 Technical appraisal

This appraisal is done to ensure that all technical aspects of the implementation of the
project are considered.
The technical examination of the project considers the following:-

a. Selection of process know how
b. Decision on determination of plant capacity
c. Selection of plant and equipment and scale of operation
d. Plant design and layout
e. General layout and material flow
f. Construction schedule
6.7.2 Economic Appraisal

This appraisal examines the project from the social point of view. It is also known as
social cost benefit analysis. It examines:
a. The impact of the project on the environment
b. The impact of the project on income distribution in the society.
c. The impact of the project on fulfillment of certain social objective like generation
of employment, attainment of self sufficiency etc.
d. Will it materially alter the level of savings and investment in the society?
53
3. Financial appraisal: This appraisal is to examine the financial viability of the project.
It assesses the risk and returns at various stages of project execution. Besides, it
examines whether the risk adjusted return from the project exceeds the cost of
financing of project.
The following aspects are examined in the process of evaluating a project in financial
terms.
a. Cost of the project
b. Investment outlay
c. Means of financing and the cost of capital
d. Expected profitability
e. Expected incremental cash flows from the project
f. Breakeven point
g. Cash break even point
h. Risk dimensions of the project
i. Will the project materially alter the risk profile of the company?
j. If the project is financed by debt, expected Debt Service Coverage Ratio
k. Tax holiday benefits, if any
6.8 Investment Evaluation

Following steps are involved in the evaluation of any investment proposal:
1. Estimates of Cash flows both inflows and outflows occurring at different stages of
project life cycle.
2. Examination of the risk profile of the project to be taken up and arriving at the
required rate of return.
3. Formulating the decision criteria.
Estimation of Cash flows: Estimating the cash flows associated with the project under
consideration is the most difficult and crucial step in the evaluation of an investment
proposal. It is the result of the team work of many professionals in an organization.
1. Capital outlays are estimated by engineering departments after examining all
aspects of production process.
2. Marketing department on the basis of market survey forecasts the expected sales
revenue during the period of accrual of benefits from project executions.
3. Operating costs are estimated by cost accountants and production engineers.
4. Incremental cash flows and cash out flow statement is prepared by the cost
accountant on the basis of the details generated in the above steps. The ability of
the firm to forecast the cash flows with reasonable accuracy lies at the root of the
success of the implementation of any capital expenditure decision.
Investment (Capital budgeting) decision required the estimation of incremental cash flow
stream over the life of the investment. Incremental cash flows are estimated on after tax
basis.
Incremental cash flows stream of a capital expenditure decision has three components.
1. Initial Cash outlay (Initial investment): Initial cash outlay to be incurred is
determined after considering any post tax cash inflows if any, In replacement
54
decisions existing old machinery is disposed of and a new machinery
incorporating the latest technology is installed in its place. On disposal of existing
old machinery the firm has a cash inflow. This inflow has to be computed on post
tax basis. The net cash out flow (total cash required for investment in capital
assets minus post tax cash inflow on disposal of the old machinery being replaced
by a new one) therefore is the incremental cash outflow. Additional net working
capital required on implementation of new project is to be added to initial
investment.
2. Operating Cash inflows: Operating Cash inflows are estimated for the entire
economic life of investment (project). Operating cash inflows constitute a stream
of inflows and outflows over the life of the project. Here also incremental inflows
and outflows attributable to operating activities are considered. Any savings in
cost on installation of a new machinery in the place of the old machinery will
have to be accounted to on post tax basis. In this connection incremental cash
flows refer to the change in cash flows on implementation of a new proposal over
the existing positions.
3. Terminal Cash inflows: At the end of the economic life of the project, the
operating assets installed now will be disposed off. It is normally known as
salvage value of equipments. This terminal cash inflows are computed on post tax
basis.
Prof. Prasanna Chandra in his book Financial Management has identified certain
basic principles of cash flow estimation. The knowledge of these principles will
help a student in understanding the basis of computing incremental cash flows.
These principles, as given by Prof. Prasanna Chandra are:

a. Separation principle
b. Incremental principle
c. Post tax principle
d. Consistency principle
a. Separation principle: The essence of this principle is the necessity to treat investment
element of the project separately (i.e. independently) from that of financing element. The
financing cost is computed by the cost of capital. Cost of capital is the cut off rate and
rate of return expected on implementation of the project is compared with the cost of
capital. Therefore, we compute separately cost of funds for execution of project through
the financing mode. The rate of return expected on implementation if the project is
arrived at by the investment profile of the projects. Therefore, interest on dept is ignored
while arriving at operating cash inflows.
The following formula is used to calculate profit after tax.

Incremental PAT = Incremental EBIT (1-t)
(Incremental) (Incremental)
EBIT = Earnings (Profit) before interest and taxes.
t = tax rate
EBIT infact represents incremental earnings before interest and tax.
55
When depreciation charges on computing incremental post tax profit is add back to
incremental profit after tax, we get incremental operating cash inflow.
b. Incremental principle: Incremental principle says that the cash flows of a project are
to be considered in incremental terms. Incremental cash flows are the changes in the
firms total cash flows arising directly from the implementation of the project.
The following are to be kept in the mind in determining incremental cash flows.
1. Ignore Sunk costs: A sunk cost means an outlay already incurred. It is not a
relevant cost for the project decisions to be taken now. It is ignored when the
decisions on project now under consideration is to be taken.
2. Opportunity Costs: If the firm already owns an asset or resource which could be
used in the execution of the project under consideration the asset of resource has
an opportunity cost. The opportunity cost of such resources will have to be taken
into account in the evaluation of the project for acceptance or rejection. For
example, the firm wants to open a branch in Chennai for expansion of its market
in Tamil Nadu. The firm already owns a building in Chennai. The building in
Chennai is let out to some other firm on an annual rent of Rs.1 Crore. The firm
takes a decision to open a branch at Chennai. For opening the branch at Chennai
the firm uses the building it owns by sacrificing the rental income which it
receivers now. The opportunity cost of the building at Chennai is Rs. 1 Crore.
This will have to be considered in arriving at the operating cash flows associated
with the decision to open a branch at Chennai.
3. Need to take into account all incident effect: Effects of a project on the working
of other parts of a firm also known as externalities must be taken into account. For
example, expansion or establishment of a branch at a new place may increase the
profitability of existing branches because the branch at the new place competes
with the business of other existing branches or takes away some business
activities from the existing branches.
4. Cannibalization: another problem that a firm faces on introduction of a new
product is the reduction in the sale of an existing product. This is called
cannibalization. The most challenging task is the handling of problems of
cannibalization. Depending on the companys position with that of the
competitors in the market, appropriate strategy has to follow. Correspondingly the
cost of cannibalization will have to be treated either as relevant cost of the
decision or ignored.
Product cannibalization will affect the companys sales if the firm is marketing its
products in a market characterized by severe competition, without any entry barriers.
In this case costs are not relevant for decision. On the other hand if the firms sales are
not affected by competitors activities due to certain unique protection that it enjoys on
account of brand positioning or patent protection the costs of cannibalization cannot be
ignored in taking decisions.
c. Post Tax Principle: all cash flows should be computed on post tax basis
56
d. Consistency principle: cash flows and discount rates used in project evaluation need
to consistent with the investor group and inflation.
In capital budgeting, the cash flows applicable to all investors (i.e. equity, preference
share holders and debt holders) and weighted average cost of capital are considered.
Nominal cash flows and nominal discounts are considered in capital budgeting decision.
6.9 Appraisal Criteria

The methods of appraising an investment proposal can be grouped into
1. Traditional methods
2. Modern methods
Traditional Methods are:

i. Payback method
ii. Accounting Rate of Return
Modern techniques are:

a. Net present value
b. Internal Rate of Return
c. Modified internal rate of return
d. Profitability index
6.9.1 Traditional Techniques

a. Payback method: Payback period is defined as the length of time required to recover
the initial cash out lay.
Example: The following details are available in respect of the cash flows of two projects
A & B.
Year Project A Project B

Cash flows (Rs.) Cash flows (Rs.)
0 (4,00,000) (5,00,000)
1 2,00,000 1,00,000
2 1,75,000 2,00,000
3 25,000 3,00,000
4 2,00,000 4,00,000
5 1,50,000 2,00,000
Compute pay back period for A and B.
Solution:
Year Project A Project B
Cash flows Cumulative Cash flows Cumulative
(Rs.) Cash flows (Rs.) Cash flows
1 2,00,000 2,00,000 1,00,000 1,00,000
2 1,75,000 3,75,000 2,00,000 3,00,000
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3 25,000 4,00,000 3,00,000 6,00,000
4 2,00,000 6,00,000 4,00,000 10,00,000
5 1,50,000 7,50,000 2,00,000 12,00,000
From the cumulative cash flows column project A recovers the initial cash outlay of
Rs.4,00,000 at the end of the third year. Therefore, payback period of project A is 3
years.
From the cumulative cash flow column the initial cash outlay of Rs.5,00,000 lies between
2nd year and 3rd year in respect of project B. Therefore, payback period for project B is:
5,00,0000-3,00,000
2+
3,00,000
= 2.67 years
Evaluation of payback period:

Merits:
1. Simple in concept and application.
2. Since emphasis is on recovery of initial cash outlay it is the best method for
evaluation of projects with very high uncertainty.
3. With respect to accept or reject criterion pay back method favors a project with is less
than or equal to the standard pay back set by the management. In this process 3early
cash flows get due recognition than later cash flows. Therefore, pay back period
could be used as a tool to deal with the ranking of projects on the basis of risk
criterion.
4. For firms with shortage funds this is preferred because it measures liquidity of the
project.
Demerits:
1. It ignores time value of money.
2. It does not consider the cash flows that occur after the pay back period.
3. It does not measure the profitability of the project.
4. It does not throw any light on the firms liquidity position but just tells about the
ability of the project to return the cash out lay originally made.
5. Project selected on the basis of pay back criterion may be in conflict with the wealth
maximization goal of the firm.
Accept or reject criterion

a. If projects are mutually exclusive, select the project which has the least pay back
period.
b. In respect of other projects, select the project which have pay back period less
than or equal to the standard pay back stipulated by the management.
Illustration:
Following details are available
Pay back period:
58
Project A = 3 years
Project B = 2.5 years
Standards set up by management = 3 years
If projects are mutually exclusive, accept project B which has the least pay back period.
If projects are not mutually exclusive, accept both the project because both have pay back
period less than or equal to original to the standard pay back period set by the
management.
Pay back period formula
Year Prior to full recovery of initial out lay + (Balance of initial out lay to be recovered
at the beginning of the year in which full
Recovery takes place) / Cash in flow of the
year in which full recovery takes place
6.9.2 Discounted Pay Back Period:

The length in years required to recover the initial cash out lay on the present value basis
is called the discounted pay back period. The opportunity cost of capital is used for
calculating present values of cash inflows.
Discounted pay back period for a project will be always higher than simple pay back
period because the calculation of discounted pay back period is based on discounted cash
flows.
For example:
Year Project A PV factor at PV of Cash Cumulative
Cash flows 10% flows positive Cash
flows
0 (4,00,000) 1 (4,00,000)
1 2,00,000 0.909 1,81,800 1,81,800
2 1,75,000 0.826 1,44,550 3,26,350
3 25,000 0.751 18,775 3,45,125
4 2,00,000 0.683 1,36,600 4,81,725
5 1,50,000 0.621 93,150 5,74,875
Discounted Pay back period:
4,00,0000-3,45,125 = 3.4 years

3+
1,36,600
Accounting rate of returns:

ARR measures the profitability of investment (project) using information taken from
financial statements:
Average Income
ARR =
Average investment
Average of post tax operating profit
=
59
Average investment
Average investment =
Book Value of the investment in the + Book value of investment at the end of
beginning the life of the project or investment
2
Illustration:
The following particular refer to two projects:-
X Y
Cost 40,00. 60,000
Estimated life 5 years 5 years
Salvage value Rs.3,000 Rs.3,000
Estimate income
After tax
Rs. Rs.
1 3,000 10,000
2 4,000 8,000
3 7,000 2,000
4 6,000 6,000
5 8,000 5,000
Total 28,000 31,000
Average 5,600 6,200
Average investment 21,500 31,500
5,600 6,200
ARR =
21,500 31,500
= 26% 19.7%
Merits of Accounting rate of return:

1. It is based on accounting information.
2. Simple to understand
3. It considers the profits of entire economic life of the project.
4. Since it based on accounting information the business executives familiar with the
accounting information understand this technique.
Demerits:
1. It is based on accounting income and not based on cash flows, as the cash flow
approach is considered superior to accounting information based approach.
2. It does not consider the time value of money.
3. Different investment proposals which require different amounts of investment
may have the same accounting rate of return. The ARR fails to differentiate
projects on the basis of the amount required for investment.
60
4. ARR is based on the investment required for the project. There are many
approaches for the calculation of denominator of average investment. Existence of
more than one basis for arriving at the denominator of average investment may
result in adoption of many arbitrary bases.
Because of this the reliability of ARR as a technique of appraisal is reduced when two
projects with the same ARR but with differing investment amounts are to be evaluated.
Accept or reject criterion:

Any project which has an ARR more the minimum rate fixed by the management is
accepted. If actual ARR is less than the cut rate (minimum rate specified by the
management ) then that project is rejected. When projects are to be ranked for deciding
on the allocation of capital on account of the need for capital rationing, project with
higher ARR are preferred to the ones with lower ARR.
Discounted cash flow method:

Discounted cash flow method or time adjusted technique is an improvement over the
traditional techniques. In evaluation of the projects the need to give weightage to the
timing of return is effectively considered in all DCF methods. DCF methods are cash
flow based and take the cognizance of both the interest factors and cash flow after the pay
back period.
DCF technique involves the following:

1. Estimation of cash flows, both inflows and outflows of a project over the entire
life of the project.
2. Discounting the cash flows by an appropriate interest factor (discount factor).
3. Sum of the present value of cash outflow is deducted from the sum of present
value of cash inflows to arrive at net present value of cash flows.
The most popular techniques of DCF methods are:
DCF methods are 3 types:

1. The net present value.
2. The internal rate of return.
3. Profitability index.
The net present value:

NPV method recognizes the time value of money. It correctly admits that cash flows
occurring at different time periods differ in value. Therefore, there is the need to find out
the present values of all cash flows.
NPV method is the most widely used technique among the DCF methods.
Steps involved in NPV method:
1. Forecast the cash flows, both inflows and outflows of the projects to be taken up
for execution.
61
2. Decisions on discount factor or interest factor. The appropriate discount rate is the
firms cost of capital or required rate of return expected by the investors.
3. Compute the present value of cash inflows and outflows using the discount factor
selected.
4. NPV is calculated by subtracting the PV of cash outflows from the present value
of cash inflows.
Accept or reject criterion:

If NPV is positive, the project should be accepted. If NPV is negative the project should
be rejected.
Accept or reject criterion can be summarized as given below:
1. NPV > Zero = accept
2. NPV < Zero = reject
NPV method can be used to select between mutually exclusive projects by examining
whether incremental investment generates a positive net present value.
Merits of NPV method:

1. It takes into account the time value of money.
2. It considers cash flows occurring over the entire life of the project.
3. NPV method is consistent with the goal of maximizing the net wealth of the
company.
4. It analyses the merits of relative capital investments.
5. Since cost of capital of the firm is the hurdle rate, the NPV ensures that the
project generates profits from the investment made for it.
Demerits:
1. Forecasting of cash flows is difficult as it involves dealing with effect of elements
of uncertainties on operating activities of firm.
2. To decide on the discounting factor, there is the need to assess the investors
required rate of return. But it is not possible to compute the discount rate
precisely.
3. There are partial problems associated with the evaluation of projects with unequal
lives or under funds constraints.
For ranking of projects under NPV approach the project with the highest positive NPV is
preferred to that with lower NPV.
Problem: A company is evaluating two alternatives for distribution within the plant. Two
alternatives are
1. C system with a high initial cost but low annual operating costs.
2. F system which costs less but have considerably higher operating costs. The
decision to construct the plant has already been made, and the choice here will
have no effect on the overall revenues of the project. The cost of capital of the
plant is 12% and the projects expected net cash costs are listed below:
62
Year Expected Net Cash Costs
C Systems F Systems
0 (3,00,000) (1,20,000)
1 (66,000) (96,000)
2 (66,000) (96,000)
3 (66,000) (96,000)
4 (66,000) (96,000)
5 (66,000) (96,000)
What is present value of costs of each alternative?
Which method should be chosen?
Solution: Computation of present value
Year C Systems F Systems Incremental

1 (66,000) (96,000) 30,0000
2 (66,000) (96,000) 30,0000
3 (66,000) (96,000) 30,0000
4 (66,000) (96,000) 30,0000
5 (66,000) (96,000) 30,0000
Present value of incremental savings = 30,000 x PVIFA(12%, 5)

= 30,000 x 3.605 = 1,08,150
Incremental cash out lay = 1,80,000
(71,850)
Since the present value of incremental net cash inflows of C system over F system is
negative. C system is not recommended.
Therefore, F system is recommended.
Properties of the NPV

1. NPV are additive. If two projects A and B have NPV (A) and NPV(B) then by
additive rule the net present value of the combined investment is NPV(A + B).
2. Intermediate cash inflows are reinvested at a rate of return equal to the cost of
capital.
Demerits of NPV:
1. NPV expresses the absolute positive or negative present value of net cash flows.
Therefore, it fails to capture the scale of investment.
2. In the application of NPV rule in the evaluation of mutually exclusive projects
with different lives, bias occurs in favour of the long term projects.
Internal Rate of Return: It is the rate of return (i.e. discount rate) which makes the NPV
of any project equal to zero. IRR is the rate of interest which equates the PV of cash
inflows with the PV of cash flows.
63
IRR is also called yield on investment, managerial efficiency of capital, marginal
productivity of capital, rate of return, time adjusted rate of return, IRR is the rate of return
that project earns.
Evaluation of IRR:
1. IRR takes into account the time value of money
2. IRR calculates the rate of return of the project, taking into account the cash flows
over the entire life of the project.
3. It gives a rate of return that reflects the profitability of the project.
4. It is consistent with the goal of financial management i.e. maximization of net
wealth of share holders.
5. IRR can be compared with the firms cost of capital.
6. To calculate the NPV the discount rate normally used is cost of capital. But to
calculate IRR, there is no need to calculate and employ the cost of capital for
discounting because the project is evaluated at the rate of return generated by the
project. The rate of return is internal to the project.
Demerits:
1. IRR does not satisfy the additive principle.
2. Multiple rates of return or absence of a unique rate of return in certain projects
will affect the utility of this techniques as a tool of decision making in project
evaluation.
3. In project evaluation, the projects with the highest IRR are given preference to the
ones with low internal rates.
Application of this criterion to mutually exclusive projects may lead under certain
situations to acceptance of projects of low profitability at the cost of high
profitability projects.
4. IRR computation is quite tedious.
Accept or Reject Criterion:

If the projects internal rate of return is greater than the firms cost of capital, accept the
proposal. Otherwise reject the proposal.
IRR can be determine by solving the following equation for r =
CF0 = _Ct where t = 1 to n

(1+r)t
Example: A project requires an initial out lay of Rs.1,00,000. It is expected to generate

the following cash inflows:
Year Cash inflows

1 50,000
2 50,000
3 30,000
4 40,000
64
What is the IRR of the project?
Step I
Compute the average of annual cash inflows
Year Cash inflows
1 50,000
2 50,000
3 30,000
4 40,000
Total 1,70,000
Average = 1,70,000 = Rs.42,500

4
Step II: Divide the initial investment by the average of annual cash inflows:
=1,00,000 = 2.35
42,500
Step III: From the PVIFA table for 4 years, the annuity factor very near 2.35 is 25%.
Therefore the first initial rate is 25%.
Year Cash flows PV factor at 25% PV of Cash flows

1 50,000 0.800 40,000
2 50,000 0.640 32,000
3 30,000 0.512 15,360
4 40,000 0.410 16,400
Total 1,03,760
Since the initial investment of Rs.1,00,000 is less than the computed value at 25% of
Rs.1,03,760 the next trial rate is 26%.

