Financial Management PDF

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STUDY NOTES
Financial Management
MBA/112 (MBA 2nd Sem.)
Department of Management
SHRI RAM COLLEGE OF ENGINEERING AND MANAGEMENT
SRCEM, Palwal
Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

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UNIT - I
THE FINANCE FUNCTION
INTRODUCTION:
In our present day economy, Finance is defined as the provision of
money at the time when it is required. Every enterprise, whether big,
medium or small needs finance to carry on its operations and to achieve its
targets. In fact, finance is so indispensable today that it is rightly said to be
the life blood of an enterprise.
MEANING OF FINANCE
Finance may be defined as the art and science of managing money. It

includes financial service and financial instruments. Finance also is referred
as the provision of money at the time when it is needed. Finance function is
the procurement of funds and their effective utilization in business concerns.
The concept of finance includes capital, funds, money, and amount. But each
word is having unique meaning. Studying and understanding the concept of
finance become an important part of the business concern
TYPES OF FINANCE
Finance is one of the important and integral part of business concerns,
hence, it plays a major role in every part of the business activities. It is used
in all the area of the activities under the different names. Finance can be
classified into two major parts:
Private Finance, which includes the Individual, Firms, Business or Corporate

Financial activities to meet the requirements. Public Finance which concerns
with revenue and disbursement of Government such
as Central Government, State Government and Semi-Government Financial matters.

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Definition:
Finance may be defined as the provision of money at the time when it is required. Finance refers
to the management of flow of money through an organization
According to WHEELER, business finance may be defined as “that business activity which is
concerned with the acquisition and conservation of capita
SCOPE OF FINANCIAL MANAGEMENT:
The main objective of financial management is to arrange sufficient

finance for meeting short term and long term needs. A financial manager
will have to concentrate on the following areas of finance function.
1. Estimating financial requirements:

The first task of a financial manager is to estimate short term and long term
financial requirements of his business. For that, he will prepare a financial
plan for present as well as for future. The amount required for purchasing
fixed assets as well as needs for working capital will have to be ascertained.
2. Deciding capital structure:

Capital structure refers to kind and proportion of different securities for
raising funds. After deciding the quantum of funds required it should be
decided which type of securities should be raised. It may be wise to finance
fixed assets through long term debts. Even here if gestation period is longer
than share capital may be the most suitable. Long term funds should be
employed to finance working capital also, if not wholly then partially.
Entirely depending on overdrafts and cash credits for meeting working
capital needs may not be suitable. A decision about various sources for funds
should be linked to the cost of raising funds.
3. Selecting a source of finance:

An appropriate source of finance is selected after preparing a capital
structure which includes share capital, debentures, financial institutions,
public deposits etc. If finance is needed for short term periods then banks,
public deposits and financial institutions may be the appropriate. On the
other hand, if long term finance is required then share capital and debentures
may be the useful.
4. Selecting a pattern of investment:

When funds have been procured then a decision about investment pattern is
to be taken. The selection of an investment pattern is related to the use of
funds. A decision will have to be taken as to which assets are to be
purchased? The funds will have to be spent first on fixed assets and then an
appropriate portion will be retained for working capital and for other
requirements.
5. Proper cash management:

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Cash management is an important task of finance manager. He has to assess

various cash needs at different times and then make arrangements for
arranging cash. Cash may be required to purchase of raw materials, make
payments to creditors, meet wage bills and meet day to day expenses. The
idle cash with the business will mean that it is not properly used.
6. Implementing financial controls:

An efficient system of financial management necessitates the use of various
control devices. They are ROI, break even analysis, cost control, ratio
analysis, cost and internal audit. ROI is the best control device in order to
evaluate the performance of various financial policies.
7. Proper use of surpluses:

The utilization of profits or surpluses is also an important factor in financial
management. A judicious use of surpluses is essential for expansion and
diversification plans and also in protecting the interests of share holders. The
ploughing back of profits is the best policy of further financing but it clashes
with the interests of share holders. A balance should be struck in using funds
for paying dividend and retaining earnings for financing expansion plans.
FINANCE FUNCTION – AIM

The objective of finance function is to arrange as much funds for the
business as are required from time to time. This function has the following
objectives.
1. Assessing the Financial requirements. The main objective of

finance function is to assess the financial needs of an organization
and then finding out suitable sources for raising them. The sources
should be commensurate with the needs of the business. If funds are
needed for longer periods then long-term sources like share capital,
debentures, term loans may be explored.
2. Proper Utilization of Funds: Though raising of funds is important

but their effective utilisation is more important. The funds should be
used in such a way that maximum benefit is derived from them. The
returns from their use should be more than their cost. It should be
ensured that funds do not remain idle at any point of time. The funds
committed to various operations should be effectively utilised. Those
projects should be preferred which are beneficial to the business.
3. Increasing Profitability. The planning and control of finance

function aims at increasing profitability of the concern. It is true that
money generates money. To increase profitability, sufficient funds
will have to be invested. Finance Function should be so planned that
the concern neither suffers from inadequacy of funds nor wastes
more funds than required. A proper control should also be exercised

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so that scarce resources are not frittered away on uneconomical

operations. The cost of acquiring funds also influences profitability
of the business.
4. Maximizing Value of Firm. Finance function also aims at
maximizing the value of the firm. It is generally said that a concern's
value is linked with its profitability.
Due to recent trends in business environment, financial managers are identifying new
ways through which finance function can generate great value to their organization.
1. Current Business Environment: The progress in financial analytics is
because of development of new business models, trends in role of traditional
finance department, alternations in business processes and progress in
technology.
Finance function in this vital environment emerged with enormous
opportunities and challenges.
2. New Business Model: At the time when internet was introduced, three
new e- business models have evolved. They are business-to-business (B2B),
business-to-
customer (B2C) and business-to-employees (B2E) future of financial
analytics can be improved with the help of this new model of business.
Traditionally, financial analytical is emphasizing on utilization of
tangible assets like cash, machinery etc, whereas some companies are
mainly focused on intangible assets which are not easy to evaluate
and control. Hence financial analytics solved this problem by:
i) Recognizing the complete performance of organization.
ii) Determining the source through which value of intangible assets
can be evaluated and increased.
iii) Predict the trends in market.
iv) The abilities of information system is encouraged.
v) Minimizes the operating costs and enterprise-wide investments are
effectively controlled and upgrade the business processes.
3. Changing Role of the Finance Department: The role of finance
function has been changing simultaneously with the changes in
economy. These changes are mainly due to Enterprise Resource Planning
(ERP), shared services and alternations in its reporting role.
In the field of transaction processing, the role of financial staff has
been widened up because of automated financial transactions. Now
financial executives are not just processing and balancing
transactions but they are focusing on decision- making processes.

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International organizations are facilitating their customers by

providing financial information and facility to update both finance
and non-finance functions from any place around the world. It
resulted in the department of decision support in the organization.
Finance professionals are held responsible for supplying suitable
analytical tools and methods to decision makers.
i) Business Processes: With the evolution of business processes,
queries regarding business are becoming more complicated. In order to
solve, it requires analytics with high level of data integration and
organizational collaboration. In the last few decades, organizations are
replacing function based legacy systems with new methods like ERP, BRP
etc., in order to get accurate and consistent financial and non- financial
information.
In 1990’s organizations were applying some modern systems like supply
chain management, Customer Relationship Management (CRM) and many
others to encourage their transactions. Overall organizations were building
strong relations with customers.
ii) Technology: With the developments in technology, ERP, internet, data
warehousing have also improved. Internet helps in increasing the sources of
acquiring financial data, whereas ERP vendors are building their own
financial analytics which helps I n evaluating the performance, planning and
estimating, management and statutory reporting and financial consolidation.
Till now, data warehousing solutions used to emphasize on developing
elements of analytical infrastructure such as data stores, data marts and
reporting applications but in future these data ware housings provide
advances analytical abilities to data stores.
iii) Integrated Analytics: To survive in this competitive environment,

organizations must have advanced level of integrated financial analytics.
Integrated financial analytics are useful for organizations to evaluate,
combine and share information inside and outside the organization.
Hence, with the progress in role of finance function, the financial
analytics are used in organizations effectively.
EVOLUTION OF FINANCE FUNCTION:
Financial management came into existence as a separate field of

study from finance function in the early stages of 20th century. The
evolution of financial management can be separated into three stages:
1. Traditional stage (Finance up to 1940): The traditional stage of
financial management continued till four decades. Some of the important
characteristics of this stage are:

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i) In this stage, financial management mainly focuses on specific events like

formation expansion, merger and liquidation of the firm.
ii) The techniques and methods used in financial management are mainly
illustrated and in an organized manner.
iii) The essence of financial management was based on principles and
policies used in capital market, equipments of financing and lawful matters
of financial events.
iv) Financial management was observed mainly from the prospective of
investment bankers, lenders and others.
2. Transactional stage (After 1940): The transactional stage started in
the beginning years of 1940’s and continued till the beginning of 1950’s.
The features of this stage were similar to the traditional stage. But this stage
mainly focused on the routine problems of financial managers in the field of
funds analysis, planning and control. In this stage, the essence of financial
management was transferred to working capital management.
3. Modern stage (After 1950): The modern stage started in the middle of
1950’s and observed tremendous change in the development of financial
management with the ideas from economic theory and implementation of
quantitative methods of analysis. Some unique characteristics of modern
stage are:
i) The main focus of financial management was on proper utilization of
funds so that wealth of current share holders can be maximized.
ii) The techniques and methods used in modern stage of financial
management were analytical and quantitative.
Since the starting of modern stage of financial management many
important developments took place. Some of them are in the fields of capital
budgeting, valuation models, dividend policy, option pricing theory,
behavioral finance etc.
GOALS OF FINANCE FUNCTION
Effective procurement and efficient use of finance lead to proper utilization

of the finance by the business concern. It is the essential part of the financial
manager. Hence, the financial manager must determine the basic objectives
of the financial management. Objectives of Financial Management may be
broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.

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Share holders BOD CFO
1. Profit Maximization
Main aim of any kind of economic activity is earning profit. A business
concern is also functioning mainly for the purpose of earning profit. Profit is
the measuring techniques
to understand the business efficiency of the concern. Profit maximization is
also the traditional and narrow approach, which aims at, maximizes the
profit of the concern. Profit maximization consists of the following
important features.
1. Profit maximization is also called as cashing per share maximization. It
leads to maximize the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers
all the possible ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business
concern. So it shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favorable Arguments for Profit Maximization
The following important points are in support of the profit maximization

objectives of the business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.

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(v) Profitability meets the social needs also.
Unfavorable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice,
unfair trade practice, etc.
(iii) Profit maximization objectives leads to inequalities among the sake
holders such as customers, suppliers, public shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:

(i) It is vague: In this objective, profit is not defined precisely or correctly. It
creates some unnecessary opinion regarding earning habits of the business
concern.
It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the actual
cash inflow and net present cash flow during a particular period.
(ii) It ignores risk: Profit maximization does not consider risk of the
business concern. Risks may be internal or external which will affect the
overall operation of the business concern.
2. Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest

innovations and improvements in the field of the business concern. The term
wealth means shareholder wealth or the wealth of the persons those who are
involved in the business concern. Wealth maximization is also known as
value maximization or net present worth maximization. This objective is an
universally accepted concept in the field of business
Favorable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the

main aim of the business concern under this concept is to improve the value
or wealth of the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost
associated with the business concern. Total value detected from the total cost
incurred for the business operation. It provides extract value of the business
concern.
(iii) Wealth maximization considers both time and risk of the business concern.

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(iv) Wealth maximization provides efficient allocation of resources.

(v) It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern

but it may not be suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the
indirect name of the profit maximization.
(iii) Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi) Wealth maximization can be activated only with the help of the
profitable position of the business concern.
S.NO. PROFITMAXIMIZATION WEALTH MAXIMIZATION WELFARE

MAXIMIZATION
1) Profits are earned Wealth is maximized, so that Welfare maximization is

maximized, so that firm wealth of share-holders can be done with the help of micro
can over-come future risks maximized. economic techniques to
which are uncertain. examine a locative
distribution.
2) Profit maximization is a In wealth maximization In welfare maximization,

yards stick for calculating stockholders current wealth is social welfare is evaluated
efficiency and economic evaluated in order to maximize by calculating economic
prosperity of the concern. the value of shares in the activities of individuals in
market. the society.
3) Profit is measured in terms Wealth is measured in terms of Welfare can be measured in

of efficiency of the firm. market price of shares. two ways, either by pare to
efficiency or in units or
dollars.
4) Profit maximization Wealth maximization involves Wealth maximization

involvesproblemof problems related to involves problem of
uncertainty because profits maximizing shareholder’s combining the utilities of
are uncertain. wealth or wealth of the firm different people.

