Goal of The Firm

In finance , the goal of the firm is always described as "maximization of

shareholders' wealth".

Profit Maximization - is always used as a goal of the firm in

microeconomics. Focus on short term goal to be achieved within a year. It
stresses on the efficient use of capital resources. In order to maximize profit,
the financial manager will implement actions that would result in maximum
profits without considering the consequence of his actions towards the
company's future performance.

Drawbacks of Profit Maximization

- Profit maximization is a short-term concept.
- Profit maximization does not consider the timing of returns.
- Profit maximization ignores risk.

Maximization of Shareholders' Wealth

The goal is o maximize the shareholders' wealth for whom it is being operated.
It being measured by the share price of the stock, which in turn is based on the
timing of returns, the amount of the returns and the risk or uncertainty of the
returns.

It also means maximizing the total market value of the existing shareholders'
common stock. All financial decisions will affect the achievement of this goal.
Shareholders' wealth maximization can be achieved by considering the present
and potential future earnings per share, timing of returns, dividend policy and
other factors that affect the market price of the company's stock.
Definition of Profit Maximization

Profit Maximization is the capability of the firm in producing

maximum output with the limited input, or it uses minimum
input for producing stated output. It is termed as the foremost
objective of the company.
It has been traditionally recommended that the apparent motive
of any business organisation is to earn a profit, it is essential for
the success, survival, and growth of the company. Profit is a
long term objective, but it has a short-term perspective i.e. one
financial year.
Profit can be calculated by deducting total cost from total
revenue. Through profit maximization, a firm can be able to
ascertain the input-output levels, which gives the highest
amount of profit. Therefore, the finance officer of an
organisation should take his decision in the direction
of maximizing profit although it is not the only objective of the
company.
Definition of Wealth Maximization

Wealth maximizsation is the ability of a company to increase the

market value of its common stock over time. The market value
of the firm is based on many factors like their goodwill, sales,
services, quality of products, etc.
It is the versatile goal of the company and highly recommended
criterion for evaluating the performance of a business
organisation. This will help the firm to increase their share in
the market, attain leadership, maintain consumer satisfaction
and many other benefits are also there.
It has been universally accepted that the fundamental goal of
the business enterprise is to increase the wealth of its
shareholders, as they are the owners of the undertaking, and
they buy the shares of the company with the expectation that it
will give some return after a period. This states that the
financial decisions of the firm should be taken in such a manner
that will increase the Net Present Worth of the company’s
profit. The value is based on two factors:
1. Rate of Earning per share
2. Capitalization Rate

Key Differences Between Profit Maximization and Wealth

Maximization
The fundamental differences between profit maximization and
wealth maximization is explained in points below:
1. The process through which the company is capable of
increasing earning capacity known as Profit Maximization.
On the other hand, the ability of the company in increasing
the value of its stock in the market is known as wealth
maximization.
2. Profit maximization is a short term objective of the firm
while the long-term objective is Wealth Maximization.
3. Profit Maximization ignores risk and uncertainty. Unlike
Wealth Maximization, which considers both.
4. Profit Maximization avoids time value of money, but
Wealth Maximization recognises it.
5. Profit Maximization is necessary for the survival and
growth of the enterprise. Conversely, Wealth Maximization
accelerates the growth rate of the enterprise and aims at
attaining the maximum market share of the economy.
Conclusion

There is always a contradiction between Profit Maximization

and Wealth Maximization. We cannot say that which one is
better, but we can discuss which is more important for a
company. Profit is the basic requirement of any entity.
Otherwise, it will lose its capital and cannot be able to survive in
the long run. But, as we all know, the risk is always associated
with profit or in the simple language profit is directly
proportional to risk and the higher the profit, the higher will be
the risk involved with it. So, for gaining the larger amount of
profit a finance manager has to take such decision which will
give a boost to the profitability of the enterprise.
In the short run, the risk factor can be neglected, but in the
long-term, the entity cannot ignore the uncertainty.
Shareholders are investing their money in the company with the
hope of getting good returns and if they see that nothing is done
to increase their wealth. They will invest somewhere else. If the
finance manager takes reckless decisions regarding risky
investments, shareholders will lose their trust in that company
and sell out the shares which will adversely effect on the
reputation of the company and ultimately the market value of
the shares will fall.
Therefore, it can be said that for day to day decision making,
Profit Maximization can be taken into consideration as a sole
parameter but when it comes to decisions which will directly
affect the interest of the shareholders, then Wealth
Maximization should be exclusively considered.

Profit Maximization Vs Wealth Maximization

1. Comparison Chart
2. Definition
 3. Key Differences
4. Conclusion
Comparison Chart

BASIS FOR PROFIT WEALTH

COMPARISON MAXIMIZATION MAXIMIZATION

Concept The main objective The ultimate goal of

of a concern is to the concern is to
earn a larger amount improve the market
of profit. value of its shares.

Emphasizes on Achieving short term Achieving long term

objectives. objectives.

Consideration of No Yes
Risks and
Uncertainty

Advantage Acts as a yardstick Gaining a large

for computing the market share.
operational
efficiency of the
entity.

Recognition of No Yes
Time Pattern of
Returns
 Capital Asset Pricing Model – CAPM

Definition
The capital asset pricing model (CAPM) is the equation that describes the relationship between the
expected return of a given security and systematic risk as measured by its beta coefficient. Besides
risk the model considers the effect of risk-free interest rates and expected market return.
Assumptions
Basic assumptions of the CAPM model are as follows.
i. Markets are ideal—no transaction fees, taxes, inflation, or short selling restrictions.
ii. All investors are averse to risk.
iii. Markets are highly efficient. All investors have equal access to all available information.
iv. All investors can borrow and lend unlimited amounts under a risk-free rate.
v. Beta coefficient is the only measure of risk.
vi. All assets are absolutely liquid and infinitely divided.
vii. The amount of available assets is fixed during a given period of time.
viii. Markets are in equilibrium. All investors are price takers, not price makers.
ix. Return of all available assets is subject to normal distribution function.
Formula
The CAPM model allows you to assess the expected return of a given security using the following
formula:
E(Ri) = RF + βi × (E(RM) - RF)
where E(Ri) is an expected return of a security, RF is a risk-free rate, βi is the beta coefficient of a
security, and E(RM) is an expected market return.
Market risk premium (RPM) can be calculated as follows.
RPM) = E(RM) - RF
The risk premium of a given security (RP ) can be assessed as follows:
i

RPi) = βi × (E(RM) - RF)

Example
Let’s assume an investor is thinking of buying one of three stocks: Stock A with a beta of 0.85, Stock
B with a beta of 1.25, and Stock C with a beta of 1.65. If the risk-free rate is 4.50% and the expected
market return is 12.35%, the expected return of each security can be assessed under CAPM.
E(RA) = 4.50 + 0.85 × (12.35 - 4.50) = 11.17%
E(RB) = 4.50 + 0.85 × (12.35 - 4.50) = 14.31%
E(RC) = 4.50 + 0.85 × (12.35 - 4.50) = 17.45%
Thus, a relationship exists between risk and the expected return of a security. So, the higher the
beta, the higher the expected return and vice versa.
Limitations of use
The capital asset pricing model is a widely used concept, but some assumptions can’t be met in real
market conditions.
i. Real markets have transaction costs; moreover, they can differ significantly for market participants,
e.g., institutional investors have lower transaction costs than other investors.
ii. Several taxes are present on invested capital, e.g., capital gains tax and income tax. Investors try to
maximize their economic utility by considering the effect of taxation. Such behavior reduces the
efficiency of investments and affects the pricing of assets.
iii. Real markets are not always efficient, so investors do not have homogeneous expectations.
iv. No asset is free of risk. Even T-bills are exposed to inflation risk, liquidity risk, and reinvestment risk.
v. Investors have different abilities to borrow at a risk-free rate. For institutional investors, the interest
rate is lower than it is for private investors.
vi. The beta coefficient isn’t the only risk measurement in CAPM because it only reflects the ratio
between a given security’s return volatility and market return volatility.
vii. Empirical studies have shown that the return of a security doesn’t follow any normal distribution
function.
CAPM and market equilibrium
Stock market equilibrium is one CAPM model basic assumption, which means that the expected rate
of return is equal to the required rate of return, and the current price of a given security is equal to its
intrinsic value. If the stock market is in equilibrium, no securities are undervalued or overvalued. The
actual stock market, however, is not in equilibrium, so both undervalued and overvalued stocks are
present, and their expected return is different from the CAPM assessment.
CAPM ASSUMPTIONS
The CAPM is often criticised as being unrealistic because of the assumptions on which it is
based, so it is important to be aware of these assumptions and the reasons why they are
criticised. The assumptions are as follows (Watson D and Head A, 2007, Corporate
Finance: Principles and Practice, 4th edition, FT Prentice Hall, pp222–3):

Investors hold diversified portfolios

This assumption means that investors will only require a return for the systematic risk of
their portfolios, since unsystematic risk has been removed and can be ignored.

Single-period transaction horizon

A standardised holding period is assumed by the CAPM in order to make comparable the
returns on different securities. A return over six months, for example, cannot be compared
to a return over 12 months. A holding period of one year is usually used.

Investors can borrow and lend at the risk-free rate of return

This is an assumption made by portfolio theory, from which the CAPM was developed, and
provides a minimum level of return required by investors. The risk-free rate of return
corresponds to the intersection of the security market line (SML) and the y-axis (see Figure
1). The SML is a graphical representation of the CAPM formula.

Perfect capital market

This assumption means that all securities are valued correctly and that their returns will plot
on to the SML. A perfect capital market requires the following: that there are no taxes or
transaction costs; that perfect information is freely available to all investors who, as a result,
have the same expectations; that all investors are risk averse, rational and desire to
maximise their own utility; and that there are a large number of buyers and sellers in the
market.
While the assumptions made by the CAPM allow it to focus on the relationship between
return and systematic risk, the idealised world created by the assumptions is not the same
as the real world in which investment decisions are made by companies and individuals.