1 50,000 0.7937 39,685
2 50,000 0.6299 31,495
3 30,000 0.4999 14,997
4 40,000 0.3968 15,872
Total 1,02,049
The next trial rate is 27%

1 50,000 0.7874 39,370
2 50,000 0.6200 31,000
3 30,000 0.4882 14,646
4 40,000 0.3844 15,376
65
Total 1,00,392
The next trial rate is 28%

1 50,000 0.7813 39,065
2 50,000 0.6104 30,520
3 30,000 0.4768 14,304
4 40,000 0.3725 14,900
Total 98,789
Since initial investment of Rs.1,00,000 lies between 98789 (28%) and 1,00,392 (27%) the
IRR by interpolation.
1,00,392-1,00,000
27+ X1
1,00,392-98,789
392
27+ X1
1603
= 27 + 0.2445
= 27.2445 = 27.24%
Modified Internal Rate of Return:

MIRR is a distinct improvement over the IRR. Managers find IRR intuitively more
appealing than the rupees of NPV because IRR is expressed on a percentage rates of
return. MIRR modifies IRR. MIRR is a better indicator or relative profitability of the
projects.
MIRR is defined as
PV of Costs = PV of terminal value
TV
PVC =
(1+MIRR)n
PVC = PV of costs
To calculate PVC, the discount rate used is the cost of capital.
To calculate the terminal value, the future value factor is based on the cost of capital.
Then obtain MIRR on solving the following equation.

TV
PV of Costs =
(1+MIRR)n
Superiority of MIRR over IRR

1. MIRR assumes that cash flows from the project are reinvested at the cost of
capital. The IRR assumes that the cash flows from the project are reinvested at the
66
projects own IRR. Since reinvestment at the cost of capital is considered realistic
and correct, the MIRR measures the projects true profitability.
2. MIRR does not have the problem of multiple rates which we come across in IRR.
Illustration:
Year 0 1 2 3 4 5 6
Cash flows (100) (100) 30 60 90 120 130
(Rs.in million)
Cost of Capital is 12%
Present value of cost = 100 + 100

1.12
= 100 + 89.29 = 189.29
Terminal value of cash flows:

= 30(1.12)4 + 60(1.12)3 + 90(1.12)2 + 120(1.12) + 130
= 30 x 1.5735 + 60 x 1.4049 + 90 x 1.2544 + 120 x 1.12 + 130
=47.205 + 84.294 + 112.896 + 134.4 + 130
= 508.80
MIRR is obtained on solving the following equation
508.80
189.29 =
(1+MIRR)6
508.80
(1+MIRR)6 =
189.29
(1+MIRR)6 = 2.6879
MIRR = 17.9%
Profitability Index : It is also known as Benefit cost ratio.

Profitability Index is the ratio of the present value of cash inflows to initial cash outlay.
The discount factor based on the required rate of return in used to discount the cash in
flows.
Present value of cash inflows
PI =
Initial Cash outlay
Accept or Reject Criterion:

1. Accept the project if PI is greater than 1
2. Reject the project if PI is less than 1
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If profitability index is 1 then the management may accept the project because the sum of
the present value of cash inflows is equal to the sum of present value of cash outflows. It
neither adds nor reduces the existing wealth of the company.
Merits of PI:
1. It takes into account the time value of money
2. It is consistent with the principle of maximization of share holders wealth.
3. It measures the relative profitability.
Demerits
1. Estimation of cash flows and discount rate cannot be done accurately with
certainty.
2. A conflict may arise between NPV and profitability index if a choice between
mutually exclusive projects has to be made.
Example
X Y
PV of Cash inflows 4,00,000 2,00,000
Initial cash outlay 2,00,000 80,000
NPV 2,00,000 1,20,000
Profitability Index 2 2.5
As per NPV method project X should be accepted. As per profitability index project Y
should be accepted. This leads to a conflicting situation. The NPV method is to be
preferred to profitability index because the NPV represents the net increase in the firms
wealth.
6.10 Summary
Capital investment proposals involve current outlay of funds in the expectation of a
stream of cash in flow in future. Various techniques are available for evaluating
investment projects. They are grouped into traditional and modern techniques. The major
traditional techniques are payback period and accounting rate of return. The important
discounting criteria are net present value, internal rate of return and profitability index. A
major deficiency of payback period is that it does not take into account the time value of
money. DCF techniques overcome this limitation. Each method has both positive and
negative aspects. The most popular method for large project is the internal rate of return.
Payback period and accounting rate of return are popular for evaluating small projects.

1. ____________ make or mar a business.
a) Capital Budgeting
b) Capital
c) Fixed capital
d) Working capital
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2. ____________ decisions involve large outlay of funds now in anticipation of cash
inflows in future.
a) Make or buy
b) Capital budgeting
c) Fixed capital
d) Working capital
3. Social, political, economic and technological forces make capital budgeting decisions
______________.
a) Complex
b) Simple
c) Analytical
d) Easy
4. ____________decisions are very expensive.

a) Make or buy
b) Capital budgeting
c) Fixed capital
d) Working capital
5. Capital expenditure decisions are ____________.

a) Irreversible
b) Reversible
c) Very simple
d) Middle level
6. Forcasting of future operating cash flows suffers from ____________ because the
future is ____________.
a) Certainty, highly uncertain
b) Certainty, certain
c) Uncertainty, certain
d) Uncertainty, highly uncertain
7. Post completion audit is ____________ in the phases of capital budgeting decisions.

a) First Step
b) Third step
c) Fifth step
d) Final step
8. Identification of investment opportunity is ____________ in the phases of capital

budgeting decisions.
a) First Step
b) Third step
c) Fifth step
d) Final step
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9. Analyzing the demand and supply condition of the market for the companys products
could be a __________ source of potential investment proposal.
a) Fertile
b) Futile
c) Primary
d) Secondary
10. Generation of ideas for capital budgets and screening the same can be considered the
most ________ phase of capital budgeting decision.
a) Useless
b) Crucial
c) Beneficial
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Chapter 7 Risk Analysis in Capital Budgeting
Structure:
7.1 Introduction
Objectives
7.2 Types and sources of Risk in Capital Budgeting
7.3 Risk Adjusted Discount Rate
7.4 Certainty Equivalent
7.5 Sensitivity Analysis
7.6 Probability Distribution Approach
7.7 Decision tree approach
7.8 Summary
7.1 Introduction
In the previous chapter on capital budgeting the project appraisal techniques were applied
on the assumption that the project will generate a given set of cash flows.
It is quite obvious that one of the limitations of DCF techniques is the difficulty in
estimating cash flows with certain degree of certainty. Certain projects when taken up by
the firm will change the business risk complexion of the firm.
This business risk complexion of the firm influences the required rate of return of the
investors. Suppliers of capital to the firm tend to be risk averse and the acceptance of a
project that changes the risk profile of the firm may change their perception of required
rates of return for investing in firms project. Generally the projects that generate high
returns are risky. This will naturally alter the business risk of the firm. Because of this
high risk perception associated with the new project a firm is forced to asses the impact
of the risk on the firms cash flows and the discount factor to be employed in the process
of evaluation.
Definition of Risk: Risk may be defined as the variation of actual cash flows from the
expected cash flows.
There are many factors that affect forecasts of investment, cost and revenue.
1. The business is affected by changes in political situations, monetary policies,
taxation, interest rates, policies of the central bank of the country on lending by
banks etc.
2. Industry specific factors influence the demand for the products of the industry to
which the firm belongs.
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3. Company specific factors like change in management, wage negotiation with the
workers, strikes or lockouts affect companys cost and revenue position.
Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk
management. The best business decision may not yield the desired results because the
uncertain conditions likely to emerge in future can materially alter the fortunes of the
company.
After studying this unit, you should be able to understand the following:
1. Define risk in capital budgeting.
2. Examine the importance of risk analysis in capital budgeting.
3. Methods of incorporating the risk factor in capital budgeting decision.
4. Understand the types and sources of risk in capital budgeting decision.
7.2 Types and sources of Risk in Capital Budgeting

Risks in a project are many. It is possible to identify three separate and distinct types of
risk in any project.
1. Stand alone risk: it is measured by the variability of expected returns of the
project.
2. Portfolio risk: A firm can be viewed as portfolio of project having a certain
degree of risk. When new project is added to the existing portfolio of project, the
risk profile of firm will alter. The degree of the change in the risk depends on the
covariance of return from the new project and the return from the existing
portfolio of the projects. If the return from the new project is negatively correlated
with the return from portfolio, the risk of the firm will be further diversified away.
3. Market or beta risk: It is measured by the effect of the project on the beta of the
firm. The market risk for a project is difficult to estimate.
Stand alone risk is the risk of project when the project is considered in isolation.
Corporate risk is the projects risks of the firm. Market risk is systematic risk. The
market risk is the most important risk because of the direct influence it has on
stock prices.
Sources of risk: The sources of risks are

1. Project specific risk
2. Competitive or Competition risk
3. Industry specific risk
4. International risk
5. Market risk
1. Project specific risk: The source of this risk could be traced to something quite
specific to the project. Managerial deficiencies or error in estimation of cash flows or
discount rate may lead to a situation of actual cash flows realised being less than that
projected.
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2. Competitive risk or Competition risk: unanticipated actions of a firms competitors
will materially affect the cash flows expected from a project. Because of this the actual
cash flows a project will be less than that of the forecast.
3. Industry specific: industry specific risks are those that affect all the firms in
industry. It could be again grouped into technological risk, commodity risk and legal risk.
4. International Risk: These types of risks are faced by firms whose business consists
mainly of exports or those who procure their main raw material from international
markets. For example, rupee dollar crisis affected the software and BPOs because it
drastically reduced their profitability. Another best example is that of the textile units in
Tirupur in Tamilnadu, exporting their major part of garments produced. Rupee gaining
and dollar Weakening reduced their competitiveness in the global markets. The surging
Crude oil prices coupled with the governments delay in taking decision on pricing of
petro products eroded the profitability of oil marketing Companies in public sector like
Hindustan Petroleum Corporation Limited. Another example is the impact of US sub
prime crisis on certain segments of Indian economy.
The changes in international political scenario also affect the operations of certain firms.
5. Market Risk: Factors like inflation, changes in interest rates, and changing general
economic conditions affect all firms and all industries.
Firms cannot diversify this risk in the normal course of business.
Techniques used for incorporation of risk factor in capital budgeting decisions.
There are many techniques of incorporation of risk perceived in the evaluation of capital
budgeting proposals. They differ in their approach and methodology so far as
incorporation of risk in the evaluation process is concerned.
Conventional techniques
Pay Back Period
The oldest and commonly used method of recognizing risk associated with a capital
budgeting proposal is pay back period. Under this method, shorter pay back period is
given preference to longer ones.
For example, the following details are available in respect of two projects.
Particulars Project A (Rs) Project B(Rs)
Initial cash outlay 10 lakhs 10 lakhs
Cash flows
Year 1 5 lakhs 2 lakhs
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Both the projects have a pay back period of 4 years. The project B is riskier than the
Project A because Project A recovers 80% of initial cash outlay in the first two years of
its operation where as Project B generates higher Cash inflows only in the latter half of
the payback period.
This method considers only time related risks and ignores all other risk of the project
under consideration.
7.3 Risk Adjusted Discount Rate

Risk premium need to be incorporated in discount rate in the evaluation of risky project
proposals.
Therefore the discount rate for appraisal of projects has two components.
Those components are

1. Risk free rate and risk premium
Risk adjusted Discount rate = Risk free rate + Risk premium
Risk free rate is computed based on the return on government securities.
Risk premium is the additional return that investors require as compensation for assuming
the additional risk associated with the project.
7.4 Certainty Equivalent

Under this method the risking uncertain, unexpected future cash flows are converted into
cash flows with certainly. Here we multiply uncertain future cash flows by the certainty
equivalent coefficient to convert uncertain cash flows into certain cash flows. The
certainty equivalent coefficient is also known as the risk adjustment factor. Risk
adjustment factor is normally denoted by (Alpha). It is the ratio of certain net cash flow
to risky net cash flow
Certain Cash flow

= Certainty Equivalent =
Risky Cash flow
The discount factor to be used is the risk free rate of interest. Certainty equivalent
coefficient is between 0 and 1. This risk adjustment factor varies inversely with risk. If
risk is high a lower value is used for risk adjustment. If risk is low a higher coefficient of
certainty equivalent is used.
Illustration (Example)
A project costs Rs.50, 000. It is expected to generate cash inflows as under
Year Cash in Flows Certainty Equivalent
1 32,000 0.9
2 27,000 0.6
3 20,000 0.5
4 10,000 0.3
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Risk free discount rate is 10% compute NPV
Answer:
Year Uncertain CE Certain PV PV of certain
cash in cash flows Factor cash inflows
flows at 10%
1 32,000 0.9 28,800 0.909 26,179
2 27,000 0.6 16,200 0.826 13,381
3 20,000 0.5 10,000 0.751 7,510
4 10,000 0.3 3,000 0.683 2,049
PV of certain cash 49,119
in flows
Initial cash out lay 50,000
NPV (881) negative
The project has a negative NPV.

Therefore, it is rejected.
If IRR is used, the rate of discount at which NPV is equal to zero is computed and then
compared with the minimum (required) risk free rate. If IRR is greater than specified
minimum risk free rate, the project is accepted, other wise rejected.
Evaluation:
It recognises risk. Recognition of risk by risk adjustment factor facilitates the
conversion of risky cash flows into certain cash flows. But there are chances of being
inconsistent in the procedure employed from one project to another.
When forecasts pass through many layers of management, original forecasts may become
highly conservative.
Because of high conservation in this process only, good projects are likely to be cleared
when this method is employed.
Certainty equivalent approach is considered to be theoretically superior to the risk

adjusted discount rate.
7.5 Sensitivity Analysis

There are many variables like sales, cost of sales, investments, tax rates etc which affect
the NPV and IRR of a project. Analysing the change in the projects NPV or IRR on
account of a given change in one of the variables is called Sensitivity Analysis. It is a
technique that shows the change in NPV given a change in one of the variables that
determine cash flows of a project. It measures the sensitivity of NPV of a project in
respect to a change in one of the input variables of NPV.
75
The reliability of the NPV depends on the reliability of cash flows. If forecasts go wrong
on account of changes in assumed economic environments, reliability of NPV & IRR is
lost. Therefore, forecasts are made under different economic condition viz pessimistic,
expected and optimistic. NPV is arrived at for all the three assumptions.
Following steps are involved in Sensitivity analysis:

1. Identification of variables that influence the NPV & IRR of the project.
2. Examining and defining the mathematical relationship between the variables.
3. Analysis of the effect of the change in each of the variables on the NPV of the
project.
Example: A company has two mutually exclusive projects under consideration viz
project A & project B.
Each project requires an initial cash outlay of Rs.3,00,000 and has an effective life of 10
years. The companys cost of capital is 12%. The following fore cast of cash flows are
made by the management.
Economic Project A Project B
Environment Annual cash inflows Annual cash inflows
Pessimistic 65,000 25,000
Expected 75,000 75,000
Optimistic 90,000 1,00,000
What is the NPV of the project?

