Financial Management

Subject: Financial Management
Chapter: One
Introduction
Financial Management is an integral part of Business Management. Finance is one of the key functions in an organisation. The
other key functions in an organisation are:
Production
Human Resources
Marketing
Each of the above function has got sub-divisions – for example Production has maintenance, Administration has purchases etc.
Finance deals with financial resources. Financial management as a corollary would deal with management of financial resources
and related areas.
Some of the key finance functions are:

Financial planning and estimation of finance required for the organisation
Mobilisation of financial resources required as above
Ensuring that the funds are available in adequate quantity at appropriate time and at an affordable cost
Management of cash in the organisation through cash flow statement
Management of investment outside the business enterprise in other organisations
Management of risk in dealing with foreign exchange for imports and exports
Note: The above list is not exhaustive.
Let us examine briefly the above functions with some examples.

Financial planning and estimation of finance required for the organisation
Any activity in a business enterprise requires planning for proper execution in time. Finance is required for any activity at least in
the beginning and hence financial planning is the prime function of “Finance”. This involves detailed study of any activity from
understanding the total funds requirement for that activity, when the funds will be required and how much funds will be required
at different stages. For a new enterprise the entire resources have to come from outside (externally); for an existing enterprise, a
part of the resources at least will be available from the profits made in the past and retained in business after declaring dividend.
Example No. 1:
We require Rs. 200 lacs for an activity. Let us see how it affects an existing enterprise. Let us assume the profits available to be
Rs. 60 lacs. Then we require further resources of Rs. 140 lacs only. This is the difference between an existing enterprise and a
new one. Financial planning will take this into account.
Mobilisation of financial resources

Having ascertained in the above example that we require Rs. 200 lacs for a set activity, for a new enterprise we require the entire
amount to be mobilised. For an existing enterprise with available profits of Rs. 60 lacs, we require only Rs. 140 lacs. The
Financial manager will then assess all the alternative resources available to him (for details please refer to Chapter no. 4) keeping
in mind the following parameters:
Adequacy (availability in adequate quantity)
Timely (availability in time) and
At an affordable cost
Adequate supply in time etc.
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Chapter: One
This has been explained this in the above point. For reinforcement the student’s attention is drawn to one of the objectives of
financial management at least in the short run, the objective of maximising profits of the organisation. The profits so maximised
in turn enhance the Earning Per Share (EPS – for formula please refer to Chapter no. 9).
Management of cash in the organisation

This involves the following steps:
Ascertaining the average cash requirement by looking at the past figures and for a new enterprise, estimating this
figure.
Preparing the cash flow statement for a given period, taking all the cash inflows and cash outflows during the period to
determine whether there is a surplus or deficit at the end of the period
Arranging for funds from outside especially through a bank with whom the enterprise has loan facilities in case of
deficit in the cash flow statement; if on the contrary, the cash flow statement reveals a surplus, dealing with this surplus
in a suitable manner (For further details, please refer to chapter no. 7 on “working capital management”)
Management of investment outside the organisation
Over a period of time the enterprise reinvests a part of the profits for future growth of the organisation in business. The Finance
manager can invest such funds outside the business in other enterprises also provided the parent enterprise does not require them
immediately. Short-term surplus as revealed by the Cash flow statement is also invested for short duration. Thus investment
outside one’s own business becomes the responsibility of the Finance Manager
Management of risk in foreign exchange etc.

A business enterprise may require imports and do exports also. Whenever this is done the invoice is in foreign currency. In
imports the business enterprise requires foreign exchange while in exports it gets foreign exchange. There is a risk involved while
doing imports or exports. The risk is that the exchange rate of the foreign currency in terms of Indian Rupees can keep changing.
We will explain this through an example.
Example no. 2
We have a US Dollar bill for 1000 receivable after a month. Presently the exchange rate is 1 US Dollar = Rs.48.25. By the time
the money is received after a month, in case the rate is less than Rs. 48.25, we will lose money. On the contrary if the exchange
rate is more than Rs. 48.25 we will gain. Exactly opposite will be the effect in the case of imports. The importer will pay less if
the exchange rate decreases and more if the exchange rate increases. There are ways and means of minimising the risk of foreign
exchange. Finance manager is expected to take care of such risks.
Difference between finance function and accounts function

Finance and accounts functions may be integrated in an organisation. This means that one department handles both. In most of
the small and medium size units in India, the functions will be integrated. A business enterprise will require a full-fledged finance
department only when the functions listed above are predominant functions impacting business in a big way. If the finance
functions are not predominant functions, Accounts department looks after Finance also. Constant requirement of funds, surplus
for investment etc, could be some of the factors influencing the need for a full-fledged Finance department.
Accounts function
Core accounts have to take care of the following areas:
Maintaining accounts on a regular basis for all items of income, expenditure, assets and liabilities
Conforming to Generally Accepted Accounting Practices (GAAP – India), Accounting principles, Various Accounting
standards of the Institute of Chartered Accountants of India (ICAI), Requirements under the Companies’ Act like
following “Accrual system of accounting” (as opposed to cash system of accounting), Requirements under The Income
Tax Act while maintaining the Accounts of the limited company
Finalisation of accounts at the end of the accounting period (financial year) and preparation of final accounts in the
formats prescribed in the Companies’ Act – Schedule VI after claiming depreciation as per provisions of Companies’
Act – Schedule XIV

Chapter: One
Conforming to provisions relating to Advance Tax payment in four instalments – first instalment by 15/6, second
instalment by 15/9, third instalment by 15/12 and the last instalment by 15/3.
Conforming to provisions relating to statutory audit of accounts under the Companies’ Act
Preparation of revenue and capital budgets
Management Information System (MIS) relating to Accounts and Finance
Note: Further details on the above are not given here as they are outside the scope of textbook on “Financial Management”. As
the students can see, most of them are self-explanatory.
Short-term and long-term objectives of Financial Management

Short-term objective
The short-term objective of Financial Management is to procure financial resources at an affordable cost thereby increasing the
return to the shareholders in the form of Earnings Per Share (EPS). EPS comprises two elements namely Dividend per share
(DPS) and Retained Earnings per share (REPS or Reserves per share). This objective is often times referred to as “profit
maximisation”. This is known as the short-term objective as it is done on a continuous, year-to-year basis. One or more of the
following measures can achieve this:
Monitoring of costs on a continuous basis through budgets
Suitable cost reduction techniques wherever the costs are high
Minimisation of cost of borrowed capital from outside through financial discipline
Proper mix of equity and debt (known as financial leverage – for further details please refer to Chapter no. 5 –
Operating and financial leverages
Control over liquidity available in the organisation so as to minimise the cost of carrying too much cash1 etc.
Long-term objective
The long-term objective of financial management is to increase the wealth of the shareholders. The term “wealth” refers to
various business assets of the enterprise that are free of debt. This means that this wealth belongs to the equity shareholders. It is
often reflected in the “book value” of the share as reflected in the balance sheet.
The formula for book value is:
Equity share capital + Reserves and Surplus
Number of equity shares issued
This can be explained through an example.
Example no. 3
Equity share capital = Rs. 100 lacs (paid up capital)
Reserves and surplus = Rs. 200 lacs
Number of shares = 10 lacs with the Face Value being Rs.10/-
Then the book value of the share would be = Rs. 100 lacs + Rs. 200 lacs = Rs. 30/-.
10 lacs shares
This means that at the starting point the book value was Rs.10/- and this has gone up to Rs. 30/- due to the prudent policy of the
management of retaining profits within the organisation. Thus the short-term objective also is a contributory factor to realising
the long-term objective of wealth maximisation.
Some of the measures through which we achieve the long-term objective are:
1
Carrying too much liquidity involves cost. This cost is referred to as “opportunity cost”. It simply means that by
carrying too much liquidity, the business enterprise has foregone an opportunity of getting a return on such amount
that it will have got by employing the funds in business. On the contrary, carrying too little cash is also risky as the
enterprise may not be able to fulfil its obligations to creditors etc. in time.

Chapter: One
Strategic financial management decisions relating to expansion, take over of another business, financial re-restructuring
through financial re-engineering (example – swap a costly loan for a cheaper loan provided the credibility of the firm is
quite high), joint venture etc. Thus while profitability reflects the operating efficiency wealth maximisation reflects the
managerial/entrepreneurial efficiency.
To sum up, both short-term objective and long-term objective need to be put in place for sustained growth of a business
enterprise. To an extent at least, the long-term objective is dependent upon the short-term objective of profit maximisation.
Financial system in India

In order to understand financial management better, we need to understand the “Financial System” that exists in India. Any
country needs a system to regulate, supervise, monitor and control the players, intermediaries, the investors etc. who take part in
the financial markets in the system. Further an efficient system alone can ensure that the national objective on “Economy” of the
country is met by aligning the developments in the system with the national priorities. An example of the national priority
deciding the development in the financial markets is – “infrastructure development and need for longer duration financial
resources” and development of “deep discounted bonds” to meet this requirement. (For further details please refer to Chapter no.
4 – Financial sources)
Constituents of the Indian Financial System

The Government of India, Ministry of Finance, heads the Indian financial system. The ministry in turn is bifurcated into various
departments like the Department of Economic Affairs, the Department of Company Affairs etc.
The Indian financial system consists of:
The financial markets
The statutes governing the various segments of the financial markets
The statutory authorities responsible for regulating, supervising, monitoring and controlling the markets and its
components
The financial intermediaries
Special organisations
Agents operating in different segments of the financial markets and
Financial instruments/securities issued in the markets to raise resources
The financial markets

The financial markets consist of:
Money markets – maximum duration of 12 months
Capital markets – Minimum duration 12 months and maximum duration could be even 20-25 years
Foreign exchange markets
Insurance market
Banking and
Mutual funds
The money markets and capital markets in turn do have “Primary market” and “Secondary market”. Primary market means issue
of financial instruments by companies and others that want to raise financial resources from the market. Secondary market refers
to that market wherein the financial instruments issued in the Primary market change hands from one investor to another for
financial consideration.
Segments of money markets: Call money market exclusively for banks to be borrowers – inter-bank operations for a
very short period. One day to fourteen days. Fourteen day borrowing is in the notice
money market that is also a part of the Call Money Market. Only scheduled commercial
banks are permitted to be borrowers in this market. While some banks will be borrowers,

Chapter: One
some others will be lenders. There is no specific market place. Deals are done over the
phone.
Segments of money markets Commercial paper issued by companies and Public Sector Undertakings as part of
working capital requirement. This is a promissory note issued by companies requiring
short-term funds (say from 15 days to 180 days or six months). Maximum period is
twelve months. The six-month commercial paper can be extended for a further period of
six months, making a total of 12 months.
Commercial bills discounted by banks and Non-banking Financial Institutions. These are
short-term bills usually not exceeding 90-120 days covering commercial transactions in
the private sector.
Treasury bills issued by Government of India through the RBI for meeting
budgetary deficits. These are for fixed maturity periods of 91 days and 364 days.
The Reserve Bank of India controls the money markets in India. It is known as money market regulator.
Primary market
Primary market in the money market is wherein the Institutions requiring funds issue securities like treasury bills and get finance
and there is no specific market place excepting in the case of treasury bills. RBI conducts auction of treasury bills after due notice
in national dailies and hence this can be construed as the “market place”.
Secondary market
The secondary market is provided by Discount and Finance House of India Limited (DFHI) a subsidiary of RBI. It provides a
two-way quotation, one for purchasing money market instruments and another for selling money market instruments. For
example, a holder of Treasury bill of Government of India can sell it to DFHI and anyone wants to purchase treasury bills, he can
approach DFHI who can sell it to him. There is no secondary market for call money or notice money market.
Segments of capital markets: GOI bonds

Various state government bonds
Bonds issued by Public Sector undertakings like BHEL etc.
Bonds issued by private sector companies, banks and financial institutions
Debentures issued by private sector companies
Equity share capital issued by private sector companies
Preference share capital issued by private sector companies
In the case of public issues by private sector companies, banks, financial institutions and mutual funds, Securities Exchange
Board of India (SEBI) is the controlling authority. It is referred to as the capital market regulator. However SEBI does not control
Government bonds or securities issued by Public Sector Undertakings. GOI bonds and state government bonds are handled and
controlled by RBI. Public sector undertaking like Bharat Heavy Electricals Limited (BHEL) come directly under GOI – MOF.
Primary market
There is no specific market place for this. This again, like in the case of money market, facilitates issue of securities by those who
require funds in the medium to long-term. The public issue process is supervised and controlled by the lead merchant
banker/bankers in the case of all public issues. Primary market ends with the listing of securities on stock exchanges by the
Registrar to the Issue. Details of operators in the primary market have been given under “Agents operating in financial markets”.
Secondary market
The secondary market begins with the listing of securities on the stock exchanges by the Registrar to the issue. It has a market
place in the form of stock exchanges. Its operations are through share brokers who are registered with respective stock

Chapter: One
exchanges. The stock exchanges in turn are controlled and regulated by SEBI. Details of operators in the secondary market have
also been given under “Agents operating in the financial markets”.
Statutes governing the various segments of the financial markets and the statutory authorities
Statute means an Act passed either by the Parliament or State legislature.
Money market – No specific statute – controlled by RBI
Capital market – Securities Contracts Regulations Act and Rules as well as SEBI regulations for the various operators in the
Capital market – controlled by SEBI. Mutual Funds also come under the Regulations of SEBI.
Insurance – Insurance Regulatory and Development Act (IRDA) – controlled by the Insurance Regulatory and Development
Authority coming under GOI, Ministry of Finance
Banking – Banking Regulations Act controlled by RBI
Non-banking Financial Companies (NBFCs – example Kotak Mahindra Finance Company Limited) – Non-Banking Financial
Companies Act of RBI
Functioning of limited companies registered in India – The Companies’ Act – controlled by the Company Law Board 2 (CLB)
coming under GOI, Ministry of Finance. The principal officer is known as “The Registrar of Companies” (ROC).
Foreign Exchange market – Foreign Exchange Management Act and Exchange Control Regulations Act both coming under the
RBI
Some segments of the financial markets like the Indian companies accessing international markets come directly under the GOI,
Ministry of Finance
The financial intermediaries

A financial intermediary means an institution like a bank mobilising resources from saving units in the economy and deploying
these resources by giving loans to or by investment in users of these financial resources for creating economic wealth.
Banking companies
Financial Institutions (FIs)
Mutual Funds (MFs)
Non-banking Financial Companies (NBFCs)
Special organisations
These come under one of the financial market regulators or directly under GOI – Ministry of Finance
All-India Financial Institutions – GOI – MOF
Central Board of Direct Taxes – CBDT – GOI – MOF
Stock Exchanges – SEBI
National Bank for Agriculture and Rural Development (NABARD) – RBI
Institute of Chartered Accountants of India (ICAI) – GOI – MOF
Institute of Cost and Works Accountants of India (ICWA) – GOI – MOF
Institute of Company Secretaries of India (ICSI) – GOI – MOF
Institute of Chartered Financial Analysts of India (ICFAI) – GOI – MOF
Foreign Investment Promotion Board (FIPB) – GOI - MOF
2
Company Law Board is primarily responsible for conduct of the affairs of limited companies registered in India
under the Companies’ Act. The difference in roles of CLB and SEBI is that the latter is mainly concerned with issue
of securities in the capital market protecting the interests of various kinds of investors. SEBI is not controlling The
Companies’ Act while CLB is not controlling the SCRA. They play complementary roles.

Chapter: One
Agents operating in different segments of the financial markets

The agents operating in the capital market are more. Hence we examine them briefly here. In respect of other
segments of the financial markets from a study of the above it will be clear to the students as to who the operators
are in the respective segments.
Primary market: Merchant bankeri (the principal operator)
Share brokers who underwriteii besides marketing the issue
Bankers to the issue who collect the share application money along with the share application
forms
Advertisement companies and publicity companies
Printers for printing the stationery required for the issue
Registrars to the Issue who take the responsibility of issuing the securities to successful investors
(in case the issue collects more money than the issue size), refund excess money together with
interest and getting the securities listed on a Stock Exchange
Secondary market: Stock Exchanges – controlled and regulated by SEBI

Share brokers – controlled by respective stock exchanges
iii
Depositories – National level special organisations coming under the national stock
exchanges and assume responsibility for collating details of ownership of shares issued
by a limited company.
Depository participants – Retail level operators who maintain Electronic Share Accounts
of various owners of securities
Chapter No. 10 – Dividend policy

Need for dividend policy – balance between dividend payment and retention for growth
As the students know by now “dividend” is paid on share capital. Share capital of both the kinds – equity share capital and
preference share capital. However there is a difference in respect to dividend between the two. In chapter no. 4 on “Financial
resources”, we have seen this difference. In case of preference shares, the dividend rate is fixed whereas on equity share capital,
the dividend rate is not fixed; it can vary depending upon profits for the year and available cash for disbursement of dividend.
Hence “dividend policy” omits preference share capital and our discussions will only be concerned with equity share capital.
Can a company distribute its entire profits as dividend? Even if the board of directors wants it that way it is not possible as per
provisions of The Companies’ Act. It clearly states that depending upon the percentage of dividend on equity share capital, a
certain percentage of profits after tax (PAT) needs to be transferred to General Reserves. Hence 100% of PAT cannot be given
away as dividend. Further the company needs funds for future growth. Where is it going to get it from in case it distributes more
dividends? It can raise fresh equity from its existing shareholders as well as the market. However there is “public issue” cost to
be taken care of.
The students will further recall that we need to plough back profits during the year into business to take care of the following:
♦ Repayment of medium and long-term obligations
♦ Contribution towards increase in current assets – a portion of it in the form of Net Working Capital (please see the chapter
on “financial statements analysis” under “funds flow” statement
Thus there are three distinct reasons as to why a business enterprise needs to have a balance between dividends paid out to the
shareholders and amount retained in business in the form of reserves.

Chapter: One
In this context the students may refer to the chapter on “capital structure” in which the difference between the resources of a new
unit and an existing unit has been shown. “Retained earnings” are readymade resource available to a business enterprise.
Measures of Dividend Policy

Dividend Payout measures the percentage of earnings that the company pays in dividends
=Dividends/Earnings
Example no. 1
Suppose the PAT of a limited company is Rs. 100 lacs. If it pays Rs. 50 lacs as dividend, the DPO ratio is 50%.
The higher the DPO ratio, the less the retention ratio and vice-versa
Dividend yield measures the return that an investor can make from dividends alone. It is related to the market price for the share.
= Dividends / Stock Price
Example no. 2
The market price of a stock is Rs. 4000/- and the dividend is Rs. 50/-. Then the dividend yield is 1.25%, which is very poor in
Indian conditions. Thus while dividend rate for the above stock assuming Rs. 100/- as the face value would be 50%, the dividend
yield is just Rs. 1.25%
Different kinds of dividend policies – factors influencing dividend policy

The dividend policy of a limited company is closely linked to its profitability and need for cash for financing future growth. Thus
there are definite factors influencing dividend policy in a limited company besides the attitude of the management – a
management may be conservative, declaring less dividends and transferring more to reserves while aggressive management will
declare more dividends and transfer less to “Reserves and surplus”. Let us examine some of the critical factors influencing
“dividend policy” in a limited company.
1. Profitability of operations – If the operations are very profitable there is a strong possibility that the dividend rate is high.
2. If the company is in the growth phase, the % of dividend will be less – any enterprise in its initial stages of business
immediately after commencement of commercial operations. Just to recap – any business has three distinct phases in its
business, the growth phase, the plateau phase when the % growth is “nil” and the decline phase when the growth is negative.
Progressive business houses plan for diversification or any other strategic initiative that will again take it to the growth
phase from the plateau phase, although in a different product line.
3. The effective tax rate of the enterprise. Effective tax rate is different from income-tax rate. Income tax rate is 35% + 10%
surcharge thereon, making a total of 38.5%. The amount of actual tax paid by the enterprise depends upon the degree of tax
planning – in short how much the profit subject to tax is different from the profits shown in the books. “Depreciation” is one
of the most important tools in tax planning. The amount of income-tax depreciation will usually be higher than the
depreciation in the books (as per The Companies’ Act) so much so the book profit (as shown in the audited annual
statements of the company) is higher than the income-tax profit. Companies that pay high tax rate (whose effective tax rate
is high), pay up higher dividend than companies whose effective tax rate is low.
4. The expectations of the investors in the market – this is one of the strongest factors influencing dividend policy. Investors
are of different kinds. Better known kinds are – those who prefer dividend, those who prefer capital gains, i.e., market
appreciation, difference between purchase price and present market price and those who indulge in stocks purely for reasons
of speculation. Hence companies do have the compulsion to satisfy the needs of at least a section of investors who look
forward to dividends. In fact dividends declared by competitors in the same industry would be a strong factor in the
expectations of investors in a company.
5. Cost of borrowing – if the cost of borrowing is less and liquidity in the market is easy, within the debt to equity norms
imposed by the lenders, limited companies will like to retain less and give more dividends. Example – Present debt to equity
ratio – 1.5:1. This can go up to 2:1. The cost of borrowing is low. Under the circumstances, a limited company will prefer to
retain less earnings and give away more dividends.
6. Cost of public issues – if the capital market is active and the cost of raising public issue is not high, limited companies may
risk paying high dividends and as and when need arises in future issue further stocks. This has to be weighed with the need

Chapter: One
of the management to retain its control of the company. If this need is high, it may not issue further stocks, which will dilute
its control.
7. The restrictions imposed by lenders, bond trustees, debenture trustees and others on % of dividends declared by a limited
company. As a part of loan agreement, debenture trustee agreement or bond trustee agreement, there is a clause that restricts
the companies from declaring dividends beyond a specified rate without their written consent.
8. The compulsion to declare dividend to foreign joint venture partners and institutional investors – when you have strategic
partners in business including foreign investors, you may be required to declare minimum % of dividend. This is true of
institutional investors in India too, who have contributed to the company’s equity. This is more relevant in the case of
management of limited companies who left to themselves, will not declare any dividends.
9. Effects of dividend policy on the market value of the firm – in case in the perception of the management, the market value is
largely dependent upon the rate of dividend, the management will try to increase the rate of dividend.
Note: It will be apparent to the students that the dividend policy decisions based on above factors can at best
be exercises in informed judgement but not decisions that can be quantified precisely. In spite of this, the
above factors do contribute to make rational dividend decisions by Finance Managers.
From the factors influencing dividend policy flow the different kinds of dividend policies as under:
1. Stable dividend policy irrespective of profitability – increasing or decreasing. This means that over the years the company
declares the same % of dividend on the equity share capital. The rates3 will neither be too high nor too low – they will be
moderate.
2. Stable Dividend payout ratios – Dividend payout ratio is the ratio of dividend payable by a limited company to its Profit
After Tax. This could be more or less the same over a period, irrespective of whether the profits are going up or coming
down. The assumption here is that there are no drastic changes in the profitability of the organisation, especially when it is
on the decrease. It can be visualised by the students that any drastic reduction in profits will result in changes in the DPO.
3. Dividend being stepped up periodically – this is possible in the growth phase of the company. The company can come up
with the financial forecast say for the next 10 years and decide to increase the rate of dividend every 5 years or three years or
so. This may not be true of companies that have been in existence for a long period of time.
Most observers believe that dividend stability if a desirable attribute as seen by investors in the secondary market before they
decide to invest in a stock. If this were to be true, it means that investors prefer more predictable dividends to stocks that pay the
same average amount of dividends but in an erratic fashion. This means that the cost of equity 4 will be minimised and stock price
maximised if a firm stabilises its dividends as much as possible.
Indian companies declaring dividend – need for cash retention for growth and effective tax rate influencing
dividend policy
The following is based on an empirical study made by Mr. Ajay Shah of Indira Gandhi Institute for Development Research in the
year 1996. The researcher had studied 1725 companies out of the listed companies in Mumbai Stock Exchange. These firms met
the following three criteria:
(a) Had net profits in 1994-95 of more than 1% of sales;
(b) Are in manufacturing and not in finance or trading and
(c) Are a part of the databases of CMIE5
The 1725 firms were broken up into two groups, high-tax firms where the average tax rate in 1994-95 was above 10%and the
remaining low-tax firms
The findings in these two groups are compiled in the table below.
3
The rate of dividend is always expressed as a percentage of the face value.
4
Cost of equity, ke = (D1/P0) + g. Refer to chapter on “capital structure and cost of capital”. If “g” in dividend rate
is minimal, the cost of equity automatically comes down and this pushes up P 0. This means that the market value
increases with stable dividend policy.
5
CMIE = Centre for Monitoring Indian Economy., Mumbai. This Institute brings out statistics for the Indian markets,
private sector, public sector etc. periodically.