For example, real-world capital markets are clearly not perfect. Even though it can be
argued that well-developed stock markets do, in practice, exhibit a high degree of efficiency,
there is scope for stock market securities to be priced incorrectly and, as a result, for their
returns not to plot on to the SML.

The assumption of a single-period transaction horizon appears reasonable from a real-world

perspective, because even though many investors hold securities for much longer than one
year, returns on securities are usually quoted on an annual basis.

The assumption that investors hold diversified portfolios means that all investors want to
hold a portfolio that reflects the stock market as a whole. Although it is not possible to own
the market portfolio itself, it is quite easy and inexpensive for investors to diversify away
specific or unsystematic risk and to construct portfolios that ‘track’ the stock market.
Assuming that investors are concerned only with receiving financial compensation for
systematic risk seems therefore to be quite reasonable.

A more serious problem is that, in reality, it is not possible for investors to borrow at the risk-
free rate (for which the yield on short-dated Government debt is taken as a proxy). The
reason for this is that the risk associated with individual investors is much higher than that
associated with the Government. This inability to borrow at the risk-free rate means that the
slope of the SML is shallower in practice than in theory.

Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent
an idealised rather than real-world view, there is a strong possibility, in reality, of a linear
relationship existing between required return and systematic risk.
Total Risk= Systematic Risk+ Unsystematic Risk
Systematic Risk: It is the variability on stocks or portfolios associated with the changes in
return on the market as a whole.
Unsystematic Risk: It is the variability of return on stocks or portfolios not explained by
general market movements. It is avoidable through diversification.

Comparison Chart

BASIS FOR SYSTEMATIC UNSYSTEMATIC

COMPARISON RISK RISK

Meaning Systematic risk Unsystematic risk

refers to the hazard
which is associated
with the market or
market segment as
a whole.
refers to the risk
associated with a
particular security,
company or industry.

Nature Uncontrollable Controllable

Factors External factors Internal factors

Affects Large number of Only particular

securities in the company.
market.

Types Interest risk, Business risk and

market risk and financial risk
purchasing power
risk.
 BASIS FOR SYSTEMATIC UNSYSTEMATIC
COMPARISON RISK RISK

Protection Asset allocation Portfolio

diversification

BASIS FOR
COMPOUNDING DISCOUNTING
COMPARISON

Meaning The method used to The method used to

determine the future determine the
value of present present value of
investment is known future cash flows is
as Compounding. known as
Discounting.

Concept If we invest some What should be the

money today, what amount we need to
will be the amount we invest today, to get a
get at a future date. specific amount in
future.

Use of Compound interest Discount rate

rate.

Known Present Value Future Value

 BASIS FOR
COMPOUNDING DISCOUNTING
COMPARISON

Factor Future Value Factor Present Value

or Compounding Factor or
Factor Discounting Factor

Formula FV = PV (1 + r)^n PV = FV / (1 + r)^n

Definition of Compounding

For understanding the concept of compounding, first of all, you

need to know about the term future value. The money you
invest today, will grow and earn interest on it, after a certain
period, which will automatically change its value in future. So
the worth of the investment in future is known as its Future
Value. Compounding refers to the process of earning interest on
both the principal amount, as well as accrued interest by
reinvesting the entire amount to generate more interest.
Compounding is the method used in finding out the future value
of the present investment. The future value can be computed by
applying the compound interest formula which is as under:

Where n = number of years

R = Rate of return on investment.
Definition of Discounting

Discounting is the process of converting the future amount into

its Present Value. Now you may wonder what is the present
value? The current value of the given future value is known as
Present Value. The discounting technique helps to ascertain the
present value of future cash flows by applying a discount rate.
The following formula is used to know the present value of a
future sum:

Where 1,2,3,…..n represents future years

FV = Cash flows generated in different years,
R = Discount Rate
For calculating the present value of single cash flow and annuity
the following formula should be used:

Where R = Discount Rate

n = number of years
You can also use discount factor to arrive at the present value of
a future amount by simply multiplying the factor with the future
value. For this purpose, you need to refer the present value
table.
Multistage growth rate of valuation of securities( Multi-stage
Dividend Discount Model)
 Multi-stage dividend discount model is a technique used to calculate intrinsic value of a stock by
identifying different growth phases of a stock; projecting dividends per share for each the periods in
the high growth phase and discounting them to valuation date, finding terminal value at the start of
the stable growth phase using the Gordon growth model, discounting it back to the valuation date and
adding it to the present value of the high-growth phase dividends.
The basic concept behind the multi-stage dividend discount model is the same as constant-growth
model, i.e. it bases intrinsic value on the present value of expected future cash flows of a stock. The
difference is that instead of assuming a constant dividend growth rate for all periods in future, the
present value calculation is broken down into different phases.

Formula
Intrinsic value = PV of high growth phase dividends + PV of stable growth phase dividends

To calculate the present value of dividend payments in the high growth phase, dividend per share for
each year is individually projected and then discounted.

Dividend per share in year 1 = current dividend × (1 + growth rate in year 1).

It is discounted one year back to valuation date (i.e. time=0).

Dividend per share in Year 2 = dividend per share in year 1 * (1 + growth rate in year 2).

It is discounted 2 years back to t=0.

D1 D2 D3 Dn
PV of high growth dividends = + 2
+ 3
+ ... +
(1+r) (1+r) (1+r) (1+r)n
Where r is the cost of equity and n is number of years in the high-growth phase.

The present value calculation of dividend payments in stable growth phase involves used of Gordon
growth model, because in that phase the dividend growth rate is constant. However, since the Gordon
growth model calculates present value at the end for high growth period, it is further discounted back
to t=0.

1 Dn+1
PV of stable growth dividends ×
(1+ r)n
r–g
Where,
Dn+1 is the dividend in the first year of the stable growth phase
r is the cost of equity
g is the constant dividend growth rate

Example
Flamingo Communications (FC) is fast-growing IT startup specializing in social-media marketing. You
are a financial analyst at AH Ventures, a diversified conglomerate, which has 10% stake in the
company.

Your in-house economist projects that FC dividends are expected to grow at 25%, 20%, 15% and
10% and 5% for the next 5 years. From 6th year onwards a stable growth rate of 5% is expected.

If FC’s current stock price is $41, its most recent dividend per share was $1.5 per share and its cost of
equity is 10%, what would you recommend to your CFO regarding what to do with the investment?

Solution

In the first step, you need to project dividend expectation for each year in the high-growth phase.

The following table summarizes the calculations:

Year Growth rate Dividend per share Phase Formula

Time 0 1.50
Year 1 25% 1.88 High-growth = 1.5 * (1 + 25%)
Year 2 20% 2.25 High-growth = 1.88 * (1 + 20%)
Year 3 15% 2.59 High-growth = 2.25 * (1+15%)
Year 4 10% 2.85 High-growth = 2.59 * (1 + 10%)
Year 5 5% 2.99 High-growth = 2.85 * (1 + 5%)
Year 6 5% 3.14 Stable growth = 2.99 * (1 + 5%)
The first 5 years make the high-growth phase. Dividend per share expected for each of the first 5
years must be discounted back to t=0 individually as follows:

Year Growth rate Dividend per share PV at t=0 Formula

Year 1 25% 1.88 1.70 = 1.88 / (1 + 10%)
Year 2 20% 2.25 1.86 = 2.25 * (1 + 10%)^2
Year 3 15% 2.59 1.94 = 2.59 * (1+10%)^3
Year 4 10% 2.85 1.94 = 2.85 * (1 + 10%)^4
Year 5 5% 2.99 1.86 = 2.99 * (1 + 5%)^5
Sum 9.31
Year 6 onwards is the stable growth phase.

Using the Gordon growth model formula, you can arrive at the present value of perpetual dividends
from 6th year onwards at the start of the stable growth phase. This value is called terminal value.

Terminal value = PV of perpetual dividends 6th year onwards = $3.14/(10% - 5%) = $62.8

Since the PV calculated above is at the end of 5th year (i.e. start of stable growth phase), it must be
discounted back 5 years as follows:

PV at t=0 = $62.8/(1+10%)^5 = $39

Intrinsic value of the stock

= PV of dividends in high-growth phase + PV of terminal value
= $9.31 + $39
= $48.3

Since the current stock price is $41 and the intrinsic value is $48.3, AH Venture should keep invested
in the company because it has upward potential.

Capital budgeting
Ideally, businesses should pursue all projects and opportunities that enhance
shareholder value. However, because the amount of capital available at any given time
for new projects is limited, management needs to use capital budgeting techniques to
determine which projects will yield the most return over an applicable period of time.
Various methods of capital budgeting can include throughput analysis, net present value
(NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.

IMPORTANCE OF CAPITAL BUDGETING

1) Long term investments involve risks: Capital expenditures are long term
investments which involve more financial risks. That is why proper planning
through capital budgeting is needed.

2) Huge investments and irreversible ones: As the investments are huge but the
funds are limited, proper planning through capital expenditure is a pre-requisite.
Also, the capital investment decisions are irreversible in nature, i.e. once a
permanent asset is purchased its disposal shall incur losses.

3) Long run in the business: Capital budgeting reduces the costs as well as
brings changes in the profitability of the company. It helps avoid over or under
investments. Proper planning and analysis of the projects helps in the long run.

SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial management

 Capital budgeting provides a wide scope for financial managers to

evaluate different projects in terms of their viability to be taken up for
investments

 It helps in exposing the risk and uncertainty of different projects

 It helps in keeping a check on over or under investments

 The management is provided with an effective control on cost of capital

expenditure projects

 Ultimately the fate of a business is decided on how optimally the available

resources are used

Example of Capital Budgeting:

Capital budgeting for a small scale expansion involves three steps: recording the
investment’s cost, projecting the investment’s cash flows and comparing the
projected earnings with inflation rates and the time value of the investment.

For example, equipment that costs $15,000 and generates a $5,000 annual return
would appear to "pay back" on the investment in 3 years. However, if economists
expect inflation to rise 30 percent annually, then the estimated return value at the
end of the first year ($20,000) is actually worth $15,385 when you account for
inflation ($20,000 divided by 1.3 equals $15,385). The investment generates only
$385 in real value after the first year.