Which project should the management consider?
Given PVIFA = 5.650

Answer / Solutions
NPV of project A
Economic Project PVIFA PV of cash in NPV
flows
Environment Cash inflows at 12% 10 years
Pessimistic 65,000 5.650 3,67,250 67,250
Expected 75,000 5.650 4,23,750 1,23,750
Optimistic 90,000 5.650 5,08,500 2,08,500
NPV of Project B
Pessimistic 25,000 5.650 1,41,250 (1,58,750)
Expected 75,000 5.650 4,23,750 1,23,750
Optimistic 1,00,000 5.650 5,65,000 2,65,000
Decision
1. Under pessimistic conditions project A gives a positive NPV of Rs.67,250 and
Project B has a negative NPV of Rs.1,58,750 Project A is accepted.
2. Under expected conditions, both gave some positive NPV of Rs.1,23,000. Any
one of two may be accepted.
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3. Under optimistic conditions Project B has a higher NPV of Rs.2,65,000 compared
to that of As NPV of Rs.2,08,500.
4. Difference between optimistic and pessimistic NPV for project A is Rs.1,41,250
and for project B the difference is Rs.4,23,750.
5. Project B is risky compared to Project A because the NPV range is of large
difference.
7.6 Probability Distribution Approach

When we incorporate the chances of occurrences of various economic environments
computed, NPV becomes more reliable. The chances of occurrences are expressed in the
form of probability. Probability is the likelihood of occurrence of a particular economic
environment. After assigning probabilities to future cash flows expected net present value
is computed.
Illustration: A company has identified a project with an initial cash outlay of Rs.50,000.
The following distribution of cash flow is given below for the life of the project of 3
years.
Year1 Year2 Year3
Cash in flow Probability Cash in flow Probability Cash in flow Probability
15,000 0.2 20,000 0.3 25,000 0.4
18,000 0.1 15,000 0.2 20,000 0.3
35,000 0.4 15,000 0.2 20,000 0.3
32,000 0.3 30,000 0.2 45,000 0.1
Discount rate is 10%

Year 1
=15,000 x 0.2 + 18,000 x 0.1 + 35,000 x 0.4 + 32,000 x 0.300
3,000 + 1,800 +14,000 + 9,600 = 28,400
Year 2
20,000 x 0.3 + 15,000 x 0.2 + 30,000 x 0.3 + 30,000 x 0.2
= 6,000 + 3,000 + 9,000 + 6,000 = 24,000
Year 3
25,000 x 0.4 + 20,000 x 0.3 + 40,000 x 0.2 +5,000 x 0.1=
10,000 + 6,000 + 8,000 + 4,500 = = 28,500
Year Expected cash inflows PV factor at 10% PV of expected

cash in flows
1 28,400 0.909 25,816
2 24,000 0.826 19,824
3 28,500 0.751 21,403
PV of expected cash in flows 67,043
PV of initial cash out lay 50,000
Expected NPV 17,043
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Variance:
A study of dispersion of cash flows of projects will help the management in assessing the
risk associated with the investment proposal. Dispersion is computed by variance or
standard deviation. Variance measures the deviation of each possible cash flow the
expected. Square root of variance is standard deviation
7.7 Decision tree approach

Many project decisions are complex investment decisions. Such complex investment
decisions involve a sequence of decision over time. Decisions tree can handle the
sequential decisions of complex investment proposals.
Example
R & D section of a company has developed an electric moped. The firm is ready for pilot
production and test marketing. This will cost Rs.20 million and take six months.
Management believes that there is a 70% chance that the pilot production and test
marketing will be successful.
If successful the company can build a plant costing Rs.200 million.
The plant will generate annual cash in flow of Rs.50 million for 20 years if the demand is
high or an annual cash inflow or 20 million if the demand is low.
High demand has a probability of 0.6 and low demand has a probability of 0.4. Cost of
capital is 12%.
Suggest the optimal course of action using decision tree analysis
High Demand
D11 Carry out pilot
Probability 0.6
Production
D21 Investment C21
And Market Annual Cash inflow
Rs.200 million
test (20 million) Rs.50 million
C2
C11 Success 0.7 Annual Cash inflow
D2 Rs.20 million
C1 C22 Low Demand
D22 Stop Probability 0.4
D
D12 Do Nothing C12 D3

D31 Stop
Failure
Probability 0.3
Working Notes: From right hand side of the decision tree
78
Step 1: Computation of Expected Monetary Value at point C2. Here EMV represents
expected NPV.
Cash in Probability Expected value of cash inflows
flow
50 0.6 30
20 0.4 8
EMV 38
Present Value of EMV = Expected value of cash inflow x PVIFA (12% 20)
38 x 7.469 = Rs.283.82 million
Step 2:
Computation of EMV at decision point D2.
Decision taken Consequences The resulting EMV at this
level
D2 Invest Rs.200 million 283.82 200 83.82
D22 Stop 0
Here the decision criterion is select the EMV with the highest value.
Step 3:
Therefore EMV with Rs.83.82 million will be considered therefore; we select the
decision taken at D2,
Step 4:
Computation of EMV at the point C,
EMV Probability Expected Value
83.82 0.7 58.67
0 0.3 0
EMV at this stage 58.67
Step 5:
Compute EMV at decisions point D,
Decision taken Consequences The resulting Em at this level
D11 carry out pilot Invest 20 million 58.67 20 = Rs.38.67 million
production and market
test
D12 Do nothing 0 0
EMV at this stage 38.67 million
(Apply the EMV criterion) i.e
select the EMV with the highest
value
Therefore optimal strategy is

1. Carry out pilot production and market test.
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2. If the result of pilot production and market test is successful, go ahead with the
investment decision of Rs.200 million in establishing a plant.
3. If the result of pilot production and market test is future, stop.
Evaluation of Decision tree approach:

1. It portrays inter related, sequential and critical multi dimensional elements of
major project decisions.
2. Adequate attention is given to the critical aspects in an investment decision which
spread over a time sequence.
3. Complex projects involve huge out lay and hence risky. There is the need to
define and evaluate scientifically the complex managerial problems arising out of
the sequence of interrelated decisions with consequential outcomes of high risk. It
is effectively answered by decision tree approach.
4. Structuring a complex project decision with many sequential investment decisions
demands effective project risk management. This is possible only with the help of
an analytical tool like decision tree approach.
5. Able to eliminate unprofitable outcomes and helps in arriving at optimum
decision stages in time sequence.
7.8 Summary
Risk in project evaluation arises on account of the inability of the firm to predict the
performance of the firm with certainty. Risk in capital budgeting decision may be defined
as the variability of actual return from the expected. There are many factors that affect
forecasts of investment, costs and revenues of a project. It is possible to identify three
types of risk in any project, viz stand alone risk, corporate risk and market risk. The
sources of risks are:
a. Project
b. Competition
c. Industry
d. International factors and
e. Market
The techniques for incorporation of risk factor in capital budgeting decision could be
grouped into conventional techniques and statistical techniques.
1._____________ is measured by the variability of expected returns of the

project.
a) Stand alone profit
b) Stand alone risk
c) Net profit
d) Dividend paying capacity
80
2. Market risk is measured by the effect of the project on the _________ of the
firm.
a) Theta
b) PI
c) IRR
d) Beta
3. Firms cannot __________ market risk in the normal course of business.

a) Diversify
b) Ignore
c) Multiply
d) Generate
4. Impact of U.S. sub prime crisis on certain segments of Indian Economy is an

example of _______________ risk.
a) National
b) Regional
c) International
d) Industrial
5. The RADR for appraisal of projects has two components i,e, ___________and
______________ .
a) Rate, free premium
b) Rate, risk free premium
c) Risk free rate, risk premium
d) Premium rate, return
6. Risk premium is the ___________ for assumption of additional risk of project.

a) Additional return
b) Risk free return
c) Discounted Inflow
7. Higher the risk __________ the premium.

a) Lower
b) Higher
8. CE coefficient is the ___________.

a) Return adjusted factor
b) Risk premium
c) Risk adjusted factor
d) Certain Earning
9. Discount factors to be used under CE approach is __________.

a) Risk free rate
b) Risk adjusted rate
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c) Sensitivity rate
d) Risk premium rate
10. Because of high _______ CE clears only good projects.

a) Outflow
b) Turnover
c) Conservation
d) Rating
82
Chapter 8 Working Capital Management
Structure:
8.1 Introduction
8.2 Components of Current Assets and Current Liabilities
8.3 Concepts of Working Capital
8.4 Objective of Working Capital Management
8.5 Need for working capital
8.6 Operating Cycle
8.7 Determinants of Working Capital
8.8 Estimation of Working Capital
8.9 Summary
8.1 Introduction
Sound working Capital Management has become a necessity in an era of information
technology for a company to succeed. The best example to support this argument is the
performance of Dell Computers as reported in one of the recent Fortune article.
A perusal of the article will give us an insight into how Dell could use technology for
improving the performance of components of working capital.
1. Use of internet as a tool for reducing costs of linking manufacturer with their
suppliers and dealers.
2. Outsourcing an operation if the firms core competence does not permit the
performance of the operation effectively.
3. Train the employees to accept change.
4. Introduction of internet business.
5. Releasing Capital by reduction in investment in inventory for improving the
profitability of operating capital.
A financial manager spends a large part of his time in managing working capital.
There are two important elements of working capital management.

1. Decisions on the amount of current assets to be held by a firm for efficient
operations of its business.
2. Decisions on financing working capital requirement.
Inadequacy or mismanagement of Working Capital is the leading cause of many business

failures. Working Capital is that portion of asset of a business which are used in current
83
operations. They are used in the operating cycle of the firm. It is defined as the excess of
Current Assets over Current Liabilities and provisions.
1. Explain the meaning, definition and concepts of Working Capital.
2. State the objectives of Working Capital management.
3. Bring out the importance of Working Capital Management.
4. Explain the process of estimation of Working Capital.
8.2 Components of Current Assets and Current Liabilities

8.2.1 Current Assets are:
1) Inventories 2) Sundry Debtors 3) Bills Receivables 4) Cash and Bank Balances 5)
Short term investments 6) Advances such as advances for purchase of raw materials,
components and consumable stores, prepaid expenses etc.
8.2.2 Current Liabilities are:-

1) Sundry Creditors 2) Bills Payable 3) Creditors for outstanding expenses 4) Provision
for tax 5) Other provisions against the liabilities payable within a period of 12 months.
Working Capital Management is concerned with managing the different components of

current assets and current liabilities. A firm must have adequate Working Capital neither
excess nor shortage. Maintaining adequate Working Capital at the satisfactory level is
crucial for maintaining the competitiveness of a firm.
Any lapse of a firm on this account may lead a firm to the state of insolvency.
8.3 Concepts of Working Capital

There are two important concepts of Working Capital gross and net
Gross Working Capital: Gross Working Capital refers to the amounts invested in the
various components of current assets. This concept has the following practical relevance.
a. Management of current assets is the crucial aspect of Working Capital
Management.
b. It is an important component of operating capital. Therefore, for improving the
profitability on its investment a finance manger of a company must give top
priority to efficient management of current assets.
c. The need to plan and monitor the utilization of funds of a firm demands working
capital management as applied to current assets.
d. It helps in the fixation of various areas of financial responsibility.
Net Working Capital

Net Working Capital is the excess of current assets over current liabilities and provisions.
Net Working Capital is positive, when current assets exceed current liabilities and
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negative when current liabilities exceed current assets. This concept has the following
practical relevance.
1. It indicates the ability of the firm to effectively use the spontaneous finance in
managing the firms Working Capital requirements.
2. A firms short term solvency is measured through the net Working Capital
position it commands.
Permanent Working Capital

Permanent Working Capital is the minimum amount of investment required to be made in
current assets at all times to carry on the day to day operation of firms business. This
minimum level of current assets has been given the name of core current assets by the
Tandon Committee. It is also know as fixed Working Capital.
Temporary Working Capital

It is also know as Variable Working Capital or fluctuating Working Capital. The firms
working capital requirements vary depending upon the seasonal and cyclical changes in
demand for a firms products. The extra Working Capital required as per the changing
production and sales levels of a firm is known as Temporary Working Capital.
8.4 Objective of Working Capital Management

The basic objective of financial management is maximizing the net wealth of
shareholders. A firm must earn sufficient returns from its operations to ensure the
realization of this objective. There exists a positive correlation between sales and firms
return on its investment. The amount of earnings that a firm earns depends upon the
volume of sales achieved. There is the need to ensure adequate investment in current
assets, keeping pace with accelerating sales volume. Firms make sales on credit. There is
always a time gap between sale of goods on credit and the realization of proceeds of sales
from the firms customers. Finance manger of a firm is required to finance the operation
during this time gap. Therefore, objective of Working Capital Management is to ensure
smooth functioning of the normal business operations of a firm. The firm has to decide on
the amount of Working Capital to be employed.
The firm may have a conservative policy of holding large quantum of current assets to
ensure larger market share and to prevent the competitors from snatching any market for
their products. But such a policy will affect the firms return on its investment. The firm
will have higher than the required amount of investment in current assets. This excess
funds locked in current assets will reduce the firms profitability on operating capital.
On the other hand a firm may have an aggressive policy of depending on spontaneous
finance to the maximum extent. Credit obtained by a firm from its suppliers is known as
spontaneous finance. Here a firm will try to reduce its investments in current assets as
much as possible but without affecting the firms ability to meet working capital needs
for sales growth targets. Such a policy will ensure higher return on its investment as the
firm will not be locking in any excess funds in current assets. However, any error in
forecasting can affect the operations of the firm unfavorably if the error is fraught with
85
the down side risk. There is also another risk of firm losing on maintaining its liquidity
position.
Objective of working capital management is achieving a trade off between liquidity and
profitability of operations for the smooth conduct of normal business operations of the
firm.
8.5 Need for working Capital

The need for working capital arises on account of two reasons:
a. To finance operations during the time gap between sale of goods on credit and
realization of money from customers of the firm.
b. To finance investments in current assets for achieving the growth target in sales.
Therefore, finance the operations in operating cycle of a firm working capital is required.
8.6 Operating Cycle

Operating cycle of a firm has the following elements.
1. Acquisition of resources from suppliers.
2. Marketing Payments to suppliers.
3. Conversion of raw materials into finished products.
4. Sale of finished products to customers.
5. Collection of cash customers for the goods sold.
The time gap between acquisition of resources and collection of cash from customers is
known as the operating cycle. These five phases occur on a continuous basis. There is no
synchronization between the activities in operating cycle. Cash out flows occur before the
occurrences of cash inflows in operating cycle. Cash out flows are certain. On the other
hand cash in flows are uncertain because of uncertainty associated. With effecting sales
as per the sales forecast and ultimate timely collection of amount due from the customers
to whom the firm has sold its goods. Since cash inflows do not match with cash out
flows, firm has to invest in various current assets to ensure smooth conduct of day to day
business operation. Therefore, the firm has assess the operating cycle time of its
operation for providing adequately for its working capital requirements.
Operating cycle = IC period + RC period

IC period = Inventory conversion period
RC period = Receivables conversion period
Inventory conversion period is the average length of time required to produce and sell the
product.
1. Inventory Conversion period = Average Inventory x 365
Annual Cost of goods sold
2. Receivables conversion period = Average Accounts Receivables x 365

Annual Sales
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Accounts payables period is also known as payables deferral period.
3. Accounts payables period = Average Creditors

Purchases per day
(Payables deferral period)
Purchase per day = Total Purchases for year

365
Receivables conversion period is the average length of time required to convert the firms
receivables into cash.
4. Cash Conversion Cycle: Is the length of time between the firms actual cash
expenditure and its own cash receipt. The cash conversion cycle is the average length of
time a rupee is tied up in current assets.
Cash Conversion Cycle is

CCC = ICP + RCP PDP
CCC = Cash Conversion Cycle
ICP = Inventory Conversion Period
RCP = Receivables Conversion Period
PDP = Payables deferral period
Example: The following details are available for XYZ Ltd. for the year ended 31.03.08
Sales 80,000 Inventory
Costs of goods 56,000 31.03.07 9,000
31.03.08 12,000
Accounts Receivables
31.03.07 12,000
31.03.08 16,000
Account Payable
31.03.07 7,000
31.03.08 10,000
What is the length of the operating cycle?

What is the cash cycle?
Assume 365 days in the year.
Answer
Operating Cycle = Inventory Conversion Period + Accounts Receivables
Conversion Period
Inventory Conversion Period
Average Inventory x 365 (9000 + 12000) / 2 x 365
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Annual Cost of goods sold 56000
10500x365 =68.4 days

56000
Receivables Conversion Period = Average Accounts Receivables x 365

Annual Sales
(12000 + 16000) / 2x365 = 63.9 days

80000
Payables Conversion Period = Average Accounts Payables x 365

Annual Cost of goods sold
(7000 + 10000) / 2x365
56000
8500x365 = 55.4 days

56000
Operating Cycle = ICP + RCP

= 68.4 + 63.9 = 132.3 days
Cash Conversion cycle
= OC PDP
= 132.3 55.4 = 79.9 days
The Cash conversion cycle shows the time interval over which additional non
spontaneous sources of working capital financing must be obtained to carry out firms
activities. An increase in the length of operating cycle, without a corresponding increase
in payable deferral period, increases the cash conversion cycle. Any increase in cash
conversion cycle leads to additional working capital needs of the firm.
8.7 Determinants of Working Capital

A large number of factors influence Working Capital needs of a firm. The basic objective
of a firms Working Capital management is to ensure that the firm has adequate working
capital for its operations, neither too much not too little. Investing heavily in current
assets will drain the firms earnings and inadequate investment in current assets will
reduce the firms credibility as it affects the firms liquidity. Therefore, the need to strike
a balance between liquidity and profitability cannot be ignored. The following factors
determine a firms working capital requirements.
1. Nature of business: Working Capital requirements are basically influenced by

the nature of business of the firm. Trading organizations are forced to carry large
stocks of goods, accounts receivables and accounts payable. Public utilities
require lesser investment in working capital.
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2. Size of Business Operation: Size is measured in terms of a scale of operation. A
firm with large scale of operation normally requires more Working Capital than a
firm with low scale of operation.
3. Manufacturing Cycle: Capital intensive industries with longer

manufacturing process will have higher requirements of Working Capital because
of the need to run their sophisticated and long production process.
4. Products Policy: Production schedule of a firm influences the investments in

inventories. A firm, exposed to seasonal changes in demand when following a
steady production policy will have to face the costs and risks associated with
inventory accumulation during the off-season periods. On the other hand a firm
with a variable production policy will be facing different dimensions of
management of working capital. Such a firm may have to effectively handle
problem of production planning and control associated with utilization of installed
plant capacity under conditions of varying volumes of production of products of
seasonal demand.
5. Volume of sales: There is a positive direct correlation between the volume of

sales and the size of working capital of a firm.
6. Term of Purchase and Sales: A firm which allows liberal credit to its
customers will need more working capital than that of a firm with strict credit
policy. A firm which enjoys liberal credit facilities from its suppliers requires
lower amount of working capital when compared to a firm which does not have
such a facility.
7. Operating efficiency: The firm with high efficiency in operation can bring
down the total investment in working capital to lower levels. Here effective
utilization of resources helps the firm in bringing down the investment in working
capital.
8. Price level changes: Inflation affects the working capital levels in a firm. To
maintain the operating efficiency under an inflationary set up a firm should
examine the maintenance of working capital position under constant price level.
The financial capital maintenance demands a firm to maintain higher amount of
working capital keeping pace with rising price levels. Under inflationary
conditions same levels of inventory will require increased investment. The ability
of a firm to revise its products prices with rising price levels will decide the
additional investment to be made to maintain the working capital intact.
9. Business Cycle: During boom, sales rise as business expands. Depression is

marked by a decline in sale. During boom, expansion of business can be achieved
only by augmenting investment in various assets that constitute working capital of
a firm. When there a decline in business on account of depression in economy,
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inventory glut forces a firm to maintain working capital at a level far in excess of
the requirements under normal conditions.
10. Processing technology: Longer the manufacturing cycle the larger the
investment in working capital. When raw material passes through several stages
in the production process work in process inventory will increase
correspondingly.
11. Fluctuations in the supply of raw materials: Companies which use raw
materials available only from one or two sources are forced to maintain buffer
stock of raw materials to meet the requirements of uncertainly in lead time.
Such firm normally carry more inventory than it would have, had the materials
been available in normal market conditions.
8.8 Estimation of Working Capital

The best approach to estimate is based on operating cycle. Therefore, the two
components of working capital are current assets and current liabilities. This approach is
based on the assumption that production and sales occur on a continuous basis and all
costs occur accordingly.
Estimation of Current Assets.