Chapter: One
1993-94 1994-95
Low-tax High-tax Low-tax High-tax
Growth in GFA (%) 18.75 16.66 28.90 20.77
Uses of funds (%)
GFA 65.08 39.03 66.49 44.08
Inventories 3.84 13.68 8.62 14.54
Receivables 17.42 21.54 14.54 22.59
Investments 8.78 13.08 7.20 16.29
Cash 4.88 12.66 3.16 2.49
Dividend payout (%) 18.61 25.65 18.77 22.17
Number of companies 1043 682 1043 682
GFA = Gross Fixed Assets
Summary of observations:
♦ Low-tax companies have had faster growth of GFA
♦ They allocated a much larger fraction of their incremental resources into asset formation; around 65% of the incremental
resources were directed to GFA addition as compared with around 42% in the case of high-tax companies
♦ Low-tax companies pay out a smaller fraction of earnings as dividends, as compared with high-tax companies
♦ Finally, low-tax companies invested a much smaller fraction of their incremental resources into financial markets.
♦ This evidence is consistent with the view that the low-tax phenomenon is primarily driven by the depreciation which is
allowed to be written off in the income-tax at a rate that is higher than the rate in the books.
Theories on dividend policy

Some facts about dividend policy:
♦ Dividends are sticky – you just cannot afford not to issue them by ignoring the preferences of investors
♦ Dividends follow earnings – a natural conclusion based on evidence produced in the above table.
There are three different theories:
Theory no. 1 - Dividend irrelevance theory – Miller and Modigliani

Preposition - Dividends do not affect the value of a limited company
Basis:
If a firm’s investment policy (and hence its cash flows) doesn’t change, the value of the firm cannot change with dividend policy.
If we ignore personal taxes, investors have to be indifferent to receiving either dividends or capital gains on selling their shares in
the market at a value higher than the purchase price.
Underlying assumptions
♦ There are not tax differences between dividends and capital gains for shares
♦ If a company pays too much in cash, they can issue new stock with no floatation costs or signalling consequences to replace
this cash

Chapter: One
♦ If companies pay too little in dividends, they do not use the excess cash for bad projects or acquisitions but use them only
for their existing business
♦ Investors are rational and dissemination of information is effective
Examination with reference to India
1. Prior to 01-04-2002, there was no tax on dividend in the hands of the shareholders. With effect from 01-04-2002, tax on
dividend in the hands of the investors has resumed. Further the capital gains tax on indexed stocks is 10% as against
personal tax that would vary from one slab of income to another. Even then it would be prudent to assume that on an
average the tax rate would not be less than 20% and hence capital gains tax is less than income-tax
2. No transaction costs – impossible to raise resources without any transaction costs in India especially if the firm were coming
out with “Initial Public Offer”. This is true of developed markets in the West too.
3. Although investors are getting to be rational in India and that dissemination of information is improving, there is still much
scope for improvement.
Theory no. 2 – Walter’s Theory – Long-term capital gains preferred to dividend, as tax on dividend is higher
than long-term capital gains
Preposition – Long-term capital gains are less than tax on dividends. This is true of India at present.
Basis:
The higher the rate of dividend, the less the amount available for retention and growth and vice-versa. Hence the less the value of
the firm. The premises for this position is that the market value of the firm is not due to dividends paid but funds retained in
business. As such this is logical as growth of the firm occurs due to the funds retained.
Underlying assumptions:
Dividend rate does not influence the market value. Profit retention rate influences the market. The short-term tax on dividends is
higher than the long-term capital gains on the shares.
Examination with reference to India:
Please refer to the explanation under “dividend irrelevance” theory of Miller and Modigliani
Relevant issue out of this theory is “growth rate”

Growth rate = (1 – DPO) x Return on equity
Mathematically speaking:
Price for a given share = D + r (E - D)/ ke
ke ke
Where,
P = Market price per share,
D = Dividend per share
E = Earnings per share and
r = Return on equity
Example no. 3
A listed company’s return on equity is 18% and its dividend payout is 50%. The growth rate = (1 - 0.5) x 0.18 = 0.09 x 100 = 9%.
This is the growth rate that is expected in dividend amount paid out to the shareholders. In India, at present the long-term capital
gains tax is 10% and hence the investors would prefer market appreciation to dividends.

Chapter: One
To sum up Walter’s theory on dividend, as dividends have a tax disadvantage, they are bad and increasing dividends will reduce
the value of the firm. As a corollary, it is only the retained earnings that give growth to an organisation and contribute to the
increase in value of the firm.
Theory no. 3 – Gordon’s model – “ a bird in the hand” theory

Preposition
If stockholders like dividends or dividends operate as a signal of future prospects, dividends are good and increasing dividends
will increase the value of the firm.
Basis:
If a limited company has continuous good showing, it will be reflected in the growth of dividends over a period of time. This in
turn will turn the sentiments of investors in favour of the firm. More and more demand for the shares of the company in the
secondary market will be made. This will increase the market value of the firm. Thus the market value of the firm is dependent
upon the dividends declared. Further it is also called “ a bird in the hand” theory as dividend is more certain than the unknown
appreciation in market price in the future.
Underlying assumptions:
Tax on dividend will be the same as long-term capital gains tax. Investors have high preference for dividends and they are the
prime reason for investment.
Examination with reference to India:
Tax on dividend is more than long-term capital gains. “Dividends” are not the only motivation for investors although it does
occupy an important place in the preference of investors. Poor and old investors still prefer dividends.
Mathematically expressing:
As per Gordon’s theory, the cost of equity, ke = (D1/P0) + g. In this equation, D1 = dividend at T1, P0 = market value of the share
at T0 and g = growth rate in decimals. We can have variations of this equation and find out any of the four parameters, given the
other parameters. The variations are:
To determine growth rate, g = ke – (D1/P0),
To determine P0 = D1/(ke – g) and
To determine D1 = P0 x (ke – g)
Example no. 4
A firm has dividend of Rs. 25/- and growth rate of the company is 5%. If the cost of equity is 18%, what is the price at which the
stock would have been purchased?
Applying the formula, P0 = D1/(ke – g), we get 25/0.136 (in decimals) = Rs. 192.31
The balanced viewpoint

If a company has excess cash and few good projects (NPV > 0), returning money to stockholders (by way of dividends or buy
backs) is GOOD
If a company does not have excess cash and/or has several good projects (NPV>0), returning money to stockholders (by way of
dividends or buy backs) is BAD
6
This is crucial in this kind of numerical exercise. The student will be tempted to write 13 in the denominator and
this would give an absurd answer of Rs.2/- nearly. The growth rate, cost of equity and return on equity have to be
expressed in decimals always.

Chapter: One
Following is the sum and substance of the survey conducted in the US market to find out the management beliefs about dividend
policy.
Statement of Management Beliefs Agree No Opinion Disagree

1. A firm's dividend payout ratio affects the price of the stock 61% 33% 6%
2. Dividend payments provide a signalling device of future
prospects 52% 41% 7%
3.The market uses dividend announcements as information for

assessing firm value. 43% 51% 6%
4.Investors have different perceptions of the relative riskiness

of dividends and retained earnings. 56% 42% 2%
5.Investors are basically indifferent with regard to returns from

dividends and capital gains. 6% 30% 64%
6. A stockholder is attracted to firms that have dividend

policies appropriate to the stockholders' tax environment. 44% 49% 7%
7. Management should be responsive to shareholders'

preferences regarding dividends. 41% 49% 10%
Determining growth rate based on return on equity

The students will appreciate that growth in a business enterprise takes place due to exploitation of commercial opportunities that
are available. For this, the enterprise needs funds and a part of the funds will have to come from internal generation. Another part
will come from external debts. Thus funds retained in business in the form of reserves do create a positive impact on the business
and contribute to its growth. The term “growth rate” needs explanation as more than one growth rate can be determined for a
business enterprise. Hence the following lines are given.
♦ Growth rate in market value of the share – this is impossible to predict and hence no use attempting this. However it is
generally held that the increase in market value of the share closely follows the increase in book value; increase in book
value7 is a factor of funds retained in business
♦ Growth rate in book value of the share – this is due to funds retained in business. Hence the formula = Return on Equity
x (1-DPO) as already explained in the preceding paragraphs under Walter’s theory
Equity valuation based on dividend declared and growth rate

Please refer to Gordon’s model discussed above. Equity valuation based on this model assumes that the growth rate is constant.
The formula P0 = D1/(ke – g) is derived based on this assumption.
Certain issues relating to dividend at present in India

Suppose a firm has excess cash and profitability of operations is quite satisfactory. What are the options before it? In Indian
conditions, families own most of the business houses and the temptation is very strong to declare high percentage of dividends.
This is true especially of the recent past when recessionary conditions were experienced in most of the conventional industries. Is
there an alternative under the conditions? Yes, of course:
You are not certain as to when the recessionary conditions would end and market conditions would be conducive for growth.
With comfortable position of cash, “buy back” of equity shares is a very good option. The advantages are:
7
Book value of equity share = {Net worth (-) Preference share capital}/number of equity shares. This truly reflects
the increase in value of equity share due to profits retained in business.

Chapter: One
♦ You have less number of equity shares on which to declare dividend in future. This saves a lot of cash every year.
♦ You have less number of shares and hence “Earnings Per Share” goes up. This in turn would improve market value. Market
value = EPS x P/E ratio
♦ Less number of shares in the market available for purchase. Hence chances of increasing the demand for a company’s
stocks, thereby increasing its price
The option of “buy back” is especially good under certain conditions. Some of the conditions are:
♦ The number of shares issued by a limited company is very large and demand is perceptibly less. This is affecting the market
value of the share
♦ Opportunities for growth are limited or negligible and hence investment in fixed assets is not much
♦ Market conditions are uncertain or recession is on and time for revival cannot be estimated
♦ Right now cash is available and profitability could be under pressure in foreseeable future
Indian companies have started preferring “buy back” to “bonus issue” of shares as the latter is only going to increase the number
of shares for servicing by way of dividend. This will only add to the pressure on profits. In quite a few developed markets,
limited companies have “buy back” programmes in preference to “dividend” even. This has not started happening in a big way in
India. In fact some of the excellently performing companies abroad do not give dividend – example, Microsoft. It has never
declared dividend in its corporate history.
Chapter No. 2 - Time Value of Money
Concept of “Inflation” – Wholesale Price Index and Consumer Price Index

Inflation means to increase. In this context, it means increase in prices of commodities. The price increase is due to the difference
between “supply” and “demand” for a given commodity. If the supply is more than demand, prices decline and if the demand is
more, prices increase. In a developing country like India, the demand for most of the commodities will always be more than the
supply. Hence “inflation” will always be experienced in developing markets.
The increase is constantly measured in all the countries. The items included for determining the prices would be different from
country to country. For example, in India, essential commodities like sugar, kerosene, a loaf of bread etc. are included in the
basket of commodities considered for calculation of “inflation”. Different from this, in a developed country, items that are luxury
items in a developing country would also be included. For example, automobile could be included. The increase is expressed in
% terms. For example if the rate of inflation is 5%, this means that over a period of one year, the prices have increased by 5%.
The details of inflation are published regularly in all leading dailies in the country.
Wholesale price and not the retail price

The prices of the selected commodities for determining the rate of inflation over a period of one year could be on the wholesale
or retail. The latter one is mostly referred to as “consumer price”. Thus we have a “wholesale price index” and “consumer price
index” for expressing rates of inflation. Conventionally in India the rate of inflation has always been expressed in “wholesale
price index” basis rather than “consumer price index” basis although the consumer price index increase is also published
regularly. At present the wholesale price index inflation is around 3%. We will explain this concept through an example.
Example no. 1
I had spent Rs. 100/- in getting a basket of commodities one year ago. If the rate of inflation is say 3%, now I will be required to
spend Rs. 103/- to get the same basket of commodities. How do we get Rs.103/-? Rs. 100/- x 1.03 = Rs. 103/-. This means that
due to “inflation”, the purchasing power of the local currency decreases with the passage of time. This is exactly the concept of
“time value of money”. In simple words, “time value of money” means that with the passage of time, money loses its value.

Chapter: One
Is there a situation in which the prices decrease over a period of time and opposite of “inflation” takes place?
Usually in a developing country, such a situation does not arise, as the demand is always greater than supply. However currently
Japan is experiencing “deflation” in which current prices would be less than the past prices. This is harmful to a developing
economy, as units that save money would get very low interest or no interest. Hence there will be no incentive for the units to
invest money in bonds, fixed deposits etc.
Concept of Interest as compensation for loss of purchasing power due to “inflation”:

You keep money in a deposit with a bank. It could be a Savings Bank or a Fixed Deposit. What does the bank pay to you?
“Interest”. This is the “return” on your investment. Why should the bank pay interest to you? Let us enumerate the possible
reasons for the bank’s action.
♦ The bank does the business of lending. For this, it requires funds through deposits. It earns interest on loans and pays
interest on deposits;
♦ With the passage of time, the purchasing power of money reduces. The same thing will happen to your deposit with the
bank. The bank gives compensation to you for this loss in value of money;
♦ In case the bank does not pay interest, it will not get funds for lending. You will not keep deposits with it. You will
choose other willing banks or avenues of investment.
While all of them are correct, we are more interested in the second reason. Value of money erodes due to “inflation” as we have
seen in the earlier paragraph. The rates of inflation would be different for different countries. Further, it could be different for the
same country at different times. Sometimes it could be high while at some other times, it could be low.
Note:8
Would interest be less in case the rate of inflation comes down?
Absolutely. As an example, we have already seen what is happening in Japan. The Japanese banks are practically not paying
interest on deposits right now. The rate of inflation in the US is around 2% p.a. and accordingly the rate of interest on investment
would be around 3% to 3.5% p.a. Thus the rate of inflation in a country and the rate of interest on investment are closely linked to
each other. For further details, please look at the “Tier structure” of rates of interest given below.
Consider Indian market conditions. Hypothetically if the inflation comes down to say 1%, the rat e of interest on bank deposits
and bank loans in turn would also come down. The banks would not pay the current rate of interest. If the students may recall in
India, the rates of interest on savings are constantly coming down. This is the result of the rate of inflation coming down
constantly at least till the last year.
Four tier structure for rates of interest in any economy

The starting point for any interest is the rate of inflation in the economy. Like for example, in India at present, it is around 3%
now. We have seen earlier that interest is the compensation for loss of purchasing power of Indian Rupee. This loss is due to the
phenomenon of “inflation”. We have also learnt that the banks would normally offer a rate of interest higher than the rate of
inflation. Based on this, let us construct a 4-tier system of interest rates. This would build up stage-wise rates of interest till
investment in a project.
Tier 1 – Rate of inflation, say 3%
Tier 2 – Rate of interest on investment say in bank deposit
Rate of inflation + some compensation from the acceptor of deposits, say banks. = 3% + 4% = 7%, that is the lowest interest
offered by a public sector bank now on fixed deposits. The exact premium paid to the depositor depends on the following:
♦ The duration of the deposit – the longer the duration, the higher the premium and vice-versa. That is why the longer
duration deposits would attract higher rates of interest and shorter duration deposits would have a lower rate of interest.
♦ The need for deposits by the banking company for a specific period. The bank would offer a higher rate for that period.
Suppose a bank wants more deposits for six months rather than one year. It will attract deposits for six months by
offering higher rate of interest than the market.
8
“Rate of inflation coming down” - What does it mean? Does it mean that the prices of commodities are coming
down or the increase in prices of commodities is coming down? – Answer is: The increase in prices of commodities
is coming down; in actual terms, the prices of commodities are not reducing.

Chapter: One
Tier 3 – What does the bank do with the deposits that it accepts? It gives loans. The rate of interest on loans becomes the next
tier, Tier 3.
What are the factors that a bank would consider to determine its lending rate?
Average interest paid out on deposits and expenses
Minimum expected profit from lending operations
Degree of risk in lending – specific to a borrower, depending upon his business
Continuing discussion on Tier 3, we see that the minimum rate of interest on loans would be 7% + 3% + 1% = 11%. This is the
lowest interest that any bank offers now in India on loans. There is a specific name for this rate. It is referred to as “Prime
Lending Rate” or PLR. The bank would add further to this rate depending upon risk etc., which is called “risk premium” 9. This
would again be different from borrower to borrower.
Why discuss about a loan here?

Who takes loans in a big way from the banks? This does not refer to the housing or consumer loans taken by salaried persons.
Obviously, business enterprises. It is for investment in their business/projects. Hence the rate of return on a project would be the
last Tier, called “Tier 4”.
Can you determine this rate? Yes and no. Yes, as you will be able to determine a formula for this. No, because, it is not always
possible to evaluate risk associated with a project correctly.
The formula is:
Rate of interest on loans, say 11% + compensation for the additional risk taken by the project owner. For an outsider, it will not
be possible to put a figure on this. This will depend upon the risk associated with the specific project.
From whose point of view? - Both from the points of view of the owner and the lender/investor. This compensation is referred to
as “risk premium” of the project.
The question that could come to one’s mind while reading these lines is:
Why should a project owner expect a higher rate of return than the rate of interest on loans?
Consider the following and learn the risk associated with a project.
♦ The project owner’s investment does not have the backing of assets. A lender, on the contrary, has backing of assets for
his loan.
♦ The enterprise pays the lender interest periodically. The owners on the contrary, get return in the form of dividend. This
is not certain.
♦ Besides interest, the enterprise should also have sufficient surplus after paying interest to repay the loan amount
♦ Risk of project failure affects the owners more than the lenders for the same reason as mentioned in the first bullet
point
Example No. 2
Let us summarise the above as under:
Rate of inflation = Tier no. 1 = 3% p.a.
Rate of interest on investment = Tier no. 2 = 7% p.a.
Rate of interest on loans = Tier no. 3 = 11% p.a.
9
This is the reason that for different activities, the same bank charges different rates of interest at the
same time. Similarly for different borrowers pursuing the same activity, the rates of interest would be
different as per perception of risk associated with them.

Chapter: One
Rate of return from investment in projects = Tier no. 4 = 15% p.a. (This is just an example. The rate of return expected from a
project would actually depend upon the degree of risk associated with the project in the perception of the project owners
primarily and project lenders secondarily)
Future value of Re.1 - Process of compounding

Refer to Example no. 1. We found out that we would require Rs.103/- to purchase a basket of commodities that we could
purchase at Rs.100/- a year ago and the rate of inflation works out to 3% p.a. Can we give another name for the value after one
year? Yes. It is called the “future value”, while Rs.100/- is called the present value. The other name for the future value is
“compounded value” as this is obtained by a process called “compounding”.
Can we have a formula for this process of compounding?

n
Future value (F.V.) at T1 = PV at T0 x (1+r/100) , wherein T1 is the end of year 1 and T0 is the beginning of year 1.
n
(1 + r/100) is known as compounding factor.
Let us apply this formula to another investment example and determine the future value.
Example no. 3
You have a fixed deposit for Rs.10,000/- in a bank. Terms of deposit are:
Period – Two years
Rate of interest = 10% p.a.
The bank does not pay interest periodically. Interest gets accumulated to the principal amount; it gets paid at the end of the period
along with principal amount.
What is the future value of this investment?
The future value is Rs.12,100/-. In the compounding formula, by substituting 10% for “r” and 2 for “n”, we get this value. The
break-up of principal and interest amount for the period of investment, i.e., two years is as under:
Principal – Rs.10,000/-
Interest – Rs.2,100/-
Does the future value alter with the change in the frequency of compounding?
In the above example, we have assumed that the bank pays interest at the frequency of one year. Suppose the bank pays interest at
a higher frequency, would the future value turn out to be different? Let us see the following example.
Example no. 4
Suppose the bank increases the frequency of compounding from yearly to half-yearly. What will be the future value? We can use
the same formula with an amendment. The amended formula would be:
Future value = Present investment x (1 + r/200) n x 2

As interest gets compounded twice as frequently, r is divided by 200. Similarly the number of periods for compounding also gets
doubled and hence it is 2 x n instead of “n”. Accordingly, in our formula, what would be the values of “r” and “n”?
r = 5% and n = 4
With these values, the future value FV at T2 works out to 10,000 x (1.05) 4 = Rs.12,155/-.
Similarly we can see that in case the frequency of compounding increases to quarterly from half-yearly, the future value works
out to Rs. 12,184/-.