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TIME VALUE OF MONEY
Most students agree that what $10, today, will buy will be more than what $10 will buy in 5
years in the future. Similarly, they also agree $10 would have got them a lot more 5 years ago
than what it will get them today. Since they agree that this is true, I tell them that they have
understood the time value of money concept! This is exactly what the time value of money
concept in finance is trying to show. As time flows the value of money declines.
Why does the Value of Money Decline?
The value of money declines due to the combined impact of the following:
1. Inflation in the economy;

2. Risks involved in delayed receipts of cash or financial transactions; and
3. Opportunity cost of capital delayed.
While each of these forces alone can cause the value of money to decline individually, all the
three usually act with different degrees of impact to cause a decline in the value of money as
time flows.
The Present Value Formula:
The present value formula quantifies how fast the value of money declines. This formula shows
you how much once single cash payment (FV) received in a future time period (t) is worth in
today’s terms (PV).
Present Value (PV) stands for the value of the money in today’s terms.
Future Value (FV) stands for the amount of cash received in the future.
r is the discount rate or the speed at which the decline in value is happening (covered in detail
later).
t is the time period in which the future value or cash is received.

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Infographic on the Time Value of Money
The GraduateTutor.com finance team

has put together this infographic on
the Time Value of Money for the
visual learners. We have a follow up
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used Time Value of Money formulas.
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Please feel free to embed this

infographic using the code below this
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poster by linking to us.
Computing the Time Value of

Money
If a sum is invested today, it will

earn interest and increase in value
over time. The value that the sum
grows to is known as its future
value. Computing the future value of
a sum is known as compounding.
The present value of a sum is the
amount that would need to be
invested today in order to be worth
that sum in the future. Computing
the present value of a sum is known
as discounting.
The Future Value of a Sum
The future value of a sum depends
on the interest rate and the interval of
time over which the sum is invested.
This is shown with the following
formula:
FVt = PV*(1+r)t

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where:
FVt = future value of a sum invested for t periods

r = periodic interest rate
PV = present value
t = number of periods until the sum is received
Each period may be a year, a month, a week, etc. The terms in the formula must be consistent
with each other; for example, if it is measured in months, then r must be a monthly rate of
interest.
As an example, suppose that a sum of $1,000 is invested for four years at an annual rate of
interest of 3%. What is the future value of this sum? In this case, t = 4, r = 3% and PV = $1,000.
FVt = PV(1+r)t
FV4 = 1,000(1+.03)4
FV4 = 1,000(1.12551)
FV4 = $1,125.51
The Present Value of a Sum
The formula for computing the present value of a sum is:
Note that the present value is simply the inverse of the future value.
As an example, how much must be deposited in a bank account that pays 5% interest per year in
order to be worth $1,000 in three years? In this case, t = 3, r = 5% and FV3 = $1,000.
Present Value Or What must be deposited to get $1,000 = 1,000/(1.1576) = $863.84
Interest Rates and Compounding Frequencies:
Compounding refers to the frequency with which interest rates are charged or paid during a
given year. In practice, interest rates can be compounded anywhere from once per year to once
per day; the theoretical limiting case is known as continuous compounding, in which rates are
compounded at every instant in time. Compounding frequency is one of the most important
determinants of the future value and the present value of a sum.

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For example, if a bank offers a 4% rate of interest with annual compounding, an investor who
holds $1,000 in the bank for one year will have a balance of: $1,000(1 + 0.04) = $1,040 at the
end of the year. In other words, the future value of this sum is $1,040.
If the interest is compounded semi-annually, then the investor will receive half of the annual rate
twice per year; i.e., 2% every six months during the year. At the end of six months, the investor
will have a balance of: $1,000(1 + 0.02) = $1,020 at the end of the year, the investor will have a
balance of: $1,020(1 + 0.02) = $1,000(1 + 0.02)(1 + 0.02) = $1,000(1 + 0.02)2 = $1,040.40
In this case, since the principal is $1,000, the total interest is $40.40. Of this:
$40 is simple interest (interest on principal)

$0.40 is compound interest (interest on interest)
In this case, the investor received an interest payment of $1,000(0.02) = $20 at the end of six
months, for a balance of $1,020. The interest payment at the end of the year was based on the
principal ($1,000) and the interest ($20) in the account. The interest paid on the principal was
$1,000(0.02) = $20 and the interest paid on the interest was $20(0.02) = $0.40. Combined with
the $20 interest paid at the end of six months, the total interest paid during the year was $20 +
$20 + $0.40 = $40.40. Of this, the $40 was based on the principal; this is the simple interest. The
remaining $0.40 was based on the interest earned during the year; this is the compound interest.
As the compounding frequency increases, the simple interest earned during a given period
remains fixed, but the compound interest increases. For example, with quarterly compounding,
the investor in the previous example will receive 1% every three months; at the end of the year
the investor will have a balance of:
$1,000(1 + 0.01)(1 + 0.01) (1 + 0.01)(1 + 0.01)

= $1,000(1 + 0.01)4 = $1,040.60
In this case, the total interest is $40.60. Of this:
$40 is simple interest (interest on principal)

$0.60 is compound interest (interest on interest)
This demonstrates an important result: as the compounding frequency increases, the future value
of a sum increases.
As another example, suppose that a sum of $1,000 is invested for two years at an annual rate of
interest of 8%. What is the future value of this sum based on the following compounding
frequencies?
 Annual compounding

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 Semi-annual compounding
 Monthly compounding
With annual compounding, t = 2, r = 8% and PV = $1,000.
FVt = PV*(1+r)^t
FV2 = 1,000*(1+.08)^2
FV2 = 1,000*(1.16640)
FV2 = $1,166.40
With semi-annual compounding, t = 4, r = 4% and PV = $1,000. The time frame is now 4 semi-
annual periods, and the rate of interest is 4% per semi-annual period.
FVt = PV*(1+r)^t
FV4 = 1,000*(1+.04)^4
FV4 = 1,000*(1.16986)
FV4 = $1,169.86
With monthly compounding, t = 24, r = 0.6667% and PV = $1,000.
FVt = PV*(1+r)^t
FV24 = 1,000*(1+.006667)^24
FV24 = 1,000*(1.17289)
FV24 = $1,172.89
These results show that the future value of a sum continues to increase as the compounding
frequency increases.
For the present value, a higher compounding frequency reduces the present value. This is
because more compound interest is earned, which reduces the amount that must be saved today
to be worth a specified sum in the future.
As an example, suppose that an investor has a target of $100,000 in five years, and can invest in
a bank account that pays an annual rate of interest of 6%. How much must the investor save
today in order to reach this goal based on the following compounding frequencies?
 Annual compounding
 Semi-annual compounding
 Monthly compounding
With annual compounding, t = 5, r = 6% and FV5 = $100,000.
PV = FVt / (1+r)^t
PV = 100,000 / (1+.06)^5

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PV = 100,000 / 1.33823
PV = $74,725.82
With semi-annual compounding, t = 10, r = 3% and FV10 = $100,000.
PV = FVt / (1+r)^t
PV = 100,000 / (1+.03)^10
PV = 100,000 / 1.34392
PV = $74,409.39
With monthly compounding, t = 60, r = 0.5% and FV60 = $100,000.
PV = FVt / (1+r)^t
PV = 100,000 / (1+.005)^60
PV = 100,000 / 1.34885
PV = $74,137.22 (Article Index)
Annuities:
An annuity is a periodic stream of equally-sized payments. The word annuity is derived from the
Latin word annum (yearly). In spite of this, any stream of periodic payments of equal size can be
treated as an annuity. As an example, mortgage payments are made monthly and are of equal
size, and so can be thought of as a type of annuity.
The two basic types of annuities are:
 Ordinary annuity
 Annuity due
Ordinary Annuities
With an ordinary annuity, the first payment takes place one period in the future. Most annuities
are ordinary; some examples are:
 Coupons paid by a bond

 Dividend payments by a share of preferred stock
 Car loan payments
 Mortgage payments
 Student loan payments
 Social security payments
The Future Value of an Ordinary Annuity
The formula for computing the future value of an ordinary annuity is:

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where:
FVAt = future value of a t-period annuity
C = the periodic cash flow
r = periodic interest rate
t = number of periods until the sum is received
As an example, suppose that a sum of $1,000 is invested each year for four years, starting next
year, at an annual rate of interest of 3%. Since the cash flows start next year, this is an ordinary
annuity. What is its future value? In this case, t = 4, r = 3% and C = $1,000.
Alternatively, the future value of each individual cash flow can be computed and then combined
as follows:
The first cash flow is invested for three years (from year one to year four):
FV3 = PV(1+r)t
FV3 = 1,000(1+.03)3
FV3 = 1,000(1.09273)
FV3 = $1,092.73
The second cash flow is invested for two years (from year two to year four):
FV2 = PV(1+r)t
FV2 = 1,000(1+.03)2
FV2 = 1,000(1.06090)
FV2 = $1,060.90
The third cash flow is invested for one year (from year three to year four):
FV1 = PV(1+r)t
FV1 = 1,000(1+.03)1
FV1 = 1,000(1.03)
FV1 = $1,030.00
The fourth and final cash flow does not earn any interest since it is not deposited into the bank
until year four. The future value is therefore $1,000.

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The sum of these future values is:
$1,092.73 + $1,060.90 + $1,030.00 + $1,000.00 = $4,183.63
The Present Value of an Ordinary Annuity
The formula for computing the present value of an ordinary annuity is:
where:
PVAt = present value of a t-period ordinary annuity
C = the value of the periodic cash flow
As an example, how much must be invested today in a bank account that pays 5% interest per
year in order to generate a stream of payments of $1,000 in each of the following three years? In
this case, t = 3, r = 5% and C = $1,000.
Alternatively, the present value of each individual cash flow can be computed and then
combined as follows:
The present value of the first cash flow (paid in one year) is:
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)1
PV = 1,000 / 1.05
PV = $952.38
The present value of the second cash flow (paid in two years) is:
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)2
PV = 1,000 / 1.10250
PV = $907.03
The present value of the third cash flow (paid in three years) is:
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)3

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PV = 1,000 / 1.15763
PV = $863.84
The sum of these present values is:
$952.38 + $907.03 + $863.84 = $2,723.25
Annuities Due
With an annuity due, the first payment takes place immediately. This is a less common type of
annuity than the ordinary annuity. An example of this would be a lease agreement or a loan
where the first payment is due immediately.
Due to the timing of the cash flows, the present value and future value of an annuity will be
affected by whether the annuity is an ordinary annuity or an annuity due.
The Future Value of an Annuity Due
The future value of an annuity due is computed as follows:
FVAdue = FVA ordinary * (1+r)

This shows that the future value of an annuity due is greater than the future value of an ordinary
annuity. This is because each cash flow of an annuity due is invested for one additional year.
Referring to the previous example, the future value of an annuity due would be: 4,183.63(1+.03)
= $4,309.14
This can be confirmed by computing the future value of each cash flow individually. Each cash
flow will be invested for one additional year compared with the ordinary annuity.
The first cash flow is invested for four years (from today to year four):
FV4 = PV(1+r)t
FV4 = 1,000(1+.03)4
FV4 = 1,000(1.12551)
FV4 = $1,125.51
The second cash flow is invested for three years (from year one to year four):
FV3 = PV(1+r)t
FV3 = 1,000(1+.03)3
FV3 = 1,000(1.09273)
FV3 = $1,092.73
The third cash flow is invested for two years (from year two to year four):

20
FV2 = PV(1+r)t
FV2 = 1,000(1+.03)2
FV2 = 1,000(1.06090)
FV2 = $1,060.90
The fourth cash flow is invested for one year (from year three to year four):
FV3 = PV(1+r)t
FV3 = 1,000(1+.03)1
FV3 = 1,000(1.03)
FV3 = $1,030.00
The sum of these future values is:
$1,125.51 + $1,092.73 + $1,060.90 + $1,030.00 = $4,309.14
The Present Value of an Annuity Due
The present value of an annuity due is computed as follows:
PVA due = PVA ordinary * (1+r)

This shows that the present value of an annuity due is greater than the present value of an
ordinary annuity. This is because each cash flow of an annuity due is paid one year sooner, so
that the invested principal earns less interest. As a result, a larger sum must be invested in order
to generate the appropriate cash flows.
Referring to the previous example, the present value of an annuity due would be:
2,723.25(1+.05) = $2,859.41
Alternatively, the present value of each individual cash flow can be computed and then
combined as follows:
The first cash flow is withdrawn immediately, so the present value equals $1,000.
The present value of the second cash flow (paid in one year) is:
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)1
PV = 1,000 / 1.05
PV = $952.38
The present value of the third cash flow (paid in two years) is:

21
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)2
PV = 1,000 / 1.10250
PV = $907.03
The sum of these present values is:
$1,000 + $952.38 + $907.03 = $2,859.41
Perpetuities
A perpetuity is an investment in which interest payments are made forever, but principal is not
repaid. As an example, a stock that pays a regular stream of constant dividends can be thought of
as a perpetuity. This is because the same cash flows are paid each year, and the stock has an
infinite lifetime. Another example is a consol, which is a bond that makes interest payments
forever but does not repay the principal.
The Present Value of a Perpetuity

The present value of a perpetuity that pays an annual cash flow of $C per period is:
PV = C/r
As an example, suppose that a perpetuity pays $100 per year; assume that the appropriate rate of
interest is 5% per year. The present value of the perpetuity is $100/0.05 = $2,000.
The Present Value of a Growing Perpetuity