1. Raw materials inventory: Average investment in raw material is estimated.
2. Average investment in work-in-progress inventory is estimated.
3. Average investment in finished goods inventory is estimated.
4. Average investment in receivables (i,e both in debtors and bills receivables) is
estimated based on credit policy that the firm wishes to pursue.
5. Based on the firms attitude towards risk, access to borrowing sources, past
experience and nature of business, firms decide on the policy of maintaining the
minimum cash balances.
Estimation of Current Liabilities:

1. Trade Creditors: Based on production budget, raw material consumption, credit
period enjoyed from suppliers, average amount of financing available to the firm is
estimated.
2. Direct wages: Based on production budget, direct labour cost per unit, average time-
lag in payment of wages, estimation is made on total wages to be paid on an average
basis.
3. Overheads: Based on production budget, overhead cost per unit and average time-
lag in payment of overhead, an estimation on an average basis of the amount
outstanding to be paid to creditors for overhead is estimated.
8.9 Summary
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All companies are required to maintain a minimum level of current assets at all point to
time. This level is called core or permanent working Capital of the company. Working
capital management is concerned with the determination of optimum level of working
capital and its effective utilization. To assets the working capital required for a form to
conduct its operations smoothly, firm use operating cycle concept and compute each
component of working capital.
8.10End chapter quiz

1.Maintaining adequate working capital at the satisfactory level is crucial for
__________ the ____________ of a firm
a) Maintaining, competitiveness
b) Maintaining, profitability
c) Maintaining, capital structure
d) Maintaining, investment
2.Prepaid expenses are ______________.

a) Current liability
b) Current asset
c) Term loan
d) Provision
3.Provision for tax is ____________.
a) Current liability
b) Current asset
c) Term loan
d) Provision
4.A firm must have _______________ working capital.
a) As much possible
b) As low as possible
c) Adequate
5. _____________ refers to the amount invested in current assets.
a) Gross working capital
b) Net working capital
c) Investment
d) Current investment
6. When current assets exceed current liabilities the net working capital is _____.
a) Negative
b) Positive
c) None of the above
7 Permanent working capital is called __________ working capital.
a) Current
b) Fixed
c) Invested
d) Capitalized
8. Objective of working capital management is achieving a trade off between
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____________ and _________.
a) Liquidity, profitability
b) Assets, liabilities
c) Cash, inventory
d) Fixed assets, current assets
9. To finance the operations in ____________ of a firm, working capital is
required.
a) Factory
b) Office work
c) Operating cycle
10. To finance operations during the time gap between __________ and ______
working capital is required.
a) Credit sale, cash sale
b) Credit sale, realization of money
c) Sale, purchase
d) Credit purchase, cash purchase
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Chapter - 9 Cash Management
Structure:
9.1 Introduction
9.1.1 Meaning of Cash
9.2 Meaning and importance of cash management
9.3 Motives for holding Cash
9.4 Objectives of Cash Management
9.5 Determining the Cash Needs- Models for Determining Optimal Cash
9.5.1 Baumol Model
9.5.2 Miller-Orr model
9.5.3 Cash Planning
9.5.4 Cash Forecasting and Budgeting
9.6 Summary
9.1 Introduction
Cash is the most important current asset for a business operation. It is the energy that
drives business activities and also the ultimate output expected by the owners. The firm
should keep sufficient cash at all times. Excessive cash will not contribute to the firm's
profits and shortage of cash will disrupt its manufacturing operations.
9.1.1 Meaning of Cash

The term 'cash' can be used in two senses - in a narrow sense it means the currency and
other cash equivalents such as cheques, drafts and demand deposits in banks. In a broader
sense, it includes near-cash assets like marketable securities and time deposits in banks.
The distinguishing nature of this kind of asset is that they can be converted into cash very
quickly.
Cash in its own form is an idle asset. Unless employed in some form or another, it does
not earn any revenue.
1. Meaning of cash and near cash assets
2. The importance of cash management in a firm
3. The different models of determining the optimal cash balances
4. Techniques for forecasting the cash inflows and outflows.
9.2 Meaning and importance of Cash Management

Cash management is concerned with (a) management of cash flows into and out of the
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firm, (b) cash management within the firm and (c) management of cash balances held by
the firm - deficit financing or investing surplus cash. Cash management tries to
accomplish at a minimum cost the various tasks of cash collection, payment of
outstandings and arranging for deficit funding or surplus investment. It is very difficult to
predict cash flows accurately. Generally, there is no correlation between inflows and
outflows. At some points of time, cash inflows may be lower than outflows because of
the seasonal nature of product sale thus prompting the firm to resort to borrowings and
sometimes outflows may be lesser than inflows resulting in surplus cash. There is always
an element of uncertainty about the inflows and outflows. The firm should therefore
evolve strategies to manage cash in the best possible way. These can be broadly
summarized as:
Cash planning: Cash flows should be appropriately planned to avoid excessive

or shortage of cash. Cash budgets can be prepared to aid this activity
Managing cash flows: The flow of cash should be properly managed. Steps to
speed up cash collection and inflows should be implemented while cash outflows
should be slowed down.
Optimum cash level: The firm should decide on the appropriate level of cash
balance. Balance should be struck between excess cash and cash deficient stage.
Investing surplus cash: The surplus cash should be properly invested to earn
profits. Many investment avenues to invest surplus cash are available in the
market such as, bank short term deposits, T-Bills, inter corporate lending etc.
The ideal cash management system will depend on a number of issues like, firm's
product, competition, collection program, delay in payments, availability of cash at low
rates of interests and investment opportunities available.
9.3 Motives of Holding Cash

There are four motives of holding cash. They are:
Transaction motive: This refers to a firm holding cash to meet its routine expenses
which are incurred in the ordinary course of business. A firm will need finances to meet a
plethora of payments like wages, salaries, rent, selling expenses, taxes, interests, etc. The
necessity to hold cash will not arise if there were a perfect co-ordination between the
inflows and outflows. These two never coincide. At times, receipts may exceed outflows
and at other times, payments outrun inflows. For such periods when payments exceed
inflows the firm should maintain sufficient balances to be able to make the required
payments. For transactions motive, a firm may invest its cash in marketable securities.
Generally, they purchase such securities whose maturity will coincide with payment
obligations.
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Precautionary motive: This refers to the need to hold cash to meet some exigencies
which cannot be foreseen. Such unexpected needs may arise due to sudden slow-down in
collection of accounts receivable, cancellation of an order by a customer, sharp increase
in prices of raw materials and skilled labour etc. The moneys held to meet such
unforeseen fluctuations in cash flows are called precautionary balances. The amount of
precautionary balance also depends on the firm's ability to raise additional money at a
short notice. The greater the creditworthiness of the firm in the market, the lesser is the
need for such balances. Generally, such cash balances are invested in highly liquid and
low risk marketable securities.
Speculative motive: This relates to holding cash to take advantage of unexpected

changes in business scenario which are not normal in the usual course of firm's dealings.
It may also result in investing in profit-backed opportunities as the firm comes across.
The firm may hold cash to benefit from a falling price scenario or getting a quantity
discount when paid in cash or delay purchases of raw materials in anticipation of decline
in prices. By and large, business firms do not hold cash for speculative purposes and even
if it is done, it is done only with small amounts of cash. Speculation may sometimes also
boomerang in which case the firms lose a lot.
Compensating motive: This is yet another motive to hold cash to compensate banks for
providing certain services and loans. Banks provide a variety of services like cheque
collection, transfer of funds through DO, MT, etc. To avail all these purposes, the
customers need to maintain a minimum balance in their account at all times. The balance
so maintained cannot be utilized for any other purpose. Such balances are called
compensating balances. Compensating balances can take any of the following two
forms - (a) maintaining an absolute minimum, say for example, a minimum of Rs.25000
in current account or (b) maintaining an average minimum balance of Rs.25000 over the
month. A firm is more affected by the first restriction than the second restriction.
9.4 Objectives of Cash Management:

There are two major objectives for cash management in a firm (a) meeting payments
schedule and (b) minimizing funds held in the form of cash balances.
Meeting payments schedule: In the normal course of functioning, a firm will have to
make many payments by cash to its employees, suppliers, infrastructure bills, etc. It will
also receive cash through sales of its products and collection of receivables. Both these
do not happen simultaneously. A basic objective of cash management is therefore to meet
the payment schedule in time. Timely payments will help the firm to maintain its
creditworthiness in the market and to foster good and cordial relationships with creditors
and suppliers. Creditors give a cash discount if payments are made in time and the firm
can avail this discount as well. Trade credit refers to the credit extended by the supplier
of goods and services in the normal course of business transactions. Generally, cash is not
paid immediately for purchases but after an agreed period of time. There is deferral of
payment and is a source of finance. Trade credit does not involve explicit interest
charges, but there is an implicit cost involved. If the credit terms are, say, 2/10, net 30, it
means the company will get a cash discount of 2% for prompt payment made within 10
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days or else the entire payment is to be made within 30 days. Since the net amount is due
within 30 days, not availing discount means paying an extra 2% for 20-day period.
The other advantage of meeting the payments in time is that it prevents bankruptcy that
arises out9f the firm's inability to honour its commitments. At the same time, care should
be taken not to keep large cash reserves as it involves high cost.
Minimize funds committed to cash balances: Trying to achieve the second objective is
very difficult. A high level of cash balances will help the firm to meet its first objective
discussed above, but keeping excess reserves is also not desirable as funds in its original
form is idle cash and a non-earning asset. It is not profitable for firms to keep huge
balances. A low level of cash balances may mean failure to meet the payment schedule.
The aim of cash management is therefore to have an optimal level of cash by bringing
about a proper synchronization of inflows and outflows and check the spells of cash
deficits and cash surpluses. Seasonal industries are classic examples of mismatches
between inflows and outflows.
The efficiency of cash management can be augmented by controlling a few important
factors described below:
Prompt billing and mailing: There is a time lag between the dispatch of goods and
preparation of invoice. Reduction of this gap will bring in early remittances.
Collection of cheques and remittances of cash: It is generally found that there is a

delay in the receipt of cheques and their deposits into banks. The delay can be reduced by
speeding up the process of collection and depositing cash or other instruments from
customers. The concept of 'float' helps firms to a certain extent in cash management.
Float arises because of the practice of banks not crediting firm's account in its books
when a cheque is deposited by it and not debit firm's account in its books when a cheque
is issued by it until the cheque is cleared and cash is realized or paid respectively. A firm
issues and receives cheques on a regular basis. It can take advantage of the concept of
float. Whenever cheques are deposited with the bank, credit balance increases in the
firm's books but not in bank's books until the cheque is cleared and money realized. This
refers to 'collection float', that is, the amount of cheques deposited into a bank and
clearance awaited. Likewise the firm may take benefit of 'payment float'.
The difference between payment float and collection float is called as 'net float'. When
net float is positive, the balance in the firm's books is less than the bank's books; when
net float is negative; the firm's book balance is higher than in the bank's books.
9.5 Determining the Cash Needs - Models for Determining

Optimal Cash
One of the prime responsibilities of a Finance Manager is to maintain an appropriate
balance between cash and marketable securities. The amount of cash balance will depend
on risk-return trade-off. A firm with less cash balances has a weak liquidity position but
may be earning profits by investing its surplus cash and on the other hand it loses on the
profits by holding too much cash. A balance has to be maintained between these aspects
at all times. So how much is optimum cash? This section explains the models for
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determining the appropriate balance. Two important models are studied here - Baumol
model and Miller-Orr model.
9.5.1 Baumol Model

The Baumol model helps in determining the minimum cost amount of cash that a
manager can obtain by converting securities into cash. It is an approach to establish a
firm's optimum cash balance under certainty. As such, firms attempt to minimize the sum
of the cost of holding cash and the cost of converting marketable securities to cash. The
Baumol model is based on the following assumptions:
The firm is able to forecast its cash requirements in an accurate way.
The firm's pay-outs are uniform over a period of time.
The opportunity cost of holding cash is known and does not change with time.
The firm will incur the same transaction cost for all conversions of securities into
cash.
A company will sell securities and realizes cash and this cash is used to make payments.
As the cash balance comes down and reaches a point, the Finance Manager replenishes
its cash balance by selling marketable securities available with it and this pattern
continues. Cash balances are refilled and brought back to normal levels by the acts of sale
of securities. The average cash balance is C/2. The firm buys securities as and when they
have above-normal cash balances. This pattern is explained below:
C/2 Average
0
T1 T2 T3
Baumol's Model
The total cost associated with cash management has two elements-(a) cost of conversion
of marketable securities into cash and (b) the opportunity cost.
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The firm incurs a holding cost for keeping cash balance which is the opportunity cost.
Opportunity cost is the benefit foregone on the next best alternative for the current action.
Holding cost is k(C/2).
The firm also incurs a transaction cost whenever it converts its marketable securities into
cash. Total number of transactions during the year will be the total funds requirement, T,
divided by the cash balance, C, Le. TIC. If per transaction cost is c, then the total
transaction cost is c(T/C).
The total annual cost of the demand for cash is k(C/2) + c(T/C).
Total Cost
Holding Cost
Transaction Cost
Cash balance C*
The optimum cash balance C* is obtained when the total cost is minimum which is
expressed as C* = 2cT/k where C* is the optimum cash balance, c is the cost per
transaction, T is the total cash needed during the year and k is the opportunity cost of
holding cash balance. The optimum cash balance will increase with increase in the per
transaction cost and total funds required and decrease with the opportunity cost.
Example:
A firm's annual cost requirement is Rs. 20000000. The opportunity cost of capital is 15%
per annum. Rs. 150 is the per transaction cost for the firm when it converts is short-term
securities to cash. Find out the optimum cash balance. What is the annual cost of the
demand for the optimum cash balance?
Solution
C* = 2cT/k = [2(150)(20000000)] I 0.15 = Rs. 200000
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The annual cost is 150(20000000/200000) + 0.15 (200000/2) = Rs. 30000.
Example:
Mysore Lamps Ltd. requires Rs. 30 lakhs to meet its quarterly cash requirements. The
annual return on its marketable securities which are of the tune of Rs. 30 lakhs is 20%.
The conversion of the securities into cash necessitates a fixed cost of Rs. 3000 per
transaction. Compute the optimum conversion amount.
Solution
C* = 2cT/k = [2*3000*3000000] I 0.05@ = Rs. 600000
@ is 20% / 4 as 20% is annual return and fund requirement is done on a quarterly basis.
9.5.2 Miller-Orr model

Miller-Orr came out with another model due to the limitation of the Baumol model.
Baumol model assumes that cash flow does not fluctuate. In the real world, rarely do we
come across firms which have their cash needs as constant. Keeping other factors such as
expansion, modernization, diversification constant, firms face situations wherein they
need additional cash to maintain their present position because of the effect of
inflationary pressures. The firms therefore cannot forecast their fund requirements
accurately. The Miller-Orr model overcomes this shortcoming and considers daily cash
fluctuations. The MO model assumes that cash balances randomly fluctuate between an
upper bound (upper control limit) and a lower bound (lower control limit). When cash
balances hit the upper limit, the firm has too much cash and it is time to buy enough
marketable securities to bring back to the optimal bound. When cash balances touch zero
level, the level is brought up by selling securities into cash. Return point lies between the
upper and lower limits. Symbolically, this can be expressed as Z = 33/4*(c2/i) where Z
is the optimal cash balance, c is the transaction cost, 2 is the standard deviation of the
net cash flows and i is the interest rate. MO model also suggests the optimum upper
boundary b as three times the optimal cash balance and lower limit, i.e. upper limit
b=lower limit + 3Z and return point=lower limit + Z. This is shown graphically as
follows:
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Upper limit
Return point
Lower limit
Time
Miller-Orr Model
Example:
Mehta industries have a policy of maintaining Rs. 500000 minimum cash balance. The
standard deviation of the company's daily cash flows is Rs. 200000. The interest rate is
14%. The company has to spend Rs. 150 per transaction. Calculate the upper and lower
limits and the return point as per MO model.
Solution
Z = 33/4*(c2/i)
33/4**(150*2000002)/ 0.14/365 = Rs. 227226
The Upper control limit = lower limit + 3Z = 500000 + 3*227226 = Rs.1181678
Return point = lower limit + Z = 500000 + 227226 = Rs. 727226
Average cash balance = lower limit + 4/3Z = 500000 + 4/3*227226 = Rs. 802968
9.5.3 Cash Planning

Cash planning is a technique to plan and control the use of cash. It helps in developing a
projected cash statement from the expected inflows and outflows of cash. Forecasts are
based on the past performance and future anticipation of events. Cash planning can be
done a daily, weekly or on a monthly basis. Generally, monthly forecasts are commonly
prepared by firms.
9.5.4 Cash Forecasting and Budgeting