Chapter: One
Let us summarise what we have learnt so far on “compounding and future value”:
♦ The amount that you get back at the end is called “future value”
♦ Future value is determined by “compounding”
♦ Future value depends upon:
♦ Rate of interest and
♦ Frequency of compounding
♦ The multiplying factor is known as “compounding factor”
♦ The more the frequency, the higher the amount of interest
Doubling period
A frequent question posed by an investor is: “How much time it will take for my investment to double in value”? This question
can be answered by a rule known as “Rule of 72”. It is an approximate way of finding out the doubling period. Suppose the rate
of interest is 12%. The doubling period is 6 years.
A more accurate answer can be had by a better formula like:
0.35 + 69/interest rate in % terms. Employing the same rate of 12%, we find that the doubling period is 6.10 years instead of 6
years. This is more accurate than the Rule of 72 formula.
Present value of a future rupee – Process of discounting

So far we have seen “future value”. We are now going to see “present value” of a future sum. Suppose we want to have
Rs.10,000/- after say two years (T2). We want to know how much we should save now (T0). This situation is exactly the opposite
of the earlier future value situation. The investment at T0 should increase to the desired future value at a desired rate of interest.
The process of determining the present value from future value is known as “discounting”. “Discounting” is converse of
“compounding”.
Example no. 5
We want to get Rs.108/- at the end of T1. The desired rate of interest is 8% per annum. What is the amount that we should invest
at T0?
Can we use the “future value” formula here?
Yes – with necessary modification as under:
n
Future value = Present investment x (1 + r/100)
Future value at T1, Rs.108/- = PV at T0 (to be determined) x (1.08)
PV at T0 = Rs. 108/1.08 = Rs.100/-.
Thus the formula for present value is as under:

n
Present value = Future value = Future value x [1/(1 + r/100) ]
--------------------
n
(1 + r/100)

Chapter: One
The reciprocal of compounding factor is referred to as “discounting factor. We need to multiply the future value by this
n
discounting factor and not divide. In the above formula, 1/(1+r/100) is referred to as “discounting factor”.
Discounting factor = 1/compounding factor; discounting factor x compounding factor = 1. Discounting factor would
always be less than 1.
Example no. 6
We want to get Rs.10,000/- after two years. The desired rate of interest is 12% p.a. The frequency of is yearly.
What is the present value of this future sum of Rs.10,000/-?
Present value = Rs. 7,971/-
The two-step process in determining present value is:
Step 1 = determine the discounting factor = 1/[1 + 12/200]4 = 0.7924

Step 2 = multiply the future value by this factor to get the present value
Present value of Rs.10,000/- = Rs.7,924/-
We have already seen under “future value” that higher frequency of compounding increases the future value. Conversely, higher
frequency of discounting decreases the present value. The students are advised to take the following exercise and verify for
themselves.
Exercise No. 1
After three years we are likely to get a windfall of Rs.1,00,000/-. What will be the present value of this windfall, in case the
expected rate of return is 15% p.a.?
Answer – Rs.65,751/-
Let us summarise what you have learnt so far on “discounting and present value”:
♦ Discounting is the converse of compounding
♦ It is used when you want to determine the present value of a future sum
♦ Just as there is a compounding factor, there is a discounting factor
♦ In case you determine the discounting factor, you should multiply the future value by this factor to get the present value
♦ The more the frequency the of discounting, the less will be the value of present value
♦ Present value will always be less than future value by the same token of inflation.
Application of concepts of future value and present value in business

Where does one apply the future value and present value in business?
As discussed earlier, future value is helpful in determining the compounded return of an investment and hence is more useful in
the case of personal investment.
However, in the case of discounted value, the relevance is more to business. The following example illustrates this.
Example no. 6 - Application 1

We want to start an Industrial project at T0 with an investment of Rs.100 lacs.
We expect to get a return of 20% from the project.

Chapter: One
The estimated future earnings are:
T1 – Rs.30 lacs
T2 – Rs.35 lacs
T3 – Rs.40 lacs
T4 – Rs.45 lacs
We want to evaluate our investment decision in the project. How do we do this? By applying discounting factor for 20% to the
future earnings.
Present value of T1 = Value at T0 = Rs. 30lacs/1.20 = Rs.25 lacs
Present value of T2 = Value at T0 = Rs.35 lacs/(1.20)2 = Rs.24.30 lacs
Present value of T3 = Value at T0 = Rs.40 lacs/(1.20)3 = Rs.23.14 lacs
And Present value of T4 = Value atT0 = Rs.45 lacs/(1.20)4 = Rs.21.69 lacs
The “sum total” of all the T0 values = Rs.94.13 lacs = Present value of future earnings for a period of four years.
What does this mean? It means that at 20% expected return the project has given back only Rs.94.13 lacs. This is against Rs.100
lacs that have been invested in it. That is, the present value of future earnings is less than original investment. Hence we will not
invest in the project. The difference between the present value of future earnings and the investment at T 0 is called the “Net
present value” or NPV. This is one of the fundamental methods of selecting a project.
Here is how we can use it for selecting a project:

♦ Determine the amount we need to invest in a project.
♦ Estimate future earnings from the project on certain working assumptions.
♦ Discount the future earnings by a suitable rate of discount. This depends upon the market rate for borrowing and our
perception of risk in the project. This gives the present value of all future earnings.
♦ Compare this with the present value of investment. We invest in the project if the present value of the future earnings is
more than present value of investment.
♦ In the above example, suppose the present value is greater than Rs.100 lacs. Then we would select the project for
investment.
Exercise No. 2
We are investing in a project Rs. 1000 lacs. The rate of return that we expect from the project is 18% p.a. The estimated future
earnings for three years are:
T1 = Rs.450 lacs
T2 = Rs.500 lacs
T3 = Rs.550 lacs
The above are also referred to as cash flows 10(in this case cash inflows)
Examine as to whether it is worthwhile investing in the project. Find out the Net Present Value of the project.
10
Cash flow could either be cash inflow or cash outflow. When an investment is made at T0 it is called “cash out
flow”. Similarly when returns are received they are called “cash in flows. Cash out flow is denoted by mentioning
the figure within bracket like (50 lacs)

Chapter: One
Answer:
Present value of future earnings = Rs.1071 lacs
Net Present Value = Rs.71 lacs
We can invest in the project
Example No. 7 - Application 2

Suppose there is a bond that has been floated in the market with face value of Rs.1000/-. The interest per year is Rs.100/-. The
period is 5 years. The expected rate of return is 8% p.a. What is the price at which an investor will be willing to purchase the
bond from the market now?
Step 1 = to construct the future returns including the principal amount

Year from now Payment expected (cash inflow)
1 Rs.100/-
2 Rs.100/-
3 Rs.100/-
4 Rs.100/-
5 Rs.1100/-
Step 2 = discounting the payment expected by the rate of return, i.e., 8% p.a., we can determine the present value of the future
cash flows. It is Rs.1080.30. This means that an investor will be willing to purchase this bond now from the market provided the
market price of this bond is less than Rs.1080.30.
Exercise No. 3
We have a bond with the face value of Rs.5,000/-. The interest on the bond is Rs.600/- per year. We are supposed to get a
premium on the bond of Rs.250/- at the end of the maturity period. Expected rate of return by us = 10% p.a. Suppose the maturity
is after 5 years, what is the price at which an investor would be willing to purchase it from us?
(Note – please add the premium amount to the face value. You will get Rs.5,250/- on maturity)
Answer: Present value of future returns = Rs.5534/-. An investor will be willing to pay anything less than this value for
purchasing the bond from you.
Example no. 8 - Application 3

Evaluation of opening of a branch office by discounting the expected future returns at a suitable rate of discount and comparing
the present value with the investment required in capital assets to open a branch office.
As you will have realised by now, the investment in a branch office is very similar to investment in a project. You are investing
in a project to get returns from it. Similarly, you invest in a branch office based on expectation of additional returns.
As it is very similar to a project, separate example or exercise is not given here.
Example No. 9 - Application 4

Suppose we develop a product by spending say Rs.10 lacs. This amount will be recovered along with profit through sales of a
number of units over a period of time. Suppose we project sales in unit terms as well as value terms over a period of time. Let us
assume this period to be three years. Suppose the expected rate of return is 15% p.a. Further, assume projected sales for the next
three years to be as under:
No. of units expected to be sold Unit Rate Expected sales in lacs of Rupees

Chapter: One
2000 Rs.250/- Rs.5 lacs
2200 Rs.250/- Rs.5.5 lacs
2500 Rs.250/- Rs.6.25 lacs
This is similar to finding out the net present value in the case of projects. We discount the expected sales by the expected rate of
return of 15% p.a. This determines the present value of the expected sales. Let us compare this with the total product
development expenses.
Exercise No. 4
Find out the net present value in the above example. Also confirm that the total product development costs stand fully recovered
at T3.
Answer – The product development costs stand fully recovered at T3.
Let us summarise what we have learnt on application of “Time value of money” to business
♦ Compounding and discounting have a number of applications to Finance decisions.
♦ Compounding has greater application to personal investment while discounting has greater application to business.
♦ Discounting is useful in a number of decisions like project, product development, opening a branch office etc.
♦ Bond valuation is also done through discounting.
Let us look at one more example for reinforcing our learning. Let us select the best project out of the three
projects proposed.
Consider the following 3 alternative projects. Assumptions are also given below:
Investment at T0 for all the projects is Rs.500 lacs.
Future cash flows are considered for T1 to T5.

Although the scale of operations for all the projects is the same, the projects have different future earnings or returns.
The promoters expect a rate of return of 15% p.a. hence; this is the rate by which the future returns are discounted.
(Rupees in Lacs)
Project 1 Project 2 Project 3
Future Future Future

Year No. Disc. Value Disc. Value Disc. Value
Earnings Earnings Earnings

Chapter: One
1 100 86.96 150 130.44 175 152.18
2 120 90.73 150 113.42 150 113.42
3 200 131.5 150 98.63 180 118.35
4 250 142.95 200 114.36 225 128.66
5 250 124.3 200 99.44 250 124.3
Total 576.4 556.29 636.91
As Project 3 has the highest NPV it would be selected. NPV = PV of future earnings (-) original investment. Accordingly, the net
present values for the three projects would be:
Project 1 76.44 lacs
On the basis of net present value, project 3 would get selected.
Concept of annuity
So far we have seen the following in respect of application of time value of money:
Investment lump sum at T0 and get lump sum at Tn = Future value; process is “compounding”. This is called future value of a
single stream.
Suppose we are given a future value and want to know how much should be invested at present. We use the process that is
converse of compounding and this is called “discounting”. In order to get lump sum after a given period, we should invest the
present value at the beginning, again a lump sum. This is called the present value of a single stream.
Invest lump sum at T0 in a project and get annual returns. The returns will not be equal to each other. To determine the present
value of the future returns to determine Net Present Value = Present value; process is “discounting”. This is the example of
present value of multiple streams.
Annuity refers to “multiple stream” of cash flows but which are equal to each other and occurring annually. The cash flows
could either be in flows or out flows. This means that the following alternatives are available to us when we are talking of
“annuity”.
♦ We invest at the beginning one lump sum amount and get returns over a period of time that are equal to each
other. The cash in flows that are equal to each other are called “annuity”. Herein we use what is known as
Present Value Interest Factor Annuity (PVIFA). We multiply the Annuity by this factor and get the present
value of the future cash flows in one shot. Then we compare this present value with our proposed investment at T0
taking decision on investment. We invest provided the Present value of future annuities is at least equal to our
investment at T0.
♦ We invest in equal instalments over a period of time and get one lump sum at the end of the period. The cash
outflows that are equal to each other are called “annuity”. Herein we use what is known as Future Value
Interest Factor Annuity (FVIFA) .We multiply the Annuity by this factor and get the future value of the cash out
flows in one shot.
Let us study the following examples to understand the concept of “annuity”.

Chapter: One
Example no. 10
We are able to invest every year Rs.1000/- for a period of 5 years. We expect a return of 10% p.a. What will be the value of this
investment at the end of 5 years?
Let us represent this by way of a timeline
At T0 T1 T2 T3 T4 T5
Investment = zero 1,000/- 1,000/- 1,000/- 1,000/- 1,000/-
Can we use the future value formula, find out the future value of each stream of Rs.1000/- and add them up? Thus T 1 investment
would earn interest for 4 years, the 2nd year investment would earn interest for 3 years, the 3rd year investment would earn interest
for 2 years, the 4th year investment would earn interest for 1 year and the last year investment would not earn any interest. Instead
of doing such an elaborate exercise, we use the alternative “FVIFA”.
Practical applications of “Annuity”11 for future value
♦ Life Insurance policy premium
♦ Recurring deposit account with a bank
Example no. 11
Similar in concept to Example no. 10, we can think of investment lump sum at T0 and getting returns over a period of time, the
returns being equal in value. Example is investment in bank deposit floated by competitive banking industry at present. Each
return will be partly principal amount and partly interest amount. Our aim is to determine the present value of the future returns
by discounting them and comparing the present value with our investment value.
Can we use PVIF and find out the present value of future cash flows? Yes. The cash flow at T 1 is discounted for one year, the
cash flow at the end of the second year is discounted for two years, the cash flow at the end of the third year is discounted for
three years and so on and so forth. Instead of repeating the discounting process so many times, we have the easy alternative of
Present Value Interest Factor Annuity.
It is okay for discussion. However the students will be interested in knowing as to where he will get the PVIFA and FVIFA
values. These will be available as annexure with any standard textbook on “Financial Management” and multiply with the
annuity to arrive at the Present Value or Future value as the case may be.
Concept of perpetuity
This is the concept applicable in the case of pension. Pension is taken to be perpetual. Can we find out the lump sum amount in
case the pension amount is given?
Example no. 12
Suppose the pension amount is Rs. 1000/-. The expected rate of return is 10% p.a. What is the core amount out of which interest
is paid? The annual payment is Rs.12,000/-. Hence the lump sum amount is Annual payment/rate of interest expressed in
decimals.
Accordingly the lump sum amount is Rs. 12,000/0.1 = Rs. 1,20,000/-.
Chapter 3 – Risk and Return

Introduction – Risk and Return go together
11
Annuity could be at a frequency more than one year. In fact in the case of recurring deposit, the annuity is
monthly.

Chapter: One
One of the fundamentals in Finance is – “Risk and Return go together”. Recall what we learnt in Chapter 2 under “4 tier structure
for interest rates”. We saw that from tier 2 onwards the rate of interest starts progressively increasing. Why? This is because in
each successive tier, the risk is higher than the immediately preceding tier. For example, we saw that the loan given by a bank
carries more risk than the deposit kept with the bank. This is so as the bank is much more broad based with so many customers
than the borrower to whom the loan is given. We mean that the chances of failure of an individual business are more than the
chances of failure of a larger bank. Similarly the rate of return from a project is the highest at Tier no. 4, as entrepreneurial risk is
the highest risk in any economy – the risk of running a business enterprise. Please recall the factors considered by us while
concluding that the rate of return from a project should be the highest. We repeat here for facilitating recall.
♦ The project owner’s investment does not have the backing of assets. A lender, on the contrary, has backing of assets for
his loan.
♦ The enterprise pays the lender interest periodically. The owners on the contrary, get return in the form of dividend. This
is not certain.
♦ Besides interest, the enterprise should also have sufficient surplus after paying interest to repay the loan amount
♦ Risk of project failure affects the owners more than the lenders for the same reason as mentioned in the first bullet
point
Thus we prove the point mentioned at commencing this chapter namely “risk and return go together”. The question relevant here
is that “can we define risk?’ Let us make an attempt here. We make an investment in bank’s fixed deposit at 8% p.a. We have an
agreement with the bank that if the market rate comes down the rate of interest offered on the deposit would also come down. Is
there a risk here? Definitely, if the market rate comes down. What is this risk? The risk of not getting the expected return of 8%.
Thus the first definition of “risk” is the “uncertainty”. Uncertainty relating to what? In the given example, uncertainty relates to
“outcome” of an “activity”, i.e., investment. Is the “outcome” stated? Yes. Right in the beginning when we contracted with the
bank to get 8% return.
So, we build up the definition of “risk”. We can define risk in general as “uncertainty relating to a stated outcome of a specific
activity”. The activity could be anything and the outcome automatically gets related to this. For example, undergoing a post
graduation course in “Management” could be the activity and the risk could be relating to the stated outcome of landing oneself
in a well-paid job. In finance terms, the “risk” obviously relates to the activity of investment and the stated outcome relating to
this would be the “return” on this investment. Thus going back to our example of investment in a bank deposit, the activity is
“investment in a bank deposit”. The risk relates to the outcome of return on this investment namely interest not coming down
from the expected rate of 8%.
Is risk related only to possible reduction in rate of return? Or in other words, is there no risk in case the
return is higher than the expected rate of return?
Suppose the bank deposit referred to above fetches us higher return than expected rate of 8%. Is there no risk? There apparently
is no risk from the point of view of the depositor. However this is not the correct picture. The very fact that the return is higher
than the expected rate due to increase in market rate of interest could also bring the rate down in future any time. Thus
going by the accepted definition of “risk” relating to investment, it relates to uncertainty of the return from the investment and not
specifically to whether the deviation (fluctuation) is positive (return being higher than expected) or negative (return being less
than expected). In both the cases of deviation or fluctuation from the expected rate of return, risk exists. Let us examine the
following graph.
Return
On
investment
Expected rate of return Duration of investment

Chapter: One
The above graph shows returns deviating from the expected rate of return both positively and negatively. Does it mean that when
it deviates positively there is no risk for us? There is a risk of uncertainty that the returns could go down and be less than the
expected rate of return.
Conclusion:
The higher the uncertainty the higher the risk. The higher the risk the higher the return expectation. This is because the investors
are risk averse and would expect a higher return in case the risk increases. In terms of probability of return, the higher the
probability, the less the uncertainty and less the risk. Conversely the less the probability, the more the uncertainty and higher the
risk.
In this chapter, we are going to study the return on investment in stock markets, i.e., in shares and bonds and not any other
investment as these are subject to market risk and fluctuations. This enhances the risk associated with investment into equity
market and bond market. We will examine as to what kind of risk can be minimized and what cannot be minimized. We are also
going to see how the risk of an individual stock (share) can be minimized by including the same in a bunch of securities
(investment instruments) that is called “portfolio”.
Probability of distribution of outcome (return) for a given investment

Example no. 1
Suppose we invest Rs.1000/- in shares of a limited company. The different expected returns on this investment and the
probabilities assigned to them are as under:
14% = 35%
16% = 22%
13% = 43%
The weighted average rate of return expected from this investment is:
0.14 x 35 = 4.9
0.16 x 22 = 3.52
0.13 x 43 = 5.59
Wt. Av. = 14.01%. This is referred to as the expected rate of return from this investment.
What is return from share investment?