Suppose that the cash flows provided by a perpetuity grow at a fixed rate each year. The present
value formula is adjusted as follows:
PV = C/(r – g)
where:
g = annual growth rate of the perpetuity
As an example, suppose that a perpetuity currently pays $50 per year; assume that the
appropriate rate of interest is 7% per year, and that the cash flow paid by the perpetuity is
estimated to grow at a rate of 3% per year. The present value of the perpetuity is: $50/(0.07 –
0.03) = $1,250.
Interest Rate Conventions:

Interest rates for loans, bank accounts, etc. can be quoted in two basic ways:

22
1. Annual percentage rate (APR)

2. Effective annual rate (EAR)
The annual percentage rate reflects the simple interest of a loan or an investment, while the
effective annual rate reflects both the simple and compound interest.
Converting APR to EAR
In order to compare interest rates with different compounding frequencies, they can be converted
into an effective annual rate (EAR); this reflects the true cost of borrowing (or the return to
lending) when interest is compounded more than once per year. EAR is computed from APR as
follows:
where:
m = the number of compounding periods per year
As an example, suppose that a bank charges an APR of 6% per year, compounded quarterly for a
loan, what is the effective annual rate? This can be determined as follows:
This indicates that the borrower is actually paying 6.136% per year for this loan.
Converting EAR to APR
An effective annual rate may be converted to an annual percentage rate by inverting the previous
formula:
As an example, if a bank charges an EAR of 5.25% per year, compounded monthly for a loan,
what is the annual percentage rate? This can be determined as follows:
Long Term Finance – Its meaning and purpose

23
A business requires funds to purchase fixed assets like land and building, plant and machinery,
furniture etc. These assets may be regarded as the foundation of a business. The capital required
for these assets is called fixed capital. A part of the working capital is also of a permanent nature.
Funds required for this part of the working capital and for fixed capital is called long term
finance.
Purpose of long term finance:
1. To Finance fixed assets : Business requires fixed assets like machines, Building, furniture
etc. Finance required to buy these assets is for a long period, because such assets can be used for
a long period and are not for resale.
2. To finance the permanent part of working capital: Business is a continuing activity. It must
have a certain amount of working capital which would be needed again and again. This part of
working capital is of a fixed or permanent nature. This requirement is also met from long term
funds.
3. To finance growth and expansion of business: Expansion of business requires investment

of a huge amount of capital permanently or for a long period.
Sources of long term finance
1. Shares: These are issued to the general public. These may be of two types: (i) Equity and (ii)
Preference. The holders of shares are the owners of the business.
2. Debentures: These are also issued to the general public. The holders of debentures are the
creditors of the company.
3. Public Deposits : General public also like to deposit their savings with a popular and well
established company which can pay interest periodically and pay-back the deposit when due.
4. Retained earnings: The company may not distribute the whole of its profits among its
shareholders. It may retain a part of the profits and utilize it as capital.
5. Term loans from banks: Many industrial development banks, cooperative banks and
commercial banks grant medium term loans for a period of three to five years.
6. Loan from financial institutions: There are many specialised financial institutions
established by the Central and State governments which give long term loans at reasonable rate
of interest. Some of these institutions are: Industrial Finance Corporation of India ( IFCI),
Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of
India (ICICI), Unit Trust of India ( UTI ), State Finance Corporations etc.

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UNIT – II
THE INVESTMENT DECISION (CAPITAL BUDGETING)
INTRODUCTION
The word Capital refers to be the total investment of a company of firm in

money, tangible and intangible assets. Whereas budgeting defined by the
“Rowland and William” it may be said to be the art of building budgets.
Budgets are a blue print of a plan and action expressed in quantities and
manners. Investment decision is the process of making investment decisions
in capital expenditure. A capital expenditure may be defined as an
expenditure the benefits of which are expected to be received over period of
time exceeding one year. The main characteristic of a capital expenditure is
that the expenditure is incurred at one point of time whereas benefits of the
expenditure are realized at different points of time in future. The examples of
capital expenditure:
1. Purchase of fixed assets such as land and building, plant and machinery,
good will, etc.
2. The expenditure relating to addition, expansion, improvement and

alteration to the fixed assets.
3. The replacement of fixed assets.
4. Research and development project.
MEANING
The process through which different projects are evaluated is known as
capital budgeting. Capital budgeting is defined “as the firm’s formal process
for the acquisition and investment of capital. It involves firm’s decisions to
invest its current funds for addition, disposition, modification and
replacement of fixed assets”.
DEFINITION
Capital budgeting (investment decision) as, “Capital budgeting is
long term planning for making and financing proposed capital outlays.” --
--- Charles T.Horngreen
“Capital budgeting consists in planning development of available capital for
the purpose of maximizing the long term profitability of the concern” –
Lynch

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NEED AND IMPORTANCE OF CAPITAL BUDGETING
1. Huge investments: Capital budgeting requires huge investments of

funds, but the available funds are limited, therefore the firm before
investing projects, plan are control its capital expenditure.
2. Long-term: Capital expenditure is long-term in nature or permanent in

nature. Therefore financial risks involved in the investment decision are
more. If higher risks are involved, it needs careful planning of capital
budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not

changed back. Once the decision is taken for purchasing a permanent asset,
it is very difficult to dispose of those assets without involving huge losses.
4. Long-term effect: Capital budgeting not only reduces the cost but also
increases the revenue in long-term and will bring significant changes in the
profit of the company by avoiding over or more investment or under
investment. Over investments leads to be unable to utilize assets or over
utilization of fixed assets. Therefore before making the investment, it is
required carefully planning and analysis of the project thoroughly.
CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process as it involves decisions
relating to the investment of current funds for the benefit to the achieved in
future and the future is always uncertain. However the following procedure
may be adopted in the process of capital budgeting:

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Step 1 and 2 = Project generation,

Step3 = Project evaluation
Step4 and 5 =project selection
Step 6 = project execution.
PROJECT GENERATION
1. Identification of Investment Proposals:
The capital budgeting process begins with the identification of

investment proposals. The proposal or the idea about potential investment
opportunities may originate from the top management or may come from the
rank and file worker of any department or from any officer of the
organization. The departmental head analyses the various proposals in the
light of the corporate strategies and submits the suitable proposals to the
capital expenditure planning committee in case of large organizations or to
the officers concerned with the process of long-term decisions.
2. Screening the Proposals:

The expenditure planning committee screens the various proposals
received from different departments. The committee views these proposals
from various angels to ensure that these are in accordance with the corporate
strategies or a selection criterion’s of the firm and also do not lead to
departmental imbalances.
PROJECT EVALUATION
3. Evaluation of Various Proposals:

The next step in the capital budgeting process is to evaluate the
profitability of various proposals. There are many methods which may be
used for this purpose such as payback period method, rate of return method,
net present value method, internal rate of return method etc. All these
methods of evaluating profitability of capital investment proposals have
been discussed in detail separately in the following pages of this chapter.
It should, however, be noted that the various proposals to the
evaluated may be classified as:
(I) Independent proposals
(ii) Contingent or dependent proposals and
(iii) Mutually exclusive proposals.

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Independent proposals are those which do not compete with one another and
the same may be either accepted or rejected on the basis of a minimum
return on investment required. The contingent proposals are those whose
acceptance depends upon the acceptance of one or more other proposals, eg.,
further investment in building or machineries may have to be undertaken as
a result of expansion programmed. Mutually exclusive proposals are those
which compete with each other and one of those may have to be selected at
the cost of the other.
PROJECT SELECTION
1. Fixing Priorities:
After evaluating various proposals, the unprofitable or uneconomic
proposals may be rejected straight ways. But it may not be possible for the
firm to invest immediately in all the acceptable proposals due to limitation
of funds. Hence, it is very essential to rank the various proposals and to
establish priorities after considering urgency, risk and profitability involved
therein.
2. Final Approval and Preparation of Capital Expenditure Budget:

Proposals meeting the evaluation and other criteria are finally
approved to be included in the Capital expenditure budget. However,
proposals involving smaller investment may be decided at the lower levels
for expeditious action. The capital expenditure budget lays down the amount
of estimated expenditure to be incurred on fixed assets during the budget
period.
PROJECT EXECUTION
3. Implementing Proposal:
Preparation of a capital expenditure budgeting and incorporation of a
particular proposal in the budget does not itself authorize to go ahead with
the implementation of the project. A request for authority to spend the
amount should further be made to the Capital Expenditure Committee which
may like to review the profitability of the project in the changed
circumstances.
Further, while implementing the project, it is better to assign

responsibilities for completing the project within the given time frame and
cost limit so as to avoid unnecessary delays and cost over runs. Network
techniques used in the project management such as PERT and CPM can also
be applied to control and monitor the implementation of the projects.
4. Performance Review:
The last stage in the process of capital budgeting is the evaluation of
the performance of the project. The evaluation is made through post

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completion audit by way of comparison of actual expenditure of the project

with the budgeted one, and also by comparing the actual return from the
investment with the anticipated return. The
unfavorable variances, if any should be looked into and the causes of the
same are identified so that corrective action may be taken in future.
DEVOLOPING CAH FLOW DATA (cash inflow and cash outflow)

Before we can compute a project’s value, we must estimate the cash
flows both current and future associated with it. We therefore begin by
discussing cash flow estimation, which is the most important and perhaps the
most difficult, step in the analysis of a capital project. The process of cash
flow estimation is problematic because it is difficult to accurately forecast
the costs and revenues associated with large, complex projects that are
expected to affect operations for long periods of time.
Calculation of cash inflow
Sales xxxx
Less: Cash expenses xxxx
PBDT xxxx
Less: Depreciation xxxx
PBT xxxx
less: Tax xxxx
PAT xxxx
Add: Depreciation xxxx
Cash inflow p.a xxxx
Calculation of cash outflow
Cost of project/asset xxxx
Transportation/installation charges xxxx
Working capital xxxx
Cash outflow xxxx

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PROJECT EVALUATION TECHNIQUES (OR) CAPITAL

BUDGETING TECHNIQUES
At each point of time a business firm has a number of proposals

regarding various projects in which it can invest funds. But the funds
available with the firm are always limited and it is not possible to invest
funds in all the proposals at a time. Hence, it is very essential to select from
amongst the various competing proposals, those which give the highest
benefits. The crux of the capital budgeting is the allocation of available
resources to various proposals.
There are many methods of evaluating profitability of capital
investment proposals. The various commonly used methods are as follows:
(A) Traditional methods:

(1) Pay-back Period Method or Pay out or Pay off Method.
(2) Improvement of Traditional Approach to pay back Period

Method.(post payback method)
(3) Accounting or Average Rate of Return Method.
(B) Time-adjusted method or discounted methods:
(4) Net Present Value Method.
(5) Internal Rate of Return Method.
(6) Profitability Index Method.
(A) TRADITIONAL METHODS:
1. PAY-BACK PERIOD METHOD
The ‘pay back’ sometimes called as pay out or pay off period method
represents the period in which the total investment in permanent assets pays
back itself. This method is based on the principle that every capital
expenditure pays itself back within a certain period out of the additional

30
earnings generated from the capital assets.
Under this method, various investments are ranked according to the

length of their payback period in such a manner that the investment within a
shorter payback period is preferred to the one which has longer pay back
period. (It is one of the non- discounted cash flow methods of capital
budgeting).
MERITS
The following are the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over the accounting rate return.
3. Pay-back method reduces the possibility of loss on account of obsolescence.
DEMERITS
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting.
ACCEPT /REJECT CRITERIA

If the actual pay-back period is less than the predetermined pay-back period,
the project would be accepted. If not, it would be rejected.
2. POST PAY-BACK PROFITABILITY METHOD:

One of the serious limitations of Pay-back period method is that it
does not take into account the cash inflows earned after pay-back period and
hence the true profitability of the project cannot be assessed. Hence, an,
improvement over this method can be made by taking into account the
return receivable beyond the pay-back period.
Post pay-back profitability =Cash inflow (Estimated life – Pay-
back period) Post pay-back profitability index= Post pay-back
profitability/original investment
3. AVERAGE RATE OF RETURN:

This method takes into account the earnings expected from the

31
investment over their whole life. It is known as accounting rate of return

method for the reason that under this method, the Accounting concept of
profit (net profit after tax and depreciation) is used rather than cash inflows.
According to this method, various projects are ranked in order of the rate of
earnings or rate of return. The project with the higher rate of return is
selected as compared to the one with lower rate of return. This method can
also be used
to make decision as to accepting or rejecting a proposal. Average rate of
return means the average rate of return or profit taken for considering
(a) Average Rate of Return Method (ARR):

Under this method average profit after tax and depreciation is calculated
and then it is divided by the total capital outlay or total investment in the
project. The project evaluation. This method is one of the traditional
methods for evaluating
The project proposals
ARR = (Total profits (after dep & taxes))/ (Net Investment in the project X
No. of years of profits) x 100
OR
ARR = (Average Annual profits)/ (Net investment in the project) x 100
(b) Average Return on Average Investment Method:

This is the most appropriate method of rate of return on investment
Under this method, average profit after depreciation and taxes is divided by
the average amount of investment; thus:
Average Return on Average Investment = (Average Annual Profit after
depreciation and taxes)/ (Average Investment) x 100
Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.
Demerits
1. It ignores the time value of money.