Cash budget is a device to plan for and control cash receipts and payments. It gives a
summary of cash flows over a period of time. The Finance Manager can plan the future
cash requirements of a firm based on the cash budgets. The first element of a cash budget
is the selection of the time period which is referred to as the planning horizon. Selecting
the appropriate time period is based on the factors exclusive to the firms. Some firms may
prefer to prepare weekly budget while others may work out monthly estimates while
some others may be preparing quarterly or yearly budgets. Firms should keep in mind
that the period selected should be neither too long nor too short. Too long a period,
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estimates will not be accurate and too short a period requires periodic changes. Yearly
budgets can be prepared by such companies whose business is very stable and they do not
expect major changes affecting the company's flow of cash.
The second element that has a bearing on cash budget preparation is the selection of
factors that have a bearing on cash flows. Only items of cash nature are to be selected
while non-cash items such as depreciation and amortization are excluded.
Cash budgets are prepared under three methods:

1. Receipts and Payments method
2. Income and Expenditure method
3. Balance Sheet method
We shall be discussing only the receipts and payments method of preparing cash budgets.
Example:
Given below is the prepared a cash budget of Mis. Panduranga Sheet Metals Ltd. for the
6 months ending 30th June 2007. It has an opening cash balance of Rs. 60000 on 1st Jan
2007.
Production Selling
Month Sales Purchases Wages
overheads overheads
Jan 60000 24000 10000 6000 5000
Feb 70000 27000 11000 6300 5500
March 82000 32000 10000 6400 6200
April 85000 35000 10500 6600 6500
May 96000 38800 11000 6400 7200
June 110000 41600 12500 6500 7500
The company has a policy of selling its goods 50% on cash basis and the rest on credit
terms. Debtors are given a month's time period to pay their dues. Purchases are to be paid
off two months from the date of purchase. The company has a time lag in the payment of
wages of 'l'2 a month and the overheads are paid after a month. The company is also
planning to invest in a machine which will be useful for packing purposes, the cost being
Rs. 45000, payable in 3 equal installments starting bi-monthly from April. It also expects
to make a loan application to a bank for Rs. 50000 and the loan will be granted in the
month of July. The company has to pay advance income tax of Rs. 20000 in the month of
April. Salesmen are eligible for a commission of 4% on total sales effected by them and
this is payable one month after the date of sale.
Solution
Jan Feb March April May June
Opening cash balance 60000 85000 126100 153000 118850 150100
Cash receipts:
Cash sales 30000 35000 41000 42500 48000 55000
Credit sales 30000 35000 41000 42500 48000
Total cash available 90000 150000 202100 236500 209350 253100
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Cash payments
Materials 24000 27000 32000 35000
Wages 5000 10500 10500 10250 10750 11750
Production overheads 6000 6300 6400 6600 6400
Selling overheads 5000 5500 6200 6500 7200
Sales commission 2400 2800 3280 3400 3840
Purchase of asset 15000 15000
Total cash payments 5000 23900 49100 117650 59250 79190
Closing cash balances 85000 126100 153000 118850 150100 173930
Working note:
Wages calculation
Jan Feb Mar Apr May Jun
10000 11000 10000 10500 11000 12500
5000 5500-feb 5000-mar 5250-apr 5500-may 6250-jun
5000-mar 5500-feb 5000-mar 5250-apr 5500-may
5000 10500 10500 10250 10750 11750
9.6 Summary
All companies are required to maintain a minimum level of current assets at all points of
time. Cash management is concerned with determination of relevant levels of cash
balances and near cash assets and their efficient use.
The need for holding cash arises due to a variety of motives- transaction motives,
speculation motive, precautionary motive and compensating motive. The objective of
cash management is to make short-term forecasts of cash inflows and outflows, investing
surplus cash and finding means to arrange for cash deficits. Cash budgets help Finance
Manger to forecast the cash requirements.
1. Management of cash balances can be done by __________ and ____________.

a) Trade credit, investing surplus cash
b) Deficit financing, investing surplus cash
c) Deficit financing, trade credit
d) Cash budget, control
2. The four motives of holding cash are __________, ___________, __________ and
_________.
a) Transaction, speculative, precautionary, compensating
b) Budgetary, speculative, precautionary, compensating
c) Investment, Transaction, speculative, precautionary
d) Investment, budgetary, speculative, precautionary
3. The greater the creditworthiness of the firm in the market lesser is the need for
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________ balances.
a) Transaction
b) Speculative
c) Precautionary
d) Compensating
4. __________ refers to the credit extended by the supplier of goods and services in the
normal course of business transactions.
a) Transaction
b) Credit worthiness
c) Trade credit
d) Holding cash
5. When cheques are deposited in a bank, credit balance increases in the firms books
but not in banks books until the cheque is cleared and money realized. This is called
as _________.
a) Transaction float
b) Credit worthiness
c) Trade credit
d) Collection float
6. According to Baumol model, the total cost associated with cash management has two
elements _________ and ___________.
a) Cost of conversion of marketable securities into cash, opportunity cost
b) Marketable securities, conversion expense
c) Forecasting expense, opportunity cost
7. The MO model assumes that cash balances randomly fluctuate between a

___________ and a ____________.
a) Upper bound, lower bound
b) Trade credit, investing surplus cash
b) Deficit financing, investing surplus cash
c) Deficit financing, trade credit
d) Cash budget, control
8. Cash management is concerned with determination of relevant ________ balances and
_________ and their efficient use.
a) Fixed asset balances, current asset balances

b) levels of cash balances, near cash assets
c) Upper bound, lower bound
b) Trade credit, surplus cash
9. Baumol model assumes that cash flow does not __________.
a) Increase
b) Decrease
c) Fluctuate
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10.The Miller-Orr model ___________ daily cash fluctuations.

a) Does not consider
b) Considers
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Chapter - 10 Inventory Management
Structure:
10.1 Introduction
10.2 Costs associated with inventories
10.3 Inventory management Techniques
10.3.1 Determination of Stock Levels
10.3.2 Pricing of inventories
10.4 Summary
10.1 Introduction
Inventories are the most significant part of current assets of most of the firms in India.
Since they constitute an important element of total current assets held by a firm, the need
to manage inventories efficiently and effectively for ensuring optimal investment in
inventory cannot be ignored. Any lapse on the part of management of a firm in managing
inventories may cause the failure of the firm. The major objectives of inventory
management
are:
a. Maximum satisfaction to customer.
b. Minimum investment in inventory.
c. Achieving low cost plant operation.
These objectives conflict each other. Therefore, a scientific approach is required to arrive
at an optimal solution for earning maximum profit on investment in inventories.
Decisions on inventories involve many departments:

a. Raw material policies are decided by purchasing and production departments;
b. Production department plays an important role in work - in process inventory, policy
and
c. Finished goods inventory policy is shaped by production and marketing departments.
But the decisions of these departments have financial implications. Therefore, as an

executive entrusted with the responsibility of managing finance of the company, the
financial manager of the firm has to ensure that monitoring and controlling inventories of
the firm are executed in a scientific manner for attaining the goal of wealth maximization
of the firm.
After studying this unit, you should be able to understand the following. 1. Explain the
meaning of inventory management.
2. State the objectives of inventory management.
3. Bring out the importance of inventory management.
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4. State the purpose of inventory.
5. Discuss the techniques of inventory control.
Role of inventory in working Capital:

Inventories constitute an important component of a firm's working capital. The following
features of inventory highlight the significance of inventory in working capital
management.
1. Characteristics of inventory as current assets

Current assets are those assets which are expected to be realized in cash or sold or
consumed during the normal operating cycle of the business. Various forms of inventory
in any manufacturing unit are:
a. Raw materials to be converted into finished goods through the process of production.
b. Work - in - process inventories are semi finished products in the process of being
converted into finished good.
c. Finished goods inventories are completely manufactured products that can be sold
immediately.
The first two are inventories concerned with production and the third is meant for smooth
performance of marketing function of the firm.
Nature of business influences the levels of inventory that a firm has to maintain in these
three kinds. A manufacturing unit will have to maintain high levels of inventory in all the
three forms. A retail firm will be maintaining very high level of finished goods inventory
only.
The three kinds of inventories listed above are direct inventories. There is an another
form of indirect inventories. These indirect inventories are those items which are
necessary for manufacturing but do not become part of the finished goods. They are
lubricants, grease, oil, petrol, office material maintenance material etc.
The Inventories are held for the following reasons.

1. Smooth production: To ensure smooth production as per the requirements of
marketing department, inventories are procured and sold.
2. To achieve Competitive edge: Most of the retail and industrial organizations carry
inventory to ensure prompt delivery to customers. No firm likes to lose customers
on account of the item being out of stock.
3. To reap the benefits of buying in large volume. Sometimes buying in large
volumes may give the firm quantity discounts. This quantity discounts may be
substantial that the firm will take benefit of it.
4. Hedge against uncertain lead times: Lead time is the time required to procure
fresh supplies of inventory. Uncertainty due to supplier taking more than the
normal lead time will affect the production schedule and the execution of the
orders of customers as per the orders received from customers. To avoid all these
problems arising from uncertainty inprocurement of fresh supplies of inventories,
the firms maintain higher levels of inventories for certain items of inventory.
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2. Level of liquidity: Inventories are meant for consumption or sale. Both excess and
shortage of inventory affect of the firm's Profitability.
Though inventories are called current assets, in calculating absolute liquidity of a firm
inventories are excluded because it may have slow moving or dormant items of inventory
which cannot be easily disposed of. Therefore level and composition of inventory
significantly influence the quantum of working capital and hence profitability of the firm.
3. Liquidity Lags: Inventories have three types of lags.

a. Creation lag: Raw materials are purchased on credit and consumed to produce
finished goods. There is always a lag in payment to suppliers from whom raw
materials are procured. This is called spontaneous finance. The amount of
spontaneous finance that a firm is capable of enjoying influences the quantum of
working capital of a firm.
b. Storage lag: The goods manufactured or held for sale cannot be converted into
cash immediately. Before dispatching the goods to customers on sale, there is
always a time lag. During this time lag goods are stored in warehouse. Many
expenses of storage will be recurring in nature and cannot be avoided. The level
of expenditure that a firm incurs on this account is influenced by the inventory
levels of the firm. This influences the working capital management of a firm.
c. Sale Lag: Firms sell their products on credit. There is some time lag between sale
of finished goods and collection of dues from customers. Firms which are
aggressive in capturing markets for their products maintain high levels of
inventory and allow its customers liberal credit period. This will increase its
investment in receivables. This increase in investment in receivables will have its
effect on working capital of the firm.
Purpose of inventory:
The purpose of holding inventory is achieving efficiency through cost reduction and
increased sales volume. The following are the purposes of holding inventories.
1. Sales: Customers place orders for goods only when they need it. But when
customers approach the firm with orders the firms must have adequate inventory
of finished goods to execute it. This is possible only when firms maintain ready
stock of finished goods in anticipation of orders from customers. If a firm suffers
from complaints from customers of constantly the product being out of stock,
customers may migrate to other producers. It will affect the firm's customer's
base, customer loyalty and market share.
2. To avail quantity discounts: Suppliers give discounts for bulk purchases. Such
discounts decrease the cost per unit of inventory purchased. Such cost reduction
increase firm's profits. Firms may go in for orders of large quantity to avail
themselves of the benefit of quantity discounts.
3. Reducing ordering Costs and time
Every time a firm places an order it incurs cost of procuring it. It also involves a
lead time in procurement. In some cases the uncertainty in supply due to certain
administrative problems of the supplier of the product will affect the production
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schedules of the organization. Therefore, firms maintain higher levels of
inventory to avoid the risks of lengthening the lead time in procurement.
Therefore, to save on time and costs firms may place orders for large quantities.
4. Reduce risk of production stoppages

Manufacturing firms require a lot of raw materials and spares and tools for
production and maintenance of machines. Non availability of any vital item can
stop the production process. Production stoppage has serious consequences. Loss
of customers on account of the failure to execute their orders will affect the firm's
profitability. To avoid such situations, firms maintain inventories as hedge against
production stoppages.
Therefore, it can be concluded that the motives for holding inventories are
1. Transaction motive: for making available inventories to facilitate smooth
production and sales.
2. Precautionary motive: For guarding against the risk of unexpected changes in
demand and supply.
3. Speculative motive: To take benefit out of the changes in prices firms increase or
decrease the inventory levels.
10.2 Costs associated with inventories

1. Material costs: These are the costs of purchasing the goods and related costs such
as transportation and handling costs associated with it.
2. Ordering Cost: The expenses incurred to place orders with suppliers and replenish
the inventory of raw material are called ordering costs. They include costs of the
following.
a. Requisitioning
b. Purchase ordering or set-up
c. Transportation
d. Receiving, inspecting and receiving at the ware house. These costs
increase in proportion to the number of orders placed. Firms maintaining
large inventory levels, place a few orders and incur less ordering costs.
3. Carrying Costs: costs incurred for maintaining the inventory in ware house are
called carrying costs. They include interest on capital locked up in inventory,
storage, insurance, taxes, obsolescence, deterioration spoilage, salaries of ware
house staff and expenses on maintenance of ware house building. The greater the
inventory held the higher the carrying costs.
4. Shortage costs or stock out costs: These are the costs associated with either a
delay in meeting the demand or inability to meet the demand at all due to shortage
of stock. These costs include.
a. Loss of profit on account of sales lost caused by the stock out.
b. Loss of future sales as customers migrate to other dealers.
c. Loss of customer goodwill and
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d. Extra costs associated with urgent replenishment purchases.
Measurement of shortage cost attributable to the firm's failure to meet customers demand
is difficult because it is intangible in nature and it affects the operation of the firm now
and in future.
10.3 Inventory management Techniques

There are many techniques of management of inventory. Some of them are:
Economic Order Quantity:

EOQ refers to the optimal order size that will result in the lowest ordering and carrying
costs for an item of inventory based on its expected usage.
EOQ model answers the following key quantum of inventory management.

a. What should be the quantity ordered for each replenishment of stock?
b. How many orders are to be paced in a year to ensure effective inventory
Management?
EOQ is defined as the order quantity that minimizes the total cost associated with
inventory management.
It is based on the following assumptions:
1. Constant or uniform demand. The demand or usage is even throughout the period.
2. Known demand or usage: Demand or usage for a given period is known Le
deterministic.
3. Constant Unit price: Per unit price of material does not change and is constant
irrespective of the order size.
4. Constant Carrying Costs
The cost of carrying is a fixed percentage of the average value of inventory.
5. Constant ordering cost
Cost per order is constant whatever be the size of the order.
6. Inventories can be replenished immediately as the stock level reaches exactly
equal to zero. Consequently there is no shortage of inventory.
7.
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Total Cost
Carrying Cost
x
Cost
Ordering Cost
Economic order Quantity

2DK
QX =
Kc
D = Annual usage or demand

QX = Economic order Quantity
K = ordering cost per order
kc = Pc = price per unit x percent carrying cost = carrying cost of inventory per unit per
annum.
Example:
Annual consumption of raw materials is 40,000 units. Cost per unit Rs 16
Carrying cost is 15% per annum.
Cost of placing an order = Rs 480
Solution:
2 x 40000 x 480 = 4000 units
EOQ = 16 x 0.15
Example:
A company has gathered the following information:
Annual demand 30,000 units
Ordering cost per order = Rs 20 (Fixed)

Carrying cost = Rs 10 per unit per annum
Purchase cost per unit i.e. price per unit = Rs 32 per unit
Determine EOQ, total number of orders in a year and the time - gap between two orders.
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Solution:
QX = 2DK = 2 x 30000 x 20
Kc 10
= 346 units
K = Rs.20
Kc = Rs.10
D = 30000
The total number of orders in a year = 30,000

346
= 87 orders
Time gap between two orders = 365 = 4 days

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1. ABC System: the inventory of an industrial firm generally comprises of thousands of

items with diverse prices, large lead time and procurement problems. It is not possible
to exercise the same degree of control over all these items. Items of high value require
maximum attention while items of low value do not require same degree of control.
The firm has to be selective in its approach to control its investment in various items
of inventory. Such an approach is known as selective inventory control. ABC system
belongs to selective inventory control.
ABC analysis classifies all the inventory items in an organization into three
categories.
A: Items are of high value but small in number. A items require strict control.
B: Items of moderate value and size which require reasonable attention of the
management.
C: Items represent relatively small value items and require simple control.
Since this method concentrates attention on the basis of the relative importance of
various items of inventory it is also known as control by importance and exception.
As the items are classified in order of their relative importance in terms of value, it is
also known as proportional value Analysis.
Advantages of ABC analysis:

2. It ensures closer controls on costly elements in which firm's greater part of resources
are invested.
3. By maintaining stocks at optimum level it reduces the clerical costs of inventory
control.
4. Facilitates inventory control and control over usage of materials, leading to effective
cost control.
Limitations:
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1. A never ending problem in inventory management is adequately handling
thousands of low value of c items. ABC analysis fails to answer this problem.
2. If ABC analysis is not periodically reviewed and updated, it defeats the basic
purpose of ABC approach.
10.3.1 Determination of Stock Levels

Most of the industries are subject to seasonal fluctuations and sales during different
months of the year are usually different. If, however, production during every month is
geared to sales demand of the month, facilities have to be installed to cater to for the
production required to meet the maximum demand. During the slack season, a large
portion of the installed facilities will remain idle with consequent uneconomic production
cost. To remove this disadvantage, attempt has to be made to obtain a stabilized
production programme throughout the year. During the slack season, there will be
accumulation of finished products which will be gradually cleared as sales progressively
increase. Depending upon various factors of production, storing and cost, a normal
capacity will be determined. To meet the pressure of sales during the peak season,
however, higher capacity may have to be sued for temporary periods. Similarly, during
the slack season, to avoid loss due to excessive accumulation, capacity usage may have to
be scaled down. Accordingly, there will be a maximum capacity and minimum capacity,
only consumption of raw material will accordingly vary depending upon the capacity
usage.
Again, the delivery period or lead time for procuring the materials may fluctuate.
Accordingly, there will be maximum and minimum delivery period and the average of
these two is taken as the normal delivery period.
Maximum Level:
Maximum level is that level above which stock of inventory should never rise. Maximum
level is fixed after taking in to account the following factors:
1. Requirement and availability of capital
2. Availability of storage space and cost of storing.
3. Keeping the quality of inventory intact
4. Price fluctuations
5. Risk of obsolescence, and
6. Restrictions, if any, imposed by the government.
Maximum Level = Ordering level - (MRC x MDP) + standard ordering quantity.
Where, MRC = minimum rate of consumption