What is return from our share investment of Rs.1000/- in the above example? Is it dividend or something more than dividend?
Example no. 2
Date of purchase of the above share = Dec. 2001
Dividend for the year ended 31-03-2002 = 100/-
Date of sale = Dec. 2002
Market value = Rs. 1030/-
The total return on investment = Amount received on sale of investment – Amount invested at T0
----------------------------------------------------------------------------------------------------------------
Amount invested at T0
Thus the return on our investment for a period of one year = 130/1000 = 13% p.a12.
12
Return is always expressed on annual basis. For example if the return for holding a security is 13% for a period of
six months, the annualised return would be 26% = 2 x 13%

Chapter: One
Return on investment in shares = dividend + market appreciation during the period of holding the security (difference between
selling and purchase prices). Suppose the holding period is two years, the return is determined cumulatively for a period of 2
years and divided by 2 to arrive at annual return.
Standard deviation
Investment is about selection of one stock (share or bond) in preference over another, after due consideration of the risks
associated with them respectively. Let us say for example investment in shares of two limited companies A and B. In this case we
should understand the implication of probability distribution of expected returns for a given period for both the stocks. Let us
examine the probability distribution and understand the concept of risk. We are examining below the expected value of return and
standard deviation of return for a chosen stock.
Probability of 2
Possible return (Ri) (Ri) x (Pi) (Ri – R) x (Pi)
occurrence (Pi)
- 0.10 0.05 -0.005 2

(-0.10 – 0.09) x (0.05)
-0.02 0.10 -0.002 2

(-0.02 – 0.09) x (0.10)
0.04 0.20 0.008 2

(-0.04 – 0.09) x (0.20)
0.09 0.30 0.027 2

(-0.09 – 0.09) x (0.30)
0.14 0.20 0.028 2

(-0.14 – 0.09) x (0.20)
0.20 0.10 0.020 2

(-0.20 – 0.09) x (0.10)
0.28 0.05 0.014 2

(-0.28 – 0.09) x (0.05)
2
Total = 1.00 ∑ = .090 = R σ = 0.00703 and σ = 0.0838
th
Where Ri is the return for the i possibility, Pi is the probability of that return occurring and n is the total number of possibilities.
Thus the expected value of return is simply a weighted average of the possible returns, with the weights being the probabilities of
occurrences. For the above distribution of possible returns, the expected weighted average return is 9% and the standard deviation
of the return is 0.0838 or 8.38%. We can easily see that the higher the standard deviation the higher the risk; the higher the risk,
the higher the expected rate of return in future. Thus the standard deviation is a simple measure of risk based on the distribution
of returns in the past by assigning probabilities to them. The probabilities represent the % times the return has been so. In this
case the probability is 10% for 20% return, this means that 10% of the times, the return has been 20%.
Coefficient of Variation
The standard deviation can at times be misleading in comparing the risk, or uncertainty relating to the alternative returns, if they
differ in size. Consider two alternative investment opportunities, A and B, whose normal probability distributions of one-year
returns have the following characteristics:
____________________________________
Investment
A B
____________________________________
Expected Return R 0.08 0.24
Standard deviation σ 0.06 0.08

Chapter: One
Co-efficient of variation CV 0.75 0.33
We have mentioned earlier that higher the standard deviation, the higher the risk and vice-versa. Now looking at the above table,
can we say that since the standard deviation of stock B is more than that of stock A, the risk associated with it is higher? Yes and
No. Yes if the sizes of investment is the same in both the stocks. This is best explained by taking two persons having widely
different incomes with the same standard deviation. Let us assume that the average monthly income of the first person is
Rs.10,000/- while that of the second person is Rs. 1,00,000/-. Both of them are having standard deviation of say 3,000/-. We can
very easily see that while this standard deviation would affect the first person much more than it does the second person. This is
what establishes the need for determining the co-efficient of Variation. How does one do it?
To adjust for scale or size, the standard deviation can be divided by the expected value of return to compute the coefficient of
variation (CV). Co-efficient of variation (CV) = σ /R. This in the above table gives us the values of 0.75 = 0.06/0.08 for stock A
and 0.33 = 0.08/0.24 for stock B. Thus using the co-efficient of variation (CV) we find that the riskiness of stock A is more than
the riskiness of stock B while by standard deviation method, we would have found stock B to be more risky than stock A.
Risk and Return in a portfolio context

So far we have seen measure of risk associated with single investment or investment in one stock in preference to another.
However usually the investment is not in single stock but in a combination of stocks that is called a “portfolio”. A portfolio is
defined as “mixed bag of securities”. This is best understood by taking the example of “Mutual Funds”. The students would
have heard of “mutual funds” in India, like Franklin Templeton Mutual Funds, Allianz Mutual Funds, Unit Trust of India, Kotak
Mahindra Mutual Fund etc. These funds invest in:
Different industries (also called sectors)
Different time periods (also called maturities)
Different units in the same industry (example in the Cement sector, ACC and Birla Cements)
Different instruments of finance – debt instruments like bond and debentures or share capital instruments like equity share capital
or preference share capital or even short-term instruments called money market instruments13
The above is to spread the risk of investment but at the same time optimizing the return from the investment and not minimising
it. Therefore we need to understand the concept of “risk” and “return” in the context of a portfolio.
Portfolio Return
The expected return of a portfolio is simply the weighted average of the expected returns of the securities constituting that
portfolio. The weights are equal to the proportion of total funds invested in each security (the total of weights must equal to 100
percent). The general formula for the expected return of a portfolio Rp is as follows:
m
R p = ∑ Aj x R j
J=1
Where Aj is the proportion of total funds invested in security j; Rj is the expected return for the security j and m is the total
number of different securities in the portfolio. The expected return and standard deviation of the probability distribution of
possible returns for two securities are shown below:
Security A Security B
Expected return Rj 14.0% 11.5%
Standard deviation σ j 10.7 1.5

If equal amounts of money are invested in these two securities, the expected return of the portfolio containing two securities
namely A and B is 0.5 x 14% + 0.5 x 11.5% = 12.75%.
Portfolio Risk
13
For details of different markets and instruments, please refer to the chapter on “Financial Sources”

Chapter: One
The portfolio expected return is a straightforward weighted average of returns on the individual securities; the portfolio standard
deviation is not the weighted average of individual security standard deviations. We should not ignore the relationship or
correlation between the returns of two different securities in a portfolio. This correlation however has no impact on the portfolio’s
expected return. Let us understand what we mean by “correlation” between securities.
Suppose we have two stocks “A” and “B” in our portfolio. During a given period the return of “A” increases say by 1% while
that of “B” increases by 0.5% in the same period. This means that both are moving positively in the direction of increasing
returns. This is described as “positive” correlation. However the quantum of increase is not the same in both the cases. Hence this
is imperfect but positive correlation. In case the quantum of increase is 1% in both the cases, then the correlation is said to be
positive and perfect correlation.
If the returns move in the opposite direction, say one increasing and the other decreasing, then the correlation is negative. Still the
relationship could be perfect in the sense that the quantum of increase in return say in the case of “A” is the same in the case of
“B” but in the opposite direction. This means that while stock “A” has increased its return, stock “B” has lost its return by the
same percent. Let us try to put these in the form of equations.
“Δ” represents the increase in return and (“Δ”) (within brackets indicate that the return is decreasing). Keeping these in mind let
us attempt the following:
Δ of stock A = 1% for a given period = Δ of stock B = perfect and positive correlation
Δ of stock A = 1% for a given period; Δ of stock B = greater than or less than 1% but the return has increased and not decreased
= positive but imperfect correlation
Δ of stock A = 1% for a given period; (“Δ”) of stock B = 1%. Then stock A and stock B are said to have perfect but negative
correlation.
Δ of stock A = 1% for a given period; (“Δ”) of stock B less than or more than 1%. Then stock A and stock B are said to have
imperfect and negative correlation.
We have consciously omitted the fifth possibility of both the stocks A and B losing to the same percent during a given period.
Any portfolio would avoid such stocks unless the future is going to be completely different in which case the past is not the basis
on which stock selection is being made.
We have also tried to present these concepts in as simple a manner as possible. The students are advised to go through these
repeatedly to grasp the essence of the underlying concept in correlation between one stock and another. This is required because
the concept of correlation is the fundamental based on which the selection of stocks for a portfolio is done. The students will
appreciate that positive correlation between two stocks would mean increased risk especially if the relationship is perfect.
Negative correlation stocks are not desirable. What is then left is positive but imperfect correlation. The risk-averse investors
would invariably choose such stocks as show positive relationship between them (or among them in view of the number of stocks
in a portfolio being more than 2, which is usually the case) but not perfect relationship. Then only the risk in a portfolio is
reduced. For a given period, same degree of movement in return on different stocks in the same direction only increases
the risk in a portfolio.
Now going back to the standard deviation of a portfolio, we will appreciate that it is not merely the weighted average of the
standard deviation numbers for each stock in the portfolio. Suppose there are five stocks in a portfolio. We can appreciate that
there are quite a few possible combinations of these five stocks depending upon the proportion of investment in each of them; for
each combination, the weighted average of the standard deviation numbers has to be etermined first and then the ultimate average
standard deviation should be found out for all possible combinations. This involves a very complicated calculation and hence not
presented here.14 However before we end this topic it should be mentioned that the complicated calculation is worth the time
invested in, as the ultimate result is reduction in the total risk of the portfolio. This is the very objective of a portfolio.
Kinds of risk – diversifiable and non-diversifiable

Diversifiable or non-systemic risks
We have learnt that a portfolio aims at minimising the risk and optimising the returns. We have also learnt that any portfolio
chooses the constituent stocks based on certain parameters and one of the important parameters is the correlation among the
various stocks. We have also seen that a portfolio diversifies the risk by choosing stocks of:
Different sectors, different units in the same sector, different maturities and different instruments including money market. Are
there different kinds of risk associated with securities? Yes. Diversifiable and non-diversifiable risks. By choosing different
14
This is better explained by any standard textbook on “Security Analysis and Portfolio Management”. Any student
interested on the topic of “Investment” is well advised to refer to any standard textbook on SAPM.

Chapter: One
sectors etc. we are diversifying the risks. This means that sector specific or industry specific or instrument specific or maturity
specific risks are diversifiable. Let us explain this through examples.
Your portfolio could contain stocks of Cement, Textiles, Software and Pharmaceuticals. This is called sector diversification. You
will choose such sectors as are not having perfect correlation.
Your portfolio could contain stocks of ACC, Larsen & Toubro and Dalmia Cements. This is called unit diversification in the
same sector. You will choose again such units as are not having perfect correlation.
Your portfolio could contain one-year investment (bond or debenture), more than one-year investment and long-term investment
too. This is called maturity diversification. Here the relationship will rarely be perfect.
Your portfolio could contain investment into equity shares, debt instruments and money market instruments. This is called
instruments diversification. Here too the relationship will not be perfect as these relate to different segments of the Financial
Markets.
All the above are examples of diversifiable risks. One can use detailed analytical study of the past trends and knowledge about
the various sectors and specific units for true diversification of stocks in a portfolio. Such diversifiable risks are often referred to
as “non-systemic risks” or “specific risks” as such risks are not thrown in by the system.
Non-diversifiable or systemic risks
Suppose we do all the above and arrive at a very good portfolio. The US and their allies decide to bomb IRAQ. All hell breaks
loose. All the markets internationally are nervous. Can you and I do something about it besides feeling helpless about the whole
thing? Such kind of risks could be specific to a country or economy or universal in its impact. The universality of market risks
depends upon the degree of integration of different countries into the global system. The more they are integrated the higher will
be the degree of uniformity of impact due to US bombing IRAQ. We cannot diversify this kind of risk at least within a country or
system, although global investors are in a better position to diversify the country specific risk by pulling out of the country and
reinvesting the amount in less risky markets.
Typical example of a market risk in India – Sensex crashing from 6000 odd points in early 2000 to less than 3000 points in 2002.
The markets becoming nervous on news of Indo-Pak war is another example.
Total risk of a portfolio = market risk of the portfolio + specific risk of the portfolio
Concept of “Beta” and the Capital Asset Pricing Model (CAPM)

Before we examine “Beta”, let us examine some fundamental concepts in the context of investment in securities like “risk free”
investment, “risk premium”, “market portfolio” etc. Globally investment in Government securities is considered to be “risk free”
investment. We may not agree with the statement that they are totally risk-free. In the absence of any better alternative that is
100% risk free, this has been accepted as “risk-free” investment. Suppose the average return from investment in Govt. securities
in India say, is 6.5% p.a. Risk-averse investors would be induced to invest in market securities like shares or debentures or bonds
only when they get what is known as “risk premium”. Let us assume this to be 6%. This means that the market investment should
fetch us 6.5% + 6% = 12.5%. Unless we are sure of this return we will not invest in market securities.
Is there any readymade portfolio whose return represents the market return? Yes. The BSE sensex represents the market portfolio
and the return on this for a given period is the market rate of return. The difference between this market rate of return (12.5%)
and risk free rate (6.5%) represents the market premium (6%). Is BSE sensex the only portfolio? No. NSE’s 50 stock index is
another one. However let us bear in mind that BSE sensex or NIFTY FIFTY does not include any debt instrument like debenture
or bond or short-term money market instruments. Hence the parameter of market premium as applicable to BSE sensex etc.
relates only to investment in equity shares.
What is “Beta” of a stock?

We have learnt that the risk associated with a given stock can be measured either by standard deviation or the co-efficient of
variation. We have also learnt that the parameter of co-efficient of variation includes the scale of expected return unlike the
standard deviation and hence is more comprehensive as a measure of risk. Let us extend whatever we have learnt to comparison
of co-efficient of variation in returns of a given stock with the co-efficient of variation in returns of market portfolio during the
same time. This comparison is called “Beta”. We examine the following example.
Our investment in Reliance Industries Limited (RIL) has the co-efficient of variation as 10% for a given period of 6 months. Let
us say that during the same period the co-efficient of variation of BSE sensex is 15%. Then the Beta for RIL stock is = 10%/15%.
This gives us a number of 0.667. Thus “Beta” is the relationship between the co-efficient of variation of selected stock to the co-
efficient of variation of market portfolio. At times students are confused with this concept and mistakenly identify as the

Chapter: One
relationship between the returns of selected stock and market portfolio. This is not the correct definition of “Beta”– please
note.
Example no. 3
Let us say that the risk-free rate is 6.5% as assumed in the above paragraphs. Let us say that the market premium is also 6% as
assumed before. The Beta of a given stock is 1.2. Then the expected rate of return from this stock is = R j = Risk free rate + (Beta
of selected stock x market premium) = 6.5% + 6% x 1.2 = 13.7%. This means that the expected rate of return from selected stock
is 13.7%. This equation is the famous equation called “Capital Asset Pricing Model (CAPM)”
The higher the Beta, the higher the risk and the higher the risk premium in comparison with the market premium and vice-versa.
In the preceding paragraph we saw that the Beta for RIL is less than 1. What does it mean? The risk associated with RIL stock is
less than the risk associated with market portfolio. It is safer. Beta is a true measure of the relative volatility of the return of a
given stock in comparison with the volatility of return of market portfolio.
Is Beta different from co-efficient of variation in the way in which it is determined?

Yes. This exercise does consider not only the probability distribution of returns for a given stock but also the actual changes in
the return due to movement of market price of the stock for a given period. The data 15 collected for a given period are subject to
“regression analysis” for determining the Beta for a given stock. The students are well advised to attempt the numerical exercises
given at the end of the chapter to familiarise themselves with this concept.
Please reproduce here graph as shown in the photocopy attached
Some concerns about Beta and CAPM

The CAPM model as detailed above is very useful without any doubt. However this has certain limitations. One of the most
important limitations is that most of the times the trend in the past based on which Beta is determined may not influence the
returns of the future. There could be other factors happening only in the future that could alter the rate of return expectation in a
given stock either by reducing or increasing the risk associated with it. As a result of this, stocks’ Betas most of the times do not
have any relationship with the returns in future. There have been successful attempts to overcome this constraint in the CAPM
model and it is beyond the scope of this book to discuss these attempts. However before closing this point, it will be relevant to
mention that two distinguished factors influence the market return of a selected stock. They are:
The firm’s size – the smaller the size the higher the returns and
Market value to book value ratio – the lower the ratio the higher the returns
Let us conclude this topic by giving a formula for book value of equity share:
Book value of equity share = Paid up capital + Reserves and Surplus
Number of equity shares issued
Chapter No. 4 – Financial Resources: Short-term and Long-term
Short-term, medium-term and long-term – explanation in terms of duration
Short-term
15
Datum is singular and data is a plural of datum. Hence data and are should be used and not data and is.

Chapter: One
This is up to twelve months in duration. The shortest period could be as short as one day as in the case of “call money markets”
and/or “Repo contracts”. It is convention to take a year to consist of 365 days even if the year under consideration were to be a
leap year. The short-term market is called “money market”. Hence short-term instruments are often referred to as “money
market” instruments.
Examples – Call money market, Commercial paper etc. Characteristic features of all the instruments have been detailed
elsewhere.
Medium-term
This is beyond twelve months and the maximum duration is five to seven years. Some authors and some markets consider the
maximum duration for a medium-term instrument as ten years. The students are well advised to be flexible in their understanding
of different definitions of medium-term. All the medium-term instruments are debt instruments.
Examples – Debentures, bonds, fixed deposits accepted from public etc.
Long-term
Anything beyond the medium-term period is long-term. There is no ceiling on the maximum duration of long-term instruments.
Examples – long-term bonds, Equity share capital, Preference share capital, unsecured loans from promoters, friends and
relatives etc.
Objectives for different resources depend upon the duration

Short-term
As mentioned earlier the short-term resource is up to a period of 12 months. As this is a short-term resource, it is also referred to
as “working capital” resources or “current assets” resources. Short-term resources should not be used for acquiring fixed assets
like land, building, plant and machinery etc. for which specific resources are required.
What happens in case short-term resources are used for acquiring fixed assets?
The students will recall from Chapter 1 – introduction to Financial Management that fixed assets require exclusive resources as
they give benefits over a long period of time. Hence the resources should be matching in duration to the duration of receipt of
benefits. The business enterprise will not be able to recover the investment in a short time. Hence if short-term resources are used
for fixed assets, there will be shortage of funds required for working capital. The business of the enterprise suffers for want of
funds. Let us consider the following example:
Example no. 1
Let us assume that we require Rs. 100 lacs for day-to-day operations of the business enterprise. We use Rs.30 lacs for acquiring
capital assets. Hence we have only Rs.70 lacs for day-to-day operations or working capital of the business enterprise. From where
are we going to get the shortfall of Rs. 30 lacs? It will take more than one year for recovering Rs. 30 lacs from the asset in which
we have invested by repeatedly using the asset. This is typical of any fixed asset like land, building etc. We will appreciate
another effect of reducing the working capital funds employed in business. Suppose Rs. 100 lacs can give us sales volume of Rs.
500 lacs, Rs. 70 lacs would give less than Rs. 500 lacs of sales. Thus by diverting funds from working capital, we suffer on two
counts:
Shortage of funds for day-to-day operations
Less revenues accruing to the business due to reduction of funds
Medium and long-term resources

Both medium and long-term resources, on the contrary, are primarily available for fixed assets as the funds are in the business for
periods longer than 12 months. Why primarily available for fixed assets? Does it mean that the medium and long-term
resources are available for working capital also? Yes. Some of the resources like share capital, debentures and bonds are available
both for working capital and fixed assets. Some other resources like term loans are available only for fixed assets, as we cannot

Chapter: One
use them for working capital. As we proceed further with the chapter the concept behind this will be clear to the students.
However we shall see one example here just to show that capital of the owners in business is available both for fixed assets and
working capital.
Example no. 2
Stage 1 - Starting point for a business enterprise = introduction of capital into business by the owners
Stage 2 - The capital is used for purchase of business assets and business assets comprise fixed assets and working capital. Only
if needed, the business takes loans from outside and together they constitute the funds required for business. This means that
small business may not take loans from outside in case the scale of operations or the nature of activity undertaken does not
warrant this. However most of the business enterprises would require funds from external sources.
Thus we can see that a long-term resource like capital is available both for working capital and fixed assets. Working capital
assets are also known as “current assets”. Similarly fixed assets are also known as “long-term” assets.
We keep talking of current assets of the business enterprise. What are these?
The type of current assets depends upon the type of activity undertaken by the business enterprise. A manufacturing unit requires
more funds than a trading enterprise, which in turn requires more funds than a service enterprise.
Why?
Manufacturing enterprise requires conversion of material into finished goods and then sells it. Hence it will require different
kinds of current assets.
A trading unit does not convert material into finished goods and hence the variety of current assets and investment in it will be
less than in the case of a manufacturing unit.
A service unit does not deal in finished goods. Hence the requirement of current assets is still less in this case.
Components of current assets in the case of a manufacturing unit

Raw materials
Components
Machinery spares
Consumables like oil, lubricant etc.
Work-in-process or semi-finished goods
Finished goods
Debtors representing credit sales
Cash balance for day-to-day operations and bank balances in current account (only where short-term bank borrowing like cash
credit or overdraft is absent)
Components of current assets in the case of a trading unit

Finished goods
Components of current assets in the case of a service unit

Consumables (especially in the case of a car mechanic or repair unit) – amount invested will be much less than in the case of
finished goods of a trading unit

Chapter: One
Concept of securities issued by limited companies – Financial instruments

Securities
Let us note the difference between the term “security” and “securities”. The term security refers to the legal claim on the assets of
the business enterprise that it passes on to the lenders for backing the loans taken by it from the lenders. The legal claim could be
on current assets or fixed assets or both as the case may be. The term “securities” however means financial instruments issued by
various users of resources to the investors of these resources acknowledging their indebtedness to the investors. Typical examples
of securities are – equity shares, bonds and debentures.
The securities could be short-term, medium-term or long-term. Let us examine them in detail now.
Example no.3
Suppose a limited company wants Rs. 1000 lacs from the public. It completes the necessary formalities in this behalf including
taking permission from the Securities Exchange Board of India (SEBI). It proceeds to collect the funds through duly authorised
agents and issues share certificates denoting the number of shares invested in by the investors. Equity share capital is a typical
example of long-term source available to a limited company.
Indian Financial System – Money markets and Capital markets

The Financial System is one of the most important inventions of the modern society. It is well known that certain sectors in any
society have surplus funds, which are available for investment, while certain other sectors demand funds or have use for these
funds in their activity. This fundamental forms the basis for the “financial system” anywhere in the world.
For example, there are always in any economy, seekers of funds, mainly, business firms and government and suppliers of funds,
mainly households.
The Financial System
Seekers of
Funds
Suppliers of
(mainly
Funds
business,
(mainly
firms and
households)
government)
The Financial Markets:

A Financial Market can be defined as the market in which financial assets are created of transferred. Financial assets represent
“claims” to payment of a sum of money sometime in the future and/or periodic payment in the form of dividend or interest.
Financial markets can be classified as primary and secondary markets. More often, they are also classified as money markets and
capital markets. In fact, primary and secondary markets are integral part of capital markets, as money markets have a very limited
secondary market. Primary market: The market for raising funds through share capital, debenture, bonds etc. wherein the funds
directly flow from the households and other saving units in the economy to the users of these funds, namely, Government and
Business Enterprises in the form of “Limited Companies”.
Secondary market: The market for disposing of the claims in the forms of shares, debentures of the investors to other investors
without surrendering the claim directly to the principal users of these funds, namely, business enterprises or Government. This

Chapter: One
market enables selling off investment in business enterprises by public at large either through stock exchanges or directly to other
investors.
The Financial markets are segmented into the “Money Markets” (up to 12 months) and “Capital Markets” (beyond 12 months)
Money Markets
♦ Money market-Instruments traded in the money market are as under:
♦ Commercial paper – promissory notes issued by the borrowers
♦ Bills discounted – discounting of bills of exchange drawn by the sellers of goods and/or services on the buyers of goods
and/or services
♦ Inter-corporate deposits – one company borrowing money from another company in the short-term
♦ Treasury bills of the Government of India through Reserve Bank of India;
♦ Certificate of deposits raised by banks depending upon their requirement for large amounts;
♦ Call money market wherein the major players are the banks, financial institutions, Life Insurance Corporation of India,
General Insurance Corporation of India etc. both as lenders and borrowers;
Commercial paper
Commercial papers are short term unsecured promissory notes issued at a discount value by large and well-established corporates
having good credit rating for short-term instruments. It is a part of their working capital funds and to the extent of commercial
paper borrowing; their working capital limits with the banks are reduced. As even today in India, the commercial banks’ lending
for working capital purposes is significant, their permission is a must for issuing C.P.’s. They are either issued directly to the
investors or through merchant banks and security houses. The instrument has been welcome especially by the corporates who
have been doing well as their cost of borrowing in the short-term is reduced to a great extent, because the C.P. is always at a
lower rate of interest than the rate of interest on working capital limits charged by the banks.
CP Operational Guidelines
[Following is the summary of various guidelines from RBI. The Fixed Income and Money Market Dealers’ Association
(FIMMDA) as a self-regulatory organisation is working on standardised procedure and documentation in consonance with the
international best practices. Till then, the procedures/documentation prescribed by the Indian banks’ Association would be
followed]
Eligibility: Corporates, primary dealers (PDs), satellite dealers (SDs), and all-India financial institutions (FIs); for a corporate
to be eligible, (a) the tangible net worth of Rs.4 crore; (b) having a sanctioned working capital limit from a bank/FI; and (c) the
borrowal account is a standard asset.
Rating Requirement: The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other approved agencies.
Maturity: A minimum of 15 days and a maximum up to one year.