Cash flow estimation

Cash flow estimation is a must for assessing the investment decisions of any kind. To evaluate
these investment decisions there are some principles of cash flow estimation. In any kind of
project, planning the outputs properly is an important task. At the same time, the profits from
the project should also be very clear to arrange finances in a proper way. These forecasting’s are
some of the most difficult steps involved in the capital budgeting. These are very important in
the major projects because any kind of fault in the calculations would result in huge problems.
The project cash flows consider almost every kind of inflows of cash. The capital budgeting is
done through the co-ordination of a wide range of professionals who are going to be involved in
the project. The engineering departments are responsible for the forecasting of the capital
outlays. On the other hand, there are the people from the production team who are responsible
for calculating the operational cost. The marketing team is also involved in the process and they
are responsible for forecasting the revenue. Next comes the financial manager who is responsible
to collect all the data from the related departments. On the other hand, the finance manager has
the responsibility of using the set of norms for better estimation. One of these norms uses the
principles of cash flow estimation for the process. There are a number of principles of cash flow
estimation. These are the consistency principle, separation principle, post-tax principle and
incremental principle. The separation principle holds that the project cash flows can be divided
in two types named as financing side and investment side. On the other hand, there is the
consistency principle. According to this principle, some kind consistency is necessary to be
maintained between the flow of cash in a project and the rates of discount that are applicable on
the cash flows. At the same time, there is the post-tax principle that holds that the forecast of
cash flows for any project should be done through the after-tax method.

1. Separation Principle

The Separation Principle is used to bring out the project cash flows of a particular project. .It is
an important part of capital budgeting. Before starting a new project, it is very important to
estimate properly the inflow and outflow of cash. There are several methods that are used to
bring out the exact figure of the project cash flow and Separation Principle is one of those
methods. The Separation Principle treats the cash flow in a different way. At first, the project is
divided in two parts. The first part deals with the investment side and the later part is related to
the financing side. To get proper picture of the project cash flow, the cash flow is separated
according to its relation with the investment of financing side. There are several unique features
of Separation Principle . One of these features is that the cash flow related to the investment side
of the project never considers the cost of financing. On the other hand, these charges of financing
are considered while the cash flow calculations related to the financing side are done. These
charges of financing are indicated through the charges of capital figure. The calculations of the
returns related to the investment side are based on the hurdle rate that is the capital cost. Another
important feature of separation principle is that the interest rates on the debt securities are
excluded at the time of calculating the profits and payable taxes. Now, according to this theory,
while bringing out the profit, if the applicable interest is subtracted, the same amount should be
added to the profit that remains after paying the applicable tax. On the other hand, if the tax rate
is imposed directly on the profit (from which interest and taxes are not adjusted) the results are
not going to differ.

2. Incremental Principle

The incremental principle is used to measure the profit potential of a project. According to this
theory, a project is sound if it increases total profit more than total cost. To have a proper
estimation of profit potential by application of the incremental principle, several guidelines
should be maintained: Incidental Effects: Any kind of project taken by a company remains
related to the other activities of the firm. Because of this, the particular project influences all the
other activities carried out, either negatively or positively. It can increase the profits for the firm
or it may cause losses. These incidental effects must be considered.

Sunk Costs:

These costs should not be considered. Sunk costs represent an expenditure done by the firm in
the past. These expenditures are not related with any particular project. These costs denote all
those expenditures that are done for the preliminary work related to the project, unrecoverable in
any case.

Overhead Cost:

All the costs that are not related directly with a service but have indirect influences are
considered as overhead charges. There are the legal and administrative expenses, rentals and
many more. Whenever a company takes a new project, these costs are assigned.

3. Consistency Principle is one of the four major principles that are used for estimating the
project cash flows. According to this principle, consistency in the cash flows is very necessary.
At the same time, consistency in the applicable discount rates on the cash flow should also be
maintained. There are two important factors that are related to the Consistency Principle. These
two are the investor group and the inflation.

Investor Group:
The Consistency Principle holds that while estimating the project cash flow, it is also important
to consider the investor's opinion or view. There are different types of investors in a firm like the
lenders or the stockholders and so on. Again, if it is not possible to consider every kind of
investors' view, then the stockholder's view regarding the cash flow may be considered.
According to the investor's standpoint, the project cash flow denotes that amount of cash that is
provided to the investors. The payable taxes must be deducted from this amount and if there is
any need for investment in the ongoing project then that amount should also be deducted from
the amount allotted for the investors .At the same time, if the stockholders standpoint is regarded
then the project cash flow is that amount that is offered to the stockholders. This amount should
not include any kind of payable tax or any such amount that is necessary to invest in the
particular project. Again, before offering any money to the stockholders, the firm is required to
clear all the debts. Now, the next important factor is the consistency of the discount rate that is to
be applied on the project cash flow. There are two types of discount rate known as the weighted
average cost of capital and cost of equity.

Inflation:

In case of inflation, there are two ways of estimating the project cash flow of a particular project.
The first option is to merge a likely inflation in the project cash flow estimates. After this, a
nominal discount rate is applied on the amount. Another way of handling the inflation factor is to
calculate the project cash flows of the future in real terms with real discount rates.

4. Post Tax Principle

Post Tax Principle is one of the basic principles of cash flow estimation. This is used to bring out
the project cash flows with accuracy. After tax calculations are suggested by the Post Tax
Principle for the project cash flow. There are some businesses that generally neglect the payment
of tax while measuring the cash flow of a project. Next, these businesses try to cover the fault by
using the discount rate. These discount rates are very hard to adjust and thus the after-tax rate of
discount and after-tax cash flows are used jointly. There are some important issues that are
related to the Post Tax Principle and its application. These issues are the following:

Tax Rate:

There are two different tax rates termed as the average tax rate and the marginal tax rate. The
average tax rate is considered as the entire tax as a proposal of the overall earning from the
business. On the other hand, the marginal tax rate represents those taxes that are imposed on the
earnings at margin. The tax rates are often found as progressive and because of this, the average
tax rates are always lower than the marginal tax rate. The firms run some particular projects and
the income from these projects are considered as marginal because this income is a kind of
additional income as the existing assets of the firm are the main source of income. Because of
this, the payable taxes on the project are estimated through the marginal tax rate, as it is the most
appropriate rate to do that.
Handling the Losses:

The post-tax principle holds that there remains possibility of losses for both the firm as well as
the particular project. There are several ways of minimizing these losses. In certain situations,
the tax saving is postponed until the firm or the particular project makes profit.

Non-Cash Charges:

The post-tax principle also holds that whenever the tax liabilities are affected by the non-cash
charges, the project cash flow estimation will be affected. Depreciation is one of these non-cash
charges.

CAPITAL BUDGETING TECHNIQUES / METHODS

There are different methods adopted for capital budgeting. The traditional
methods or non discount methods include: Payback period and Accounting rate
of return method. The discounted cash flow method includes the NPV method,
profitability index method and IRR.

Some of the major techniques used in capital budgeting are as follows:

1. Payback period 2. Accounting Rate of Return method 3. Net present
value method 4. Internal Rate of Return Method 5. Profitability index.

1. Payback period:
The payback (or payout) period is one of the most popular and widely
recognized traditional methods of evaluating investment proposals, it
is defined as the number of years required to recover the original cash
outlay invested in a project, if the project generates constant annual
cash inflows, the payback period can be computed dividing cash outlay
by the annual cash inflow.

Payback period = Cash outlay (investment) / Annual cash inflow = C /

A

Advantages:
1. A company can have more favourable short-run effects on earnings
per share by setting up a shorter payback period.

The riskiness of the project can be tackled by having a shorter payback

period as it may ensure guarantee against loss.

3. As the emphasis in pay back is on the early recovery of investment,

it gives an insight to the liquidity of the project.

Limitations:
1. It fails to take account of the cash inflows earned after the payback
period.

2. It is not an appropriate method of measuring the profitability of an

investment project, as it does not consider the entire cash inflows
yielded by the project.

3. It fails to consider the pattern of cash inflows, i.e., magnitude and

timing of cash inflows.

4. Administrative difficulties may be faced in determining the

maximum acceptable payback period.

2. Accounting Rate of Return method:

The Accounting rate of return (ARR) method uses accounting
information, as revealed by financial statements, to measure the profit
abilities of the investment proposals. The accounting rate of return is
found out by dividing the average income after taxes by the average
investment.
ARR= Average income/Average Investment

Advantages:
1. It is very simple to understand and use.

2. It can be readily calculated using the accounting data.

3. It uses the entire stream of incomes in calculating the accounting

rate.

Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.

2. It ignores the time value of money; profits occurring in different

periods are valued equally.

3. It does not consider the lengths of projects lives.

4. It does not allow for the fact that the profit can be reinvested.

3. Net present value method:

The net present value (NPV) method is a process of calculating the
present value of cash flows (inflows and outflows) of an investment
proposal, using the cost of capital as the appropriate discounting rate,
and finding out the net profit value, by subtracting the present value of
cash outflows from the present value of cash inflows.

The equation for the net present value, assuming that all cash outflows
are made in the initial year (tg), will be:
Where A1, A2…. represent cash inflows, K is the firm’s cost of capital,
C is the cost of the investment proposal and n is the expected life of the
proposal. It should be noted that the cost of capital, K, is assumed to
be known, otherwise the net present, value cannot be known.

Advantages:
1. It recognizes the time value of money

2. It considers all cash flows over the entire life of the project in its
calculations.

3. It is consistent with the objective of maximizing the welfare of the

owners.

Limitations:
1. It is difficult to use

2. It presupposes that the discount rate which is usually the firm’s cost
of capital is known. But in practice, to understand cost of capital is
quite a difficult concept.