MDP = minimum lead time.
Minimum level:
Minimum level is that level below which stock of inventory should not normally fall.
Minimum level = OL - (NRC x NL T)
Where,
OL = ordering level
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NRC = Normal rate of consumption
NL T = Normal Lead Time.
Ordering level:
Ordering level is that level at which action for replenishment of inventory is initiated.
OL = MRC X ML T
Where,
MRC = Maximum rate of consumption
ML T = Maximum lead time.
3. Average stock level

Average stock level can be computed in two ways
1. minimum level + maximum level
2
2. Minimum level + 1/2 of re-order quantity.
Average stock level indicates the average investment in that item of inventory. It is quite
relevant from the point of view of working capital management.
Managerial significance of fixation of Inventory level:

1. It ensure the smooth productions of the finished goods by making available the
raw material of right quality in right quantity at the right time.
2. It optimizes the investment in inventories. In this process, management can avoid
both overstocking and shortage of each and every essential and vital item of
inventory.
3. It can help the management in identifying the dormant and slow moving items of
inventory. This brings about better co-ordination between materials management
and production management on the one hand and between stores manager and
marketing manager on the other.
Re - order Point:
"When to order" is another aspect of inventory management. This is answered by re -
order point. The re - order point is that inventory level at which an order should be placed
to replenish the inventory.
To arrive at the re - order point under certainty the two key required details are:
1. Lead time
2. Average usage
lead time refers to the average time required to replenish the inventory after placing
orders for inventory
Re - order point = lead time x Average usage
Under certainty, re - order point refers to that inventory level which will meet the
consumption needs during the lead time.
Safety Stock: Since it is difficult to predict in advance usage and lead time accurately,
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provision is made for handling the uncertainty in consumption due to changes in usage
rate and lead time. The firm maintains a safety stock to manage the stock - out arising out
of this uncertainty.
When safety stock is maintained, (When Variation is only in usage rate)

Re - order point = lead time x Average usage + Safety stock
Safety stock = [(maximum usage rate) - (Average usage rate)] x lead time.
Or
Safety stock when the variation in both lead time and usage rate are to be incorporated.
Safety stock = (Maximum possible usage) - (Normal usage)
Maximum possible usage = Maximum daily usage x Maximum lead time
Normal usage = Average daily usage x Average lead time
Example: A manufacturing company has an expected usage of 50,000 units of certain

product during the next year. Re cost of processing an order is Rs 20 and the carrying
cost per unit per annum is Rs 0.50. Lead time for an order is five days and the company
will keep a reserve of two days usage.
Calculate 1. EOO 2. Re - order point. Assume 250 days in a year
Solution:
EOO = 2DK = 2 x 50000 x 20
Kc 0.50
= 2000 units
Re order point
Dally usage =50000
250
= 200 units
Safety stock = 2 x 200 = 400 units.
Re - order point (lead time x Average usage) + safety stock
(5 x 200) + 400 = 1,400 units
10.3.2 Pricing of inventories

There are different ways of pricing inventories used in production. If the items in
inventory are homogenous (identical except for in significant differences) it is not
necessary to use specific identification method. The convenient price is using a cost flow
assumption referred to as a flow assumption.
When flow assumption is used it means that the firm makes an assumption as to the
sequence in which units are released from the stores to the production department.
The flow assumptions selected by a company need not correspond to the actual physical
movement of raw materials. When units of raw material are identical, it does not matter
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which units are issued from the stores to the production department.
The method selected should match the costs with the revenue to ensure that the profits are
uncertain in a manner that reflects the conditions actually prevalent.
1. First in, first out (FIFO): It assumes that the raw materials (goods) received first
are used first. The same sequence is followed in pricing the material requisitions.
2. LIFO (last in, first out): The consignment last received is first used and if this is
not sufficient for the requisitions received from production department then the
use is made from the immediate previous consignment and so on. The requisitions
are priced accordingly. This method is considered to be suitable under inflationary
conditions. Under this method the cost of production reflects the current market
trend. The closing inventory of raw material will be valued on a conservative
basis under the inflationary conditions.
3. Weighted average: Material issues are priced, at the weighted average of cost of
materials in stock. This method considers various consignments in stock along
with their unit's prices for pricing the material issues from stores.
4. other methods are:
a. Replacement price method: This method prices the issues at the value at
which it can be procured from the market.
b. Standard price method: under this method the materials are priced at
standard price. Standard price is decided based on market conditions and
efficiency parameters. The difference between the purchase price and the
standard price is analyzed through variance analysis.
10.4 Summary
Inventories form part of current assets of firm. Objectives of inventory management are.
a. Maximum customer satisfaction
b. Optimum investment in inventory and
c. Operation of the plant at the least cost structure. Inventories could be grouped into
direct inventories are raw materials, work-in- process inventories and finished
goods inventory. Indirect inventories are those items which are necessary for
production process but do not become part of the finished goods. There are many
reasons attributable to holding of inventory by the managements.

1. Lead time is the time required to _________.
a) Obtain new inventory
b) Sell finished stock
c) Obtain new order
d) Make the product
2. Costs of not carrying enough inventory is _________.
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a) lost sales.
b) Customer disappointment.
c) Possible worker layoffs
d) All of these.
3. EOQ is the order quantity that ________________.

a) Minimizes total ordering costs
b) Minimizes total carrying costs
c) Minimizes total inventory costs
d) The required safety stock
4. _________assumes that the raw materials (goods) received first are used first.
a) LIFO
b) FIFO
c) HIFO
d) NIFO
5. Maximum level is that level above which stock of inventory should ______ rise.
a) Always
b) Sometimes
c) Yearly
d) Never
6.Both excess and shortage of inventory affect the firms ____________.

a) Reputation
b) Capacity to work
c) Profitability
7.Precautionary motive of holding inventory is for guarding against the risk of

____________ and supply.
a) Change in demand
b) Change in capital structure
c) Change in production
8. Costs incurred for maintaining the inventory in warehouse are called __________.
a) Setting up cost
b) Ordering cost
c) Labour cost
d) Carrying cost
9. A items are ______ value but ______ in numbers.

a) High, small
b) Small, high
c) Small, medium
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d) Medium, high
10. C items are ______ value but ______ in numbers.

a) High, small
b) Small, high
c) Small, medium
d) Medium, high
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Chapter - 11 Receivables Management
Structure:
11.1 Introduction
11.2 Costs associated with maintaining receivables
11.3 Credit policy variables
11.4 Evaluation of credit policy
11.5 Summary
11.1 Introduction
Firms sell goods on credit to increase the volume of sales. In the present era of intense
competition, business firms, to improve their sales, offer to their customers relaxed
conditions of payment. When goods are sold on credit, finished goods get converted into
receivables. Trade credit is a marketing tool that functions as a bridge for the movement
of goods from the firm's ware house to its customers. When a firm sells goods on credit
receivables are created. The receivables arising out of trade credit have three features.
1. It involves an element of risk. Therefore, before sanctioning credit, careful
analysis of the risk involved needs to be done;
2. It is based on economic value. Buyer gets economic value in goods immediately
on sale, while the seller will receive an equivalent value later on and
3. It has an element of futurity. The buyer makes payment in a future period.
Amounts due from customers, when goods are sold on credit, are called trade debits or
receivables. Receivables form part of current assets. They constitute a significant portion
of the total current assets of the buyers next to inventories.
Receivables are asset - accounts representing amounts owing to the firm as a result of
sale of goods/services in the ordinary course of business.
Objectives: The main objective of selling goods on credit is to promote sales for
increasing the profits of the firm. Customers will always prefer to buy on credit to buying
on cash basis. They always go to a supplier who gives credit. All firms therefore grant
credit to their customers to increase sales, profits and to meet competition.
1. Understand the meaning of receivables management.
2. What are the costs associated with maintaining receivable?
3. Understand the credit policy variables.
4. Understand the process of evaluation of credit policy.
Meaning of Receivables Management:

Receivables are a direct result of credit sales are resorted to, by a firm to push up its sales
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which ultimately result in pushing up the profits earned by the firm. At the same time,
selling goods on credit results in blocking of funds in accounts receivables. Additional
funds are, therefore, required for the operating needs of the business which involve extra
costs in terms of interest. Moreover, increase in receivables also increases the chances of
bad debts. Thus, creation of accounts receivables is beneficial as well as dangerous to the
firm.
The financial manager needs to follow a policy of using cash funds economically to the
extent possible in extending receivables without adversely affecting the chances of
increasing sales and making more profits. Management of accounts receivables may,
therefore, be defined as, the process of making decision relating to the investment of
funds in receivables which will result in maximising the overall return on the investment
of the firm.
Thus, the objective of receivables management is to promote sales and projects until the
level where the return on investment in further finding of receivables is less then the cost
of funds raised to finance that additional credit.
11.2 Costs associated with maintaining receivables:

Costs of maintaining receivables are:
1) Capital costs: A firm when sells goods credit achieves higher sales.
Selling goods on credit has consequences of blocking the firm's resources in
receivables as there is a time lag between a credit sale and cash receipt from
customers. To the extent the funds are held up in receivables, the firm has to arrange
for additional funds to meet its own obligation of monthly as well as daily recurring
expenditure. Additional funds may have to be raised either out of profits or from
outside. In both the cases, the firm incurs a cost. In the former case there is the
opportunity cost of the income the firm could have earned had the same
been invested in same other profitable avenue. In the latter case of obtaining funds
from outside, the firm has to pay interest on the loan taken. Therefore, sanctioning
credit to customers on sale of goods on credit has a capital cost.
2) Administration Cost: When a firm sells goods on credit it has to incur two types of
administration cost viz
a. Credit investigation and supervision costs and
b. Collection Costs.
Before sanctioning credit to any customer the firm has to investigate the credit rating of
the customer to ensure that credit given will recovered on time. Therefore, administration
costs have to be incurred in this process.
Costs incurred in collecting receivables are administrative in nature. These include

additional expenses on staff for administering the process of collection of receivables
from customers.
3. Delinquency Costs: The firm incurs this cost when the customer fails to pay the
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amount to it on the expiry of credit period. These costs take the form of sending
remainders and legal charges.
Bad - Debts or Default cost:

When the firm is unable to recover the amount due from its customers, it results in bad
debts. When a firm relaxes its credit policy, selling to customers with relatively low
credit rating occurs. In this process a firm may make credit sales to its customers who do
not pay at all.
Therefore, the assessing the effect of a change in credit policy of a firm involves
examination of
a. Opportunity Cost of lost contribution
b. Credit administration Cost
c. Collection Costs
d. Delinquency Cost
e. Bad - debt loses
11.3 Credit policy Variables

1. Credit standards.
2. Credit period.
3. Cash discounts and
4. Collection programme.
1. Credit standards: The term credit standards refer to the criteria for extending credit to
customers. The bases for setting credit standards are.
a. Credit rating.
b. References
c. Average payment period
d. Ratio analysis
There is always a benefit to the company with the extension of credit to its customers
but with the associated risks of delayed payments or non payment. funds blocked in
receivables etc. The firm may have light credit standards. It may sell on cash basis and
extend credit only to financially strong customers. Such strict credit standards will bring
down bad - debt. losses and reduce the cost of credit administration. But the firm may
not be able to increase its sales. The profit on lost sales may be more than the costs
saved by the firm. The firm should evaluate the trade - off between cost and benefit of
any credit standards.
2. Credit period: credit period refers to the length of time allowed to its customers by a
firm to make payment for the purchases made by customers of the firm. It is generally
expressed in days like 15 days or 20 days. Generally, firms give cash discount if
payments are made within the specified period.
If a firm follows a credit period of 'net 20' it means that it allows to its customers 20 days
of credit with no inducement for early payments. Increasing the credit period will bring in
additional sales from existing customers and new sales from new customers. Reducing
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the credit period will lower sales, decrease investments in receivables and reduce the bad
debt loss. Increasing the credit period increases sales, increases investment in receivables
and increases the incidence of bad debt loss.
The effects of increasing the credit period on profits of the firm are similar to that of
relaxing the credit standards.
3. Cash discount Firms offer cash discounts to induce their customers to make prompt
payments. Cash discounts have implications on sales volume, average collection period,
investment in receivables, incidence of bad debts and profits. A cash discount of 2/10 net
20 means that a cash discount of 2% is offered if the payment is made by the tenth day;
other wise full payment will have to be made by 20th day.
4. Collection programme
The success of a collection programme depends on the collection policy pursued by the
firm. The objective of a collection policy is to achieve. Timely collection of receivables,
there by releasing funds locked in receivables and minimizes the incidence of bad debts.
The collection programmes consists of the following.
1. Monitoring the receivables
2. Reminding customers about due date of payment
3. On line interaction through electronic media to payments due around the due date.
4. Initiating legal action to recover the amount from overdue customers as the last resort
to recover the dues from defaulted customers.
Collection policy formulated shall not lead to bad relationship with customers.
11.4 Evaluation of Credit Policy

Optimum credit policy is one which would maximize the value of the firm. Value of a
firm is maximized when the incremental rate of return on an investment is equal to the
incremental cost of funds used to finance the investment. Therefore, credit policy of a
firm can be regarded as a tradeoff between higher profits from increased sales and the
incremental cost of having large investment in receivables. The credit policy to be
adopted by a firm is influenced by the strategies pursued by its competitors. If
competitors are granting 15 days credit and if the firm decides to extend the credit period
to 30 days, the firm will be flooded with customers demand for company's products.
Credit policy variables of a firm are
1. Credit Standard
The effect of relaxing the credit standards on profit can be estimated as under:
Change in profit = P
Increase in sales = S
Contribution = c = 1 V
Where V = Variable cost of sales
Bad Debts on new sales = S x bn
K = post tax cost of capital
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Increase In receivables investment = I
Therefore
Change in profit = (Additional contribution on increase in sales - Bad Debts on new
sales)(1- tax rate) - cost of incremental investment. (1 - tax rate)) cost of capital x
incremental investment in receivables.
Increase in profit i.e. change in profit = [Incremental contribution - Bad debts on new
sales]
Example: Following details are available in respect of x ltd:

Current sales = Rs. 100 million
The company is considering relaxation of its credit policy. Such relaxation would
increase the sales by Rs 15 million on which bad debt losses would be 10%. The
contribution margin ratio for the firm is 20%. Average collection period is 40 days. Post -
tax cost of funds is 10%. Tax rate applicable to the firm is 30%. Assume 360 days in a
year.
Examine the effect of relaxing the credit policy on the profitability of the organization.
Solution:
Incremental contribution = 1,50,00,000 x 0.20 = Rs 30,00,000
Bad debts on new sales = 1,50,00,000 x 0.10 = Rs 15,00,000
Cost of capital is 10%
Incremental investment in receivables =
Investment in Sales
x Average Collection period x Variable cost to Sales ratio
No. of days in the year
= 15,000,000 x 40 x 0.8 = Rs.13,33,333

360
Cost of Incremental Investment
= 10 x 13,33,333
100
Therefore change in profit is calculated as under
Incremental Contribution 3000000

Less: Bad debts on new sales 1500000
Less: Income tax at 30% 450000
1050000
Less: Opportunity cost of Incremental investment in
Receivables 13,33,333
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Increase in profit 9 16 667
Since the impact of change in credit standards on profit is positive the change in credit
standards may be considered.
2. Credit period
The effect of changing the credit period on profits of the firm can be computed as under:
Change in profit = (Incremental contribution - Bad debts on new sales) (1- tax rate) - cost
of incremental investment in receivables.
Example:
A company is currently allowing its customers, 30 days of credit. Its present sales are Rs
100 million. The firm's cost of capital is 10% and the ratio of variables cost to sales is
0.80. The company is considering extending its credit period to 60 days. Such an
extension will increase the sales of the firm by Rs 100 million. Bad debts on additional
sales would be 8%. Tax rate is 30%. Assume 360 days in a year.
Solution:
Incremental contribution = 10,000,000 x 0.2 = Rs 2,000,000
Bad debts on new sales = 10,000,000 x 0.8 = Rs 8,000,000
Existing investment in receivables =
1,00,000,000 x 30 = Rs.8,333,333
360
Expected investment in receivables after increasing the credit period to 60 days:
Expected investment in receivables on current sales =
= 1,00,000,000 x 60 = RS.16,666,667
360
Additional investment in receivable on new sales
1,00,000,000 x 60 x 0.80 = RS.13,33,333

360
Expected total investment in receivables on increasing the period of credit = 1 80 00 000
Incremental investment in receivables = 1 80 00 000 - 8 333 333 = Rs.9666667
Opportunity cost of Incremental investment in receivables =

0.10 x 9666667 = Rs.966667
Statement showing the effect of increasing the credit period from 30 days to 60 days as
firm's project
Incremental Contribution 2 00 000
Less: Bad debts on new sales 8 00 000
1200000
Less: Income tax at 30 % 3 60 000
8 40 000
Less: Opportunity cost of incremental
123
Investment in receivables 966667
Change in profit (126667) negative
Since the impact of increasing the credit period on profits of the firm is negative, the
proposed change in credit period is not desirable.
2. Cash Discount
For assessing the effect of cash discount the following formula can be used. Change in
profit = (Incremental contribution - increase in discount cost) (1 - t) + opportunity cost of
savings in receivables investment.
Example
Present credit terms of a company are 1/10 net 30. Its sales are Rs 100 million, average
collection period is 20 days, variable cost to sales ratio is 0.8, and cost of capital is 10%.
The proportion of sales on which customers currently take discount is 0.5.
The company is considering relaxing its discount terms to 2/10, net 30. Such a relaxation
is expected to increase sales by Rs 10 million, reduce Average collection period to 14
days, increase discount sales to 0.8. Tax rate is 0.30.
Examine the effect of relaxing the discount policy on profits of the organization.
Assume 360 days in a year.
Solution
Incremental Contribution = 10 000 000 x 0.2 = RS.2 000 000
Increase in discount
Discount cost before liberalising discount terms =
0.5 x 1 00 000 000 x 0.01 = RS.5 00 000
Discount cost after liberalisation of discount terms = 0.8 x 110 000 000 x 0.002 =
Rs.1760 000
Increase in discount cost = RS.1260 000
Computation of savings in receivables investment
= 1,00,000,000 [20-14]-0.8x 10,000,000 x14
360 360
= 1,00,000,000 - 311111
60
= 1666667 - 311111 = Rs.1355556
Opportunity cost (savings of reduction in investment in receivables)