32
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some
difficulties in the calculation of the project.
Accept/Reject criteria
If the actual accounting rate of return is more than the predetermined
required rate of return, the project would be accepted. If not it would be
rejected.
(B) TIME – ADJUSTED OR DISCOUNTED CASH FLOW

METHODS: or MODERN METHOD
The traditional methods of capital budgeting i.e. pay-back method as well
as accounting rate of return method, suffer from the serious limitations that
give equal weight to present and future flow of incomes. These methods do
not take into consideration the time value of money, the fact that a rupee
earned today has more value than a rupee earned after five years.
1. NET PRESENT VALUE

Net present value method is one of the modern methods for evaluating the
project proposals. In this method cash inflows are considered with the time
value of the money. Net present value describes as the summation of the
present value of cash inflow and present value of cash outflow. Net present
value is the difference between the total present values of future cash inflows
and the total present value of future cash outflows.
NPV = Total Present value of cash inflows – Net Investment

If offered an investment that costs $5,000 today and promises to pay you
$7,000 two years from today and if your opportunity cost for projects of
similar risk is 10%, would you make this investment? You
Need to compare your $5,000 investment with the $7,000 cash flow you
expect in two years. Because you feel that a discount rate of 10% reflects the
degree of uncertainty associated with the $7,000 expected in two years,
today it is worth:
By investing $5,000 today, you are getting in return a promise of a cash flow
in the future that is worth $5,785.12 today. You increase your wealth by
$785.12 when you make this investment.

33
Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive projects.
4. It helps to achieve the maximization of shareholders’ wealth.
Demerits
1. It is difficult to understand and calculate.

It needs the discount factors for calculation of present values
1. It is not suitable for the projects having different effective lives.
If the present value of cash inflows is more than the present value of cash
outflows, it would be accepted. If not, it would be rejected.
2. PROFITABILITY INDEX METHOD

The profitability index (PI) is the ratio of the present value of change in
operating cash inflows to the present value of investment cash outflows:
Instead of the difference between the two present values, as in equation PI is

the ratio of the two present values. Hence, PI is a variation of NPV. By
construction, if the NPV is zero, PI is one.
3. INTERNAL RATE OF RETURN METHOD

This method is popularly known as time adjusted rate of return
method/discounted rate of return method also. The internal rate of return is
defined as the interest rate that equates the present value of expected future
receipts to the cost of the investment outlay. This internal rate of return is
found by trial and error. First we compute the present value of the cash-
flows from an investment, using an arbitrarily elected interest rate. Then we
compare the present value so obtained with the investment cost. If the
present value is higher than the cost figure, we try a higher rate of interest
and go through the procedure again. Conversely, if the present value is lower
than the cost, lower the interest rate and repeat the process. The interest rate
that brings about this equality is defined as the internal rate of return. This
rate of return is compared to the cost of capital and the project having higher

34
difference, if they are mutually exclusive, is adopted and other one is

rejected. As the determination of internal rate of return involves a number of
attempts to make the present value of earnings equal to the investment, this
approach is also called the Trial and Error Method. Internal rate of return is
time adjusted technique and covers the disadvantages of the Traditional
techniques. In other words it is a rate at which discount cash flows to zero. It
is expected by the following ratio
Steps to be followed:
Step1. Find out factor Factor is calculated as follows:
Step 2. Find out positive net

present value Step 3. Find out
negative net present value
Step 4. Find out formula net

present value
Base factor = Positive

discount rate DP =
Difference in
percentage Merits
1. It considers the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.

35
4. It gives the approximate/nearest rate of return.
Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking decisions.
3. It is assume that all intermediate cash flows are reinvested at the

internal rate of return.
If the present value of the sum total of the compounded reinvested cash
flows is greater than the present value of the outflows, the proposed project
is accepted. If not it would be rejected.
NPV vs. IRR Methods¶
Key differences between the most popular methods, the NPV (Net
Present Value) Method and IRR (Internal Rate of Return) Method,
include:
• NPV is calculated in terms of currency while IRR is expressed in

terms of the percentage return a firm expects the capital project
to return;
• Academic evidence suggests that the NPV Method is preferred over

other methods since it calculates additional wealth and the IRR Method
does not;
• The IRR Method cannot be used to evaluate projects where there are
changing cash flows (e.g., an initial outflow followed by in-flows and a
later out-flow, such as may be required in the case of land reclamation by
a mining firm);
• However, the IRR Method does have one significant advantage --

managers tend to better understand the concept of returns stated in
percentages and find it easy to compare to the required cost of capital;
and, finally,
• While both the NPV Method and the IRR Method are both DCF models
and can even reach similar conclusions about a single project, the use of
the IRR Method can lead to the belief that a smaller project with a shorter
life and earlier cash inflows, is preferable to a larger project that will
generate more cash.

36
• Applying NPV using different discount rates will result in

different recommendations. The IRR method always gives the
same recommendation.
Recent variations of these methods include:
• The Adjusted Present Value (APV) Method is a flexible DCF method

that takes into account interest related tax shields; it is designed for
firms with active debt and a consistent market value leverage ratio;
• The Profitability Index (PI) Method, which is modeled after the NPV
Method, is measured as the total present value of future net cash
inflows divided by the initial investment; this method tends to favor
smaller projects and is best used by firms with limited resources and
high costs of capital;
• The Bailout Payback Method, which is a variation of the Payback Method,

includes the salvage value of any equipment purchased in its calculations;
• The Real Options Approach allows for flexibility, encourages constant
reassessment based on the riskiness of the project's cash flows and is
based on the concept of creating a list of value-maximizing options to
choose projects from; management can, and is encouraged, to react to
changes that might affect the assumptions that were made about each
project being considered prior to its commencement, including postponing
the project if necessary; it is noteworthy that there is not a lot of support
for this method among financial managers at this time.

37
RISK RETURN TRADE-OFF

The Risk-Return Trade-Off is an essential concept in finance theory.
Risk implies the changes in expected return like sales, profits or cash flow
and it also includes probability that problem.
Risk analysis is a procedure of calculating and examining the risk
which is related to financial and investment decision of the company.
Finance managers must focus on expected rate of return by comparing the
level of risks involved in investment decision. When it is expected that rate
of return will be high then it involves high level of risk and vice versa.

38
The decisions which involve risk-return trade off are explained below:
1) Capital Budgeting Decisions: Capital budgeting decision is important, as

it involves proper allocation of funds. These decisions are made
considerably for long period of time in order to get benefits in future. While
taking capital budgeting decision, finance manager needs to evaluate the
cost of capital and risk involved in it. Finance manager must have complete
knowledge about the techniques used for evaluating such as Net Present
Value (NPV), IRR, discounted cash flow, etc. Finance manager must have
the capability of combining risk with returns in order to evaluate the
potential of investment appropriately.
2) Capital Structure Decisions: Capital structure decisions play an
important role in designing the capital structure which is suitable for the
company. It is the duty of finance manager to develop an optimum capital
structure which involves less amount of cost of capital, less amount of risk
but which can generate huge amount of returns. While developing capital
structure, finance managers must also consider the financial and operating
leverages of the firm.
3) Dividend Decisions: Dividend decision is also important for organization

to design the dividend policy. Dividend policy involves the amount of profits
to paid as dividend to shareholders or reinvested in the organizations.
Shareholders emphasize on getting higher amount of dividend, whereas
management of company tries to maintain profits to face uncertainties in
future. The dividend policy of the firm mainly depends of profitability.
4) Working Capital Decisions: Working capital management is an addition

of fixed capital investment. Working capital management is an important
element of every organization, as it helps in continuing the business
processes. Decisions related to working capital are known as working
capital decisions. The essential elements of working capital are cash,
accounts receivable and inventory. Each element of working capital
involves some kind of risk in it.

39
Hence, it is clear that each every decision related to finance involves

risk-return trade-off. So, it is the responsibility of finance managers to
consider both risk and return, while making these decisions.
COST OF CAPITAL
The cost of capital of a firm is the minimum rate of return expected
by its investors. It is the weighted average cost of various sources of finance
used by a firm. The capital used by a firm may be in the form of debt,
preference capital, retained earnings and equity shares. The concept of cost
of capital is very important in the financial management. A decision to
invest in a particular project depends upon the cost of capital of the firm or
the cut off rate which is the minimum rate of return expected by the
investors.
DEFINITIONS
James C.Van Horne defines cost of capital as,”a cut-off rate for the
allocation of capital to investments of projects. It is the rate of return on a
project that will leave unchanged the market price of the stock.
According to Solomon Ezra, “Cost of capital is the minimum
required rate of earning or the cut-off rate of capital expenditures”.
COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL

Weighted average cost of capital is the average cost of the costs of
various sources of Financing. Weighted average cost of capital is also known
as composite cost of capital, overall cost of capital or average cost of capital.
Once the specific cost of individual sources of finance is determined, we can
compute the weighted average cost of capital by putting weights to the
specific costs of capital in proportion of the various sources of funds to the
total. The weights may be given either by using the book value of the source
or market value of the source. The market value weights suffer from the
following limitations: It is very difficult to determine the market values
because of frequent fluctuations. With the use of market value weights,
equity capital gets greater importance. For the above limitations, it is better
to use book value which is readily available. Weighted average cost of
capital can be computed as follows:
� � =Σ� � /Σ�
� � � � , � � =� � � � � � � � � � � � � � � � � � � � � � � � � � �

40
X = Cost of specific source of finance

W = Weight, proportion of specific source of finance
MARGINAL COST OF CAPITAL
Sometimes, we may be required to calculate the cost of additional
funds to be raised, called the marginal cost of capital. The marginal cost of
capital is the weighted average cost of new capital calculated by using the
marginal weights. The marginal weights represent the proportion of various
sources of funds to be employed in raising additional funds. In case, a firm
employs the existing proportion of capital structure and the component costs
remain the same the marginal cost of capital shall be equal to the weighted
average cost of capital.
MEASUREMENT OF COST OF CAPITAL

The term cost of capital is an overall cost. This is the combination
cost of the specific cost associated with specific source of financing. The
computation of cost capital therefore, involves two steps: The computation
of the different elements of the cost in term of the cost of the different source
of finance.
The calculation of the overall cost by combining the specific cost
into a composite cost. From the view point of capital budgeting decisions the
long-term sources of fund are relevant as the constitute the major source of
financing of fixed cost. In calculating the cost of capital, therefore, the focus
is to be on the long-term funds.
In other words the specific cost has to be calculated for: 1) Long term
debt 2) Preference Shares 3) Equity Shares 4) Retained earnings
COST OF DEBT
The cost of debt is the rate of interest payable on debt. For example,
a company issues Rs.1, 00,000 10%debentures at par; the before-tax cost of
this debt issue will also be 10%. By way of a formula, before tax cost of debt
may be calculated as:
� � � =� � � =� /�
� � � � � , � � � =� � � � � � � � � � � � � � � � � � � I=Interest P=Principal
In case the debt is raised at premium or discount, we should consider P as
the amount of net proceeds received from the issue and not the face value of
securities. The formula may be changed to
� � � =� /� � (� � � � � ,� � =� � � � � � � � � � � )
Further, when debt is used as a source of finance, the firm saves a
considerable amount in payment of tax as interest is allowed as a deductible
expense in computation of tax. Hence, the effective cost of debt is reduced.

41
The After-tax cost of debt may be calculated with the help of following
formula:
� � � =� /� � (� −� )
� � � � � , � � � =� � � � � � � � � � � � � � � � � � t= Rate of Tax
COST OF PREFERENCE CAPITAL
A fixed rate of dividend is payable on preference shares. Though
dividend is payable at the discretion of the Board of directors and there is no
legal binding to pay dividend, yet it does not mean that preference capital is
cost free. The cost of preference capital is a function of dividend expected
by its investors, i.e., its stated dividend. In case dividend share not paid to
preference shareholders, it will affect the fund raising capacity of the firm.
Hence, dividends are usually paid regularly of preference shares expect
when there are no profits to pay dividends. The cost of preference capital
which is perpetual can be calculated as:
� � = � /�
Where, � � = Cost of preference Capital D = Annual Preference
Dividend P = Preference Share Capital (Proceeds.) Further, if preference
shares are issued at Premium or Discount or when costs of floatation are
incurred to issue preference shares, the nominal or par value or preference
share capital has to be adjusted to find out the net proceeds from the issue of
preference shares. In such a case, the cost of preference capital can be
computed with the following formula:
� � = � /� �
COST OF EQUITY SHARE CAPITAL
The cost of equity is the „maximum rate of return that the company
must earn of equity financed portion of its investments in order to leave
unchanged the market price of its stock‟. The cost of equity capital is a
function of the expected return by its investors. The cost of equity is not the
out-of-pocket cost of using equity capital as the equity shareholders are not
paid dividend at a fixed rate every year. Moreover, payment of dividend is
not a legal binding. It may or may not be paid. But is does not mean that
equity share capital is a cost free capital. Share holders invest money in
equity shares on the expectation of getting dividend and the company must
earn this minimum rate so that the market price of the shares remains
unchanged. Whenever a company wants to raise additional funds by the
issue of new equity shares, the expectations of the shareholders have to
evaluate.
UNIT – III