3. It may not give satisfactory answer when the projects being

compared involve different amounts of investment.
4. Internal Rate of Return Method:
The internal rate of return (IRR) equates the present value cash
inflows with the present value of cash outflows of an investment. It is
called internal rate because it depends solely on the outlay and
proceeds associated with the project and not any rate determined
outside the investment, it can be determined by solving the following
equation:

Advantages:
1. Like the NPV method, it considers the time value of money.

2. It considers cash flows over the entire life of the project.

3. It satisfies the users in terms of the rate of return on capital.

4. Unlike the NPV method, the calculation of the cost of capital is not a
precondition.

5. It is compatible with the firm’s maximising owners’ welfare.

Limitations:
1. It involves complicated computation problems.

2. It may not give unique answer in all situations. It may yield negative
rate or multiple rates under certain circumstances.
3. It implies that the intermediate cash inflows generated by the
project are reinvested at the internal rate unlike at the firm’s cost of
capital under NPV method. The latter assumption seems to be more
appropriate.

5. Profitability index:
It is the ratio of the present value of future cash benefits, at the
required rate of return to the initial cash outflow of the investment. It
may be gross or net, net being simply gross minus one. The formula to
calculate profitability index (PI) or benefit cost (BC) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A,

1. It gives due consideration to the time value of money.

2. It requires more computation than the traditional method but less

than the IRR method.

3. It can also be used to choose between mutually exclusive projects by

calculating the incremental benefit cost ratio.

What is 'Initial Cash Flow' (ICO)

Initial cash flow is the amount of money paid out or received at the start of a project or
investment. This is generally a negative amount because projects often require a large
initial capital investment by a company at the outset of a project that will generate
positive cash flow over time. This initial cash flow is factored into the profitability of a
project during the discounted cash flow analysis that is used to evaluate whether or not
undertaking the project is profitable. Initial cash flow can also be called initial investment
outlay.
Modified Accelerated Cost Recovery System Definition

The modified accelerated cost recovery system (MACRS) method of depreciation assigns
specific types of assets to categories with distinct accelerated depreciation schedules.
Furthermore, MACRS is required by the IRS for tax reporting but is not approved by GAAP for
external reporting.

MACRS Depreciation Calculation

To calculate depreciation for an asset using MACRS, first determine the asset’s
classification. Then use the table (below) to find the appropriate depreciation schedule.

When using MACRS, an asset does not have any salvage value. This is because the asset is
always depreciated down to zero as the sum of the depreciation rates for each category
always adds up to 100%. When calculating depreciation expense for MACRS, always use the
original purchase price of the asset as the depreciable base for each period. Note that you
depreciate each category for one year longer than its classification period. For example,
depreciate an asset classified under 3-Year MACRS for 4 years. Then depreciate an asset
classified under 5-Year MACRS for 6 years, and so on.

MACRS Example

For example, an asset purchased for $100,000 that falls into the 3-Year MACRS category
shown below, would be depreciated as follows:

Year Depreciation Rate Depreciation Expense

1 33.33% $33,330 (33.33% x $100,000)

2 44.45% $44,450 (44.45% x $100,000)

3 14.81% $14,810 (14.81% x $100,000)

4 7.41% $7,410 (7.41% x $100,000)

MACRS Depreciation Table

Below is the table for Half-Year Convention MACRS for 3, 5, 7, 10, 15, and 20 year
depreciation schedules.
Depreciation Rates (%)

Year 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year

1 33.33 20 14.29 10 5 3.75

2 44.45 32 24.49 18 9.5 7.219

3 14.81 19.2 17.49 14.4 8.55 6.677

4 7.41 11.52 12.49 11.52 7.7 6.177

5 11.52 8.93 9.22 6.93 5.713

6 5.76 8.92 7.37 6.23 5.285

7 8.93 6.55 5.9 4.888

8 4.46 6.55 5.9 4.522

9 6.56 5.91 4.462

10 6.55 5.9 4.461

11 3.28 5.91 4.462

12 5.9 4.461

13 5.91 4.462

14 5.9 4.461

15 5.91 4.462

16 2.95 4.461

17 4.462

18 4.461

19 4.462

20 4.461

21 2.231
 Straight Line Method (SLM) and Written Down Value (WDV) methods are the most used
methods for calculating depreciation. Although Companies Act doesn’t require any specific
method to be chosen, the income tax limits the choice for selecting options. SLM is allowed by
the Companies Act, but the Income-tax Act requires calculation of depreciation by WDV Method
only. However, certain exceptions are there where even income-tax act allows calculation of
depreciation by SLM. But, that’s part of another discussion.

Schedule II of the Companies Act, 2013 contains the useful guide for calculation of depreciation.
Although it doesn’t contain the rates to be used, it provides the useful life to be used for
different classes of assets. And based on those periods, rates for WDV can be easily calculated.

The formula used to calculate WDV rates is –

Rate of Depreciation (R) = 1 – [s/c]1/n

Where,

s = scrap value at the end of period ‘n’;

c = Written down value at present; and

n = useful life of the assets (Schedule II of Companies Act provides this useful life period for
different classes of assets)
Illustration 1 – Suppose a Plant is purchased for ₹ 10 lakhs and its estimated useful life is 10
years. The scrap value at the end of the useful life is estimated to be ₹ 2.5 lakhs. Calculate the
WDV Rates.
Here, we can use the above formula and accordingly,

WDV Rate = 1 – [2.5/10]1/10

i.e. 1 – 0.250.1 = 12.95% (approx.)
Now, you can use this WDV rate to calculate depreciation. Depreciation for the year is the rate
in percentage multiplied by the WDV at the beginning of the year. For example, for Year I –
Depreciation = 10,00,000 x 12.95% i.e. 1,29,500. New WDV for subsequent year will be
previous WDV minus Depreciation already charged. i.e. WDV for year II will be 10,00,000 –
1,29,500 i.e., 8,70,500.
Accordingly, WDV and Depreciation for all years is as below:

WDV at beginning Depreciation WDV at end

Year ( ₹ in lakhs) ( ₹ in lakhs) ( ₹ in lakhs)

10 – 10

0
 10 1.295 8.705

8.705 1.127 7.578

7.578 0.981 6.597

6.597 0.854 5.743

5.743 0.744 4.999

4.999 0.647 4.352

4.352 0.564 3.788

3.788 0.491 3.297

3.297 0.427 2.870

2.870 0.370 2.500

10

Cost of equity refers to a shareholder's required rate of return on an equity investment.

It is the rate of return that could have been earned by putting the same money into a
different investment with equal risk.

HOW IT WORKS (EXAMPLE):

The cost of equity is the rate of return required to persuade an investor to make a
given equity investment.

In general, there are two ways to determine cost of equity.

First is the dividend growth model:

Cost of Equity = (Next Year's Annual Dividend / Current Stock Price) + Dividend Growth
Rate

The capital asset pricing model (CAPM) is used to calculate the required rate of
return for any risky asset. Your required rate of return is the increase in value you
should expect to see based on the inherent risk level of the asset.

HOW IT WORKS (EXAMPLE):

As an analyst, you could use CAPM to decide what price you should pay for a
particular stock. If Stock A is riskier than Stock B, the price of Stock A should be lower
to compensate investors for taking on the increased risk.

The CAPM formula is:

ra = rrf + Ba (rm-rrf)

where:

rrf = the rate of return for a risk-free security

rm = the broad market's expected rate of return

Ba = beta of the asset

CAPM can be best explained by looking at an example.

Assume the following for Asset XYZ:

rrf = 3%
rm = 10%
Ba = 0.75

By using CAPM, we calculate that you should demand the following rate of return to
invest in Asset XYZ: ra = 0.03 + [0.75 * (0.10 - 0.03)] = 0.0825 = 8.25%

The inputs for rrf , rm and Ba are determined by the analyst and are open to
interpretation.

Beta (Ba) -- Most investors use a beta calculated by a third party, whether it's an
analyst, broker or Yahoo! Finance.

You can calculate beta yourself by running a straight-line statistical regression on data
points showing price changes of a broad market index versus price changes in your
risky asset. Note that beta can be different depending on what time frame you pull your
data from. Beta calculated with 10 years of data is different from beta calculated with 10
months of data. Neither is right or wrong – it depends totally on the rationale of the
analyst.

Market return (rm) – Your input of market rate of return, rm, can be based on past returns
or projected future returns. Economist Peter Bernstein famously calculated that over the
last 200 years, the stock market has returned an average of 9.6% per year. Whether or
not you want to use this as your projection of future stock market returns is up to you as
an analyst.

Risk-free return (rrf): U.S. Treasury bills and bonds are most often used as the proxy for
the risk-free rate. Most analysts try to match the duration of the bond with the projection
horizon of the investment. For example, if you're using CAPM to estimate Stock XYZ's
required rate of return over a 10 year time horizon, you'll want to use the 10-year
U.S. Treasury bond rate as your measure of rrf.

CAPM is most often used to determine what the fair price of an investment should be.
When you calculate the risky asset's rate of return using CAPM, that rate can then be
used to discount the investment's future cash flows to their present value and thus
arrive at the investment's fair value.

By extension, once you've calculated the investment's fair value, you can then compare
it to its market price. If your price estimate is higher than the market's, you could
consider the stock a bargain. If your price estimate is lower, you could consider the
stock to be overvalued.

WHY IT MATTERS:
Cost of equity is a key component of stock valuation. Because an investor expects his
or her equity investment to grow by at least the cost of equity, cost of equity can be
used as the discount rate used to calculate an equity investment's fair value.

Both cost of equity calculation methods have advantages and disadvantages.

The dividend growth model is simple and straightforward, but it does not apply to
companies that don't pay dividends, and it assumes that dividends grow at a constant
rate over time. The dividend growth model also quite sensitive to changes in the
dividend growth rate, and it does not explicitly consider the risk of the investment.

Meaning of Cost of Capital:

An investor provides long-term funds (i.e., Equity shares, Preference
Shares, Retained earnings, Debentures etc.) to a company and quite
naturally he expects a good return on his investment.
In order to satisfy the investor’s expectations the company should be
able to earn enough revenue.

ADVERTISEMENTS:

Thus, to the company, the cost of capital is the minimum rate of return
that the company must earn on its investments to fulfill the
expectations of the investors.