= 0.1 x 135556 = RS.135556
124
Statement showing the effect of change in discount policy as profit of the company
Increase in Contribution 2 000 000
Less: increase in discount cost 1260 000
7 40 000
Less: Tax at 30 % 2 22 000
5 18 000
Add: Benefit of savings due to

Reduction in investment in
Receivables profit 135556
653556
It is desirable to change the discount policy as it will improve the profitability of the firm.
4. Collection policy
Computation of the effect of new collection programme can be evaluated with the help of
following formula.
Change in profit = (Incremental contribution - Increase in bad debts) (1- tax rate) - cost of
increase in investment in receivables.
Example
A company is considering relaxing its collection effort. Its present sales are Rs 50
million, ACP = 20 days, variable cost to sales ratio = 0.8, cost of capital 10%. Its bad
debt ratio is 0.05.
The relaxation in collection programme is expected to increase sales by Rs 5 million,

increase ACP to 40 days and bad debts ratio to 0.56. Tax rate is 30%.
Examine the effect of change in collection programme on firm's profits. Assume 360
days in a year.
Solution
Increase in Contribution = 5 000 000 x 0.2 = Rs.1 000 000
Increase in bad debts
Bad debts on existing sales = 50 000 000 x 0.05 = 250 00 00
Bad debts on total sales after increase in sales =
55 000 000 x 0.56 = 33 00 000
Increase in bad debts = Rs.8 00 000
Incremental investment in receivables
50,000,000(40 - 20) 5,000,000 x 40 x 0.8

= +
360 360
= 2777778 + 444444 = RS.3222222
125
Opportunity cost of incremental investment in receivables =
0.1x 3222222 = Rs.322222
Statement showing the impact of new collection programme on profits of the organisation
Incremental Contribution 1 000 000

Less: Increase in bad debts 8 00 000
2 00 000
Less: Income tax at 30% 60 000
1,40,000
Less: Opportunity cost of increase
In investment in receivables
Profit 3,22,222
(182222) loss
Since the change will lead to decrease in profit (i,e a loss of Rs.182222) it is not desirable
to relax the collection programme of the firm.
11.5 Summary
Receivables are a direct result of credit sales. Management of accounts receivables is the
process of making decision relating to investment of funds in receivable which will result
in maximising the overall return on the investment of the firm. Cost of maintaining
receivables are capital costs, administration costs and delinquency costs. Credit policy
variables are credit standards, credit period, cash discounts and collection programme.
Optimum credit policy is that which Maximises the value of the firm.

1. Increasing the credit period from 30 to 60 days, in response to a similar action taken by
all of our competitors, would likely result in:
a) An increase in the average collection period.
b) A decrease in bad debt losses.
c) An increase in sales.
d) Higher profits.
2. The credit policy of Spurling Products is "1.5/10, net 35." At present 30% of the
customers take the discount, 62% pay within the net period, and the rest pay within 45
days of invoice. What would receivables be if all customers took the cash discount?
a) Lower than the present level.
b) No change from the present level.
c) Higher than the present level.
d) Unable to determine without more information.
3. An increase in the firm's receivable turnover ratio means that:

a) It is collecting credit sales more quickly than before.
b) Cash sales have decreased.
126
c) It has initiated more liberal credit terms.
d) Inventories have increased.
4.Costs of maintaining receivables are _________, _________ and ________ costs.

a) Capital, works , delinquency
b) Administration, delinquency, works
c) Capital, administration, works
d) Capital, administration, delinquency
5.To accelerate the turnover of receivables, a firm may either shorten the discount period
or increase the discount offered
a) False
b) True
6. A period of Net 30 means that it allows to its customers 30 days of credit with
____________ for __________.
a) No inducement, late payment
b) No inducement, early payment
c) Inducement, Late payment
d) Inducement, early payment
7. _________ refer to the criteria for extending credit to customers.

a) Debit standard
b) Capital structure
c) Credit standards
8. A cash discount of 2/10 net 20 means that a __________ is offered if the payment is
made __________.
a) Cash discount of 20%, 20th day
b) Cash discount of 2%, 20th day
c) Cash discount of 20%, 10th day
d) Cash discount of 2%, 10th day
9. Optimum credit policy maximizes the _______________.

a) Number of debtors of the firm
b) Number of creditors of the firm
c) Value of the firm
d) Taxes of the firm
10. Credit policy to be adopted by a firm is influenced by strategies pursued by its

competitors.
a) True
b) False
127
. Chapter - 12 Dividend Decision
Structure:
12.1 Introduction
12.2 Traditional Approach
12.3 Dividend Relevance Model
12.3.1 Walter Model
12.3.2 Gordon's Dividend Capitalization Model
12.4 Miller and Modigliani Model
12.5 Stability of Dividends
12.6 Forms of Dividends
12.7 Stock Split
12.8 Summary
12.1 Introduction
Dividends are that portion of a firm's net earnings paid to the shareholders. Preference
shareholders are entitled to a fixed rate of dividend irrespective of the firm's earnings.
Equity holders' dividends fluctuate year after year. It depends on what portion of earnings
is to be retained by the firm and what portion is to be paid off. As dividends are
distributed out of net profits, the firm's decisions on retained earnings have a bearing on
the amount to be distributed. Retained earnings constitute an important source of
financing investment requirements of a firm. However, such opportunities should have
enough growth potential and sufficient profitability. There is an inverse relationship
between these two - larger retentions, lesser dividends and vice versa. Thus two
constituents of net profits are always competitive and conflicting.
Dividend policy has a direct influence on the two components of shareholders' return -
dividends and capital gains. A low payout and high retention may have the effect of
accelerating earnings growth. Investors of growth companies realize their money in the
form of capital gains. Dividend yield will be low for such companies. The Influence of
dividend policy on future capital gains is to happen in distant future and therefore by all
means uncertain. Share prices are a reflection of many factors including dividends. Some
investors prefer current dividends to future gains as prophesied by an English saying - A
bird in hand is worth two in the bush. Given all these constraints, it is a major decision of
financial management.
Dividend policy of a firm is a residual decision. In true sense, it means that a firm with
128
sufficient investment opportunities will retain the entire earnings to fund its growth
avenues. Conversely, if no such avenues are forthcoming, the firm will pay-out its entire
earnings. So there exists a relationship between return on investments r and the cost of
capital k. So long as r exceeds k, a firm shall have good investment opportunities. That is,
if the firm can earn a return r higher than its cost of capital k, it will retain its entire
earnings and if this source is not sufficient, it will go in for additional sources in the form
of additional financing like equity issue, debenture issue or term loans. Thus, the
dividend decision is a trade-off between retained earnings and financing decisions.
Different theories have been given by various people on dividend policy. We have the
traditional theory and new sets of theories based on the relationship between dividend
policy and firm value. The modern theories can be grouped as - (a) theories that consider
dividend decision as an active variable in determining the value of the firm and (b)
theories that do not consider dividend decision as an active variable in determining the
value of the firm.
After studying this unit, you should be able to understand the following:.
1. Explain the importance of dividends to investors.
2. Discuss the effect of declaring dividends on share prices.
3. Mention the advantages of a stable dividend policy.
4. List out the various forms of dividend.
5. Give reasons for stock split.
12.2 Traditional Approach

This approach is given by B. Graham and D. L. Dodd. They clearly emphasize the
relationship between the dividends and the stock market. According to them, the stock
value responds positively to high dividends and negatively to low dividends, that is, the
share values of those companies rises considerably which pay high dividends and the
prices fall in the event of low dividends paid.
Symbolically, P = [m (D+E/3)]
Where P is the market price,
M is the multiplier,
D is dividend per share,
E is Earnings per share.
Drawbacks of the Traditional Approach: As per this approach, there is a direct

relationship between P/E ratios and dividend pay-out ratio. High dividend pay-out ratio
will increase the P/E ratio and low dividend pay-out ratio will decrease the P/E ratio. This
may not always be true. A company's share prices may rise in spite of low dividends due
to other factors.
12.3 Dividend Relevance Model

Under this section we examine two theories - Walter Model and Gordon Model.
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12.3.1 Walter Model
Prof. James E. Walter considers dividend pay-outs are relevant and have a bearing on the
share prices of the firm. He further states, investment policies of a firm cannot be
separated from its dividend policy and both are inter-linked. The choice of an appropriate
dividend policy affects the value of the firm. His model clearly establishes a relationship
between the firm's rate of return r, its cost of capital k, to give a dividend policy that
maximizes shareholders' wealth. The firm would have the optimum dividend policy that
will enhance the value of the firm. This can be studied with the relationship between r
and k. If r>k, the firm's earnings can be retained as the firm has better and profitable
investment opportunities and the firm can earn more than what the shareholders could by
re-investing, if earnings are distributed. Firms which have r>k are called 'growth firms'
and such firms should have a zero pay-out ratio.
If return on investment r is less than cost of capital k, the firm should have a 100% pay-
out ratio as the investors have better investment opportunities than the firm. Such a policy
will maximize the firm value.
If a firm has a ROI r equal to its cost of capital k, the firm's dividend policy will have no
impact on the firm's value. The dividend pay-outs can range between zero and 100% and
the firm value will remain constant in all cases. Such firms are called 'normal firms'.
Walter's Model is based on certain assumptions:

Financing: All financing is done through retained earnings. Retained earnings is
the only source of finance available and the firm does not use any external source
of funds like debt or new equity.
Constant rate of return and cost of capital: The firm's rand k remain constant
and it follows that any additional investment made by the firm will not change the
risk and return profile.
100% pay-out or retention: All earnings are either completely distributed or
reinvested entirely immediately.
Constant EPS and DPS: The earnings and dividends do not change and are
assumed to be constant forever.
Life: The firm has a perpetual life.
Walter's formula to determine the market price is as follows:
P = D + [r(E-D)/Ke]
Ke Ke
Where P is the market price per share,
D is the dividend per share,
Ke is the cost of capital,
g is the growth rate of earnings,
E is Earnings per share,
r is IRR.
Example:
The following information relates to Alpha Ltd. Show the effect of the dividend policy on
the market price of its shares using the Walter's Model
130
Equity capitalization rate Ke 11 %
Earnings per share Rs. 10
ROI (r) may be assumed as follows: 15%, 11 % and 8%
Show the effect of the dividend policies on the share value of the firm for three different
levels of r, taking the DP ratios as zero, 25%, 50%, 75% and 100%
Solution
Ke 11%, EPS 10, r 15%, DPS=0
P = D + [r/Ke(E-D)]
Ke Ke
Case I r >k (r = 15%, K = 11%)

0+[0.15/0.11(10-0)] = 13.64/0.11 = Rs. 123.97
a. DP = 0 0.11
b. DP = 25% 0 2.5+[0.15/0.11(10-2.5)] = 12.73/0.11 = Rs. 115.73

0.11
c. DP = 50% 5+[0.15/0.11(10-5)] = 11.82/0.11 = Rs. 107.44

0.11
d. DP = 75% 7.5 + [0.15/0.11(10 - 7.5)] = 10.91/0.11 = Rs. 99.17

0.11
e. DP = 100% 10+[0.15/0.11(10-10)] = 10/0.11 = Rs. 90.91

0.11
Case II r= k (r= 11%, K= 11%)
a. DP = 0 0+[0.11/0.11(10-0)] = 10/0.11 = Rs. 90.91

0.11
b. DP = 25% 2.5+[0.11/0.11(10-2.5)] = 10/0.11 = Rs. 90.91

0.11
c. DP = 50% 5+[0.11/0.11(10-5)] = 10/0.11 = Rs. 90.91
0.11
d. DP = 75% 7.5+[0.11/0.11(10-7.5)] = 10/0.11 = Rs. 90.91
0.11
e. DP = 100% 10+[0.11/0.11(10-10)] = 10/0.11 = Rs. 90.91
0.11
Case III r<k (r = 8%, K = 11%)
f. DP = 0 0+[0.11/0.08(10-0)] = 13.75/0.08 = Rs. 171.88

0.08
131
g. DP = 25% 2.5+[0.11/0.08(10-2.5)] = 12.81/0.08 = Rs. 160.13
0.08
h. DP = 50% 5+[0.11/0.08(10-5)] = 11.88/0.08 = Rs. 107.95

0.08
i. DP = 75% 7.5 + [0.11/ 0.08 (1 0 - 7.5)] = 10.94/0.08 = Rs. 99.43

0.08
j. DP= 100% 10+[0.11/0.08(10-10)] = 10/0.08 = Rs. 90.91

0.08
Interpretation: The above workings can be summarized as follows:

1. When r>k, that is, in growth firms, the value of shares is inversely related to DP
ratio, as the DP increases, market value of shares decline. Market value of share is
highest when DP is zero and least when DP is 100%.
2. When r=k, the market value of share is constant irrespective of the DP ratio. It is
not affected whether the firm retains the profits or distributes them.
3. In the third situation, when r<k, in declining firms, the market price of a share
increases as the DP increases. There is a positive correlation between the two.
Limitations:
Walter has assumed that investments are exclusively financed by retained earnings and
no external financing is used. This model is applicable only to all-equity firms. Secondly
r is assumed to be constant which again is not a realistic assumption. Finally, Ke is also
assumed to be constant and this ignores the business risk of the firm which has a direct
impact on the firm value.
12.3.2 Gordon's Dividend Capitalization Model

Gordon also contends that dividends are relevant to the share prices of a firm. Myron
Gordon uses the Dividend Capitalization Model to study the effect of the firm's dividend
policy on the stock price.
Assumptions:
All equity firm: The firm is an all equity firm with no debt.
No external financing is used and only retained earnings are used to finance any
expansion schemes.
Constant return r
Constant cost of capital Ke
The life of the firm is indefinite.
Constant retention ratio: The retention ratio g = br is constant forever.
Cost of capital greater than br, that is Ke > br
Gordon's model assumes investors are rational and risk-averse. They prefer certain
returns to uncertain returns and therefore give a premium to the constant returns and
132
discount uncertain returns. The shareholders therefore prefer current dividends to avoid
risk. In other words, they discount future dividends. Retained earnings are evaluated by
the shareholders as risky and therefore the market price of the shares would be adversely
affected. Gordon explains his theory with preference for current income. Investors prefer
to pay higher price for stocks which fetch them current dividend income. Gordon's model
can be symbolically expressed as:
P = E(1-b)
Ke - br
Where P is the price of the share,

E is Earnings Per Share,
b is Retention ratio,
(1 - b) is dividend payout ratio,
Ke is cost of equity capital,
br is growth rate in the rate of return on investment.
Example:
Given Ke as 11 %, E is Rs. 10, calculate the stock value of Mahindra Tech. for (a)
r=12%, (b) r=11% and (c) r=10% for various levels of DP ratios given under:
DP ratio (1 - b) Retention ratio
A 10% 90%
B 20% 80%
C 30% 70%
D 40% 60%
E 50% 50%
Solution
Case I r >k ( r = 12%, K = 11 %)
P= E(1-b)
Ke - br
a. DP 10%, b 90%
10 (1- 0.9)
0.11 - (0.8 * 0.12) equals 1/.002 = Rs. 500
b. DP 20%, b 80%
10 (1 - 0.8)
0.11 - (0.8 * 0.12) equals 2/.014 = Rs. 142.86
c. DP 30%, b 70%
10 (1- 0.7)
0.11- (0.7 * 0.12 equals 3/.026 = Rs. 115.38
d. DP 40%, b 60%
10 (1- 0.6)
0.11- (0.6 * 0.12) equals 4/.038 = Rs. 105.26
133
e. DP 50%, b 50%
10 (1- 0.5)
0.11 - (0.5 * 0.12) equals 5/.05 = Rs. 100
Case II r = k ( r = 11 %, K = 11 %)
P = E (1 - b)
Ke - br
a. DP 10%, b 90%
10 (1- 0.8)
0.11 - (0.9 * 0.11) equals 1/.011 = Rs.90.91
b. DP 20%, b 80%
10 (1- 0.8)
0.11 - (0.6 * 0.11) equals 2/.022 = Rs.90.91
c. DP 30%, b 70%
10 (1- 0.7)
0.11 - (0.7 * 0.11) equals 3/.033 = Rs.90.91
d. DP 40%, b 60%
10 (1 - 0.6)
0.11 - (0.6 * 0.11) equals 4/.044 = Rs.90.91
e. DP 50%, b 50%
10 (1- 0.5)
0.11 - (0.5 * 0.11) equals 5/.055 = Rs.90.91
Case III r<k (r=10%, K=11%)

P = E (1 - b)
Ke - br
a. DP 10%, b 90%
10 (1- 0.9)
0.11 - (0.9 * 0.1) equals 1/.02 = Rs. 50
b. DP 20%, b 80%
10 (1- 0.8)
0.11- (0.8 * 0.1) equals 2/.03 = Rs. 66.67
c. DP 30%, b 70%
10 (1 - 0.7)
0.11- (0.7 * 0.1) equals 3/.04 = Rs. 75
d. DP 40%, b 60%
10 (1- 0.6)
134
0.11 - (0.6 * 0.1) equals 4/.05 = Rs. 80
e. DP 50%, b 50%
10 (1- 0.5)
0.11 - (0.5 * 0.1) equals 5/.06 = Rs. 83.33
Interpretation: Gordon is of the opinion that dividend decision does have a bearing on
the market price of the share.
1. When r > k, the firm's value decreases with an increase in pay-out ratio. Market
value of share is highest when DP is least and retention highest.
2. When r = k, the market value of share is constant irrespective of the DP ratio. It is
not affected whether the firm retains the profits or distributes them.
3. When r<k, market value of share increases with an increase in DP ratio.
12.4 Miller and Modigliani Model