42
What is capital structure?
Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its
operations and finance its assets. The structure is typically expressed as a debt-to-equity or debt-
to-capital ratio.
Debt and equity capital are used to fund a business’ operations, capital expenditures,
acquisitions, and other investments. There are tradeoffs firms have to make when they decide
whether to raise debt or equity and managers will balance the two try and find the optimal capital
structure.
Optimal capital structure
The optimal capital structure of a firm is often defined as the proportion of debt and equity that
result in the lowest weighted average cost of capital (WACC) for the firm. This technical
definition is not always used in practice, and firms often have a strategic or philosophical view of
what the structure should be.
In order to optimize the structure, a firm will decide if it needs more debt or equity and can issue
whichever it requires. The new capital that’s issued may be used to invest in new assets or may
be used to repurchase debt/equity that’s currently outstanding as a form or recapitalization.
Dynamics of debt and equity
Below is an illustration of the dynamics between debt and equity from the view of investors and
the firm.
Debt investors take less risk because they have the first claim on the assets of the business in the
event of bankruptcy. For this reason, they accept a lower rate of return, and thus the firm has a
lower cost of capital when it issues debt compared to equity.
Equity investors take more risk as they only receive the residual value after debt investors have
been repaid. In exchange for this risk equity investors expect a higher rate of return and
therefore the implied cost of equity is greater than that of debt.
Factors that Influence a Company's Capital-Structure Decision
.1. Business Risk

Excluding debt, business risk is the basic risk of the company's operations. The greater the
business risk, the lower the optimal debt ratio.
As an example, let's compare a utility company with a retail apparel company. A utility company
generally has more stability in earnings. The company has les risk in its business given its stable
revenue stream. However, a retail apparel company has the potential for a bit more variability in
its earnings. Since the sales of a retail apparel company are driven primarily by trends in the
fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail
apparel company would have a lower optimal debt ratio so that investors feel comfortable with
the company's ability to meet its responsibilities with the capital structure in both good times and

43
bad.
2. Company's Tax Exposure

Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means
of financing a project is attractive because the tax deductibility of the debt payments protects
some income from taxes.
3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come as no surprise
that companies typically have no problem raising capital when sales are growing and earnings
are strong. However, given a company's strong cash flow in the good times, raising capital is not
as hard. Companies should make an effort to be prudent when raising capital in the good times,
not stretching its capabilities too far. The lower a company's debt level, the more financial
flexibility a company has.
The airline industry is a good example. In good times, the industry generates significant amounts
of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is
in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a
decreased ability to raise debt capital during these bad times because investors may doubt the
airline's ability to service its existing debt when it has new debt loaded on top.
4. Management Style
Management styles range from aggressive to conservative. The more conservative a
management's approach is, the less inclined it is to use debt to increase profits. An aggressive
management may try to grow the firm quickly, using significant amounts of debt to ramp up the
growth of the company's earnings per share (EPS).
5. Growth RateFirms that are in the growth stage of their cycle typically finance that growth
through debt, borrowing money to grow faster. The conflict that arises with this method is that
the revenues of growth firms are typically unstable and unproven. As such, a high debt load is
usually not appropriate.
More stable and mature firms typically need less debt to finance growth as its revenues are stable
and proven. These firms also generate cash flow, which can be used to finance projects when
they arise.
6. Market Conditions Market conditions can have a significant impact on a company's capital-
structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is
struggling, meaning investors are limiting companies' access to capital because of market
concerns, the interest rate to borrow may be higher than a company would want to pay. In that
situation, it may be prudent for a company to wait until market conditions return to a more
normal state before the company tries to access funds for the plant.
CAPITAL STRUCTURE

44
Capital structure is the proportion of all types of capital viz. equity, debt, preference etc. It is
synonymously used as financial leverage or financing mix. Capital structure is also referred as
the degree of debts in the financing or capital of a business firm.
Financial leverage is the extent to which a business firm employs borrowed money or debts.
In financial management, it is a significant term and an important decision in a business. In the
capital structure of a company, broadly, there are mainly two types of capital i.e. Equity and
Debt. Out of the two, debt is considered a cheaper source of finance because the interest
payments are a tax-deductible expense.
Capital structure or financial leverage deals with a very important financial management
question. The question is – ‘what should be the ratio of debt and equity?’ Before scratching our
minds to find the answer to this question, we should know the objective of doing all this. In the
financial management context, the objective of any financial decision is to maximize the
shareholder’s wealth or increase the value of the firm. The other question which hits the mind in
the first place is whether a change in the financing mix would have any impact on the value of
the firm or not. The question is a valid question as there are some theories which believe that
financial mix has an impact on the value and others believe it to be not connected.
Capital structure theories

One thing is sure that wherever and whatever way one sources the finance from, it cannot change
the operating income levels. Financial leverage can, at the max, have an impact on the net
income or the EPS (Earning per Share). The reason is explained further. Changing the financing
mix means changing the level of debts and change in levels of debt can impact the interest
payable by that firm. The decrease in interest would increase the net income and thereby the EPS
and it is a general belief that the increase in EPS leads to increase in the value of the firm.
Apparently, under this view, financial leverage is a useful tool to increase value but, at the same
time, nothing comes without a cost. Financial leverage increases the risk of bankruptcy. It is
because higher the level of debt, higher would be the fixed obligation to honor the interest
payments to the debts providers.
Discussion of financial leverage has an obvious objective of finding an optimum capital structure
leading to maximization of the value of the firm. If the cost of capital is high
Important theories or approaches to financial leverage or capital structure or financing mix are as
follows:
NET INCOME APPROACH

This approach was suggested by Durand and he was in the favor of financial leverage decision.
According to him, change in financial leverage would lead to a change in the cost of capital. In
short, if the ratio of debt in the capital structure increases, the weighted average cost of
capital decreases and hence the value of the firm.
NET OPERATING INCOME APPROACH

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This approach is also provided by Durand but it is totally opposite to the Net Income Approach.
It says that the weighted average cost of capital remains constant. It believes in the fact that the
market analyses firm as a whole which discounts at a particular rate which is not related to debt-
equity ratio.
TRADITIONAL APPROACH
This approach is not defined hard and fast facts but it says that cost of capital is a function of the
capital structure. The special thing about this approach is that it believes an optimal capital
structure. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of
capital is minimum and value of the firm is maximum.
MODIGLIANI AND MILLER APPROACH (MM APPROACH)

It is a capital structure theory named after Franco Modigliani and Merton Miller. MM theory
proposed two propositions.
 Proposition I: It says that the capital structure is irrelevant to the value of a firm. The
value of two identical firms would be same and it would not be affected by the mode of finance
adopted to finance the assets. The value of a firm is dependent on the expected future earnings.
 Proposition II: It says that the financial leverage boosts the expected earnings but it does
not increase the value of the firm because the increase in earnings is compensated by the change
in the required rate of return.
To summarize, it is essential for finance professionals to know about the nitty-gritty of capital
structure they have suggested to the management. Accurate analysis of capital structure can help
a company save on the part of their cost of capital and hence improve profitability for
the shareholders.
Important Determinants of Dividend Policy
These considerations are discussed below:
(i) Type of Industry:
Industries that are characterised by stability of earnings may formulate a more consistent policy
as to dividends than those having an uneven flow of income. For example, public utilities
concerns are in a much better position to adopt a relatively fixed dividend rate than the industrial
concerns.
(ii) Age of Corporation:
Newly established enterprises require most of their earning for plant improvement and
expansion, while old companies which have attained a longer earning experience, can formulate
clear cut dividend policies and may even be liberal in the distribution of dividends.

46
(iii) Extent of share distribution::
A closely held company is likely to get consent of the shareholders for the suspension of
dividends or for following a conservative dividend policy. But a company with a large number of
shareholders widely scattered would face a great difficulty in securing such assent. Reduction in
dividends can be affected but not without the co-operation of shareholders.
(iv) Need for additional Capital:
The extent to which the profits are ploughed back into the business has got a considerable
influence on the dividend policy. The income may be conserved for meeting the increased
requirements of working capital or future expansion.
(v) Business Cycles:
During the boom, prudent corporate management creates good reserves for facing the crisis
which follows the inflationary period. Higher rates of dividend are used as a tool for marketing
the securities in an otherwise depressed market.
(vi) Changes in Government Policies:
Sometimes government limits the rate of dividend declared by companies in a particular industry
or in all spheres of business activity. The Government put temporary restrictions on payment of
dividends by companies in July 1974 by making amendment in the Indian Companies Act, 1956.
The restrictions were removed in 1975.
(vii) Trends of profits:
The past trend of the company’s profit should be thoroughly examined to find out the average
earning position of the company. The average earnings should be subjected to the trends of
general economic conditions. If depression is approaching, only a conservative dividend policy
can be regarded as prudent.
(viii) Taxation policy:
Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce the
residual profits after tax available for shareholders and indirectly, as the distribution of dividends
beyond a certain limit is itself subject to tax. At present, the amount of dividend declared is tax
free in the hands of shareholders.
(ix) Future Requirements:
Accumulation of profits becomes necessary to provide against contingencies (or hazards) of the
business, to finance future- expansion of the business and to modernise or replace equipments of
the enterprise. The conflicting claims of dividends and accumulations should be equitably settled
by the management.

47
(x) Cash Balance:
If the working capital of the company is small liberal policy of cash dividend cannot be adopted.
Dividend has to take the form of bonus shares issued to the members in lieu of cash payment.
The regularity of dividend payment and the stability of its rate are the two main objectives aimed
at by the corporate management. They are accepted as desirable
High earnings may be used to pay extra dividends but such dividend distributions should be
designed as “Extra” and care should be taken to avoid the impression that the regular dividend is
being increased.
A stable dividend policy should not be taken to mean an inflexible or rigid policy. On the other
hand, it entails the payment of a fair rate of return, taking into account the normal growth of
business and the gradual impact of external events.
A stable dividend record makes future financing easier. It not only enhances the credit- standing
of the company but also stabilises market values of the securities outstanding. The confidence of
shareholders in the corporate management is also strengthened.
Legal rules governing payment of dividends:
It is illegal to pay a dividend, if after its payment; the capital would be impaired (reduced). This
requirement might be met if only capital surplus existed. An upward revaluation of assets,
however, would create a capital surplus, but at the same time might operate as a fraud on
creditors and for that reason is illegal.
Basically the dividend laws were intended to protect creditors and therefore prohibit payment of
a dividend if a corporation is insolvent or if the dividend payment will cause insolvency.
The corporate laws must be taken into consideration by the directors before they declare a
dividend. The company can postpone the distribution of dividend in cash, which may be
conserved for strengthening the financial condition of the company by declaring stock dividend
or bonus shares.
To sum up, the decision with regard to dividend policy rests on the judgement of the
management, since it is not a contractual obligation like interest. The formulation of dividend
policy requires a balanced financial judgement by judiciously weighting the different factors
affecting the policy.
Stock dividend or bonus shares:
A stock dividend is a distribution of additional shares of stock to existing shareholders on a pro-

rata basis i.e. so much stock for each share of stock held. Thus, a 10% stock dividend would give
a holder of ICQ shares, as additional 10 shares, whereas a 250% stock dividend would give him
250 additional shares. A stock dividend has no immediate effect upon assets.

48
It results in a transfer of an amount from the accumulated earnings or surplus account to the
share capital account. In other words, the reserves are capitalised and their ownership is formally
transferred to the shareholders.
The equity of the shareholders in the corporation increases. Stock dividends do not alter the cash
position of the company. They serve to commit the retained earnings to the business as a part of
its fixed capitalisation.
Reasons for declaring a stock dividend:
Two principal reasons which usually actuate the directors to declare a stock dividend are:
(1) They consider it advisable to reduce the market value of the stock and thereby facilitate a
broader distribution of ownership.
(2) The corporation may have earnings but may find it inadvisable to pay cash dividends. The
declaration of a stock dividend will give the stock holders evidence of the increase in their
investment without interfering with the company’s cash position. If the stock holders prefer cash
to additional stock in the company, they can sell the stock received as dividend.
Sometimes, a stock dividend is declared to protect the interests of old stock holders when a
company is about to sell a new issue of stock (so that new shareholders should not share the
accumulated surplus).
Limitations of stock dividends:
The bonus shares entail an increase in the capitalisation of the corporation and this can only be
justified by a proportionate increase in the earning capacity of the corporation. Young companies
with uncertain earnings or companies with fluctuating income are likely to take great risk by
distribution stock dividends.
Every stock dividend carries an implied promise that future cash dividends will be maintained at
a steady level because of the permanent capitalisation of reserves. Unless the corporate
management has reasonable grounds of entertaining this hope, the wisdom of large stock
dividend is always subject to grave suspicion.
The existence of legal sanction for distributing the accumulated earnings or reserves does not
warrant the issue of stock dividends from the point of view of sound financial practice. There
should be other conditioning factors also for the issue of stock dividend.
(a) Bonus shares bring about a capitalisation of undistributed profits in the companies where the
profits originate and this lead to a linear development of corporate enterprise and greater
concentration of economic power.
(b) By issuing stock dividends-the corporations deprive the capital market of ‘secondary’ funds
which would otherwise have flowed into more widely dispersed investments.