If a company can raise long-term funds from the market at 10%, then
10% can be used as cut-off rate as the management gains only when
the project gives return higher than 10%. Hence 10% is the discount
rate or cut-off rate. In other words, it is the minimum rate of return
required on the investment project to keep the market value per share
unchanged.

In order to maximise the shareholders’ wealth through increased price

of shares, a company has to earn more than the cost of capital. The
firm’s cost of capital can be determined by working out weighted
average of the different costs of raising different sources of capital.

Some definitions of financial experts are given below for the clear
conception of cost of capital:
ADVERTISEMENTS:

Ezra Solomon defines “Cost of capital is the minimum required rate of

earnings or cut­off rate of capital expenditure”.

According to Mittal and Agarwal “the cost of capital is the minimum

rate of return which a company is expected to earn from a proposed
project so as to make no reduction in the earning per share to equity
shareholders and its market price”.

According to Khan and Jain, cost of capital means “the minimum rate
of return that a firm must earn on its investment for the market value
of the firm to remain unchanged”.

Cost of capital depends upon:

(a) Demand and supply of capital,

(b) Expected rate of inflation,

(c) Various risk involved, and

(d) Debt-equity ratio of the firm etc.

Significance of Cost of Capital:

The concept of cost of capital plays a vital role in decision-making
process of financial management. The financial leverage, capital
structure, dividend policy, working capital management, financial
decision, appraisal of financial performance of top management etc.
are greatly influenced by the cost of capital.

The significance or importance of cost of capital may be

stated in the following ways:
1. Maximisation of the Value of the Firm:
For the purpose of maximisation of value of the firm, a firm tries to
minimise the average cost of capital. There should be judicious mix of
debt and equity in the capital structure of a firm so that the business
does not to bear undue financial risk.

2. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking
capital budgeting decisions. Generally cost of capital is the discount
rate used in evaluating the desirability of the investment project. In
the internal rate of return method, the project will be accepted if it has
a rate of return greater than the cost of capital.

In calculating the net present value of the expected future cash flows
from the project, the cost of capital is used as the rate of discounting.
Therefore, cost of capital acts as a standard for allocating the firm’s
investible funds in the most optimum manner. For this reason, cost of
capital is also referred to as cut-off rate, target rate, hurdle rate,
minimum required rate of return etc.

3. Decisions Regarding Leasing:

Estimation of cost of capital is necessary in taking leasing decisions of
business concern.

4. Management of Working Capital:

In management of working capital the cost of capital may be used to
calculate the cost of carrying investment in receivables and to evaluate
alternative policies regarding receivables. It is also used in inventory
management also.

5. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The
dividend policy of a firm should be formulated according to the nature
of the firm— whether it is a growth firm, normal firm or declining
firm. However, the nature of the firm is determined by comparing the
internal rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or
r < k which indicate growth firm, normal firm and decline firm,
respectively.

6. Determination of Capital Structure:

Cost of capital influences the capital structure of a firm. In designing
optimum capital structure that is the proportion of debt and equity,
due importance is given to the overall or weighted average cost of
capital of the firm. The objective of the firm should be to choose such a
mix of debt and equity so that the overall cost of capital is minimised.
7. Evaluation of Financial Performance:
The concept of cost of capital can be used to evaluate the financial
performance of top management. This can be done by comparing the
actual profitability of the investment project undertaken by the firm
with the overall cost of capital.

Measurement of Cost of Capital:

Cost of capital is measured for different sources of capital structure of
a firm. It includes cost of debenture, cost of loan capital, cost of equity
share capital, cost of preference share capital, cost of retained earnings
etc.

The measurement of cost of capital of different sources of

capital structure is discussed:
A. Cost of Debentures:
The capital structure of a firm normally includes the debt capital. Debt
may be in the form of debentures bonds, term loans from financial
institutions and banks etc. The amount of interest payable for issuing
debenture is considered to be the cost of debenture or debt capital
(Kd). Cost of debt capital is much cheaper than the cost of capital
raised from other sources, because interest paid on debt capital is tax
deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: Kd = r (1 –
t)
where Kd = Cost of debenture
r = Fixed interest rate
t = Tax rate

(ii) When the debentures are issued at a premium or discount but

redeemable at par

Kd = I/NP (1 – t)
where, Kd = Cost of debenture
I = Annual interest payment

t = Tax rate

Np = Net proceeds from the issue of debenture.

(iii) When the debentures are redeemable at a premium or discount

and are redeemable after ‘n’ period:

Kd
I(1-t)+1/N(Rv – NP) / ½ (RV – NP)
where Kd = Cost of debenture .
I = Annual interest payment

t = Tax rate

NP = Net proceeds from the issue of debentures

Ry = Redeemable value of debenture at the time of maturity

Example 1:
(a) A company issues Rs. 1,00,000, 15% Debentures of Rs. 100 each.
The company is in 40% tax bracket. You are required to compute the
cost of debt after tax, if debentures are issued at (i) Par, (ii) 10%
discount, and (iii) 10% premium.

(b) If brokerage is paid at 5%, what will be the cost of debentures if

issue is at par?

Example 2:
ZED Ltd. has issued 12% Debentures of face value of Rs. 100 for Rs. 60
lakh. The floating charge of the issue is 5% on face value. The interest
is payable annually and the debentures are redeemable at a premium
of 10% after 10 years.

What will be the cost of debentures if the tax is 50%?

B. Cost of Preference Share Capital:
For preference shares, the dividend rate can be considered as its cost,
since it is this amount which the company wants to pay against the
preference shares. Like debentures, the issue expenses or the
discount/premium on issue/redemption are also to be taken into
account.

(i) The cost of preference shares (KP) = DP / NP

Where, DP = Preference dividend per share
NP = Net proceeds from the issue of preference shares.

(ii) If the preference shares are redeemable after a period of ‘n’, the
cost of preference shares (KP) will be:

where NP = Net proceeds from the issue of preference shares

RV = Net amount required for redemption of preference shares

DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its dividend
is not allowed deduction from income for income tax purposes. The
students should note that both in the case of debt and preference
shares, the cost of capital is computed with reference to the obligations
incurred and proceeds received. The net proceeds received must be
taken into account while computing cost of capital.

Example 3:
A company issues 10% Preference shares of the face value of Rs. 100
each. Floatation costs are estimated at 5% of the expected sale price.

What will be the cost of preference share capital (KP), if preference

shares are issued (i) at par, (ii) at 10% premium and (iii) at 5%
discount? Ignore dividend tax.
Solution:
We know, cost of preference share capital (KP) = DP/P

Example 4:
Ruby Ltd. issues 12%. Preference Shares of Rs. 100 each at par
redeemable after 10 years at 10% premium.

What will be the cost of preference share capital?

Example 5:
A company issues 12% redeemable preference shares of Rs. 100 each
at 5% premium redeemable after 15 years at 10% premium. If the
floatation cost of each share is Rs. 2, what is the value of KP (Cost of
preference share) to the company?

C. Cost of Equity or Ordinary Shares:

The funds required for a project may be raised by the issue of equity
shares which are of permanent nature. These funds need not be
repayable during the lifetime of the organisation. Calculation of the
cost of equity shares is complicated because, unlike debt and
preference shares, there is no fixed rate of interest or dividend
payment.

Cost of equity share is calculated by considering the earnings of the

company, market value of the shares, dividend per share and the
growth rate of dividend or earnings.

(i) Dividend/Price Ratio Method:

An investors buys equity shares of a particular company as he expects
a certain return (i.e. dividend). The expected rate of dividend per
share on the current market price per share is the cost of equity share
capital. Thus the cost of equity share capital is computed on the basis
of the present value of the expected future stream of dividends.

Thus, the cost of equity share capital (Ke) is measured by:

Ke = where D = Dividend per share
P = Current market price per share.

If dividends are expected to grow at a constant rate of ‘g’ then cost of

equity share capital

(Ke) will be Ke = D/P + g.

This method is suitable for those entities where growth rate in
dividend is relatively stable. But this method ignores the capital
appreciation in the value of shares. A company which declares a higher
amount of dividend out of given quantum of earnings will be placed at
a premium as compared to a company which earns the same amount
of profits but utilizes a major part of it in financing its expansion
programme.

Example 6:
XY Company’s share is currently quoted in market at Rs. 60. It pays a
dividend of Rs. 3 per share and investors expect a growth rate of 10%
per year.

You are required to calculate:

(i) The company’s cost of equity capital.

(ii) The indicated market price per share, if anticipated growth rate is
12%.
(iii) The market price, if the company’s cost of equity capital is 12%,
anticipated growth rate is 10% p.a., and dividend of Rs. 3 per share is
to be maintained.

Example 7:
The current market price of a share is Rs. 100. The firm needs Rs.
1,00,000 for expansion and the new shares can be sold at only Rs. 95.
The expected dividend at the end of the current year is Rs. 4.75 per
share with a growth rate of 6%.

Calculate the cost of capital of new equity.

Solution:
We know, cost of Equity Capital (Ke) = D/P + g
(i) When current market price of share (P) = Rs. 100

K = Rs 4.75 / Rs. 100 + 6% = 0.0475 + 0.06 = 0.1075 or 10.75%.

(ii) Cost of new Equity Capital = Rs. 4.75 / Rs. 95 + 6% = 0.11 or, 11%.

Example 8:
A company’s share is currently quoted in the market at Rs. 20. The
company pays a dividend of Rs. 2 per share and the investors expect a
growth rate of 5% per year.

You are required to calculate (a) Cost of equity capital of the company,
and (b) the market price per share, if the anticipated growth rate of
dividend is 7%.

Solution:
(a) Cost of equity share capital (Ke) = D/P +g = Rs. 2/Rs. 20 + 5% =
15%
(b) Ke = D/P + g
or, 0.15 = Rs. 2 / P + 0.07 or, P = 2/0.08 = Rs. 25.