The MM hypothesis seeks to explain that a firm's dividend policy is irrelevant and has no
effect on the share prices of the firm. This model advocates that it is the investment
policy through which the firm can increase its share value and hence this should be given
more importance.
Assumptions
Existence of perfect capital markets: All investors are rational and have access
to all information free of cost. There are no floatation or transaction costs,
securities are infinitely divisible and no single investor is large enough to
influence the share value.
No taxes: There are no taxes, implying there is no difference between capital
gains and dividends.
Constant investment policy: The investment policy of the company does not
change. The implication is that there is no change in the business risk position and
the rate of return.
No Risk - Certainty about future investments, dividends and profits of the firm.
This assumption was, however, dropped at a later stage.
Based on the above assumptions, Miller and Modigliani have explained the irrelevance of
dividend as the crux of the arbitrage argument. The arbitrage process refers to setting off
or balancing two transactions which are entered into simultaneously. The two
transactions are paying out dividends and raising external funds to finance additional
investment programs. If the firm pays out dividend, it will have to raise capital by selling
new shares for financing activities. The arbitrage process will neutralize the increase in
share value (due to dividends) with the issue of new shares. This makes the investor
indifferent to dividend earnings and capital gains as the share value is more dependent on
the future earnings of the firm than on its current dividend policy.
Symbolically, the model is given as:

Step I: The market price of a share in the beginning is equal to the PVof dividends paid
and market price at the end of the period.
135
P0 = 1 * (D1 + P1)
(1 + Ke)
Where P0 is the current market price,
P1 is market price at the end of period 1,
D1 is dividends to be paid at the end of period 1,
Ke is the cost of equity capital.
Step II: Assuming there is no external financing, the value of the firm is:
nP0 = 1 * (nD1 + nP1)

(1 + Ke)
Where n is number of shares outstanding.
Step III: If the firm's internal sources of financing its investment opportunities fall short
of funds required, new shares are issued at the end of year 1 at price P1. The capitalized
value of the dividends to be received during the period plus the value of the number of
shares outstanding is less than the value of new shares.
nP0 = = 1 * (nD1 + (n + n1)P1 - n1p1)

(1 + Ke)
Firms will have to raise additional capital to fund their investment requirements after
utilizing their retained earnings, that is,
n1P1 = 1- (E - nD1) which can be written as n1P1 = 1- E + nD1
Where I is total investment required,

nD1 is total dividends paid,
E is earnings during the period,
(E - nD1) is retained earnings.
Step IV: The value of share is thus:
nP0 = = 1 * (nD1 + (n + n1) P1 -I + E - nD1)

(1 + Ke)
Example:
A company has a capitalization rate of 10%. It currently has outstanding shares worth
25000 shares selling currently at Rs. 100 each. The firm expects to have a net income of
Rs. 400000 for the current financial year and it is contemplating to pay a dividend of Rs.
4 per share. The company also requires Rs. 600000 to fund its investment requirement.
Show that under MM model, the dividend payment does not affect the value of the firm.
Solution:
Case I: When dividends are paid:
136
Step I: P0 = 1 * (D1 + P1)
(1 + Ke)
100 = 1/(1+0.1) * (4 + P1)
P1 = Rs. 106
Step II: n1P1 = 1-(E-nD1), nD1 is 25000*4

n1P1 = 600000 - (400000 - 100000) = Rs. 300000
Step III: Number of additional shares to be issued 300000/106 = 2831 shares

Step IV: The firm value
(n+n1) P1-I+E
nP0 = = (1 + Ke)
(25000 + 2831) * 106600000 + 400000 equals Rs. 2500000
(1 + Ke)
Case II: When dividends are not paid:

Step I: PO = 1 * (01 + P1)
(1 + Ke)
100= 1/(1+0.1)*(O+P1)
P1 = Rs. 110
Step II: n1P1 = 1- (E - nD1), nD1 is 25000*4

n1 P1 = 600000 - (400000 - 0) = Rs. 200000
Step III: Number of additional shares to be issued

200000/110 = 1819 shares
Step IV: The firm value
nPO = = (n+n1)P1-I+E
(1 + Ke)
(25000 + 2831) * 106600000 + 400000 equals Rs. 2500000

(1 + 0.1)
Thus, the value of the firm remains the same in both the cases whether or not dividends
are declared.
Critical Analysis of MM Hypothesis:

Floatation costs: Miller and Modigliani have assumed the absence of floatation costs.
Floatation costs refer to the cost involved in raising capital from the market, that is, the
costs incurred towards underwriting commission, brokerage and other costs. These costs
ordinarily account to around 10%-15% of the total issue and they cannot be ignored given
the enormity of these costs. The presence of these costs affects the balancing nature of
retained earnings and external financing. External financing is definitely costlier than
retained earnings. For instance, if a share is issued worth Rs. 100 and floatation costs are
12%, the net proceeds are only Rs.88.
137
Transaction costs: This is another assumption made by MM that there are no transaction
costs like brokerage involved in capital market. These are the costs associated with sale
of securities by investors. This theory implies that if the company does not pay dividends,
the investors desirous of current income sell part of their holdings without any cost
incurred. This is very unrealistic as the sale of securities involves cost, investors wishing
to get current income should sell higher number of shares to get the income they are to
receive.
Under-pricing of shares: If the company has to raise funds from the market, it should
sell shares at a price lesser than the prevailing market price to attract new shareholders.
This follows that at lower prices, the firm should sell more shares to replace the dividend
amount.
Market conditions: If the market conditions are bad and the firm has some lucrative
opportunities, it is not worth-approaching new investors at this juncture, given the
presence of floatation costs. In such cases, the firms should depend on retained earnings
and low pay-out ratio to fuel such opportunities.
12.5 Stability of Dividends

Stability of dividends is the consistency in the stream of dividend payments. It is the
payment of certain amount of minimum dividend to the shareholders. The steadiness is a
sign of good health of the firm and may take any of the following forms - (a) constant
dividend per share, (b) constant DP ratio and (c) constant dividend per share plus extra
dividend.
Constant dividend per share: As per this form of dividend policy, a firm pays a fixed
amount of dividend per share year after year. For example, a firm may have a policy of
paying 25% dividend per share on its paid-up capital of Rs. 10 per share. It implies that
Rs. 2.50 is paid out every year irrespective of its earnings. Generally, a firm following
such a policy will continue payments even if it incurs losses. In such years when there is
a loss, the amount accumulated in the dividend equalization reserve is utilized. As and
when the firm starts earning a higher amount of revenue it will consider payment of
higher dividends and in future it is expected to maintain the higher level.
Constant DP ratio: With this type of DP policy, the firm pays a constant percentage of
net earnings to the shareholders. For example, if the firm fixes its DP ratio as 25% of its
earnings, it implies that shareholders get 25% of earnings as dividend year after year. In
such years where profits are high, they get higher amount.
Constant dividend per share plus extra dividend: Under this policy, a firm usually
pays a fixed dividend ordinarily and in years of good profits, additional or extra dividend
is paid over and above the regular dividend.
The stability of dividends is desirable because of the following advantages:

Build confidence amongst investors: A stable dividend policy helps to build
confidence and remove uncertainty in the minds of investors. A constant dividend
138
policy will not have any fluctuations suggesting to the investors that the firm's
future is bright. In contrast, shareholders of a firm having an unstable DP will not
be certain about their future in such a firm.
Investors' desire for current income: A firm has different categories of
investors - old and retired persons, pensioners, youngsters, salaried class,
housewives, etc. Of these, people like retired persons prefer current income. Their
living expenses are fairly stable from one period to another. Sharp changes in
current income, that is, dividends, may necessitate sale of shares. Stable dividend
policy avoids sale of securities and inconvenience to investors.
Information about firm's profitability: Investors use dividend policy as a
measure of evaluating the firm's profitability. Dividend decision is a sign of firm's
prosperity and hence firm should have a stable DP.
Institutional investors' requirements: Institutional investors like LlC, GIC and
MF prefer to invest in companies which have a record of stable DP. A company
having erratic DP is not preferred by these institutions. Thus to attract these
organizations having large quantities of investible funds, firms follow a stable DP.
Raise additional finance: Shares of a company with stable and regular dividend
payments appear as quality investment rather than a speculation. Investors of such
companies are known for their loyalty and whenever the firm comes with new
issues, they are more responsive and receptive. Thus raising additional funds
becomes easy.
Stability in market price of shares: The market price of shares varies with the
stability in dividend rates. Such shares will not have wide fluctuations in the
market prices which is good for investors.
12.6 Forms of Dividends

Dividends are that potion of earnings available to shareholders. Generally, dividends are
distributed in cash, but sometimes they may also declare dividends in other forms which
are discussed below:
Cash dividends: Most companies pay dividends in cash. The investors also,
especially the old and retired investors depend on this form of payment for want
of current income.
Scrip dividend: In this form of dividends, equity shareholders are issued
transferable promissory notes with shorter maturity periods which mayor may not
have interest bearing. This form is adopted if the firm has earned profits and it
will take some time to convert its assets into cash (having more of current sales
than cash sales). Payment of dividend in this form is done only if the firm is
suffering from weak liquidity position.
Bond dividend: Scrip and bond dividend are the same except that they differ in
terms of maturity. Bond dividends carry longer maturity period and bear interest,
whereas scrip dividends carry shorter maturity and mayor may not carry interest.
Stock dividend (Bonus shares): Stock dividend, as known is USA or bonus
shares in India, is the distribution of additional shares to the shareholders at no
additional cost. This has the effect of increasing the number of outstanding shares
of the firm. The reserves and surplus (retained earnings) are capitalized to give
139
effect to bonus issue. This decision has the effect of recapitalization, that is,
transfer from reserves to share capital not changing the total net worth. The
investors are allotted shares in proportion to their present shareholding.
Declaration of bonus shares has a favourable psychological effect on investors.
They associate it with prosperity.
12.7 Stock Split

A stock split is a method to increase the number of outstanding shares by proportionately
reducing the face value of a share. A stock split affects only the par value and does not
have any effect on the total amount outstanding in share capital. The reasons for splitting
shares are:
To make shares attractive: The prime reason for effecting a stock split is to
reduce the market price of a share to make it more attractive to investors. Shares
of some companies enter into higher trading zone making it out of reach to small
investors. Splitting the shares will place them in more popular trading range thus
providing marketability and motivating small investors to buy them.
Indication of higher future profits: Share split is generally considered a method
of management communication to investors that the company is expecting high
profits in future.
Higher dividend to shareholders: When shares are split, the company does not
resort to reducing the cash dividends. If the company follows a system of stable
dividend per share, the investors would surely get higher dividends with stock
split.
12.8 Summary
Dividends are the earnings of the company distributed to shareholders. Payment of
dividend is not mandatory, but most companies see to it that dividends are paid on a
regular basis to maintain the image of the company. As payment of dividend is not
compulsory, the question which arises in the minds of policy makers is- "Should
dividends be paid, if yes, what should be the quantum of payment?" Various theories
have come out with various suggestions on the payment of dividend. B. Graham and D.
L. Dodd are of the view that there is a close relationship between the dividends- and the
stock market. The stock value responds positively to high dividends and vice
versa.
Prof. James E. Walter considers dividend pay-outs are necessary but if the firm's ROI is
high, earnings can be retained as the firm has better and profitable investment
opportunities.
Gordon also contends that dividends are significant to determine the share prices of a
firm. Shareholders prefer certain returns (current) to uncertain returns (future) and
therefore give a premium to the constant returns and discount uncertain returns.
Miller and Modigliani explain that a firm's dividend policy is irrelevant and has no effect
on the share prices of the firm. They are of the view that it is the investment policy
through which the firm can increase its share value and hence this should be given more
140
importance.
Dividends can be paid out in various forms such as cash dividend, scrip dividend, bond
dividend and bonus shares.

1. Retained earning are ____________
a) An indication of a company's liquidity.
b) The same as cash in the bank.
c) Not important when determining dividends.
d) The cumulative earnings of the company after dividends.
2. Which of the following is an argument for the relevance of dividends?
a) Informational content.
b) Reduction of uncertainty.
c) Some investors' preference for current income.
d) All of the above
3. All of the following are true of stock splits except :
a) Market price per share is reduced after the split.
b) The number of outstanding shares is increased.
c) Retained earnings are changed.
d) Proportional ownership is unchanged.
4. The dividend-payout ratio is equal to __________
a) The dividend yield plus the capital gains yield.
b) Dividends per share divided by earnings per share.
141
c) Dividends per share divided by par value per share.
d)Dividends per share divided by current price per share.
5.Gordon's model assumes investors are ________ and risk-averse.

a) Rational
b) Irrational
c) Ignorant
6. Miller and Modigliani explain that a firm's dividend policy is _________ and has no
effect on the share prices of the firm.
a) Relevant
b) Irrelevant
c) Important
7. Dividends can be paid out in various forms such as ______ dividend, ________
dividend, ______ dividend and _________.
a) Cash, scrip, bond, bonus shares
b) Cash, scrip, bond, interest
c) Gift, scrip, bond, bonus shares
d) Gift, scrip, bond, interest
8.________ uses the Dividend Capitalization Model to study the effect of the firm's
dividend policy on the stock price.
a) James
b) Walter
c) Miller and Modigliani
d) Gordon
9. This is another assumption made by _______ that there are no transaction costs like
brokerage involved in capital market.
a) James
b) Walter
c) Miller and Modigliani
d) Gordon
10. As per _________ approach, there is a direct relationship between P/E ratios and
dividend pay-out ratio.
a) Dividend Relevance
b) Traditional
c) MM
142
ANSWER KEY
Financial Management, Chapter 1
1 (b), 2 (a), 3 (a), 4 (d), 5 (b), 6 (a), 7 (b), 8 (c), 9 (c), 10 (c)
Time value, Chapter 2
1 (a), 2 (a), 3 (a), 4 (b), 5 (c), 6 (a), 7 (c), 8 (a), 9 (d), 10 (d)
Cost of Capital, Chapter 3
1 (d), 2 (c), 3 (c), 4 (a), 5 (b), 6 (c), 7 (b), 8 (a), 9 (c), 10 (c)
Leverage, Chapter 4
1 (b), 2 (a), 3 (c), 4 (b), 5 (c), 6 (d), 7 (a), 8 (a), 9 (b), 10 (b)
Capital Structure, Chapter 5
1 (a), 2 (b), 3 (a), 4 (b), 5 (d), 6 (a)
Capital budgeting, Chapter 6
1(a), 2 (b), 3 (a), 4 (b), 5 (a), 6 (d), 7 (d), 8 (a), 9 (a), 10 (b)
Risk analysis in capital budgeting, Chapter 7
1 (b), 2 (d), 3 (a), 4 (c), 5 (b), 6 (a), 7 (b), 8 (c), 9 (a), 10 (c)
Working Capital, Chapter- 8
1 (a), 2 (b), 3 (a), 4 (c), 5 (a), 6 (b), 7 (b), 8 (a), 9 (c), 10 (b)
Cash Management, Chapter- 9
1 (b), 2 (a), 3 (c), 4 (c), 5 (d), 6 (a), 7 (a), 8 (b), 9 (c), 10 (b)
Inventory Management, Chapter-10
1 (a), 2 (b), 3 (c), 4 (b), 5 (d), 6 (c), 7 (a), 8 (d), 9 (a), 10 (b)
Receivables Management, Chapter-11
1 (a), 2 (a), 3 (a), 4 (d), 5 (b), 6 (b), 7 (c), 8 (d), 9 (c), 10 (a)
143
Dividend decision, Chapter-12
1 (d), 2 (d), 3 (c), 4 (b), 5 (a), 6 (b), 7 (a), 8 (d), 9 (c),10 (b)
144

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FINANCIAL

This study material seeks to:

2. Time Value of Money 12

7. Risk Analysis in Capital Budgeting 72

8. Working capital Management 82

10 Inventory Management 105

11 Receivables Management 118

12. Dividend Decision 128

13. Key to end chapter quizzes 142

These are the core elements of financial management of a firm.

Financial Management of a firm is concerned with procurement and effective

All corporate decision have financial implication. Therefore, financial management

1.2 Meaning and Definitions

Traditionally, financial management was considered a branch of knowledge with focus

1.3 Goal of financial management

Difference in interpretation on the concept of profit expose the weakness of

2. Profit maximization ignores time value of money because it does not

1.4 Finance Functions

1.4.1 Investment Decisions

Two critical issues to be considered in decision are:-

1.4.2 Financing Decisions

Dept is cheap because interest payable on loan is allowed as deductions in computing

1.4.3 Dividend Decisions

1.4.4 Liquidity Decision

The important element of liquidity decisions are:

1.4.5 Organization of Finance Function

A Treasurer performance the following function:

1.5 Interface between Finance and Other Business Functions

1.5.2 Finance and Marketing

1.5.3 Finance and Production (Operations)

1.5.4 Finance and HR

Chapter-2 Time Value of Money

Preference for consumption

Why should money have time value?

Some of the reasons are:

2.2 Future Value

Required rate of return=Risk free rate + Risk Premium

2.2.1 Compounding Technique

Where A = Amount at the end of the period

2.2.2 Discounting Technique

2.2.3 Future Value of a Single Flow (lump sum)

Where FVn = Future Value of the initial flow in n years hence

Period of deposit Rate per annum

How much does an investment of Rs.10000 invested today grow to in 3 years?

Solution: FVn = PV(1+i)n or PV*FVIF(11%, 3y)

Increased frequency of compounding

Where, FVn = Future value after n years

2.2.4 Future Value of Series of Cash Flows

2.2.5 Future Value of An Annuity

End of Amount Number of Compounded FV in Rs.

OR Using formula and the tables we can find that:

2.3 Present Value

2.3.1 Discounting or Present Value of a Single Flow

Where, PV = Present Value

2.3.2 Present Value of a Series of Cash Flows

Which reduces to:

The expression {1+i)n-1/i(1+i)n} is known as Present Value Interest Factor Annuity

2.3.2.1 Present Value of Perpetuity

Example: If the principal of a college wants to institute a scholarship of Rs.5000 to a

This means he should invest Rs.50000 to get an annual return of Rs.5000.

PV = 10000/(1+0.08)+ 15000/(1+0.08)2+ 8000/(1+0.08)3+ 11000/(1+0.08)4+

2.3.2.2 Capital Recovery Factor

{i(1+i)n}/(1+i)n-1} is known as the Capital Recovery Factor.

Example: A loan of Rs.100000 is to be repaid in 5 equal annual installments. If the loan