49
(c) Bonus shares enable companies to appropriate to their own use undistributed profits which,
otherwise, would have led either to an increase in the share of labour or a reduction in prices for
the consumer.
Dividend model
1. Walter’s model
2. Gordon’s model
3. Modigliani and Miller’s hypothesis
1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost always affects the
value of the enterprise. His model shows clearly the importance of the relationship between the
firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that
will maximise the wealth of shareholders.
Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is not
issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. Beginning earnings and dividends never change. The values of the earnings pershare (E), and
the divided per share (D) may be changed in the model to determine results, but any given values
of E and D are assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.
Walter’s formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K
ADVERTISEMENTS:
The above equation clearly reveals that the market price per share is the sum of the present
value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
ii) The present value of the infinite stream of stream gains.

50
[r (E-D)/K/K]
Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under
different assumptions about the rate of return. However, the simplified nature of the model can
lead to conclusions which are net true in general, though true for Walter’s model.
The criticisms on the model are as follows:

1. Walter’s model of share valuation mixes dividend policy with investment policy of the firm.
The model assumes that the investment opportunities of the firm are financed by retained
earnings only and no external financing debt or equity is used for the purpose when such a
situation exists either the firm’s investment or its dividend policy or both will be sub-optimum.
The wealth of the owners will maximise only when this optimum investment in made.
2. Walter’s model is based on the assumption that r is constant. In fact decreases as more
investment occurs. This reflects the assumption that the most profitable investments are made
first and then the poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to
optimise the wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly with
the firm’s risk. Thus, the present value of the firm’s income moves inversely with the cost of
capital. By assuming that the discount rate, K is constant, Walter’s model abstracts from the
effect of risk on the value of the firm.
2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.

51
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is equal to
the present value of an infinite stream of dividends to be received by the share. Thus:
The above equation explicitly shows the relationship of current earnings (E,), dividend policy,
(b), internal profitability (r) and the all-equity firm’s cost of capital (k), in the determination of
the value of the share (P0).
3. Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does not
affect the wealth of the shareholders. They argue that the value of the firm depends on the firm’s
earnings which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision the split of earnings
between dividends and retained earnings is of no significance in determining the value of the
firm. M – M’s hypothesis of irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As a
result, the price of each share must adjust so that the rate of return, which is composed of the rate
of dividends and capital gains, on every share will be equal to the discount rate and be identical
for all shares.
Thus, the rate of return for a share held for one year may be calculated as follows:
Where P^ is the market or purchase price per share at time 0, P, is the market price per share at
time 1 and D is dividend per share at time 1. As hypothesised by M – M, r should be equal for all
shares. If it is not so, the low-return yielding shares will be sold by investors who will purchase
the high-return yielding shares.

52
This process will tend to reduce the price of the low-return shares and to increase the prices of
the high-return shares. This switching will continue until the differentials in rates of return are
eliminated. This discount rate will also be equal for all firms under the M-M assumption since
there are no risk differences.
From the above M-M fundamental principle we can derive their valuation model as follows:
Multiplying both sides of equation by the number of shares outstanding (n), we obtain the value
of the firm if no new financing exists.
If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at time 0
will be
The above equation of M – M valuation allows for the issuance of new shares, unlike Walter’s
and Gordon’s models. Consequently, a firm can pay dividends and raise funds to undertake the
optimum investment policy. Thus, dividend and investment policies are not confounded in M –
M model, like waiter’s and Gordon’s models.
Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical relevance
in the real world situation. Thus, it is being criticised on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This cannot be true if the
costs of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm
pays dividends or not. But, because of the transactions costs and inconvenience associated with
the sale of shares to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k)
should be same whether firm uses the external or internal financing.
If investors have desire to diversify their port folios, the discount rate for external and internal
financing will be different.

53
5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of writers,
dividends are relevant under conditions of uncertainty.
UNIT – IV
Meaning of Working Capital
Capital required for a business can be classified under two main categories viz.
(i) Fixed capital
(ii) Working capital.
Every business needs funds for two purposes for its establishment and to carry out its day-to-
day operations. Long-term funds are required to create production facilities through purchase of
fixed assets such as plant and machinery, land, Building etc. Investments in these assets
represent that part of firm’s capital which is blocked on permanent basis and is called fixed
capital. Funds are also needed for short-term purposes for purchase of raw materials, payment of
wages and other day-to-day expenses etc. These funds are known as working capital which is
also known as Revolving or circulating capital or short term capital. According to Shubin,
“Working capital is amount of funds necessary to cover the cost of operating the enterprise”.
Concept of Working Capital

There are two concepts of working capital:
(i) Gross working capital
(ii) Net working capital.
Gross working capital is the capital invested in total current assets of the enterprise.
Examples of current assets are : cash in hand and bank balances, Bills Receivable, Short term
loans and advances, prepaid expenses, Accrued Incomes etc. The gross working capital is
financial or going concern concept. Net working capital is excess of Current Assets over Current
liabilities.
Net Working Capital = Current Assets – Current Liabilities
When current assets exceed the current liabilities the working capital is positive and negative
working capital results when current liabilities are more than current assets. Examples of current
liabilities are Bills Payable, Sunday debtors, accrued expenses, Bank Overdraft, Provision for
taxation etc. Net working capital is an accounting concept of working capital.
Classification or Kinds of Working Capital
Working capital may be classified in two ways:
(a) On the basis of concept

54
(b) On the basis of time

On the basis of concept working capital is classified as gross working capital and net working
capital. On the basis of time working capital may be classifies as Permanent or fixed working
capital and Temporary or variable working capital.
Permanent or Fixed working capital
It is the minimum amount which is required to ensure effective utilisation of fixed
facilities and for maintaining the circulation of current assets. There is always a minimum level
of current assets which its continuously required by enterprise to carry out its normal business
operations. As the business grows, the requirements of permanent working capital also increase
due to increase in current assets. The permanent working capital can further be classified as
regular working capital and reserve working capital required to ensure circulation of current
assets from cash to inventories, from inventories to receivables and from receivables to cash and
so on. Reserve working capital is the excess mount over the requirement for regular working
capital which may be provided for contingencies that may arise at unstated periods such as
strikes, rise in prices, depression etc.
Temporary or Variable working capital
It is the amount of working capital which is required to meet the seasonal demands and
some special exigencies. Variable working capital is further classified as seasonal working
capital and special working capital. The capital required to meet seasonal needs of the enterprise
is called seasonal working capital. Special working capital is that part of working capital which
is required to meet special exigencies such as launching of extensive marketing campaigns for
conducting research etc.
Importance or Advantages of Adequate Working Capital : Working capital is the life
blood and nerve centre of a business. Hence, it is very essential to maintain smooth running of a
business. No business can run successfully without an adequate amount of working capital. The
main advantages of maintaining adequate amount of working capital are as follows:
1. Solvency of the Business: Adequate working capital helps in maintaining solvency of
business by providing uninterrupted flow of production.
2. Goodwill: Sufficient working capital enables a business concern to make prompt
payments and hence helps in creating and maintaining goodwill.
3. Easy Loans: A concern having adequate working capital, high solvency and good
credit standing can arrange loans from banks and others on easy and favourable terms.
4. Cash Discounts: Adequate working capital also enables a concern to avail cash
discounts on purchases and hence it reduces cost.
5. Regular Supply of Raw Material: Sufficient working capital ensure regular supply of
raw materials and continuous production.
6. Regular payment of salaries, wages and other day to day commitments: A company
which has ample working capital can make regular payment of salaries, wages and other
day to day commitments which raises morale of its employees, increases their efficiency,
reduces costs and wastages.
7. Ability to face crisis: Adequate working capital enables a concern to face business
crisis in emergencies such as depression.

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8. Quick and regular return on investments: Every investor wants a quick and regular
return on his investments. Sufficiency of working capital enables a concern to pay quick
and regular dividends to is investor as there may not be much pressure to plough back
profits which gains the confidence of investors and creates a favourable market to raise
additional funds in future.
9. Exploitation of Favourable market conditions: Only concerns with adequate working
capital can exploit favourable market conditions such as purchasing its requirements in
bulk when the prices are lower and by holding its inventories for higher prices.
10. High Morale: Adequacy of working capital creates an environment of security,
confidence, high morale and creates overall efficiency in a business.
Excess or Inadequate Working Capital
Every business concern should have adequate working capital to run its business
operations. It should have neither excess working capital nor inadequate working capital. Both
excess as well as short working capital positions are bad for any business.
Disadvantages of Excessive Working Capital
1. Excessive working capital means idle funds which earn no profits for business and hence
business cannot earn a proper rate of return.
2. When there is a redundant working capital it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.
3. It may result into overall inefficiency in organization.
4. Due to low rate of return on investments, the value of shares may also fall.
5. The redundant working capital gives rise to speculative transaction.
6. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.
Disadvantages of Inadequate working capital
1. A concern which has inadequate working capital cannot pay its short-term liabilities in
time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts.
3. It becomes difficult for firm to exploit favourable market conditions and undertake
profitable projects due to lack of working capital.
4. The rate of return on investments also falls with shortage of working capital.
5. The firm cannot pay day-to-day expenses of its operations and it created inefficiencies,
increases costs and reduces the profits of business.
The Need or Objects or Working Capital

The need for working capital arises due to time gap between production and realisation of
cash from sales. There is an operating cycle involved in sales and realisation of cash. There are
time gaps in purchase of raw materials and production, production and sales, and sales and
realisation of cash. Thus, working capital is needed for following purposes.
1. For purchase of raw materials, components and spares.

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2. To pay wages and salaries.

3. To incur day-to-day expenses and overhead costs such as fuel, power etc.
4. To meet selling costs as packing, advertisement
5. To provide credit facilities to customers.
6. To maintain inventories of raw materials, work in progress, stores and spares and finished
stock.
Greater size of business unit large will be requirements of working capital. The amount of
working capital needed goes on increasing with growth and expansion of business till it attains
maturity. At maturity the amount of working capital needed is called normal working capital.
Factors Determing the Working Capital Requirements
The following are important factors which influence working capital requirements:
1. Nature or Character of Business: The working capital requirements of firm
depend upon nature of its business. Public utility undertakings like electricity, water
supply need very limited working capital because they offer cash sales only and supply
services, not products, and such no funds are tied up in inventories and receivables
whereas trading and financial firms require less investment in fixed assets but have to
invest large amounts in current assets and as such they need large amount of working
capital. Manufacturing undertaking require sizeable working capital between these
two.
2. Size of Business/Scale of Operations: Greater the size of a business unit, larger will
be requirement of working capital and vice-versa.
3. Production Policy: The requirements of working capital depend upon production
policy. If the policy is to keep production steady by accumulating inventories it will
require higher working capital. The production could be kept either steady by
accumulating inventories during slack periods with view to meet high demand during
peak season or production could be curtailed during slack season and increased during
peak season.
4. Manufacturing process / Length of Production cycle: Longer the process period
of manufacture, larger is the amount of working capital required. The longer the
manufacturing time, the raw materials and other supplies have to be carried for longer
period in the process with progressive increment of labour and service costs before
finished product is finally obtained. Therefore, if there are alternative processes of
production, the process with the shortest production period should be chosen.
5. Credit Policy: A concern that purchases its requirements on credit and sell its
products/services on cash requires lesser amount of working capital. On other hand a
concern buying its requirements for cash and allowing credit to its customers, shall
need larger amount of working capital as very huge amount of funds are bound to be
tied up in debtors or bills receivables.
6. Business Cycles: In period of boom i.e. when business is prosperous, there is
need for larger amount of working capital due to increase in sales, rise in prices etc.
On contrary in times of depression the business contracts, sales decline, difficulties are
faced in collections from debtors and firms may have large amount of working capital
lying idle.