Chapter: One
Denomination: Minimum of Rs.5 lac and its multiples.
Limits and Amount: CP can be issued as a "stand alone" product. Banks and FIs will have the flexibility to fix working capital
limits duly taking into account the resource pattern of companies’ financing including CPs.
Issuing and Paying Agent (IPA): Only a scheduled bank can act as an IPA.
Investment in CP: CP may be held by individuals, banks, corporates, unincorporated bodies, NRIs and FIIs.
Mode of Issuance: CP can be issued as a promissory note or in a dematerialised form. Underwriting is not permitted.
Preference for Demat: Issuers and subscribers are encouraged to prefer exclusive reliance on demat form. Banks, FIs, PDs and
SDs are advised to invest only in demat form as soon as arrangements are put in place.
Stand-by Facility: It is not obligatory for banks/FIs to provide stand-by facility. They have the flexibility to provide credit
enhancement facility within the prudential norms.
Bills discounted
These are the commercial bills of corporates or business houses drawn on buyers and duly accepted by them. In some of the
cases, the lender does insist on the co-acceptance of the bankers to the corporate or business house, as the case may be, which
means that this borrowing is done with the full knowledge of the banks that have lent working capital funds to the corporates.
This is a highly unorganised market with no ground rules for operations. There is no secondary market and there is always a
possibility that the bills may not be genuine trade bills but only accommodation bills. The players are N.B.F.C.’s whose banks do
not lend them money against the bills discounted by them and hence money available for such activity is minimum. Rates
entirely depend upon the lender and to an extent are influenced by the credit rating of the drawer as well as the drawee, besides
the liquidity in the market. Nowadays, in view of the fiasco in the I.C.D. market, this market has also been affected to a large
extent and the lenders have started insisting upon the “post dated cheques” from the drawees besides their banks’ approval in
some cases.
Inter Corporate Deposits (ICD’s)

The short-term borrowing that a corporate does in the market from another corporate is called inter corporate deposit. It is not
called a loan. There are no ground rules here again, as is the case with “bills discounted”. It is a highly unorganised market and
there is no secondary market. The rates entirely depend upon the money supply available in the market and to an extent the credit
rating of the borrower. It is an unsecured lending and is highly risky, as has been proved from time to time recently. Hence, this
market is shaky at present. The corporates with surplus in the short-term require the following as security for the ICD they give:
Post dated cheques, one for the principal amount and the other for interest;
Directors’ personal guarantees;

Chapter: One
Shares of blue chip companies wherever possible and in some cases shares of their own companies held by the promoter directors
etc.
The above documents are required to be submitted along with the board resolution of the company. The maturity ranges between
3 months and 6 months. The ICD is renewed once or twice at the most, subject to a maximum period of 12 months from the date
of first deposit. The companies who subscribe to ICD’s from the working capital funds they borrow from the banks do run great
risk of reduction in limits once the facts come to the notice of the lending banks
Treasury bills:
It is the short-term instrument issued by the Government to tide over short-term liquidity problems. As this resource plugs the
budget deficit, it is often referred to as “monetization” of budgetary deficit. To back up the treasury bills, currency notes are
printed to that extent. Characteristic features of treasury bills are as under:
As Treasury bills are of very limited value to the business enterprise, we shall not discuss the details or their modus operandi.
Certificate of deposits:
This is more of an investment instrument for those having investible surplus, rather than an instrument for market borrowing.
Commercial banks have been permitted by the RBI to issue certificates of deposits depending on their requirement of funds in the
short term up to 12 months by offering a higher rate of interest than on the regular deposits. Hence the details or their modus
operandi are not discussed here.
Call money market

It is a part of the national money market where day-to-day surplus funds, mostly of banks, are traded. The call money loans are
of very short-term in nature and the maturity periods of these loans vary from 1 to 15 days. The money that is lent for one day in
this market is known as “call money” and any maturity in excess of 1 day is known as “notice money”.
Purpose:
The banks to meet various urgent requirements for funds as under are resorting to call money. As in the previous two cases, this
is also not available to private sector business enterprises. Hence details are not discussed.
Besides the money market instruments, there are other resources for working capital. They are as under:
Bank borrowing for working capital

Commercial as well as co-operative banks give funds to business enterprise in the form of:
Overdraft – an extension of “current account” in which the borrowers are permitted to draw cheques up to a predetermined limit
against security like fixed deposit receipts, shares, mortgaged property etc. Usually carries a rate of interest higher than the rate
for cash credit. Most of the private sector banks do not have cash credit system. They give only overdraft facilities or loan
facilities. These include foreign banks too. It is only the public sector banks in India who have the distinction of overdraft and
cash credit.
Cash credit – given against inventory and receivables that form the bulk of current assets. Borrowers are allowed to draw cheques
up to a predetermined limit like in the case of overdraft facilities.
Bills discounted – in which bills of exchange are discounted by seller’s banks. Bills of exchange have been explained elsewhere
at a footnote.
Export credit limit – given for specific purpose of exports. Split into pre-shipment (packing credit facility) and post-shipment
(bills finance). The rates of interest are less than for overdraft or cash credit
Fixed deposits accepted from the public

Under the relevant provisions of The Companies’ Act, the limited companies or Non-Banking Financial Companies (NBFCs) can
accept “Fixed deposits” from public subject to certain ceilings prescribed in this behalf. RBI controls the ceiling of deposits
accepted by NBFC as per NBFC Act while The Companies” Act prescribes the ceiling in the case of other limited companies.

Chapter: One
RBI also prescribes the ceiling of rate of interest that can be offered on such Fixed Deposits accepted from the public. The
present ceiling is 12.5% p.a. Fixed deposits up to a maturity period of 12 months alone will constitute short-term funds.
Capital Markets
The primary market and the secondary market constitute the capital market and besides, the capital market has the share capital as
well as debt capital instruments. The primary and secondary markets are inter-dependent on each other. They are closely linked
to each other. In case there are many public issues in the primary market it automatically leads to the growth in the secondary
market, as it provides easy liquidity to the existing investors by off-loading their investment either in capital or in debt
instruments and unless the secondary market is active with transparency and efficiency, seekers of capital funds, i.e., corporate
entities cannot hope to tap the primary market for further funds through public issues.
Background:
Capital Issues in the country were being controlled by the Controller of Capital Issues;
They were determining even pricing of the issues;
CCI’s office was abolished in 1992 with The Securities Exchange Board of India being accorded “legal status” under SEBI ACT,
1992. SEBI was actually established in 1988;
Even CCI was controlling the secondary market through the Securities Contracts (Regulation) Act, 1956, which statute continues
even today. In fact, SEBI is responsible for compliance with the provisions of “SCRA 1956”.
Objectives of SEBI:
Promote fair dealings by the issuer of securities and ensure a market place where funds can be raised at a relatively low cost;
Provide a degree of protection to the investors and safeguard their rights and interests so that there is a steady flow of savings into
the market;
Regulate and develop a code of conduct and fair practices by intermediaries in the capital market like brokers and merchant
banks with a view to making them competitive and professional.
In order to carry out its functions to fulfil the above objectives, SEBI has been given various powers like the following:
Power to call for periodical returns from stock exchanges;
Power to call upon the Stock Exchange or any member of the exchange to furnish relevant information;
Power to appoint any person to make inquiries into the affairs of the Stock Exchanges;
Power to amend byelaws of Stock Exchanges;
Power to compel a public limited company to list its shares in any Stock Exchange etc.
Modus operandi in the public issue of share capital and other instruments:
The provisions of the Companies Act and SEBI guidelines apply together for any public issue;
As per the provisions of Companies Act, any capital issue to be done by a limited company should comply with the provisions
relating to prospectus, allotment, issue of shares at premium/discount, further issue of capital etc.
Under SEBI guidelines, the issues should be in conformity with the published guidelines relating to disclosure and other matters
relating to investors protection. SEBI does not make any appraisal of issue but scrutinizes the prospectus that adequate
disclosures have been made in the offer document to enable the investors to take informed investment decisions.
Types of issue:
Public issue of equity shares, preference share, debentures etc.
Rights issue
Bonus issue and

Chapter: One
Private placement
We shall see in short, the specific features of the above issues.
Public Issue
Public limited companies can either be closely held or widely held. Closely held public limited companies do not go to public to
garner resources from the public at large in the form of equity or preference share capital or even debentures. Only widely held
public limited companies go to the public for this purpose. Steps involved in any public issue:
1. Company decides about the size of the public issue;
2. It passes a board resolution to raise the issue;
3. It gets the approval of the general body for the issue;
4. It prepares the prospectus which gives salient features of the issue like:
The purpose of the issue;
The details of existing business, if any, and plans for future expansion etc.;
The details of the project for which public issue is sought, like, location, details of collaboration for
technology tie-up, background of promoters, like educational qualifications, relevant experience in the
chosen field of activity, financial background, association as director with other companies, liabilities in
personal capacity either to the company or on behalf of the company, installed capacity, cost of project,
means of finance, schedule of implementation of the project, advantages arising out of the project, earning
capacity of the project, arrangement for supply of power, water and fuel as well as materials required for
production, arrangement for distribution of finished product, marketing strategy as well as set up, effect on
environment, steps for conserving energy, foreign exchange earning potential of the project, prospective
industries using the product of the project, risks associated with the project and management’s perception of
these risks, details of companies under the same management and subsidiaries, arrangement for term loans,
appointment of all the agents to the issue, like, managers to the issue, bankers to the issue, brokers to the
issue, underwriters to the issue, registrars to the issue, the duration of the issue, etc.
5. Receipt of approval of SEBI;
6. Appointment of all the agents connected with the Issue through the Lead Manager to the Issue;
7. The issue gets underwritten by the underwriters;
8. Printing of prospectus, memorandum, share application forms, publicity material and deciding on the mode of media
publicity, either audio or visual or print or any combination thereof or all the three;
9. Holding of seminars or conferences of brokers and prospective investors respectively;
10. Despatch of publicity material to all the centres;
11. Issue opens at the appointed places;
12. Issue closes, with a minimum period of issue being 3 days;
13. All the share application forms together with the money received by the Registrar to the Issue to the credit of special
account opened for this purpose;
14. You cannot retain any over subscription, excepting to the extent required to fulfil the proportionate allotment exercise.
Similarly, wherever the issue is not underwritten, if the subscription is less than 90% of the issue size, the amount has
to be returned to the applicants. It should be noted that at present underwriting is not obligatory;
15. Allotment of the issue within a specified period from the close of the issue;
16. Issue of share certificates within specified period from the date of allotment and refund of excess money within 30 days
from the date of allotment without interest;
17. In case the refund is later than this period, then interest as per the rates stipulated by SEBI from time to time to be paid;
18. Registrar gives time to the shareholders to get the discrepancies, if any in the share certificates rectified;
19. Submission of all relevant forms and documents to the Registrar of Companies, SEBI etc.;

Chapter: One
20. Registrar to the Issues transfers all the documents and registers to the Issuing company and fulfils his obligations as the
registrar;
21. Lead manager or manager to the issue (in case only one manager) settles all the claims of all the agents to the issue and
22. Lead manager or manager to the issue is paid.
23. Fixation of overall ceiling on the cost of public issue:
For equity and convertible debentures:
Up to Rs.5crores - Mandatory cost + 5%
In excess of Rs.5crores - Mandatory cost + 2%
Non-convertible debentures:
Up to Rs.5crores - Mandatory cost + 2%
In excess of Rs.5crores - Mandatory cost + 1%
Mandatory costs include underwriting commission/brokerage payable to the bankers to the issue and the
brokers to the issue, fees of managers to the issue, fees to the registrars to the issue, mandatory press
announcements and listing fees. Other costs represent among other things, incidental expenses relating to
conferences, seminars etc., printing cost for memorandum, prospectus, share application forms, share
certificates, call notices etc.
The above steps are common in the case of all types of public issue, like for share capital, be it equity or debentures etc.
In the case of debentures, there are further steps involved as under:

1. Appointment of “Debenture Trustees” is a pre requisite for all debenture issues;
2. There should be a “Debenture Trust Deed” as well as “Debenture Trusteeship Agreement” in place;
3. The purpose for which the debenture is issued should be clear at the time of issue like, for fixed assets, working capital
etc. besides, the security offered to the debenture holders, whether there is any buy back provision or provision for “roll
over” for a specific period beyond the date of redemption;
4. Creation of debenture redemption reserves, up to 50% of the debenture issue at least one year before the specified
period from the date of redemption in the case of all debentures redeemable 36 months and beyond;
5. Any public issue of debenture has to be approved by SEBI and
6. Any public issue of debenture beyond 18 months period has to be credit rated by an independent Credit Rating Agency.
Rights Issue:
1. It can be issued only to the existing equity shareholders;
2. It has to be issued to all the existing equity share holders and the number of shares offered per share is on a pro-rata
basis – for example, it may be 3 shares for every 5 shares held as equity shares in the company or 1 share for every
share held or 3 shares for every share held etc.;
3. Rights issue cannot be made before expiration of 2 years from the date of incorporation of the company or one year
after the last allotment, whichever is earlier.
4. Rights issues are mostly at premium and rarely at par.
5. Minimum subscription 90% just as in the case of public equity issue as otherwise the entire amount has to be returned
to the applicants.
6. Shareholders have a right to renounce their rights for subscription in favour of his nominee,
7. Either fully or partly under intimation to the share issuing company.
Bonus Issue:
1. No bonus issue to be made within 12 months of any public issue;

Chapter: One
2. The issue is to be made only out of free reserves or share premium collected in cash and not out of any committed or
encumbered reserves;
3. Bonus issue cannot be made in lieu of dividend;
4. Bonus issue cannot be made unless the partly paid shares, if any, are made fully paid up;
5. The company should not have defaulted in payment of interest or principal amount in respect of fixed deposits,
debentures etc.;
6. The company should not be a defaulter in respect of statutory dues of the employees such as contribution to provident
fund, gratuity, bonus etc.;
7. The bonus issue should be completed within a period of 6 months from the date of approval of the Board of directors
and shall not have the option of changing the decision;
8. After the issue of bonus shares, there should be residual free reserves as per stipulation of Companies Act and
9. The issue of bonus shares must be recommended by the Board of Directors and approved by the General Body and the
management’s intention of the rate of dividend on the enhanced capital base is also to be included in the resolution
passed by the General Body in this behalf.
Private placement:
It is marketing of the securities of a private or a public limited company, both shares and debentures, with a limited number of
investors like UTI, LIC, GIC, State Finance Corporations etc. The intermediaries in such issues are credit rating agencies and
trustees e.g. ICICI and financial advisors such as merchant bankers etc. Private placement can be made out of promoters’ quota.
Preference share capital issued by Private Sector Companies mostly belong to this category of private placement as there will
seldom be a public issue of such security.
Govt. securities and securities issued by Public Sector Undertakings (PSUs) are excluded here from study under the “Capital
Markets” as the private sector or a commercial business enterprise is not going to benefit from these.
Some of the readers will be wondering about what the differences are between Equity shares and Preference shares and similarly
between “debentures” and “bonds”. Here are the differences.
Difference between Equity shares and Preference shares
Equity share capital Preference share capital
Any limited company has to have this This is optional
If preference share capital is also there, ESC forms the bulk of This forms a minor portion of the share capital
the share capital
Equity shareholders are the owners of the company and have Preference shareholders are not owners of the company and do
voting rights on all the administrative issues referred to the not have any voting rights on the general administration issues.
general body of shareholders by the Board of Directors In short the preference shareholders do not constitute the
general body of shareholders
Dividend is paid only after paying dividend to preference Dividend is paid first on preference share capital out of profit
shareholders after tax (PAT)
Dividend rate is not fixed. There is no ceiling on the rate of Fixed rate of dividend
dividend. There are instances in India when even 130%
(Colgate-Palmolive) or 500% (VSNL – 2000/2001) on the face
value of Equity Share have been paid
At the time of liquidation of the company money can be paid At the time of liquidation of the company, money can be paid
back to Equity shareholders only after paying off the back to the preference shareholders first before paying back to
investment made by preference shareholders the Equity shareholders

Chapter: One
Different kinds of equity share capital like cumulative and Different kinds of preference share capital like cumulative and
ordinary are absent ordinary are possible. Cumulative means that in case during a
year dividend could not be paid for want of cash, as and when
the company starts paying dividend, the cumulative preference
shareholders get dividend for the period during which dividend
has not been paid.
Equity shares can be issued either through private placement or Preference shares are usually issued through private placement
public issue
They are entitled to benefits like Bonus Issues (additional They are not entitled to any of the benefits
shares issued to the shareholders without any funds) and
Rights Issue (additional shares issued to the shareholders by
fresh subscription)
Permanent share capital in business Cannot be permanent share capital in business. As per
provisions of the Companies’ Act, they are either convertible
(converted into equity shares after a given period) or
redeemable (paid back to the investors after a specific period)
Differences between debenture and bond
Debentures Bonds
Medium term instrument – not exceeding ten years This could be for longer periods – Reliance Industries in fact in
1997 had issued bonds for 100 years in the international market
It is always a face value investment. This means that the This could be discounted value investment. This means take
amount invested by the debenture holders is the same as the for example IDBI deep discounted bond – The face value of
face value of debentures. the instrument is Rs. 1lac payable after 15 years. The amount
invested will be the present value duly discounted by the
implied rate of interest.
Debenture certificates carry stamp charges as per the Stamp Bond certificates carry stamp charges as per the India Stamp
Act of the state in which they are issued Act
Bonds in India are slowly replacing debentures. As it is, Bonds have come to stay in India. Before 1996/1997 Indian
debentures are not very popular instruments internationally. private sector was not using this instrument much. Nowadays
bonds are becoming more common
Debentures could be convertible into equity shares like Bonds are rarely convertible
preference shares
Debentures are seldom issued by Governments or Public Bonds are issued by practically all the sectors: Private sector
Sector Undertakings or Banks or Financial Institutions. They companies, public sector undertakings, Financial Institutions,
are issued by private sector companies Commercial Banks (SBI – India Resurgent Bond or Millenium
Bond as examples) and Central Government/State
Governments
Debentures issued by private sector companies carry Bonds issued by private sector companies carry an inferior
preference over bonds issued by them at the time of liquidation charge to the debentures. Bonds issued by Public Sector
of the company (debenture holders get a superior charge – Undertakings, Financial Institutions, Governments and
legal claim on assets of the company to bond holders) Commercial Banks are not secured. There is no legal claim in
favour of the bondholders.

Chapter: One
Outside the “Capital Markets”, there are other resources available for acquiring fixed assets as under:
Term loans given by banks and financial institutions

Term loans or project loans are a complete source of funds for fixed assets. Term loan or project loan is especially suitable for
project assets, as all kinds of assets acquired under a project are eligible for finance under “term loan”.
Why call it a term loan?
The repayment is as per terms agreed at the beginning and a fixed repayment schedule. Hence the term “term loan” is used. This
term is more often used in India rather than outside. Mostly it is referred to as “project loan” as it more often than not used for
creation of project assets.
Characteristic features of “term loan”
1. Finances all assets like land, building, plant and machinery, technical collaboration fees, effluent treatment plant,
patents, miscellaneous fixed assets including vehicles and furniture and fixtures, electrical installations, stand by power
arrangement like Diesel Generating sets, for projects in backward areas staff quarters etc.
2. Disbursement in stages as per requirement of funds by the borrowers
3. Extent of finance (Value of assets offered as security to the lender (-) owners’ contribution towards margin) ranges
between 70% and 90%.
4. Rate of interest could be fixed rate as agreed upon at the beginning of the loan or floating interest rate (linked to the
market rate and getting adjusted as per the movement of interest rates in the market)
5. There is non-repayment of principal amount or more popularly known as “moratorium period” during which time there
is no repayment of the principal amount. This period could be between six months for small projects to two and a half
years for very long gestation period16 projects.
6. The loan is secured by mortgage of immovable fixed assets and/or hypothecation of movable fixed assets. Very rarely
working capital assets are also offered as security.
7. The loan will be guaranteed by the owner directors especially for small and medium scale borrowers. It is 100%
applicable in the case of small limited companies like private limited companies. Personal guarantees will not be
insisted upon for large and professionally managed companies whose stocks are listed on a stock exchange.
8. The arrangement could be that the interest charged on the loan on a monthly basis is paid separately and the principal
amount is also paid separately every month or every quarter. Nowadays recovery on a half-yearly basis or annual basis
is virtually absent especially in the domestic market.
9. The instalments need not be equal unlike in the past. These could be stepped up depending upon how the cash flows
occur or even larger in the initial period and less later on. This means that the arrangement with the lenders can be fully
flexible.
Unsecured loans by promoters, friends and relatives

This could be an important source especially for private limited companies or public limited companies that have not gone to the
public for raising equity. The latter variety is referred to as “unlisted public limited companies”.
Characteristic features:
1. It can be used for any purposes, either for fixed assets or working capital assets or for both
2. It is called “unsecured” as no tangible security like fixed assets or current assets can be offered to the lender
3. Usually it carries higher rate of interest than for loans, debentures or bonds, as there is no security.
4. These loans are usually paid off after the principal debt obligations like loans for fixed assets, debentures or bonds
have been paid off
16
Gestation period for a project means the time lag between completion of the project for commercial production
and generation of positive cash flow by the project. Positive cash flow means total cash inflow is higher than total
cash outflow. Till the business starts registering positive cash flows repayment of the principal amount does not
start.