Example 9:
Green Diesel Ltd. has its equity shares of Rs. 10 each quoted in a stock
exchange at a market price of Rs. 28. A constant expected annual
growth rate of 6% and a dividend of Rs. 1.80 per share has been paid
for the current year.

Calculate the cost of equity share capital.

Solution:
D0 (1 + g)/ P0 + g = 1.80 (1 + .06)/ 28 + 0.06
= 0.0681 + 0.06 = 12.81%

(ii) Earnings/Price Ratio Method:

This method takes into consideration the earnings per share (EPS)
and the market price of share. Thus, the cost of equity share capital
will be based upon the expected rate of earnings of a company. The
argument is that each investor expects a certain amount of earnings
whether distributed or not, from the company in whose shares he
invests.

If the earnings are not distributed as dividends, it is kept in the

retained earnings and it causes future growth in the earnings of the
company as well as the increase in market price of the share.

Thus, the cost of equity capital (Ke) is measured by:

Ke = E/P where E = Current earnings per share
P = Market price per share.

If the future earnings per share will grow at a constant rate ‘g’ then
cost of equity share capital (Ke) will be
Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the
factor of capital appreciation or depreciation in the market value of
shares. Adjustment of Floatation Cost There are costs of floating
shares in market and include brokerage, underwriting commission etc.
paid to brokers, underwriters etc.

These costs are to be adjusted with the current market price of the
share at the time of computing cost of equity share capital since the
full market value per share cannot be realised. So the market price per
share will be adjusted by (1 – f) where ‘f’ stands for the rate of
floatation cost.
Thus, using the Earnings growth model the cost of equity
share capital will be:
Ke = E / P (1 – f) + g
Example 10:
The share capital of a company is represented by 10,000 Equity Shares
of Rs. 10 each, fully paid. The current market price of the share is Rs.
40. Earnings available to the equity shareholders amount to Rs.
60,000 at the end of a period.

Calculate the cost of equity share capital using Earning/Price ratio.

Example 11:
A company plans to issue 10,000 new Equity Shares of Rs. 10 each to
raise additional capital. The cost of floatation is expected to be 5%. Its
current market price per share is Rs. 40.

If the earnings per share is Rs. 7.25, find out the cost of new equity.
D. Cost of Retained Earnings:
The profits retained by a company for using in the expansion of the
business also entail cost. When earnings are retained in the business,
shareholders are forced to forego dividends. The dividends forgone by
the equity shareholders are, in fact, an opportunity cost. Thus retained
earnings involve opportunity cost.

If earnings are not retained they are passed on to the equity

shareholders who, in turn, invest the same in new equity shares and
earn a return on it. In such a case, the cost of retained earnings (Kr)
would be adjusted by the personal tax rate and applicable brokerage,
commission etc. if any.

Many accountants consider the cost of retained earnings as the same

as that of the cost of equity share capital. However, if the cost of equity
share capital i9 computed on the basis of dividend growth model (i.e.,
D/P + g), a separate cost of retained earnings need not be computed
since the cost of retained earnings is automatically included in the cost
of equity share capital.

Therefore, Kr = Ke = D/P + g.
Example 12:
It is given that the cost of equity of a company is 20%, marginal tax
rate of the shareholders is 30% and the Broker’s Commission is 2% of
the investment in share. The company proposes to utilise its retained
earnings to the extent of Rs. 6,00,000.
Find out the cost of retained earnings.

E. Overall or Weighted Average Cost of Capital:

A firm may procure long-term funds from various sources like equity
share capital, preference share capital, debentures, term loans,
retained earnings etc. at different costs depending on the risk
perceived by the investors.

When all these costs of different forms of long-term funds are

weighted by their relative proportions to get overall cost of capital it is
termed as weighted average cost of capital. It is also known as
composite cost of capital. While taking financial decisions, the
weighted or composite cost of capital is considered.

The weighted average cost of capital is used by an enterprise

because of the following reasons:
(i) It is useful in taking capital budgeting/investment decisions.

(ii) It recognises the various sources of finance from which the

investment proposal derives its life-blood (i.e., finance).

(iii) It indicates an optimum combination of various sources of finance

for the enhancement of the market value of the firm.

(iv) It provides a basis for comparison among projects as a standard or

cut-off rate.
I. Computation of Weighted Average Cost of Capital:
Computation of Weighted Average cost of capital is made in
the following ways:
(i) The specific cost of each source of funds (i.e., cost of equity,
preference shares, debts, retained earnings etc.) is to be calculated.

(ii) Weights (i.e., proportion of each, source of fund in the capital

structure) are to be computed and assigned to each type of funds. This
implies multiplication of each source of capital by appropriate weights.

Generally, the-following weights are assigned:

(a) Book values of various sources of funds

(b) Market values of various sources of capital

(c) Marginal book values of various sources of capital.

Book values of weights are based on the values reflected by the balance
sheet of a concern, prepared under historical basis and ignoring price
level changes. Most of the financial analysts prefer to use market value
as the weights to calculate the weighted average cost of capital as it
reflects the current cost of capital.

But the determination of market value involves some difficulties for

which the measurement of cost of capital becomes very difficult.

(iii) Add all the weighted component costs to obtain the firm’s
weighted average cost of capital.
Therefore, weighted average cost of capital (Ko) is to be calculated by
using the following formula:
Ko = K1w1 + K2w2 + …………
where K1, K2 ……….. are component costs and W1, W2 ………….. are
weights.
Example 13:
Jamuna Ltd has the following capital structure and, after
tax, costs for the different sources of fund used:

Example 14:
Excel Ltd. has assets of Rs. 1,60,000 which have been financed with
Rs. 52,000 of debt and Rs. 90,000 of equity and a general reserve of
Rs. 18,000. The firm’s total profits after interest and taxes for the year
ended 31st March 2006 were Rs. 13,500. It pays 8% interest on
borrowed funds and is in the 50% tax bracket. It has 900 equity shares
of Rs. 100 each selling at a market price of Rs. 120 per share.
What is the Weighted Average Cost of Capital?

Example 15:
RIL Ltd. opts for the following capital structure:
Example 16:
In considering the most desirable capital structure for a
company, the following estimates of the cost Debt and
Equity Capital (after tax) have been made at various levels of
debt-equity mix:

You are required to determine the optimum debt-equity mix for the
company by calculating composite cost of capital.
Optimal debt-equity mix for the company is at the point where the
composite cost of capital is minimum. Hence, the composite cost of
capital is minimum (10.75%) at the debt-equity mix of 3: 7 (i.e., 30%
debt and 70% equity). Therefore, 30% of debt and 70% equity mix
would be an optimal debt-equity mix for the company.

In general, leverage means affect of one variable over another.

In financial management, leverage is not much different, it
means change in one element, results in change in profit. It
implies, making use of such asset or source of funds like
debentures for which the company has to pay fixed cost or
financial charges, to get more return. There are three measures
of Leverage i.e. operating leverage, financial leverage, and
combined leverage. The operating leverage measures the
effect of fixed cost whereas the financial leverage evaluates
the effect of interest expenses.
Difference between operating leverage and
financial leverage
BASIS FOR OPERATING FINANCIAL
COMPARISON LEVERAGE LEVERAGE

Meaning Use of such assets in Use of debt in a

the company's company's capital
operations for which structure for which
it has to pay fixed it has to pay interest
costs is known as expenses is known
Operating Leverage. as Financial
Leverage.

Measures Effect of Fixed Effect of Interest

operating costs. expenses

Relates Sales and EBIT EBIT and EPS

Ascertained by Company's Cost Company's Capital

Structure Structure

Preferable Low High, only when

ROCE is higher

Formula DOL = Contribution DFL = EBIT / EBT

/ EBIT

Risk It give rise to It give rise to

 BASIS FOR OPERATING FINANCIAL
COMPARISON LEVERAGE LEVERAGE

business risk. financial risk.

EBIT-EPS analysis gives a scientific basis for comparison among

various financial plans and shows ways to maximize EPS. Hence
EBIT-EPS analysis may be defined as ‘a tool of financial planning that
evaluates various alternatives of financing a project under varying
levels of EBIT and suggests the best alternative having highest EPS
and determines the most profitable level of EBIT’.

Concept of EBIT-EPS Analysis:

The EBIT-EBT analysis is the method that studies the leverage, i.e.
comparing alternative methods of financing at different levels of EBIT.
Simply put, EBIT-EPS analysis examines the effect of financial
leverage on the EPS with varying levels of EBIT or under alternative
financial plans.

It examines the effect of financial leverage on the behavior of EPS

under different financing alternatives and with varying levels of EBIT.
EBIT-EPS analysis is used for making the choice of the combination
and of the various sources. It helps select the alternative that yields the
highest EPS.

We know that a firm can finance its investment from various sources
such as borrowed capital or equity capital. The proportion of various
sources may also be different under various financial plans. In every
financing plan the firm’s objectives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis:

We have seen that EBIT-EPS analysis examines the effect of financial
leverage on the behavior of EPS under various financing plans with
varying levels of EBIT. It helps a firm in determining optimum
financial planning having highest EPS.

Various advantages derived from EBIT-EPS analysis may be

enumerated below:
Financial Planning:
Use of EBIT-EPS analysis is indispensable for determining sources of
funds. In case of financial planning the objective of the firm lies in
maximizing EPS. EBIT-EPS analysis evaluates the alternatives and
finds the level of EBIT that maximizes EPS.

Comparative Analysis:
EBIT-EPS analysis is useful in evaluating the relative efficiency of
departments, product lines and markets. It identifies the EBIT earned
by these different departments, product lines and from various
markets, which helps financial planners rank them according to
profitability and also assess the risk associated with each.

Performance Evaluation:
This analysis is useful in comparative evaluation of performances of
various sources of funds. It evaluates whether a fund obtained from a
source is used in a project that produces a rate of return higher than
its cost.

Determining Optimum Mix:

EBIT-EPS analysis is advantageous in selecting the optimum mix of
debt and equity. By emphasizing on the relative value of EPS, this
analysis determines the optimum mix of debt and equity in the capital
structure. It helps determine the alternative that gives the highest
value of EPS as the most profitable financing plan or the most
profitable level of EBIT as the case may be.