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7. Rate of Growth of Business: The working capital requirements of a concern

increase with growth and expansion of its business activities. In fast growing concerns
large amount of working capital is required whereas in normal rate of expansion in the
volume of business the firm may have retained profits to provide for more working
capital.
8. Earning Capacity and Dividend Policy. The firms with high earning capacity
generate cash profits from operations and contribute to working capital. The dividend
policy of concern also influences the requirements of its working capital. A firm that
maintains a steady high rate of cash dividend irrespective of its generation of profits
need more working capital than firm that retains larger part of its profits and does not
pay so high rate of cash dividend.
9. Price Level Changes: Changes in price level affect the working capital
requirements. Generally, the rising prices will require the firm to maintain large
amount of working capital as more funds will be required to maintain the same current
assets. The effect of rising prices may be different for different firms.
10. Working Capital Cycle: In a manufacturing concern, the working capital cycle
starts with the purchase of raw material and ends with realisation of cash from the sale
of finished products. This cycle involves purchase of raw materials and stores, its
conversion into stocks of finished goods through work in progress with progressive
increment of labour and service costs, conversion of finished stock into sales, debtors
and receivables and ultimately realisation of cash and this cycle again from cash to
purchase of raw material and so on. The speed with which the working capital
completes one cycle determines the requirements of working capital longer the period
of cycle larger is requirement of working capital.
Managemant of Working Capital
Working capital refers to excess of current assets over current liabilities. Management of
working capital therefore is concerned with the problems that arise in attempting to manage
current assets, current liabilities and inter relationship that exists between them. The basic goal of
working capital management is to manage the current assets and current of a firm in such a way
that satisfactory level of working capital is maintained i.e. it is neither inadequate nor excessive.
This is so because both inadequate as well as excessive working capital positions are bad for any
business. Inadequacy of working capital may lead the firm to insolvency and excessive working
capital implies idle funds which earns no profits for the business. Working capital Management
policies of a firm have a great effect on its profitability, liquidity and structural health of
organization. In this context, evolving capital management is three dimensional in nature.
1. Dimension I is concerned with formulation of policies with regard to profitability, risk
and liquidity.
2. Dimension II is concerned with decisions about composition and level of current assets.
3. Dimension III is concerned with decisions about composition and level of current
liabilities.
Principles of Working Capital Management

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Principles of Working Capital Management
Principle of Risk Principle of Principle of Principle of

Variation Cost of Capital Equity position Maturity of
Payment
1. Principle of Risk Variation: Risk refers to inability of firm to meet its obligation as
and when they become due for payment. Larger investment in current assets with less
dependence on short-term borrowings increases liquidity, reduces risk and thereby decreases
opportunity for gain or loss. On other hand less investment in current assets with greater
dependence on short-term borrowings increases risk, reduces liquidity and increases profitability.
There is definite direct relationship between degree of risk and profitability. A conservative
management prefers to minimize risk by maintaining higher level of current assets while liberal
management assumes greater risk by reducing working capital. However, the goal of
management should be to establish suitable trade off between profitability and risk. The various
working capital policies indicating relationship between current assets and sales are depicted
below:-
2. Principle of Cost of Capital: The various sources of raising working capital finance
have different cost of capital and degree of risk involved. Generally, higher the risk lower is cost
and lower the risk higher is the cost. A sound working capital management should always try to
achieve proper balance between these two.
3. Principle of Equity Position: This principle is concerned with planning the total
investment in current assets. According to this principle, the amount of working capital invested
in each component should be adequately justified by firm’s equity position. Every rupee invested
in current assets should contribute to the net worth of firm. The level of current assets may be
measured with help of two ratios.
(i) Current assets as a percentage of total assets and
(ii) Current assets as a percentage of total sales.
4. Principle of Maturity of Payment: This principle is concerned with planning the sources
of finance for working capital. According to this principle, a firm should make every effort to
relate maturities of payment to its flow of internally generated funds. Generally, shorter the
maturity schedule of current liabilities in relation to expected cash inflows, the greater inability
to meet its obligations in time.
(1) The Hedging or Matching Approach: The term ‘hedging’ refers to two off-selling
transactions of a simultaneous but opposite nature which counterbalance effect of each other.
With reference to financing mix, the term hedging refers to ‘process of matching of maturities of
debt with maturities of financial needs’. According to this approach the maturity of sources of
funds should match the nature of assets to be financed. This approach is also known as ‘matching

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approach’ which classifies the requirements of total working capital into permanent and
temporary working capital.
The hedging approach suggests that permanent working capital requirements should be
financed with funds from long-term sources while temporary working capital requirements
should be financed with short-term funds.
(2) The Conservative Approach: This approach suggests that the entire estimated investments in
current assets should be financed from long-term sources and short-term sources should be used
only for emergency requirements. The distinct features of this approach are:
(ii) Liquidity is greater
(iii) Risk is minimised
(iv) The cost of financing is relatively more as interest has to be paid even on
seasonal requirements for entire period.
Management of Cash, Receivables and Inventory
Management of Cash
Cash is considered as vital asset and its proper management support company development and
financial strength. An effective cash management program designed by companies can help to
realise this growth and strength. Cash is vital element of any company needed to acquire supply
resources, equipment and other assets used in generating the products and services. Marketable
securities also come under near cash, serve as back pool of liquidity which provides quick cash
when needed.

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Cash management is the stewardship or proper use of an entity's cash resources. It assists to keep
an organization functioning by making the best use of cash or liquid resources of the
organization. Cash management is associated with management of cash in such a way as to
realise the generally accepted objectives of the firm, maximum productivity with maximum
liquidity. It is the management's capability to identify cash problems before they ascend, to solve
them when they arise and having made solution available to delegate someone carry them out.
The notion of cash management is not new and it has attained a greater significance in the
modern world of business due to change that took place in business operations and ever
increasing difficulties and the cost of borrowing" (Howard, 1953 ). It is the most liquid current
assets, cash is the common denominator to which all current assets can be reduced because the
other current assets i.e. receivables and inventory get eventually converted into cash (Khan, 1983
). This emphasises the importance of cash management. The term cash management denotes to
the management of cash resource in such a way that generally accepted business objectives could
be accomplished. In this perspective, the objectives of a firm can be combined as bringing about
consistency between maximum possible effectiveness and liquidity of a firm. Cash management
may be defined as the ability of a management to identify the problems related with cash which
may come across in future course of action, finding appropriate solution to curb such problems if
they arise, and lastly delegating these solutions to the competent authority for carrying them out.
Cash management maintains sufficient quantity of cash in such a way that the quantity denotes
the lowest adequate cash figure to meet business obligations. Cash management involves
managing cash flows (into and out of the firm), within the firm and the cash balances held by a
concern at a point of time.
In financial literature, Cash management denotes to wide area of finance involving the
collection, handling, and usage of cash. It involves assessing market liquidity, cash flow, and
investments. The notion of cash management is not novel and it has gained more significance in
contemporary business world due to change that took place in the conduct of business and ever
increasing difficulties and the cost of borrowing.
Objective of Cash Management
1. To make Payment According to Payment Schedule: Firm needs cash to meet its routine
expenses including wages, salary, taxes etc.
2. To minimise Cash Balance: The second objective of cash management is to reduce cash
balance. Excessive amount of cash balance helps in quicker payments, but excessive cash
may remain unused & reduces profitability of business. Contrarily, when cash available
with firm is less, firm is unable to pay its liabilities in time. Therefore optimum level of
cash should be maintained (Excel Books India, 2008).
An effective management is considered to be important for the following reasons:
1. Cash management guarantees that the firm has sufficient cash during peak times for
purchase and for other purposes.
2. Cash management supports to meet obligatory cash out flows when they fall due.
3. Cash management helps in planning capital expenditure projects.
4. Cash management helps to organize for outside financing at favourable terms and
conditions, if necessary.

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5. Cash management helps to allow the firm to take advantage of discount, special
purchases and business opportunities.
1.6. Cash management helps to invest surplus cash for short or long-term periods to keep the
idle funds fully employed.
General Principles of Cash Management
Harry Gross has recommended certain general principles of cash management.
1. Determinable Variations of Cash Needs: A reasonable amount of funds, in the form of

cash is required to be kept aside to overcome the period expected as the period of cash
shortage. This period may either be short and temporary or last for a longer duration of
time. Normal and regular payment of cash leads to small cutbacks in the cash balance at
periodic intervals. Making this payment to different workers on different days of a week
can balance these reductions. Another practice for balancing the level of cash is to schedule
cash disbursements to creditors during the period when accounts receivables collected
amounts to a large sum but without putting the helpfulness at stake.
2. Contingency Cash Requirement: There may arise certain cases, which fall beyond the
forecast of the management. These establish unexpected calamities, which are too difficult
to be provided in the normal course of the business. Such contingencies always demand for
special cash requirements that was not assessed and provided for in the cash budget.
Denials of wholesale product, huge amount of bad debts, strikes, and lockouts are some of
these contingencies. Only a prior experience and investigation of other similar companies
prove supportive as a customary practice. A useful procedure is to shield the business from
such calamities like bad-debt losses, fire by way of insurance coverage.
3. Availability of External Cash: This factor also has immense significance in the cash
management which refer to the availability of funds from outside sources. There resources
help in providing credit facility to the firm, which materialized the firm's objectives of
holding minimum cash balance. As such if a firm succeeds in obtaining sufficient funds
from external sources such as banks or private financers, shareholders, government
agencies, the need to maintain cash reserves lessens.
4. Maximizing Cash Receipts: Nearly, all financial managers have objective to make the
best possible use of cash receipts. Cash receipts if tackled carefully results in minimizing
cash requirements of a concern. For this purpose, the comparative cost of granting cash
discount to customer and the policy of charging interest expense for borrowing must be
appraised continually to determine the ineffectiveness of either of the alternative or both of
them during that particular period for maximizing cash receipts. Some techniques proved
helpful in this context are mentioned below:
i. Concentration Banking: In this system, a company launches banking centres for

collection of cash in different areas. Thus, the company instructs its customers of
neighbouring areas to send their payments to those centres. The collection amount
is then deposited with the local bank by these centres as early as possible. Whereby,
the collected funds are transferred to the company's central bank accounts operated
by the head office.

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ii. Local Box System: Under this system, a company rents out the local post offices
boxes of different cities and the customers are asked to forward their remittances to
it. These remittances are picked by the approved lock bank from these boxes to be
transferred to the company's central bank operated by the head office.
iii. Reviewing Credit Procedures: This type of technique assists to determine the
impact of slow payers and bad debtors on cash. The accounts of slow paying
customers should be revised to determine the volume of cash tied up. Besides this,
evaluation of credit policy must also be conducted for introducing essential
modifications. As a matter of fact, too strict a credit policy involves rejections of
sales. Thus, restricting the cash inflow. On the other hand, too lenient, a credit
policy would increase the number of slow payments and bad debts again reducing
the cash inflows.
iv. Minimizing Credit Period: Shortening the terms allowed to the customers would
definitely quicken the cash inflow side-by-side reviewing the discount offered
would prevent the customers from using the credit for financing their own
operations gainfully.
v. Others: There is a need to introduce various procedures for managing large to
very large remittances or foreign remittances such as, persona pick up of large sum
of cash using airmail, special delivery and similar techniques to accelerate such
collections.
5. Minimizing Cash Disbursements: The intention to minimize cash payments is the
ultimate benefit derived from maximizing cash receipts. Cash disbursement can be brought
under control by stopping deceitful practices, serving time draft to creditors of large sum,
making staggered payments to creditors and for payrolls.
6. Maximizing Cash Utilization: It is emphasized by financial experts that suitable and
optimum utilization leads to maximizing cash receipts and minimizing cash payments. At
times, a concern finds itself with funds in excess of its requirement, which lay idle without
bringing any return to it. At the same time, the concern finds it imprudent to dispose it, as
the concern shall soon need it. In such conditions, company must invest these funds in
some interest bearing securities. Gitman suggested some fundamental procedures, which
helps in managing cash if employed by the cash management. These include:
1. Pay accounts payables as late as possible without damaging the firm's credit rating, but take
advantage of the favourable cash discount, if any.
2. Turnover, the inventories as quickly as possible, avoiding stock outs that might
result in shutting down the productions line or loss of sales.
3. Collect accounts receivables as early as possible without losing future loss sales
because of high-pressure collections techniques. Cash discounts, if they are
economically justifiable, may be used to accomplish this objective (Gitman, 1979.).
Function of Cash Management
It is well acknowledged in financial reports and various studies that cash management is
concerned with minimizing fruitless cash balances, investing temporarily excess cash usefully
and to make the best possible arrangements for meeting planned and unexpected demands on the
firm's cash (Hunt, 1966). Cash Management must have objective to reduce the required level of
cash but minimize the risk of being unable to discharge claims against the company as they arise.
There are five cash management functions:

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1. Cash Planning: Experts emphases the wise planning of funds that can lead to huge
success. For any management decision, planning is the primary requirement. According to
theorists, "Planning is basically an intellectual process, a mental pre-disposition to do
things in an orderly way, to think before acting and to act in the light of facts rather than of
a guess." Cash planning is a practise, which comprises of planning for and controlling of
cash. It is a management process of predicting the future need of cash, its available
resources and various uses for a specified period. Cash planning deals at length with
formulation of necessary cash policies and procedures in order to perform business process
constantly. A good cash planning aims at providing cash, not only for regular but also for
irregular and abnormal requirements.
2. Managing Cash Flows: Second function of cash management is to properly manage cash
flows. It means to manage efficiently the flow of cash coming inside the business i.e. cash
inflow and cash moving out of the business i.e. cash outflow. These two can be effectively
managed when a firm succeeds in increasing the rate of cash inflow together with
minimizing the cash outflow. As observed accelerating collections, avoiding excessive
inventories, improving control over payments contribute to better management of cash.
Whereby, a business can protect cash and thereof would require lesser cash balance for its
operations.
3. Controlling the Cash Flows: It has been observed that prediction is not an exact
knowledge because it is based on certain conventions. Therefore, cash planning will
unavoidably be at variance with the results actually obtained. Due to this, control becomes
an unavoidable function of cash management. Moreover, cash controlling becomes
indispensable as it increases the availability of usable cash from within the enterprise. It is
understandable that greater the speed of cash flow cycle, greater would be the number of
times a firm can convert its goods and services into cash and so lesser will be the cash
requirement to finance the desired volume of business during that period. Additionally,
every business is in possession of some concealed cash, which if traced out significantly
decreases the cash requirement of the enterprise.
4. Optimizing the Cash Level: It is important that a financial manager must focus to
maintain sound liquidity position i.e. cash level. All his efforts relating to planning,
managing and controlling cash should be diverted towards maintaining an optimum level of
cash. The prime need of maintaining optimum level of cash is to meet all requirements and
to settle the obligations well in time. Optimization of cash level may be related to
establishing equilibrium between risk and the related profit expected to be earned by the
company.
5. Investing Idle Cash: Idle cash or surplus cash is described as the extra cash inflows over
cash outflows, which do not have any specific operations or any other purpose to solve
currently. Usually, a firm is required to hold cash for meeting working needs facing
contingencies and to maintain as well as develop friendliness of bankers.
In banking area, cash management is a marketing term for some services related to cash
flow offered mainly to huge business customers. It may be used to describe all bank
accounts (such as checking accounts) provided to businesses of a certain size, but it is more
often used to describe specific services such as cash concentration, zero balance
accounting, and automated clearing house facilities. Sometimes, private banking customers
are given cash management services.
Financial instruments involved in cash management include money market funds, treasury
bills, and certificates of deposit.