Chapter: One
Fixed Deposits accepted from public

Just like the fixed deposits we saw for short-term, we can issue fixed deposits in the medium-term also. The maximum maturity
period is 5 years. Other details have been given under short-term resources
We have seen so far in the medium and long-term:

Equity share capital
Preference share capital
Bonds
Debentures
Term loans
Unsecured loans and
Fixed deposits
All of these are available for all kinds of fixed assets and hence are major “fixed assets” financing sources. The students would
recall that some of them are also available for working capital. There are other resources available only for individual assets and
not for entire project or “Capital Assets” programme undertaken by the business enterprise. Such resources are referred to as
“Equipment Financing”. They are:
Lease and Hire Purchase
Medium term acceptances for capital equipments
Deferred Payment Guarantee for capital equipments
Let us briefly look at them as it is beyond the scope of the topic to go into details, especially of Lease and Hire purchase.
Lease
♦ The owner of the equipment leases it out to the user for a specific period on lease rentals
♦ Two kinds of leasing arrangement -:
Financial lease in which at the end of the lease period the owner (“lessor”) transfers the asset to the “lessee” who has
been using the asset for a small sum, known as “residual value” – factory equipment, office equipment like
photocopier, network of PCs, cranes, forklifts used in factories etc. fall in this category.
Operating lease in which at the end of the lease period the owner gets back the leased asset to be leased out to another
user – cars, earth moving equipment, land, building, aircraft, ships etc. fall in this category.
♦ During the period of use, the lessor charges “lease rentals” to the lessee
♦ The lease rentals in the case of “Financial lease” would be much higher than in the case of operating lease, as recovery of
capital cost of the equipment will be included in the former.
♦ Lease period for a financial lease would not exceed five years
♦ Lease period for operating lease would be less excepting land and building in which case it could be for longer periods
Hire Purchase
Very similar to “Financial Lease” arrangement. The major difference is that in Hire Purchase, the transfer of ownership from the
Financing Company to the Hirer (one who has taken the equipment on Hire Purchase) is automatic at the end of a specific period.
Medium-term acceptances for capital equipment

Chapter: One
♦ Involves a series of bills of exchanges17 drawn by the seller on the buyer and accepted by the buyer
♦ Involves co-acceptance or guarantee of payment by the buyer’s banks
♦ The seller gets payment immediately on sale of equipment from his bank
♦ The buyer’s bank honours its commitment by recovering the instalments as per due dates from the buyer and remitting the
amount to the seller’s bank
♦ The buyer’s bank gets commission for co-acceptance of the bills of exchange or guaranteeing
♦ The seller’s bank gets interest that is included in the amount of bills of exchange and provides finance immediately to the
seller. This process is called “discounting”18
♦ Period not exceeding seven years and available for indigenous equipment – rarely for import equipment
♦ Seller’s bank can have rediscounting arrangement with IDBI for rates of interest that are lower than the rates at which he
recovers interest from the buyer of the equipment
Deferred payment guarantee

♦ This is similar to medium-term acceptance as above
♦ The difference is that instead of bills of exchange drawn by the seller on the buyer of the equipment, the buyer’s bank
provides the guarantee to the seller or his bank.
♦ Based on this guarantee the seller gets finance from his bank
♦ The guarantee by the buyer’s bank is for payment on various due dates by recovering the amount from the buyer
♦ Buyer’s bank gets commission
♦ Seller’s bank gets interest
♦ Seller gets finance immediately after the sale of equipment
New instruments in India

1. As per the amended provisions of the Companies’ Act, limited companies can now issue equity shares with
differential voting rights like 10%, 20%, 30% etc.
2. Floating Rate Notes – these are promissory notes issued by limited companies or financial institutions or
banks that are unsecured. The interest rates are market adjusted and do not carry fixed rates of interest.
3. Commercial paper – becoming more and more popular in the short-term markets. Rates of interest are less
than for working capital charged by commercial banks.
4. Preference shares or debentures with participation in profits – called participating preference shares or
participating debentures. Still as a concept only. Yet to make any significant presence in the Indian
markets.
5. Floating rate discounted bonds – Usually the discounted bonds carry a contract rate of interest that does not
change during the bond period. The new instrument is called “inverse floaters” in which the interest rate
also changes. It is a complex instrument and at this stage in learning just needs introduction without going
into details.
17
Bill of exchange – as the term indicates is exchanged between the buyer and the seller whenever the sale is on
credit. Sale on credit means that the buyer is not going to pay immediately. A bill of exchange should not be
confused with “commercial bill” or “invoice”. This is accepted by the buyer acknowledging his debt to the seller or
his bank towards the cost of the equipment together with interest especially in the case of medium-term bills. The
seller of the equipment draws bill of exchange as an order on the buyer. Without this instrument, the seller’s bank
will not finance the seller.
18
The term “discount” means less than face value. The value of the bill of exchange in this case would include the
instalment payable towards the cost of the capital equipment and the interest. The seller’s bank while giving
finance to the seller would deduct the interest charged and finances only the principal amount.

Chapter: One
Chapter No. 5 – Operating and Financial Leverages in Business
Concept of leverage
What is leverage? Leverage is a handle available to facilitate doing a work as easily as possible, as in the case of a “lever” in
Physics. Let us revisit the concept of a “lever”. Suppose we want to lift a stone with a crowbar. We can lift it without any
support. We can lift it with some support called “fulcrum”. The “fulcrum” is the support on which the crowbar rests while lifting
the stone.
Suppose the fulcrum is close to the object being lifted that is “stone”. The leverage is very good, i.e., the ease with which the
stone can be lifted is high. If the “fulcrum” is in the middle of the length of the crowbar, it will be more difficult. The leverage
available to the lifter is less than in the previous case. If on the contrary, the “fulcrum” is close to the hand that exerts pressure to
lift the stone, it becomes increasingly difficult to lift it. The leverage is said to be the least. Thus the point of “fulcrum”, the
support decides the extent of ease (leverage) in completing the work of lifting the stone.
Similar is the concept of leverage in the case of a business enterprise. Leverage to a business enterprise is of two kinds:
♦ Operating leverage - leverage relating to the operations of the company, which relate either to the level of output
(production) or level of sales. In this, the business tries to leverage its operations against fixed operating costs that are
expected to be constant for some time. Here again, the operations could relate either to the output or level of sales. As sales
represent the revenues to the organisation, let us confine our discussion on “operating leverage” to the level of sales rather
than the level of output (production).
It is measured through “degree of operating leverage”, called DOL = Δ EBIT/ Δ Sales
♦ Financial leverage - leverage available in financing arrangement of the company to enhance the earnings per share of the
equity shareholders (EPS). Financial leverage is due to “interest”19 on loans being allowed as an expense. This tells us how
Earning Per Share (EPS) moves in relation to Earnings Before Interest and Tax (EBIT). Interest paid by the business
enterprise on loans enjoys what is known as “tax shield”20. In “Financial leverage”, the business enterprise tries to leverage
its finances by having a proper mix of equity and debt in its capital structure. Let us see the following example to understand
this concept.
Equation for degree of financial leverage, DFL = Δ EPS/Δ EBIT. In the following example, the assumption is that the two
enterprises under comparison are in the same line of business employing the same amount of capital in business. It is also
further assumed that the loan in both the cases carries the same rate of interest and the tax rate is 38.5% (35% basic tax rate
and 10% surcharge thereon). Face value of share is Rs.100/- in both the cases.
Thus “Operating Leverage” is leveraging the operations against the fixed operating costs of the business enterprise and
“Financial Leverage” is leveraging the earnings against the tax shield available on interest cost on borrowings form outside and
they are measured in terms of degree of operating and degree of financial leverages.
Leverage means the “risk” associated with a business enterprise. Operating leverage means the risk associated with the scale of
operations and financial leverage means the risk associated with the pattern of financing, i.e., debt financing or equity financing.
HOW?
Just as an increase in sales could impact EBIT positively, a decrease in sales also would affect EBIT negatively. Similarly an
increase in EBIT could impact EPS positively, a decrease in EBIT also would affect EPS negatively. That is why leverage is
often referred to as a “double edged sword”.
Operating leverage, its usefulness as a tool in decision making on scale of operations

This is based on the assumption that in the short-run, the fixed operating costs in a business enterprise do not change. We need to
define two things here – fixed operating costs and short-run
Fixed operating costs –
19
Interest on loans is a pre-tax expense in the sense that it is part of the revenue expenditure of the organisation
as against dividend on share capital that is profit distribution after meeting income tax obligation.
20
Tax shield is the amount of tax saved by claiming a business expense against income of the business enterprise.
Hence tax shield on interest is the tax saved by taking loans and paying interest as a pre-tax expense.

Chapter: One
They include all the costs in operation of the business enterprise that are fixed in nature with the exclusion of
interest charges and other financial charges that are mostly fixed in nature.21
Short-run:
This depends upon the industry in general and the enterprise in particular. For example in the case of a manufacturing unit, this
could be two years whereas in the case of a service industry especially like IT, this could be less than six months even. The term
short-run refers to the period in which, ignoring the impact of “inflation”, the operating costs of the business do not increase 22.
This is a very useful tool in measuring the impact of the increase in the scale of operations (preferable to take “sales” as
operations instead of “production”)23. Once the operating costs are fixed, the management can decide about the scale of
operations and the higher the scale of operations, the higher the EBIT as the operating costs would not increase with the increase
in scale of operations. Let us examine the following example.
Example no. 1 (Rupees in lacs)

Parameter Firm A Firm B
Sales 100 110
Fixed operating costs 70 20
Variable costs 20 70
EBIT 10 20
Fixed costs/Total costs 78% 22%
Fixed costs/Sales 70% 18%
50% increase in sales

Sales 150 165
F.C. 70 20
V.C. 30 105
EBIT 50 40
Change in EBIT (Δ EBIT) 400% 100%
Conclusion
It is possible to have high operating leverage, i.e., high degree of sensitivity of EBIT to change in Sales, only when the operating
fixed costs form the bulk of total costs. On the contrary if variable costs form the bulk of total costs, the operating leverage
vanishes almost.
Example no. 2
Sales 100 110
F.C. --- ---
21
Please note the difference between fixed operating costs in the context of operating leverage and fixed costs in
the context of “marginal costing”. While in the former, interest and other financial charges are excluded, the latter
would include interest and other financial charges as “fixed costs”
22
The underlying approach to fixed costs, be it in the context of “marginal costing” or “operating leverage” is that
effect of “inflation” is ignored. If we consider the effect of “inflation”, all costs of a business enterprise would be
variable.
23
Production would not recover the costs incurred whereas sales would recover the costs incurred and hence it is
preferable to take sales as the base here although a number of renowned authors still consider “production” as the
parameter while considering the scale of operations.

Chapter: One
V.C. 70 77
EBIT 30 33
Change in EBIT (Δ EBIT) --- 10%
Operating leverage ---- 1 (Δ EBIT/Δ Sales)
This means that there is practically no leverage opportunity existing. Leverage opportunity exists only when due to change in
scale of operations, the EBIT changes also to the same extent and not more than proportionately. This is called “Degree of
Operating Leverage (DOL)”.
Operating leverage through Break-even sales analysis

Quantity at break-even = Fixed costs/contribution per unit {Price per unit (-) variable cost per unit}
And sales at break-even = Fixed costs/1 – (V.C./sales)
Degree of operating leverage = % change in EBIT/% change in sales
EBIT = Q (S-V) – F, change in EBIT = Change in {Q (S-V)}
Where, Q = sales qty. in units
S = selling price per unit
V = variable cost per unit
And F = total fixed costs
= Q (S-V)/Q (S-V) – FC and dividing this by (S-V),
Q/Q – (FC/S-V) = Q/(Q – Q at break-even)

Degree of operating leverage at “R” Rupees of sales = R –VC/ R – VC – FC = (EBIT + FC)/EBIT
Note:
1. How close a firm is to its break-even point?
2. The farther it is from the point of break-even the less the degree of operating leverage
3. As a general rule, firms do not like to operate under conditions of a high degree of operating leverage
4. This means that as a general rule, firms would like to operate away from their break-even point
5. Utility – change in pricing policy and planning for sales and profits
6. While attempting problems in operating leverage formula is as under especially when two positions are not available24
DOL (degree of operating leverage) in sales volume = (EBIT + Fixed costs)/EBIT
DOL in sales output in units = Q (SP – VC)/Q (SP-VC) – FC
Example no. 3
Example of operating leverages at different levels of output – ABC Limited
Parameter Amount (Rs. In lacs)
Sales 250
Variable expenses 100
Fixed costs 90
EBIT 60
24
When two comparative positions are available as in Example nos. 1 and 2, the degree of operating leverage
would be Δ EBIT/Δ Sales. However most of the times two comparative positions may not be available. Based on a
single level of operation, the formulae given here would help in determining the DOL. The same thing holds good
for Degree of Financial leverage.

Chapter: One
Interest on debt 7.50
Profit before tax 52.50
Income Tax @ 35% 18.38
Profit After Tax 34.12
Dividend on preference share capital 5.00
Equity earnings 29.12
Quantity produced – 5000 units
Variable cost per unit – Rs. 2000/-
Selling price per unit – Rs. 5000/-
Degree of operating leverage – 5000 (5000-2000)/5000 (5000-2000) – 90,00,000 = 150/60 = 2.5
Break-even point = 3000 units when contribution = fixed costs
Let us tabulate the degree of operating leverage at different levels of outputs:

Quantity produced Degree of operating leverage
1000 - 0.50
2000 - 2.00
3000 Undefined (at break-even point)
4000 4.00
5000 2.50
The following conclusions can be drawn from the above table:
1. For each level of output, the DOL changes;
2. At the break-even point, DOL cannot be defined;
3. Below break-even point, DOL is negative;
4. Above break-even point, DOL is positive
5. Operating leverage represents the risk associated with the scale of operations.
6. Operating leverage can also be referred to as a measure of “business risk”.
Financial leverage – advantage of debt in preference to equity, its usefulness to increase Earning Per Share
(EPS) for shareholder
1. It measures the sensitivity of the undertaking’s Earnings Per Share (EPS) to the changes in the Earnings Before Interest and
Tax (EBIT)
2. The basic assumption for this is that source of funds (whether equity or debt) does not affect the EBIT whereas it does affect
the EPS
3. This is based on the advantage of interest on debt being a pre-tax expense.
Example no. 4
Unit 1 Unit 2
Equity share capital Rs. 100 lacs = 1 lac shares Rs. 200 lacs = 2 lac shares
Debt capital @ 14% interest Rs. 300 lacs Rs. 200 lacs
EBIT Rs. 150 lacs Rs. 150 lacs

Chapter: One
Less: Interest Rs. 42 lacs Rs. 28 lacs
EBT or PBT Rs. 108 lacs Rs. 122 lacs
25
Tax say at 35% Rs.37.8 lacs Rs.42.7 lacs
EAT or PAT Rs.70.2 lacs Rs.79.3 lacs
Earnings Per share (EPS) Rs. 70.20 Rs. 39.65
It can be seen from the above that increasing the debt component in a given capital structure increases the Earnings Per Share
(EPS) as the number of shares issued is less than when more equity share capital is present in the capital structure. This is the
concept of “Financial leverage”.
Observations:
1. As debt component increases in a capital structure, EPS also increases;
2. Presence of corporate tax makes the difference
3. In the absence of taxes, the difference in EPS will be negligible
Alternative 1 Alternative 2
EBIT 200 200
Interest 45 60
PBT 155 140
Tax 0 0
PAT 5.17 7
Difference = 36.6%
Earlier difference = 36.4%
So what makes the difference?
Interest being allowed as operating expense
Does it mean that we can increase the debt component without any ceiling? Answer is “No”.
Even if the project/enterprise owner wants it that way (as he will be required to put in less of his money) lenders will not permit
it. The ceiling prescribed by the market or lenders at present is 2: 1. This is considering only the medium and long-term debts and
excluding the short-term debts.
What are the risks of increased financial leverage?

1. Risk of default in repayment of debt – stage 1
2. Default in payment of interest on debt – stage 2
3. Increasing perception of risk in the eyes of the lender/market
4. Strong possibility of increase in rates of interest on various components of debt
5. Investors shying away from the company
6. Reduction in the share price in the secondary market and hence reduction in share holders’ wealth
Just like we measured the DOL for a given point, can we measure degree of financial leverage also? Yes
HOW?
DFL = EBIT/ EBIT – I – {Dp/(1-t)} --------------------- Equation no. 2
The above formula is derived as under:
25
Actual tax rate is at present = 35% + 10% Surcharge thereon making a total of 38.5%

Chapter: One
DFL = (Δ EPS/EPS)/ (Δ EBIT/EBIT) –------------------ Equation no. 1
We know that EPS = {(EBIT – I) (1-t)26 – Dp}/ no. Of equity shares in which Dp is the dividend on preference share capital.
Substituting this in equation no. 1, we get equation no. 2 as above.
How does one determine the level of finance for the firm?
When trying to determine the appropriate financial leverage for a firm, we would also analyze the cash-flow ability of the firm to
service the fixed financial charges. The greater the rupee amount of debts taken by the company, the greater the fixed financial
charges. This further increases in case the maturity of these debts is of shorter duration, i.e., less than 5 years. Before taking on
additional fixed financial charges, the firm should analyze its expected future cash flows, as fixed financial charges must be met
with cash. The inability to meet these charges may result in financial insolvency. The greater and more stable the expected future
cash flows, the greater the debt capacity of the firm.
Usefulness of financial leverage

1. It enables a business enterprise to designate its capital structure with proper mix of debt and equity
2. It also tells the management to evolve what is known as “debt policy” suitable for the industry in which they are operating.
3. It tells the management how to increase the Earnings Per Share (EPS) of course up to a point, beyond which any further
increase in debt becomes counterproductive.
4. Financial leverage is a measure of financial risk associated with a business enterprise
Total leverage – combination of operating and financial leverages

1. Total leverage is a measure of total firm risk = business risk (operating leverage) + financial risk (financial leverage)
2. It measures the sensitivity of the firm’s Earnings per share (EPS) to the changes in output, i.e., sales
3. It combines the operating leverage and financial leverages of the firm.
4. Formula is = (Δ EPS/EPS)/(Δ Sales/Sales)
5. Direct measurement formula – this uses the formulae for DOL and DFL. We get,
Q (S-V)/Q (S-V) – FC – I – Dp/(1-t)
Conclusion on leverages
1. Leverage is a double-edged sword; if used properly it will enhance the operating efficiency of the firm by increasing the
EBIT in response to sales (operating leverage) and maximize the return to shareholders by increasing the EPS in response to
EBIT.
2. Simultaneously if not used properly, the results could be disastrous in the sense that the firm’s operating risk and financial
risk both increase
3. Business enterprises use the leverage opportunities depending upon their risk taking ability or risk aversion that in turn
depend upon the corporate philosophy of the management – whether they are conservative or aggressive. If they are
conservative, they would like to operate at a very low leverage level – the DOL and DFL could be less than 1 and on the
contrary if they are aggressive, the level of leverages would also increase – the DOL and DFL would be well above 1
Chapter No. 6 – Long-term financing
26
Please note that as dividend is post-tax and interest is pre-tax, this needs to be converted into post-tax and for
this the formula is post-tax rate or value = pre-tax rate or value (1-t) wherein “t” represents the tax rate expressed
in decimals. Suppose the tax rate is 35%, then “t’ is 0.35.