Limitations of EBIT-EPS Analysis:

Finance managers are very much interested in knowing the sensitivity
of the earnings per share with the changes in EBIT; this is clearly
available with the help of EBIT-EPS analysis but this technique also
suffers from certain limitations, as described below

No Consideration for Risk:

Leverage increases the level of risk, but this technique ignores the risk
factor. When a corporation, on its borrowed capital, earns more than
the interest it has to pay on debt, any financial planning can be
accepted irrespective of risk. But in times of poor business the reverse
of this situation arises—which attracts high degree of risk. This aspect
is not dealt in EBIT-EPS analysis.

Contradictory Results:
It gives a contradictory result where under different alternative
financing plans new equity shares are not taken into consideration.
Even the comparison becomes difficult if the number of alternatives
increase and sometimes it also gives erroneous result under such
situation.

Over-capitalization:
This analysis cannot determine the state of over-capitalization of a
firm. Beyond a certain point, additional capital cannot be employed to
produce a return in excess of the payments that must be made for its
use. But this aspect is ignored in EBIT-EPS analysis.

Example 5.1:
Ankim Ltd., has an EBIT of Rs 3, 20,000. Its capital structure is given
as under:

Indifference Points:
The indifference point, often called as a breakeven point, is highly
important in financial planning because, at EBIT amounts in excess of
the EBIT indifference level, the more heavily levered financing plan
will generate a higher EPS. On the other hand, at EBIT amounts below
the EBIT indifference points the financing plan involving less leverage
will generate a higher EPS.

i. Concept:
Indifference points refer to the EBIT level at which the EPS is same for
two alternative financial plans. According to J. C. Van Home,
‘Indifference point refers to that EBIT level at which EPS remains the
same irrespective of debt equity mix’. The management is indifferent
in choosing any of the alternative financial plans at this level because
all the financial plans are equally desirable. The indifference point is
the cut-off level of EBIT below which financial leverage is disadvanta-
geous. Beyond the indifference point level of EBIT the benefit of
financial leverage with respect to EPS starts operating.

The indifference level of EBIT is significant because the financial

planner may decide to take the debt advantage if the expected EBIT
crosses this level. Beyond this level of EBIT the firm will be able to
magnify the effect of increase in EBIT on the EPS.

In other words, financial leverage will be favorable beyond the

indifference level of EBIT and will lead to an increase in the EPS. If the
expected EBIT is less than the indifference point then the financial
planners will opt for equity for financing projects, because below this
level, EPS will be more for less levered firm.
ii. Computation:
We have seen that indifference point refers to the level of EBIT at
which EPS is the same for two different financial plans. So the level of
that EBIT can easily be computed. There are two approaches to
calculate indifference point: Mathematical approach and graphical
approach.

Mathematical Approach:
Under the mathematical approach, the indifference point may be
obtained by solving equations. Let us present the income statement
given in Table 5.1 with the following symbols in Table 5.4. We are
starting from EBIT only.

Where, N represents number of equity shares.

In case of financing, three types of sources may be opted: Equity, debt

and preference shares. So we may have four possible combinations
Equity, Equity-Debt, Equity- Preference Shares and Equity- Debt-
Preference Shares.

So, EPS under various alternatives will be as follows:

Note:
The symbols have their usual meaning.

The indifference point between any two financial plans may be

obtained by equalizing the respective equations of EPS and solving
them to find the value of X.

Example 5.2:
Debarathi Co. Ltd., is planning an expansion programme. It requires
Rs 20 lakhs of external financing for which it is considering two
alternatives. The first alternative calls for issuing 15,000 equity shares
of Rs 100 each and 5,000 10% Preference Shares of Rs 100 each; the
second alternative requires 10,000 equity shares of Rs 100 each,
2,000 10% Preference Shares of Rs 100 each and Rs 8,00,000
Debentures carrying 9% interest. The company is in the tax bracket of
50%. You are required to calculate the indifference point for the plans
and verify your answer by calculating the EPS.

Solution:
Graphical Approach:
The indifference point may also be obtained using a graphical
approach. In Figure 5.1 we have measured EBIT along the horizontal
axis and EPS along the vertical axis. Suppose we have two financial
plans before us: Financing by equity only and financing by equity and
debt. Different combinations of EBIT and EPS may be plotted against
each plan. Under Plan-I the EPS will be zero when EBIT is nil so it will
start from the origin.

The curve depicting Plan I in Figure 5.1 starts from the origin. For
Plan-II EBIT will have some positive figure equal to the amount of
interest to make EPS zero. So the curve depicting Plan-II in Figure 5.1
will start from the positive intercept of X axis. The two lines intersect
at point E where the level of EBIT and EPS both are same under both
the financial plans. Point E is the indifference point. The value
corresponding to X axis is EBIT and the value corresponding to 7 axis
is EPS.

These can be found drawing two perpendiculars from the indifference

point—one on X axis and the other on Taxis. Similarly we can obtain
the indifference point between any two financial plans having various
financing options. The area above the indifference point is the debt
advantage zone and the area below the indifference point is equity
advantage zone.

Above the indifference point the Plan-II is profitable, i.e. financial

leverage is advantageous. Below the indifference point Plan I is
advantageous, i.e. financial leverage is not profitable. This can be
found by observing Figure 5.1. Above the indifference point EPS will
be higher for same level of EBIT for Plan II. Below the indifference
point EPS will be higher for same level of EBIT for Plan I. The
graphical approach of indifference point gives a better understanding
of EBIT-EPS analysis.
 Financial Breakeven
Point:
In general, the term Breakeven Point (BEP) refers to the point where
the total cost line and sales line intersect. It indicates the level of
production and sales where there is no profit and no loss because here
the contribution just equals to the fixed costs. Similarly financial
breakeven point is the level of EBIT at which after paying interest, tax
and preference dividend, nothing remains for the equity shareholders.

In other words, financial breakeven point refers to that level of EBIT at

which the firm can satisfy all fixed financial charges. EBIT less than
this level will result in negative EPS. Therefore EPS is zero at this level
of EBIT. Thus financial breakeven point refers to the level of EBIT at
which financial profit is nil.

Financial Break Even Point (FBEP) is expressed as ratio with

the following equation:
Example 5.3:
A company has formulated the following financing plans to finance Rs
15, 00,000 which is required for financing a new project.
Sources of working capital finance:
The sources of short-term funds used for financing variable part of working capital
mainly include the following:

1. Loans from commercial banks

2. Public deposits

3. Trade credit

4. Factoring

5. Discounting bills of exchange

6. Bank overdraft and cash credit

7. Advances from customers

8. Accrual accounts

These are discussed in turn.

1. Loans from Commercial Banks:

Small-scale enterprises can raise loans from the commercial banks with or without security. This
method of financing does not require any legal formality except that of creating a mortgage on the
assets. Loan can be paid in lump sum or in parts. The short-term loans can also be obtained from
banks on the personal security of the directors of a country.

Such loans are known as clean advances. Bank finance is made available to small- scale enterprises at
concessional rate of interest. Hence, it is generally a cheaper source of financing working capital
requirements of enterprise. However, this method of raising funds for working capital is a time-
consuming process.

2. Public Deposits:

Often companies find it easy and convenient to raise short- term funds by inviting shareholders,
employees and the general public to deposit their savings with the company. It is a simple method of
raising funds from public for which the company has only to advertise and inform the public that it is
authorised by the Companies Act 1956, to accept public deposits.

Public deposits can be invited by offering a higher rate of interest than the interest allowed on bank
deposits. However, the companies can raise funds through public deposits subject to a maximum of
25% of their paid up capital and free reserves.

But, the small-scale enterprises are exempted from the restrictions of the maximum
limit of public deposits if they satisfy the following conditions:

The amount of deposit does not exceed Rs. 8 lakhs or the amount of paid up capital whichever is less.

(i) The paid up capital does not exceed Rs. 12 lakhs.

(ii) The number of depositors is not more than 50%.

(iii) There is no invitation to the public for deposits.

The main merit of this source of raising funds is that it is simple as well as cheaper. But, the biggest
disadvantage associated with this source is that it is not available to the entrepreneurs during
depression and financial stringency.

3. Trade Credit:

Just as the companies sell goods on credit, they also buy raw materials, components and other goods
on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e., trade
creditors for credit purchases are regarded as sources of finance. Generally, suppliers grant credit to
their clients for a period of 3 to 6 months.

Thus, they provide, in a way, short- term finance to the purchasing company. As a matter of fact,
availability of this type of finance largely depends upon the volume of business. More the volume of
business more will be the availability of this type of finance and vice versa.

Yes, the volume of trade credit available also depends upon the reputation of the buyer company, its
financial position, degree of competition in the market, etc. However, availing of trade credit
involves loss of cash discount which could be earned if payments were made within 7 to 10 days from
the date of purchase of goods. This loss of cash discount is regarded as implicit cost of trade credit.
4. Factoring:

Factoring is a financial service designed to help firms in managing their book debts and receivables
in a better manner. The book debts and receivables are assigned to a bank called the 'factor' and cash
is realised in advance from the bank. For rendering these services, the fee or commission charged is
usually a percentage of the value of the book debts/receivables factored.

This is a method of raising short-term capital and known as 'factoring'. On the one hand, it helps the
supplier companies to secure finance against their book debts and receivables, and on the other, it
also helps in saving the effort of collecting the book debts.

The disadvantage of factoring is that customers who are really in genuine difficulty do not get the
opportunity of delaying payment which they might have otherwise got from the supplier company.

In the present context where industrial sickness is spreading like an epidemic, the reason for which
particularly in SSI sector being delayed payments from their suppliers; there is a clear-cut rationale
for introduction of factoring system. There has been some progress also on this front.

The recommendations of the Study Group (RBI 1996) to examine the feasibility of setting up of
factoring organisations in the country, under the Chairmanship of Shri C. S. Kalyanasundaram have
been accepted by the Government of India. The Group is of the view that factoring for SSI units could
prove to be mutually beneficial to both Factors and SSI units and Factors should make every effort to
orient their strategy to crystallize the potential demand from the sector.