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Benefits of Cash Management System
In the period of technology progression, the Cash Management System provides following
Benefits to its customers:
1. Funds availability as per need on day zero, day one, day two, day three etc. i.e. Corporate
can plan their cash flows.
2. Bank interest saved as instruments are collected faster.
3. Affordable and competitive rates.
4. Single point enquiry for all queries.
5. Pooling of funds at desired locations.
To summarize, Cash Management denotes to the concentration, collection and disbursement of

cash. The major role for managers is to maintain the flow of cash. Cash Management include a
series of activities aimed at competently handling the inflow and outflow of cash. This mainly
involves diverting cash from where it is to where it is needed. It is established that cash
management is the optimization of cash flows, balances and short-term investments.
Management of Receivable
Accounts receivable typically comprise more than 25 percent of a firm's assets. The term
receivables is described as debt owed to the firm by the customers resulting from the sale of
goods or services in the ordinary course of business. There are the funds blocked due to credit
sales. Receivables management denotes to the decision a business makes regarding to the overall
credit, collection policies and the evaluation of individual credit applicants. Receivables
Management is also known as trade credit management. Robert N. Anthony, explained it as
"Accounts receivables are amounts owed to the business enterprise, usually by its customers.
Sometimes it is broken down into trade accounts receivables; the former refers to amounts owed
by customers, and the latter refers to amounts owed by employees and others".
Receivables are forms of investment in any enterprise manufacturing and selling goods on credit
basis, large sums of funds are tied up in trade debtors. When company sells its products, services
on credit, and it does not receive cash for it immediately, but would be collected in near future, it
is termed as receivables. However, no receivables are created when a firm conducts cash sales as
payments are received immediately. A firm conducts credit sales to shield its sales from the
rivals and to entice the potential clienteles to buy its products at favourable terms. Generally, the
credit sales are made on open account which means that no formal reactions of debt obligations
are received from the buyers. This enables business transactions and reduces the paperwork
essential in connection with credit sales.
Accounts Receivables Management denotes to make decisions relating to the investment in the
current assets as vital part of operating process, the objective being maximization of return on
investment in receivables. It can be established that accounts receivables management involves
maintenance of receivables of optimal level, the degree of credit sales to be made, and the
debtors' collection.
Receivables are useful for clients as it increases their resources. It is preferred particularly by
those customers, who find it expensive and burdensome to borrow from other resources. Thus,

65
not only the present customers but also the Potential creditors are attracted to buy the firm's
product at terms and conditions favourable to them.
Receivables has vial function in quickening distributions. As a middleman would act fast enough
in mobilizing his quota of goods from the productions place for distribution without any
disturbance of immediate cash payment. As, he can pay the full amount after affecting his sales.
Likewise, the customers would panic for purchasing their needful even if they are not in a
position to pay cash immediately. It is for these receivables are regarded as a connection for the
movement of goods from production to distributions among the ultimate consumer.
Maintenance of receivable
Objectives of receivables management: The objective of Receivables Management is to

promote sales and profits until that point is reached where the return on investment in further
funding receivables is less than the cost of funds raised to finance that additional credit i.e. cost
of capita.
Management of Accounts Receivables is quite expensive. The following are the main costs
related with accounts receivables management:
Cost of Management of Accounts Receivables

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Advantages of accounts receivable management:
Accounts Receivables Management has numerous benefits. These include:
1. Increased Sales: Offering goods or services on credit enhances sales, by holding old
customers and attraction potential customers.
2. Increased Market Share: When the firm is able to maintain old customers and attract new
customers automatically market share will be bigger to the extent new sales.
3. Increase in profits: Increase sales, leads to increase in profits, because it need to produce
more products with a given fixed cost and sales of products with a given sales network in
both cost per unit comes down and the profit will be better.
Management of Inventory
Inventory management is basically related to task of controlling the assets that are produced to
be sold in the normal course of the firm's procedures. In supply chain management, major
variable is to effectively manage inventory. The significance of inventory management to the
company depends on the extent of its inventory investment.
The objectives of inventory management are of twofold:
1. The operational objective is to uphold enough inventory, to meet demand for product by
efficiently organizing the firm's production and sales operations.
2. Financial interpretation is to minimize unproductive inventory and reduce inventory,
carrying costs.
Effective inventory management is to make good balance between stock availability and the cost
of holding inventory.
Components of inventory management: Inventories exist in different forms in a manufacturing

company. These include:

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1. Raw materials: Raw materials are those inputs that are transformed into completed goods
throughout manufacturing process. Those form a major input for manufacturing a product.
In other words, they are very much needed for uninterrupted production.
2. Work-in-process: Work-in-process is a stage of stocks between raw materials and
finished goods. Work-in-process inventories are semi-finished products. They signify
products that need to undergo some other process to become finished goods.
3. Finished products: Finished products are those products which are totally manufactured
and company can immediately sell to customers. The stock of finished goods provides a
buffer between production and market.
4. Stores and spares: It comprises of office and plant cleaning materials like soap, brooms,
oil, fuel, light, bulbs and are purchased and stored for the purpose of maintenance of
machinery.
Component of inventory
Inventory control encompasses managing the inventory that is previously in the warehouse,
stockroom or store. This is to know the type of products are "out there", how many each item and
where it is kept. It means having accurate, complete and timely inventory transactions record and
avoiding differences between accounting and real inventory levels. Two tools commonly used to
ensure inventory accuracy and control are ABC analysis and cycle counting.
The process of Inventory management consists of determining, how to order products and how
much to order as well as identifying the most effective source of supply for each item in each
stocking location. Inventory management contains all activities of planning, forecasting and
replenishment. The main purpose of inventory management is minimize differences between
customers demand and availability of items. These differences have caused by three factors that
include customers demand fluctuations, supplier's delivery time fluctuations and inventory
control accuracy.

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Types of Inventory
The aim of carrying inventories is to separate the operations of the firm. It means to make each
function of the business independent of each other function so that delays or closures in one area
do not affect the production and sale of the final product. Because production cessations result in
increased costs, and because delays in delivery can lose customers, the management and control
of inventory are important duties of the financial manager. There are many types of inventory.
The common categories of inventory include raw materials inventory, work-in-process
inventory, and finished-goods inventory.
Raw-Materials Inventory: Raw materials inventory include basic materials purchased from other
firms to be used in the firm's production operations. These goods may include steel, lumber,
petroleum, or manufactured items such as wire, ball bearings, or tires that the firm does not
produce itself. Regardless of the specific form of the raw-materials inventory, all manufacturing
firms maintain a raw-materials inventory. The intention is to separate the production function
from the purchasing function that is, to make these two functions independent of each other so
delays in the delivery of raw materials do not cause production delays. If there is a delay, the
firm can satisfy its need for raw materials by liquidating its inventory.
Work-in-Process Inventory: Work-in-process inventory comprises of partly finished goods
requiring additional work before they become finished goods. The more difficult and lengthy the
production process, the larger the investment in work-in-process inventory. The main aim of
work-in-process inventory is to disengage the various operations in the production process so
that machine failures and work stoppages in one operation will not affect other operations.
Finished-Goods Inventory: Finished-goods inventory includes goods on which production has
been completed but that are not yet sold. The purpose of a finished-goods inventory is to separate
the production and sales functions so that it is not required to produce the goods before a sale can
occur and sales can be made directly out of inventory.
Motives of inventory management:
Managing inventories involve lack of funds and inventory holding costs.
Maintenance of inventories is luxurious. Still there is motive to retain inventories. There are
three general motives:
1. The transaction motive: Firm may hold the inventories in order to facilitate the smooth
and continuous production and sales operations. It may not be possible for the company to
obtain raw material whenever necessary. There may be a time lag between the demand for
the material and its supply. Therefore, it is needed to hold the raw material inventory.
Similarly, it may not be possible to produce the goods instantly after they are demanded by
the customers. Hence, it is needed to hold the finished goods inventory. The need to hold
work-in-progress may arise due to production cycle.
2. The precautionary motive: Firms also prefer to hold them to protect against the risk of
unpredictable changes in demand and supply forces. For example, the supply of raw
material may get delayed due to the factors like strike, transport disruption, short supply,
lengthy processes involved in import of the raw materials.
3. The speculative motive: Firms may like to buy and stock the inventory in the quantity
which is more than needed for production and sales purposes. It is done to get the
advantages in terms of quantity discounts connected with bulk purchasing or expected price
rise.

69
Merits of Inventory Management
There are several advantages of managing inventory in proper way.
1. Inventory management guarantees adequate supply of materials and stores to minimize

stock outs and shortages and avoid costly interruption in operations.
2. It keeps down investment in inventories, inventory carrying costs, and obsolescence
losses to the minimum.
3. It eases purchasing economies throughout the measurement of requirements on the basis
of recorded experience.
4. It removes duplication in ordering stock by centralizing the source from which purchase
requisition emanate.
5. It allows better utilization of available stock by enabling inter-department transfers within
a firm.
6. It offers a check against the loss of materials through carelessness or pilferage.
7. Perpetual inventory values provide a stable and reliable basis for preparing financial
statements a better utilization.
Demerits of Holding Inventory
Besides several benefits, there are some drawbacks of holding inventory.
1. Price decline: It is a major disadvantage of inventory holding. Price decline is the result
of more supply and less demand. It can be said that it may be due to introduction of
competitive product. Generally, prices are not controllable in the short term by the
individual firm. Controlling inventory is the only way that a firm can counter act with these
risks. On the demand side, a decrease in the general market demand when supply remains
the same may also cause price to increase. This is also long-lasting management problem,
because reduction in demand may be due to change in customer buying habits, tastes and
incomes.
2. Product deterioration: It is also serious demerits of inventory holding. Holding of finished
completed goods for a long period or shortage under inappropriate conditions of light, heat,
humidity and pressures lead to product worsening.
1.3. Product obsolescence: If items are hold for long time, it may become outdated. Product
may become outmoded due to improved products, changes in customer choices,
particularly in high style merchandise, changes in requirements. Then this is a major risk
and it may affect in terms of huge revenue loss. It is costly for the firms whose resources
are limited and tied up in slow moving inventories.
BEST OF LUCK
By:
SRCEM, Palwal
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1

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

Finance may be defined as the art and science of managing money. It

classified into two major parts:

Private Finance, which includes the Individual, Firms, Business or Corporate

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

SCOPE OF FINANCIAL MANAGEMENT:

The main objective of financial management is to arrange sufficient

1. Estimating financial requirements:

2. Deciding capital structure:

3. Selecting a source of finance:

4. Selecting a pattern of investment:

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

Cash management is an important task of finance manager. He has to assess

6. Implementing financial controls:

7. Proper use of surpluses:

FINANCE FUNCTION – AIM

1. Assessing the Financial requirements. The main objective of

2. Proper Utilization of Funds: Though raising of funds is important

3. Increasing Profitability. The planning and control of finance

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

so that scarce resources are not frittered away on uneconomical

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

International organizations are facilitating their customers by

iii) Integrated Analytics: To survive in this competitive environment,

EVOLUTION OF FINANCE FUNCTION:

Financial management came into existence as a separate field of

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

i) In this stage, financial management mainly focuses on specific events like

GOALS OF FINANCE FUNCTION

Effective procurement and efficient use of finance lead to proper utilization

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

Share holders BOD CFO

Favorable Arguments for Profit Maximization

The following important points are in support of the profit maximization

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

(v) Profitability meets the social needs also.

Unfavorable Arguments for Profit Maximization

Drawbacks of Profit Maximization

Profit maximization objective consists of certain drawback also:

Wealth maximization is one of the modern approaches, which involves latest

Favorable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

(iv) Wealth maximization provides efficient allocation of resources.

Unfavorable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern

S.NO. PROFITMAXIMIZATION WEALTH MAXIMIZATION WELFARE

1) Profits are earned Wealth is maximized, so that Welfare maximization is

2) Profit maximization is a In wealth maximization In welfare maximization,

3) Profit is measured in terms Wealth is measured in terms of Welfare can be measured in

4) Profit maximization Wealth maximization involves Wealth maximization

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

TIME VALUE OF MONEY

Why does the Value of Money Decline?

1. Inflation in the economy;

The Present Value Formula:

Prepared By: - Ms.Seema Garg - Assistant Professor,SRCEM, Palwal

Infographic on the Time Value of Money

The GraduateTutor.com finance team

Please feel free to embed this

Computing the Time Value of

If a sum is invested today, it will