Chapter: One
Financial planning for capital assets

What are capital assets?
A capital asset is defined as a business asset that is useful to the business for a long time. Capital
assets are also referred to as “fixed assets” or “long-term” assets. As they give benefit over a period
of time, they are subject to “wear and tear”. Hence a part of their value gets written off every year as
“depreciation”. They are (in the case of a manufacturing enterprise):
♦ Land
♦ Building
♦ Technology fees for transfer of technology from the owner
♦ Plant and Machinery
♦ Furniture and Fixtures
♦ Vehicles
♦ Electrical Installations
♦ Factory Equipment
♦ Office equipment
♦ Effluent Treatment Plant (in case the factory is generating environment polluting goods)
♦ Patent fees (in the case of Engineering firms for registering their patents)
♦ Copyright fees (in the case of a publishing company)
♦ Trademark fees (for registering the “logos”)
♦ Franchise fees (in the case of a “franchisee” who uses somebody else’s brand and does business)
♦ Aircraft or ship or railway siding taken on lease (owner is the Indian Railways from whom you take
it on lease)
♦ Computers and net working systems
Note: The list is not exhaustive. The above list contains the maximum number of items, as is always
the case with a manufacturing unit. This is precisely the reason why conventionally a “manufacturing
enterprise” is taken as an example as it is the most complex of business enterprises among all kinds of
business enterprises. The business enterprises would be under one of the following categories:
♦ Manufacturing
♦ Trading
♦ Services including I.T. enterprises
Among the three, the manufacturing enterprises would require fixed assets of different kinds and in
turn the variety of fixed assets depends upon whether the enterprise manufactures capital goods or
material/components or fast moving consumer goods etc. Generally the capital goods manufacturers
would be having more manufacturing processes and hence more variety of fixed assets. The
investment in fixed assets would be the heaviest in this category.
A brief about depreciation

All the fixed assets as aforesaid are subject to wear and tear and hence require replacement after a
specified period. This period is closely linked to the “economic life” of the asset. For example the
economic life of a machine is 5 years. It will be in the interests of the organization to replace it before
the end of 5 years, say 4 years when the repairs and maintenance amount that is required to be spent
on it would still be manageable. Where does the business enterprise get the amount? From
depreciation – by claiming a portion of the value of fixed assets as an expense towards “wear and
tear”. As this amount is not spent, depreciation is often referred to as “book expense” or “non-cash

Chapter: One
expense”. As this does not involve any outlay of funds, the cash remains within the system primarily
for giving the enterprise funds for purchase of machine at the end of 4 years in our example on
replacement basis. Depreciation can be claimed either on “Straight Line Method” basis or “Written
Down Value Method” basis.
The importance of “depreciation” does not rest there. By claiming depreciation, we are reducing the
profit for the year and thereby tax. As there is no “cash out flow” involved in depreciation, the
entire funds are available with the enterprise. Thus, depreciation is at once a “business expense”
and a “fund”. It is a well-known method of “tax planning” by acquiring fixed assets regularly, so
that you reduce your tax liability. This would be possible only if your level of income permits
absorption of “depreciation” as expenditure. Let us see the following example.
Example no. 1
Depreciation by straight line method and written down value method
Suppose we have an asset worth Rs.1lac at the beginning and we can claim depreciation either by the
straight-line method or by the written down value method. Further let us assume the rates are same
for both the methods, say 10%. Then the depreciation schedule would look like:
(Straight-line method)
Year No. Opening value Depreciation Closing value
Zero 1,00,000/- ----- 1,00,000/-
1 1,00,000/- 10,000/- 90,000/-
2 90,000/- 10,000/- 80,000/-
3 80,000/- 10,000/- 70,000/-
4 70,000/- 10,000/- 60,000/-
5 60,000/- 10,000/- 50,000/-
6 50,000/- 10,000/- 40,000/-
7 40,000/- 10,000/- 30,000/-
8 30,000/- 10,000/- 20,000/-
9 20,000/- 10,000/- 10,000/-
10 10,000/- 10,000/- Nil
(Written down value method)

Year No. Opening value Depreciation Closing value
Zero 1,00,000/- ----- 1,00,000/-
1 1,00,000/- 10,000/- 90,000/-
2 90,000/- 9,000/- 81,000/-
3 81,000/- 8,100/- 72,900/-
4 72,900/- 7,290/- 65,610/-
5 65,610/- 6,561/- 59,049/-
6 59,049/- 5,905/- 53,139/-
7 53,139/- 5,314/- 47,825/-
8 47,825/- 4,783/- 43,042/-
9 43,042/- 4,304/- 38,738/-

Chapter: One
10 38,738/- 3,874/- 34,864/-
Note: The depreciation in the straight-line method is dependent on the original value and does not
vary from year to year. Under this method, an asset would be reduced to “zero” after a period of time.
The rate of depreciation is applied on the original value and not the closing value.
The depreciation in the written down value method is dependent on the closing value only and the rate
of depreciation is applied to it. Hence, every year, the amount of depreciation varies. If the rate of
depreciation is the same under both the methods, then, while an asset gets written off under the
straight-line method, under the written down value method, it always retains a positive value. Hence,
the rates of depreciation have been so arranged in the Schedule XIV of the Companies Act, 1956, that
under either method, over a period of time the closing value remains more or less the same.
A limited company can claim depreciation either under S.L.M. or W.D.V. in the books, as per the
provisions of the Companies Act. The Income Tax rules permit only one method, i.e., the written down
value method and the rates of depreciation prescribed in the Income tax are different from the rates
prescribed in the Companies Act. These rates are the same for any form of business organisation,
namely, firms or limited companies.
Learning Points:
♦ Depreciation is at once an expense and a fund (resource).
♦ It is a part of the internal accruals.
♦ Depreciation is a part of tax planning in companies.
♦ In the books, you can claim depreciation either by SLM or WDV but in the income tax you can claim
only by WDV.
♦ In the books, only for limited companies, rates of depreciation have been prescribed by The
Companies’ Act.
♦ The rates of depreciation in the Income tax are uniform to all forms of business organisation.
♦ In the SLM the value of the asset can reduce to “zero”, while in the WDV, this would not happen.
Example no. 2 – Depreciation as a tool in tax planning
Parameter Unit No. 1 Unit No. 2

27
EBDT Rs.100 Lacs Rs.100 Lacs
Depreciation Rs. 25 Lacs Rs. 15 Lacs
Profit before tax Rs. 75 Lacs Rs. 85 Lacs
Tax at 40% Rs. 30 Lacs Rs. 34 Lacs
Profit after tax Rs. 45 Lacs Rs. 51 Lacs
Add back depreciation Rs. 25 Lacs Rs. 15 Lacs
Cash accruals Rs. 70 Lacs Rs. 66 Lacs
Note
27
EBDT = Earnings Before Depreciation and Tax

Chapter: One
Usually Profit After Tax is taken as the parameter for comparing the performance (intra-firm, i.e.,
comparison with its own past performance) or (inter-firm, i.e., with other firms in the same industry
having same scale of investment). However from what we know “depreciation” is a non-cash expense
and hence “Cash Accruals” are a better parameter as a comparison tool.
Why financial planning for capital assets? Importance of capital budgeting

Let us discuss the above example. Both the enterprises are in the same line of business and have the
same scale in terms of say the original investment in fixed assets. Over a period of time as can be
seen, Unit no. 1 is able to claim higher depreciation due to the fact that they are purchasing regularly
fixed assets on replacement basis whereas Unit no. 2 has not been able to do this. This is primarily
because Unit no. 2 does not have the priority of replacing the fixed assets in time. Hence it runs the
risk of its assets performing below par and that too after incurring heavy expense on account of
“repairs and maintenance” progressively. In our example let us say that every four years Unit no. 1 is
replacing its fixed assets whereas Unit no. 2 does not have any “asset replacement” calendar. The
availability of funds depends upon certain critical factors as under:
♦ Overall profitability of the enterprise – in this case the level of EBDT is the same in both the
enterprises
♦ Dividend policy – How much to pay by way of dividend and how much to keep back in the
business by way of “Reserves”
♦ Ability to raise medium to long-term resources from the market, promoters etc.
♦ Observance of “financial discipline” that would include continuous “financial planning” and
strict monitoring of use of funds for optimization of results
This is where the importance of “capital budgeting” lies. As we know any business enterprise has two
kinds of budgets prepared by the Accounts/Finance departments. One is “revenue budget” and the
other one is “capital budget”. The former one is for working capital expenses and the latter one is for
fixed assets. Capital budgeting as an exercise would involve “effective tax planning” through “capital
assets replacement plan” so as to minimize the tax liability and maximize the “accruals” available to
the business enterprise. Availability of funds in turn depends upon its credit worthiness and ability to
raise resources as well as its “dividend policy”. If the business is very free with its available cash and
dispenses more dividends, it would have less amount with it for investment in fixed assets. We will
appreciate this in the following paragraphs. The effectiveness of financial planning that a business
enterprise does is more validated by its capital budgeting discipline rather than its revenue budgets.
Sources of funds available for capital expenditure:

Capital expenditure requires huge outlay of funds;
Working capital funds cannot and should not be diverted to fixed assets as that lands the enterprise in
liquidity problems;
Capital expenditure requires medium to long-term funds as under:
♦ Share capital
♦ Profits retained in business in the form of reserves (only for existing enterprises)
♦ Depreciation claimed on fixed assets (only for existing enterprises)
♦ External loans like –
o Debentures
o Project loans
o Bonds
o Unsecured loans from promoters, friends and relatives
o Fixed deposits accepted from the public for a period exceeding 12 months

Chapter: One
o Lease and/or hire purchase for purchase of specific fixed assets or what is called
“equipment financing”
o Medium-term acceptances for purchase of specific capital equipments under IDBI or
SIDBI schemes
o Deferred Payment Guarantee scheme for purchase of specific capital equipment under
which the buyer’s bank gives guarantee in favour of the seller and/or his bank – the
seller obtains finance against this guarantee. This is very similar to medium-term
acceptance as above
The details of all the resources have already been discussed in Chapter no. 4. Hence they are not
repeated here.
From the list above it can be seen that in the case of existing enterprises, two additional resources are
available, namely depreciation on fixed assets and profits earned and retained in the business
enterprise. This is the difference in approach between the existing enterprise and a new enterprise. Let
us examine it through an example.
Example no. 3
Let us take a business enterprise that starts with a total capital of Rs. 1000 lacs – financed by equity to
the extent of Rs. 400 lacs and loans to the extent of Rs. 600 lacs. The business enterprise is supposed
to repay the loans over a period of five years at the rate of Rs. 200 lacs every year. Let us also assume
that it has earned sufficient profits to be in a position to repay the loan as per the loan amortization 28
schedule. Let us map their capital structure as under:
(Amount in lacs of rupees)
Parameter in the capital structure Period T0 Period T5
Equity share capital 400 400
Loans 600 ----
Reserves and surplus ---- 40029
Applying the debt to equity ratio, it is 1.5:1 at the beginning and it is “infinity” at the end of five years
as there is no debt obligation outstanding. Hence the business enterprise is in a position to raise
further resources for financing its fixed assets and put in a part of the amount required as “margin
money” from its internal accruals. This is the most important difference between new business
enterprise and an existing one in as much as resources that are available for fixed assets.
Thus in financial planning for fixed assets for an existing enterprise, internal
accruals including depreciation form a very important source whereas in the case
of a new enterprise internal accruals would not be there.
Let us see one more example to get this reinforced in our minds.
Example no. 4
The enterprise in the above example requires Rs. 600 lacs. It would first see how much it could commit
from its internal accruals to the fixed assets funding. Let us say Rs. 100 lacs. Suppose it has to observe
a debt to equity ratio of 1.5:1. Then it has to raise by way of internal accruals and fresh capital Rs. 240
lacs (600/5 * 2). As it has internal accruals of Rs. 100 lacs, it is enough for it to raise equity of Rs. 140
lacs {240 lacs (-) 100 lacs}, whereas in the case of a new enterprise, it requires entire Rs. 240 lacs by
way of equity.
28
The students should progressively learn to adopt international finance language as in the case of “amortization”.
Loan amortization schedule is very common internationally, by which they mean the repayment schedule.
29
The balance amount of Rs.200 lacs have come from the depreciation claimed on fixed assets and utilized for this
purpose. The business enterprise would have claimed more than Rs.200 lacs by way of depreciation and it is
assumed here that a part of this amount, it has utilized for replacement of fixed assets.

Chapter: One
Financial projections – assumptions underlying them

Capital budgets belong to one of the three following kinds:
1. Projects in which substantial funds are required and elaborate exercise in estimated financial
working is done to determine the ability of the enterprise to service the debt taken both by way of
interest (revenue expense) and repayment of loans (capital expense)
2. Capital expenditure in which moderate or low amount of funds would be required for replacement
of existing assets so as to improve operating efficiency of the production unit but would not
involve an elaborate exercise as above. Most of the times this may result in cost reduction and this
amount would be treated as though they are incremental cash flows
3. Capital expenditure which is purely undertaken as a matter of routine like “employee canteen” or
“water cooler” or like establishing networking of computers. This would only involve cash outlay at
the beginning and mostly would not result into savings (even if savings result it is very difficult to
quantify and measure it). The objective of such expense is “employee satisfaction” primarily or
“operating efficiency” over a period of time due to availability of ready infrastructure or increased
employee satisfaction.
Projects in which substantial funds are required

1. Horizontal expansion – The existing installed capacity of the manufacturing plant (capacity at
100% utilization is called “installed capacity”) is enhanced by adding to the production line by
installing additional plant and machinery. Large amount of capital is required
2. Vertical expansion – Process integration – it could be forward integration in which a forward
process is begun that was so far being outsourced (example in a textile plant – manufacturing
readymade garments) or backward integration in which a backward process is begun that was so
far being outsourced (example in a textile plant – manufacture of yarn in a weaving unit). This
most of the times would involve very huge capital outlay of funds or at times even taking over of
an existing enterprise.
3. Modernisation – Existing product subject to technology up gradation. Substantial funds required.
Mostly would result in dramatic improvement of operating efficiency and cost reduction.
4. Diversification – New product line – could be in related areas (Hindustan Levers diversifying into
“tea” or “coffee”) or in totally new areas (The Tatas reputed for Engineering Enterprises launching
Hotel business). This would be more strategic in nature and involve taking tremendous business
risks besides usual financial risks.
All the above projects would work on what is known as a set of “working assumptions”. The
assumptions form the core of a project decision as above. Some of the assumptions are:
1. Capacity utilisation of the installed capacity – Year 1 – 50%, Year 2 – 60%, Year 3 – 65% and so on
and so forth
2. Costs of all inputs like materials, bought out components, foreign exchange appreciation over the
project period, power, water and fuel (together called utilities), other manufacturing expenses,
administrative expenses, marketing and/or selling expenses
3. Cost of capital – otherwise known as the cost of borrowed funds and equity put in by the project
owners
4. Selling price of the product and estimated demand
5. Requirement of working capital for the business enterprise
6. Number of days working
7. Number of shifts working
8. Corporate tax payable on the profits
9. Rates of depreciation on fixed assets
10. Repayment schedule for loans taken

Chapter: One
11. Salaries and wages for staff and workers
12. Material consumption as a % of cost of production or sales
13. Fixed costs and break-even sales etc.
The above list is not exhaustive but fairly indicative of the working assumptions of any project
Based on the above, the finance department prepares the first year’s projected profit and loss
statement, balance sheet at the end of the period, cash f low and funds flow statements.
Once Year 1 projections are ready, bifurcation of expenses into variable and fixed expenses takes
place. Fixed expenses are projected to increase by “Budgeted Expenses Method (BEM)” and variable
expenses are increased by “Percentage Sales Method (PSM)”. Let us see examples for both of these as
under:
Example No. 4 – Projections by BEM and PSM

Administrative expenses – typical example of fixed expense – last year = Rs.10 lacs. The projected
increase in the coming year is independent of the % increase in sales. The total expenses such as
these are budgeted through revenue budgets at the beginning of the year and allocated to various
departments, divisions, offices etc. This could be projected to increase say by 7% whereas the
projected increase in sales could be much higher than that say 25%.
The materials consumed – typical example of variable expense – last year = Rs. 25 lacs. As the
projected increase in sales is 25%, the projected materials consumption for the following year would
be = Rs. 25 lacs x 1.25 = Rs. 31.25 lacs. This is the difference between how one estimates “fixed
costs” and “variable costs” in a project. The above % of materials consumption could vary further due
to “change in product mix” which could alter the amount of consumption as a % of sales or production.
Role of strategy in financial planning in the long-term

At a very preliminary level, let us examine the impact of long-term strategic planning on capital
expenditure decisions. Take for example creating infrastructure in another city for making inroads into
a new market. This would initially involve huge capital investment but may not give immediate
returns. This is where strategy comes in. If the management were to take a decision based only on
immediate benefits, this may not be possible. The decision would be against opening of a branch office
or divisional office. However if the strategy were to be ready when the competition arrives or pre-empt
the likely competition in future or prepare a base for launching new and critical products in future,
then mere numbers do not count. This is exactly what is called “strategy in financial management”.
Similar strategic financial management decisions could be:
♦ Take over of another unit
♦ Merger with another unit
♦ Diversify into unrelated areas
♦ Taking a strategic partner either from within the country or abroad
♦ Continuing with low return high volume product in the product mix – could be because of % share
in the market that is critical to the enterprise
Chapter No. 7 – Working Capital Management
What is working capital?

Capital in any business is split into long-term capital and working capital. Working capital is used for
day-to-day operations of the business enterprise and hence the name. It does not mean that the other

Chapter: One
capital namely the long-term capital does not work. Working capital has got two connotations – gross
working capital and net working capital.
Gross working capital = Sum total of current assets
Net working capital = Difference between gross working capital and current liabilities.
What are working capital assets? Are there other names for these terms?
Gross working capital is also known as short-term assets or current assets
Current liabilities that finance working capital are also known as short-term liabilities or working capital
liabilities
Current assets are:

Cash
Bank balances
Inventory of materials, work-in-progress, finished goods, components and consumables
Inland short-term receivables
Loans and advances given including advance tax paid
Pre paid expenses
Accrued income
Investments that can be converted into cash
Current liabilities are:

Short-term bank borrowing like overdraft, cash credit, bills discounted and export finance
Creditors outstanding for materials, components, consumables etc.
Other short-term loans and advances for working capital like Commercial paper, fixed deposits
accepted from public for less than 12 months, inter-corporate deposits etc.
Outstanding expenses or provision for expenses, tax and dividend payable etc.
Objectives of working capital management

Having seen the components of working capital – both assets and liabilities, let us understand the
objectives of working capital management through following examples.
Example no. 1
ABC Enterprises on an average require Rs. 20 lacs in cash (not physical cash but in ready to draw
facility like current account or overdraft account) but have Rs. 30 lacs on an average on a conservative
basis. At the end of the accounting period, the management is upset that its estimated profits do not
materialise although the sales and other parameters are as per the estimates. What could be one of
the reasons for reduced profits?
Obviously excess cash that they are carrying. The excess cash of Rs. 10 lacs suffers what is known as
“opportunity cost”. In this case, it is loss of interest on cash credit or overdraft facility. Thus the
objective of cash management is to minimise the cost of idle cash but at the same time not run the
risk of little liquidity.
Similar to this is the entire objective of working capital management –

♦ Manage all the components of working capital in an efficient manner so that

Chapter: One
♦ We do not run out of cash or materials;

♦ We are able to cut down process time;
♦ Hold optimum level of finished goods and
♦ Collect money from debtors without carrying receivables longer than necessary.
In short manage all the components efficiently. Hence working capital management has the following
components:
♦ Cash management
♦ Inventory management
♦ Creditors management
♦ Bank finance management
♦ Receivables management
♦ Short-term excess liquidity management by investment in short-term securities
Why should current assets be greater in value than current liabilities?

Current assets include receivables that include profit. Further inventory excepting materials,
components that are bought out and consumables would be valued after value addition. For example,
work in progress and finished goods would be higher in value than the materials that have gone into
them; whereas the current liabilities would be at cost and hence less in value than the value of current
assets. Further the value of current assets is always expected to be higher than the value of current
liabilities as the difference represents the net liquidity available in the business enterprise.
In other words, let us say that current liabilities for a firm are Rs. 100 lacs and the current assets are
Rs. 80 lacs. This means that the net working capital is negative and that the enterprise does not have
any liquidity. This is a very dangerous situation. An examination of the current assets as above would
reveal that all the current assets are not the same in the context of convertibility into cash. While
some of them like inventory of materials, components, work-in-progress cannot be converted into cash
immediately; the debtors outstanding (unless it happens to be bad debts) could be converted into cash
with a little more ease.
Thus can we differentiate between some current assets and others in the context of liquidity? Yes.
Those assets that can be converted into cash without difficulty are known as “liquid assets”. They are:
♦ Cash on hand
♦ Receivables (conventional thinking whereas in reality, there could be some percentage of debtors
that cannot be converted into cash easily)
♦ Investments that can be converted into cash immediately like investment in limited companies
whose shares are listed on stock exchanges
♦ Bank balances like current account etc.
Current assets to current liabilities relationship is known as “current ratio”. Current ratio should always
be greater than 1:1
What is the nature of working capital assets?

Working capital assets are distinct in their characteristic feature from the long-term fixed assets.
Current assets turn over from one from into another and this characteristic trait of current assets is
known as “turn over”. This term is mistaken to mean the value of sales or operating income in a given
period. There should be no doubt in the readers’ minds about the linkage between the current assets
turning over and the value of sales revenue in a given period. The sales are due to the “turnover” of
current assets. This is unlike the fixed assets that provide the platform for the activity but do not
turnover by changing form. The time taken for cash to be converted back to cash is known as

Chapter: One
“Operating Cycle” or “Working Capital Cycle”. Let us examine the following diagrammatic
representation to understand this.
Cash Materials
Work in progress or semi-finished goods

Sales
Finished goods
The above cycle is known as “operating cycle” or “working capital cycle”. This can be expressed in
value as well as in number of days.
Example no. 2
Cash to materials = 10 days = “procurement time” or “lead time”
Material to finished goods = 21 days = process time or production time through work-in-progress
stage
Finished goods to sales = 10 days = stocking time
Sales to cash = 30 days = Average collection period (ACP) or this can be nil (in most of the companies,
this would be existent and very rarely this would be “zero”)
The operating cycle in number of days would simply be the sum total of all the components of the
cycle = 71 days.
Suppose there is credit on purchases, what would be its impact on the above?
To the extent credit is available on purchases, the cycle would shorten as due to availability of
material on credit, there would be no lead-time or procurement time or usual procurement time would
reduce to that extent. If we take 10 days as credit period given by suppliers on the purchases, the
operating cycle would be 71 days (-) 10 days = 61 days.
What is the use of this operating cycle?