5. Discounting Bills of Exchange:

When goods are sold on credit, bills of exchange are generally drawn for acceptance by the buyers of
goods. The bills are generally drawn for a period of 3 to 6 months. In practice, the writer of the bill,
instead of holding the bill till the date of maturity, prefers to discount them with commercial banks
on payment of a charge known as discount.

The term 'discounting of bills' is used in case of time bills whereas the term, 'purchasing of bills' is
used in respect of demand bills. The rate of discount to be charged by the bank is prescribed by the
Reserve Bank of India (RBI) from time to time. It generally amounts to the interest for the period
from the date of discounting to the date of maturity of bills.

If a bill is dishonoured on maturity, the bank returns the dishonoured bill to the company who then
becomes liable to pay the amount to the bank. The cost of raising finance by this method is the
amount of discount charged by the bank. This method is widely used by companies for raising short-
term finance.

6. Bank Overdraft and Cash Credit:

Overdraft is a facility extended by the banks to their current account holders for a short-period
generally a week. A current account holder is allowed to withdraw from its current deposit account
upto a certain limit over the balance with the bank. The interest is charged only on the amount
actually overdrawn. The overdraft facility is also granted against securities.

Cash credit is an arrangement whereby the commercial banks allow borrowing money up to a
specified-limit known as 'cash credit limit.' The cash credit facility is allowed against the security.
The cash credit limit can be revised from time to time according to the value of securities. The money
so drawn can be repaid as and when possible.
The interest is charged on the actual amount drawn during the period rather on limit sanctioned.
The rate of interest charged on both overdraft and cash credit is relatively higher than the rate of
interest given on bank deposits. Arranging overdraft and cash credit with the commercial banks has
become a common method adopted by companies for meeting their short- term financial, or say,
working capital requirements.

7. Advances from Customers:

One way of raising funds for short-term requirement is to demand for advance from one's own
customers. Examples of advances from the customers are advance paid at the time of booking a car, a
telephone connection, a flat, etc. This has become an increasingly popular source of short-term
finance among the small business enterprises mainly due to two reasons.

First, the enterprises do not pay any interest on advances from their customers. Second, if any
company pays interest on advances, that too at a nominal rate. Thus, advances from customers
become one of the cheapest sources of raising funds for meeting working capital requirements of
companies.

8. Accrual Accounts:

Generally, there is a certain amount of time gap between incomes is earned and is actually received
or expenditure becomes due and is actually paid. Salaries, wages and taxes, for example, become due
at the end of the month but are usually paid in the first week of the next month. Thus, the
outstanding salaries and wages as expenses for a week help the enterprise in meeting their working
capital requirements. This source of raising funds does not involve any cost.

Types of working capital:

Types of working capital
1. Permanent Working Capital
It is otherwise called as Fixed Working Capital. Tandon committee has
referred to this type of working capital as Hard Core Working Capital.
Permanent working capital implies the base investment amount in all types of
current resources which is respected at all times to carry on business activities.
The value of current assets have been increased or decreased over a period of
time. Even though, there is a need of having minimum level of current assets
at all times in order to carry on the business activities effectively.

Features of Permanent Working Capital

a) The gross value of permanent working capital remain constant but the value
of components of current assets is differing from each other.

b) There is a positive correlation between the size of business and the amount
of permanent working capital.

c) Only long term sources of funds are used for permanent working capital.
2. Temporary Working Capital
It is otherwise called as Fluctuating or Variable Working Capital. There is a
close relationship prevailing between temporary working capital and the level
of production and sales. There is no uniform production and sales throughout
the year. If heavy order is received for production and there is a large amount
of credit sales, there is a need of more amount of temporary working capital.
At the same time, if production is carried on in anticipation of demand in near
future, temporary working capital is required.

In nutshell, temporary working capital is an extra working capital required to

support the changing production and sales activities.
3. Gross & Net Working Capital
Discussed in previous article here Gross & Net Working Capital.
4. Negative Working Capital
Sometimes, the value of current assets is less than the current liabilities, it
shows negative working capital. If such type of situation arise, the firm is
going to meet the financial crisis very shortly.
5. Reserve Working Capital
It is otherwise called as Cushion Working Capital. It refers to the short term
financial arrangement made by the business units to meet uncertain changes
or to meet uncertainties. A firm is always working with the expectation of
some risks which may be controllable or uncontrollable. The reserve working
capital can be used in order to meet the uncontrollable risks and sustain in the
business world.
6. Regular Working Capital
The minimum amount of working capital to be maintained in normal
condition is called Regular Working Capital.

7. Seasonal Working Capital

Some products have seasonal demand. Seasonal demand arises due to festival.
In this way, seasonal working capital means an amount of working capital
maintained to meet the seasonal demand of the product.
8. Special Working Capital
Special programmes may be conducted for business development. The
programmes may be advertisement campaign, sales promotion activities,
product development activities, marketing research activities, launching of
new products, expansion of markets and the like. Therefore, special working
capital means an amount of working capital maintained to meet the expenses
of special programmes of the company.
FACTORS AFFECTING WORKING FACTOR REQUIRMENTS:

1. NATURE OF THE INDUSTRY / BUSINESS

The management of working capital is completely different from industry to industry. A simple
comparison of the service industry and manufacturing industry can clarify the point. In a
service industry, there is no inventory and therefore, one big component of working capital is
already avoided. So, the nature of the industry is a factor in determining the working capital
requirement.
2. SEASONALITY OF INDUSTRY AND PRODUCTION POLICY
Businesses based on seasons like manufacturing of ACs whose demand peaks in summer
and dips in winter. The requirement of working capital will be more in summer compared to
winter if they are produced in the fashion of their demand. The policy of producing
throughout the year can smoothen the fluctuation of working capital requirement.
3. COMPETITION
If the industry is competitive, quick response to customer needs is compulsory and therefore
a higher level of inventory is maintained. Liberal credit terms are also mandatory with good
service to survive in the market. So, higher the competition, higher would be the requirement
of working capital.
4. PRODUCTION CYCLE TIME
The production cycle time refers to the time required for converting the raw materials into
finished goods. Higher, this time, higher would be the time of blocking funds in the working
capital.
5. CREDIT POLICY
Liberal credit policy demands a higher level of working capital and tight credit policy reduces
it.
6. GROWTH AND EXPANSION
Some industries are static and others are growing. Obviously, growing industry grows the
requirement of working capital also as compared to static industry.
7. RAW MATERIAL SHORT SUPPLY
If the raw material supply is not smooth for any reason, companies tend to store more of raw
materials than needed and that increased requirement of working capital.
8. NET CASH PROFIT
Profit or retained earnings are one of the sources of working capital for the business. It will
depend on net cash profits as to how much working capital financingis required from external
sources.
9. TAXES
Taxes are often paid in advance. This also blocks a part of working capital. Depending on
the tax environment of the industry, working capital needs are also affected.
10. DIVIDEND POLICY
Dividend policy determines the level of retained profits with the business and retained profits
are also used for working capital. This is how; dividend policy affects the need for working
capital.
11. PRICE LEVELS
The price levels of inventory and other expenses such as labour rates etc increase the
working capital requirement. If the company also is able to increase the price of their finished
goods, it reduces this impact.

Other factors that determine or impact the working capital in some or the other way are as follows:
• Cash Requirements
• Volume of Sales
• Terms of Purchase and Sales
• Inventory Turnover
• Business Turnover
• Current Assets Requirements
• Profit Planning and Control
• Repayment Ability
• Cash Reserves
• Operation Efficiency

Bankruptcy cost:
Bankruptcy Costs

M&M II might make it sound as if it is always a good

thing when a company increases its proportion of
debt relative to equity, but that's not the case.
Additional debt is good only up to a certain point
because of bankruptcy costs.

Bankruptcy costs can significantly affect a company's

cost of capital. When a company invests in debt, the
company is required to service that debt by making
required interest payments. Interest payments alter a
company's earnings as well as cash flow.

For each company there is an optimal capital

structure, including a percentage of debt and equity,
and a balance between the tax benefits of the debt and
the equity. As a company continues to increase its
debt over the amount stated by the optimal capital
structure, the cost to finance the debt becomes higher
as the debt is now riskier to the lender.

The risk of bankruptcy increases with the increased

debt load. Since the cost of debt becomes higher, the
WACC is thus affected. With the addition of debt, the
WACC will at first fall as the benefits are realized, but
once the optimal capital structure is reached and then
surpassed, the increased debt load will then cause the
WACC to increase significantly.

The Trade-off theory of capital structure

The trade-off theory states that the optimal capital structure is a trade-off between interest tax
shields and cost of financial distress:.

47) Value of firm = Value if all-equity financed + PV(tax shield) - PV(cost of financial distress)

The trade-off theory can be summarized graphically. The starting point is the value of the all-
equity financed firm illustrated by the black horizontal line in Figure 10. The present value of tax
shields is then added to form the red line. Note that PV(tax shield) initially increases as the firm
borrows more, until additional borrowing increases the probability of financial distress rapidly. In
addition, the firm cannot be sure to benefit from the full tax shield if it borrows excessively as it takes
positive earnings to save corporate taxes. Cost of financial distress is assumed to increase with the
debt level.

The cost of financial distress is illustrated in the diagram as the difference between the red and
blue curve. Thus, the blue curve shows firm value as a function of the debt level. Moreover, as the
graph suggest an optimal debt policy exists which maximized firm value.
 Figure 10, Trade-off theory of capital structure

In summary, the trade-off theory states that capital structure is based on a trade-off between tax
savings and distress costs of debt. Firms with safe, tangible assets and plenty of taxable income to
shield should have high target debt ratios. The theory is capable of explaining why capital structures
differ between industries, whereas it cannot explain why profitable companies within the industry
have lower debt ratios (trade-off theory predicts the opposite as profitable firms have a larger scope
for tax shields and therefore subsequently should have higher debt levels).