The cycle indicates the operating efficiency of the enterprise. The higher the number the better the
efficiency. Let us study the following example for understanding this.
Example no. 3
Let us compare two business enterprises with differing operating cycles in number of days.
Unit 1 = 60 days Turnover = 6 times; 360/60 (for sake of convenience the year is taken to consist of
360 days instead of 365 days)
Unit 2 = 90 days Turnover = 4 times; 360/90
It is obvious that the turnover of unit 1 is more efficient. This is also referred to as “operating efficiency
index” Formula for operating efficiency index = number of days in a year/no. of days per working
capital cycle.
It should be borne in mind in the above example that the two units under comparison should be from
the same industry and have comparable scale of operations.
Operating cycle in practice

Although we have seen in Example no. 1 how one determines the number of days in a cycle, in
practice the cash portion is neglected and instead credit on purchases is considered. Let us see the
following example to understand this.
Example no. 4
Item in the current assets Number of days Value of item
(Rupees in lacs)

Chapter: One
Materials 45 230
Work in progress 21 200
Finished goods 15 180
Receivables or debtors 30 500
Creditors outstanding or credit on 15 76
Purchases
Then the operating cycle in number of days = 45 + 21 + 15 + 30 – 15 = 96 days
Operating cycle in value = 230 + 200 + 180 + 500 – 76 = Rs. 1034 lacs
Is there any difference between operating cycle in value and operating cycle in
terms of funds invested?
Yes. In the above case, the value of operating cycle is Rs. 1034 lacs. However this is not the same as
the amount of funds invested in operating cycle. The difference is the profit on outstanding debtors.
Let us assume that the profit margin is 10%. Hence in the above example, the profit on Rs. 500 lacs
works out to be Rs. 50 lacs. This is return on investment and not a part of investment. Hence to
determine how much of funds have been invested in current assets, we will have to deduct this
amount. After deducting Rs. 50 lacs, the resultant figure is Rs.984 lacs.
Thus in the given example, the investment in operating cycle is Rs. 984 lacs and the value of one
operating cycle is Rs.1034 lacs.
How is working capital financed in practice?

Example no. 5
Working capital assets = Rs. 200 lacs = Gross working capital
Current liabilities like creditors, outstanding expenses = Rs. 40 lacs
Net working capital = Total current assets (-) Total current liabilities = funds from medium and long-
term = Rs. 60 lacs
Bank finance = Rs. 200 lacs (-) Rs. 40 lacs (-) Rs. 60 lacs = Rs. 100 lacs
Thus current assets in practice are financed by:
♦ Medium and long-term permanent finance called “net working capital”
♦ Current liabilities other than bank borrowing due to the market position of the enterprise
♦ Finance by commercial banks like cash credit, overdraft and bills discounted
In a business enterprise that is showing continuous incremental sales, what will

be the impact on its working capital requirement?
Example no. 6
Let us say that the working capital requirement for 2001-2002 was Rs. 100 lacs for a sale of Rs. 300
lacs
Let us assume that the sales are estimated to increase by 30% during 2002-2003. Then it is very likely
that the working capital requirement (i.e., gross working capital) would increase by 30% to Rs. 130
lacs. Under very few circumstances wherein the holding period of materials is less or process time is
less etc. the working capital increase will be less than proportionate to increase in sales. At times this
could be more than proportionate to the increase in sales due to change in Average Collection Period
(average credit period on sales) or circumstances forcing the unit to hold inventory for a longer time
than in the previous year.

Chapter: One
Thus very rarely the working capital requirement of a business enterprise gets reduced in future. So
long as the business enterprise is working, the working capital requirement would only increase. Along
with increase in gross working capital, the net working capital would also increase proportionately. In
case this does not happen the current ratio is likely to reduce. We will examine this example to
understand this.

Parameter Year 1 Year 2
Sales 1000 1300
Gross working capital 250 325
Net working capital 80 90 (increase less than 30%)
Current liabilities other than bank finance 50 65 (increase
30% - proportionate)
Eligible bank finance 120 170
Current ratio 1.47 1.38
Thus the current ratio gets impaired when the incremental sales do not get proportionate increase in
net working capital. There are two more alternatives that could push up the bank borrowing in the year
2. They are:
Current liabilities other than bank finance reducing or increasing less than proportionately to
incremental sales
Both current liabilities other than bank finance and net working capital are estimated to increase less
than proportionately
The banks financing current assets would be reluctant to accede to the borrower’s request of reduction
in net working capital that affects the current ratio. From the above it is very clear that any business
enterprise has certain minimum working capital at all times. This is called the “core working capital”.
Invariably this is financed by net working capital and rarely by current liabilities. Thus in most of the
business enterprises, core working capital = net working capital = permanent working capital =
medium and long-term investment in current assets that only goes on increasing with growth and not
reduce.
Are there factors that influence working capital requirement of a business

enterprise?
1. The type of activity that the business enterprise is carrying on:
♦ Manufacturing = maximum investment in current assets
♦ Trading = no investment in material but investment only in finished goods and no requirement
of cash for conversion of materials into finished goods
♦ Service industry = no investment in material or finished goods and hence least investment in
current assets
2. The kind of product that the manufacturing enterprise produces:
♦ Capital goods = requirement of funds especially work-in-process will be high
♦ FMCG = requirement of funds especially in finished goods will be high but overall inventory
held will be less than in the case of capital goods manufacturer
♦ Manufacturer of components or intermediaries = requirement will be in between the capital
goods manufacturer and FMCG
3. Dependence upon imports for materials or components or spares or consumables:

Chapter: One
♦ If it is high the lead time30 will be high and accordingly the amount invested in materials or
components or spares or consumables as the case may be will be high
4. Whether the operations are seasonal or not?
♦ For example a sugarcane crushing industry is a seasonal industry – the material of sugar cane
is not available throughout the year. Hence whenever available stocking in large quantities is
necessary. The same thing is true of a manufacturer producing edibles that are dependent
upon availability of the required agricultural products in the market.
5. What is the policy of the management towards current assets?
♦ Is it conservative? If it is the management is risk-averse and tends to carry higher inventory of
materials and cash on hand at least. The current ratio tends to be high with higher
dependence on medium and long-term sources for financing current assets rather than short-
term liabilities
♦ If it is aggressive, it is risk taking and tends to carry less inventory of materials and cash on
hand. The current ratio tends to be low with higher dependence on short-term liabilities for
financing current assets
♦ If it moderate, it is between conservative and aggressive and hence investment in materials
and cash on hand is moderate. The current ratio would also be moderate with balanced
dependence on medium and long-term liabilities on one hand and short-term liabilities on the
other hand to finance current assets.
6. The degree of process automation in the industry
♦ If it is more = less investment in work in progress or semi finished goods
♦ If it is less = more investment in work in progress or semi finished goods
7. Government policy in the country
♦ If it allows freely imports just as it is at present in India, imported materials will be higher in
the inventory with consequent higher holding and higher requirement of working capital funds
8. Who the customers are for the industry?
♦ If the unit supplies more to Government agencies = more outstanding debtors and hence
higher requirement of working capital
9. Whether the unit is in a buyer’s position or seller’s position as a supplier and as a customer?
♦ If the unit is in the buyer’s position as a supplier = more outstanding debtors due to higher
ACP
♦ If the unit is in the buyer’s position as a customer = longer credit on purchases and less
requirement of working capital
♦ Contrary would be true for the opposite position, i.e., unit is in seller’s position as a supplier
and seller’s position as a customer.
10. The market acceptance for the unit – the credit rating given by suppliers, banks etc. The better the
rating the better the terms of supply or lower the cost of borrowed funds and hence the
requirement of working capital funds would alter
11. Availability of bank finance – freely and on easy terms:
♦ If it is so the enterprise tends to stock more and draw more finance from banks; if it converse,
it will be less bank finance. The same goes for rates of interest on working capital finance
charged by the banks. If it is less – dependence on bank finance would increase; if it is
converse, it would reduce
12. Market conditions and availability of alternative instruments of finance like commercial paper etc.
30
Lead time is the time gap between placing the order for materials and its receipt at the factory

Chapter: One
♦ Increasingly commercial paper is being adopted as reliable means of short-term finance. The
rates are very competitive. They depend upon the credit rating of the commercial paper
floated by the company. If more and more such instruments of short-term finance are
available, dependence upon bank finance will reduce and one’s own investment in current
assets in the form of net working capital will reduce.
13. Easy availability of materials, components and consumables in the local markets:
♦ If they are freely available then there is no need to stock it and the unit can adopt what is
known as “Just In Time (JIT). Their investment in inventory of materials, components and
consumables would be less
Estimation of working capital requirement for a business enterprise

Factors considered are:
1. What is the desired level of stocks for materials, consumables, components and spares that the
unit should have to ensure that it does not run the risk of suspension of operations?
2. What is the credit policy on sales? Or Average Collection Period (ACP)
3. What is the period of credit available on purchases?
4. What is the expected increase in production/sales and accordingly what is the expected increase in
stocks etc.?
5. What is the policy of stocking of finished goods?
6. Is the product more customized or standard?
7. What is the lead-time for materials and dispatch of finished goods – location of the factory – is it in
a backward area or a developed area nearer to the market?
Based on the above factors, the unit estimates the gross working capital and then the level of net
working capital that it is required to bring in as a % of gross working capital. It also estimates the level
of current liabilities other than bank finance that could be available to it without any difficulty. The
balance is the bank finance. Please refer to previous examples for understanding this.
Are there banking norms for giving bank finance?

Yes. The controlling central banking authority in India namely the Reserve Bank of India (RBI) through
various committees that it had constituted over a period of time, has evolved certain lending norms for
banks for working capital. These have been captured in the following paragraph in its essence.
1. By and large the banks at present are free to evolve their own norms including the current ratio
and permissible levels of inventory and receivables etc.
2. Tandon Committee had suggested levels of inventory and receivables in the late 1970s and these
have been modified from time to time. These are only recommendations and not binding on the
banks. The levels of inventory and receivables depend upon the industry. There are more than 25
to 30 industries covered by the modified norms that have evolved over a period of time. As per
this the parameters for holding are:
a. Materials, consumables, stores/spares and bought out components = Average daily
consumption x number of days permitted
b. Work-in-progress or semi-finished goods = Average daily cost of production x number of
days permitted
c. Finished goods = Average daily cost of goods sold x number of days permitted
d. Receivables = Average daily credit sales x number of days permitted
Cost of goods sold = Sales (-) finance expenses (-) direct marketing expenses (-) profit
Cost of production = Direct and indirect production costs (excludes administrative costs,
marketing and finance costs as well as profits)

Chapter: One
3. Bill finance – both seller’s bills and purchaser’s bills should be encouraged more in comparison
with funding through overdraft/cash credit. The rate of interest should be at least 1% less than for
overdraft/cash credit facility.
4. Bulk of the finance for borrowers having working capital limits of Rs. 10 crores and above, the
funding should be through loan facility rather than cash credit/overdraft. The amount of loan
should be 85% and cash credit/overdraft cannot be more than 15%
5. Banks can evolve their own lending norms
6. Export finance should be given priority
7. Banks should have statements from the borrower for post-sanction monitoring on a continuous
basis
8. Banks should have credit rating of their borrowers done on a regular basis so as to give benefit or
increase the rates or maintain at the current level the rates of interest on working capital finances.
The banks by and large lend evolving their own lending norms including minimum current ratio, extent
of finance, minimum credit rating required, prime security, additional security (collateral security), rate
of interest depending upon the credit rating given to the borrower, preference to bill finance and
export finance etc.
Cash management
Objective – to minimize holding of cash that is at once liquid and unproductive. Conventional authors
have written about various cash management models like Miller-Orr model etc. However in practice
these models are seldom used. The control over cash is more through cash flow statement or in some
cases cash budgeting. This is similar to funds flow statement. All cash inflow items and cash outflow
items are listed out with due bifurcation as shown in the Annexure to the chapter. Cash budgeting
could also be for estimates of income and expenses whereas cash flow statement is essentially for
monitoring available cash at the end of the period vis-à-vis the actual requirement. On review, this
enables to take a suitable decision to reduce the average requirement of cash or increase it as the
case may be.
There could be three alternative positions in respect of cash in an enterprise as under:

Parameter Alternative 1 Alternative 2 Alternative 3
Opening balance 5 5 5
Cash receipts during the period 105 105 105
Cash outgo during the period 100 107 115
Cash surplus during the period 5 (2) (10)
Overall cash position at the end
Of the period 10 3 (5)
In the first, the cash position is surplus during the month getting added to the opening balance of cash
In the second, the cash position is deficit during the month reducing the opening balance of cash. The
unit is required to draw cash to the extent of average desired holding from bank overdraft or cash
credit.
It is the third one that is alarming or should be sounding warning signal to the business enterprise. If
the trend continues the unit would face liquidity crunch sooner or later – more chances for “sooner”
rather than “later”.
The student should understand that any short-term excess can be invested in short-term securities
provided cost benefit analysis has been done and return on investment in short-term security is more
than the overdraft interest. This is unlikely to be nowadays. If the short-term surplus represents the

Chapter: One
profit of the organisation that partially can be committed to investment in the medium to long-term,
this can be done without fear of liquidity problems in future.
What is cash float and what is its impact on cash management?

Cash float has impact on available liquidity in the system. The word “float” means that the money is in
transit, belonging to the customer of the business enterprise or to the bank in case of drafts purchased
and sent outstation. Let us examine the following example.
Example no. 9
A company has outstanding cheques deposited in its current account to the extent of Rs. 13 lacs at
any given time. Simultaneously it has Rs. 4 lacs cheques issued by it in favour of its suppliers
outstation but not yet debited to its account. On an average it purchases Rs. 2 lacs drafts in favour of
suppliers towards advance or settlement of bills. What is the average float outstanding? Is it in its
favour? What is the cost of it?
Average float outstanding = Rs. 13 lacs + Rs. 2 lacs (-) Rs. 4 lacs = Rs. 11 lacs
Float is against it as the money to be credited to its account or debited in advance is higher than the
money to be debited
The cost of outstanding float is the rate of interest on cash credit/overdraft for the entire year on the
average.
How to minimize float against us?

There are a number of cash management products that the present banking system offers that cash
management is not such a serious problem as it used to be. Advanced techniques of cash
management are beyond the scope of this book. Cash management is closely related to
receivable management. Decentralized cash collection system in a business enterprise having
branch networking throughout the country, Electronic Funds Transfer facility etc. have reduced the
criticality of cash management to the business enterprise.
Inventory management
What do you mean by "inventory management"?
In simple terms, it means effective management of all the components of inventory in a business
enterprise with the objective of and resulting in -
Optimum utilization of resources - this will be possible only if the unit carries neither too much nor too
little inventory. There should be just sufficient investment in the inventory so as to maximize the
number of times the inventory turns over in one accounting period and simultaneously the unit's
production or selling is not hampered for want of inventory. This means striking a balance between
carrying larger inventory than necessary (conservative inventory or working capital policy - too much
of "elbow" room) and high risk of stoppage of activity for want of inventory (aggressive inventory or
working capital policy or the practice of over trading - too little "elbow" room).
Please refer to example above on “operating efficiency”.
Who takes more risk? - A person holding higher inventory or less inventory?
Assuming that the person holding too much inventory has the right mix of inventory that is needed for
his business, carries less risk of stoppage of production or selling but ends up paying higher cost in
carrying higher inventory. On the other hand, the person carrying less inventory incurs less cost in
carrying inventory but runs the risk of stoppage of production of selling for want of resources. He is
perhaps rewarded with higher sales revenue and profits for the higher risk that he takes, provided that
his operations are not hampered for want of resources. Thus inventory management as a subject

Chapter: One
offers a classic proof for one of the two popular maxims in Finance, namely "Risk" and "Return" go
together.
What are the specific objectives of inventory management then?

♦ To minimize investment in inventory and to ensure maximum turnover of the inventory in an
accounting period
♦ To ensure stocking of relevant materials in adequate quantities and to ensure that unwanted
or slow-moving/non-moving items do not pile up
♦ To minimize the inventory carrying costs in business - both ordering and carrying costs
♦ To eliminate waste/delay in the process of manufacturing at all stages so as to reduce
inventory pile-up
♦ To ensure adequate/timely supply of finished goods to the market through proper distribution
Other components of inventory namely work-in-progress and finished goods are not discussed here, as
they require different kind of handling.
What are the costs associated with inventory?

Ordering costs: Carriage inward
Insurance inward
Salaries of purchase department
Communication cost
Stationery cost
Other administration costs
Demurrage charges
Carrying costs: Salaries of material department

Storage costs including rent, depreciation on fixed assets
Administrative costs of the department
Insurance on stocks
Interest on working capital blocked in inventory including return on margin
money provided by the owners
As mentioned earlier, one of the objectives of inventory management is to minimize the total costs
associated with it, namely ordering costs and carrying costs. The underlying principle that should be
kept in mind while discussing this is that ordering cost and carrying cost are inversely related to each
other. Suppose the ordering cost increases because of more number of times the order is repeated, a
direct consequence would be reduction in inventory held (average value of inventory held) and hence
carrying cost would be less. Conversely if the number of orders is less, this means that the average
value of inventory held is higher with the consequence of higher inventory carrying costs.
Average inventory could be the average of opening and closing stocks or wherever this information is
not available, this could be half of the size of inventory per order.
Are there tools for effective inventory management?
Yes. The tool depends upon the type of inventory, namely materials, work-in-progress or finished
goods. Let us examine the tools for managing materials.

Chapter: One
Tool No. 1: Economic order quantity (EOQ)

This refers to that quantity per order, which ensures that the total of ordering and carrying costs is the
minimum. Above this quantity per order, the ordering costs reduce while carrying costs increase and
below this quantity per order, the converse effect is felt.
The formula is 2xAxO

C
Wherein, A = Annual requirement of a particular
material in units or numbers or kgs.
O = ordering cost per order
And C = carrying cost per unit or as a % of per unit cost
Assumptions:
The demand is estimable and it is uniform throughout the period without any seasonal variation.
The ordering costs do not depend upon the size of the order; they are the same for all orders.
The carrying cost can be determined per unit either in terms of % of the unit's value or in actual
numbers, wherein the total carrying costs in a year is divided by the actual inventory carried
(expressed in number of units)
Tool No. 2 - ABC analysis

Each management has its own way of classifying the items into A, B or C. One of the ways usually
adopted in this behalf is based on the experience that 10% - 15% of the items in inventory account for
60% to 65% of consumption in value - "A" class items
"B" class - 20% to 25% of the items in inventory accounting for 20% to 25% of the consumption in
value
"C" class - 60% to 65% of the items in inventory accounting for 10% to 15% of the consumption in
value.
Based on this, items of regular consumption ("A" class items) would be ordered regularly and other
items would be progressively less stocked or ordered when you go "B" and then to "C" items.
Tool No. 3 - Movement analysis

Inventory items are bifurcated into fast moving, moderate moving, slow moving or non-moving as the
case may be. The parameter for this bifurcation depends exclusively on the experience of the
management or materials department in this behalf. This bifurcation leads to better inventory
management by not ordering items in the category of slow moving or non-moving and reducing the
stocks of moderately moving items. Further efforts will also be on to eliminate non-moving items even
at reduced prices so that future inventory carrying costs would be less.
There are other tools in material management like JIT (Just In Time technique), XYZ analysis etc.
Receivables management:
Receivables form the bulk of the current assets in most of the business today, as business firms
generally sell goods or services on credit and it takes a little time for the receivables to realise. Hence
“receivables management” forms an important part of working capital management, as it involves the
following:
1. Company’s cash flow very much depends on the timely realisation of receivables, so much so that
the cash inflow assumed in the cash flow statement turns out to be reliable;

Chapter: One
2. With any delay in realisation of bills, the likelihood of bad debts increases automatically and
3. There is a cost associated with the bills or book-debts in the form of following costs:
♦ Receivable carrying cost in the form of interest on bank borrowing against the receivables as
well as on the margin brought in by the promoters;
♦ Administrative costs associated with the maintenance of receivables;
♦ Costs relating to recovery of receivables and
♦ Defaulting cost due to bad debts.
Hence “receivables management” assumes significance in the context of overall efficient working
capital management.
Steps involved in “receivables management” or “monitoring receivables”:
1. Selective extension of credit to customers instead of uniform credit “across the board” to all the
customers. In fact, there should be a well designed “credit policy” in a company, which lays down
the parameters for “credit decision” on sales. In fact, the company should have its own credit
rating system of all its customers and details of these have been discussed under “credit
evaluation” elsewhere in the note.
2. Availing the services of “Consignment agents” who would take the responsibility of collection of
receivables for payment of a suitable commission. In fact, all the companies who do not enjoy
their own network of sales force or branch offices are effectively controlling their receivables
through this. Of late the consignment agents have started acting as “factoring service agents”
called “factors” who extend collection of receivables service besides the service of financing.
3. Try to raise bill of exchange on the customers especially for bills with credit period and route the
documents through the banks, so that there is a control over the customers due to their
acceptance on the bill of exchange. Acceptance means commitment to payment on due dates.
Even in the case of bills not involving any credit period, i.e., “sight bills” or “demand bills”, it
should be customary to despatch documents through banks so that better control can be
exercised on the “receivables”.
4. Try and obtain “Advance money” against bank guarantees so that the outstanding comes down
automatically, besides improving the liquidity available with the company.
5. Try for early release of payment by offering “cash discount”. Any decision of this kind should take
into consideration both the cost saved due to interest on bank borrowing and margin money on
one hand and the increase in cost due to the discount. For example, let us say that the interest on
bank borrowing and margin money is 15% p.a. The present credit period is 30 days and you desire
to have immediate payment by offering 1.5% cash discount. The decision should be taken after
comparing the saving of interest due to immediate payment with the amount of cash discount. At
15% p.a., the interest burden per month is 1.25%, as against the additional cost of 1.5% cash
discount. Hence, cash discount is costlier.
Note: Here, the matter has been considered only from “finance point of view” and not from the
“liquidity” point of view. All credit decisions are influenced to a great extent by consideration of
“liquidity” also.
6. Proper bifurcation of receivables of the company into different credit periods for which they have
been outstanding from the respective dates of invoices like the following. This is more from the
point of view of control and easy review rather than anything else:
Receivables up to 30 days;
Receivables between 31 days and 60 days;
Receivables above 180 days up to 1 year;
Receivables between 1 year and 2 years and so on.

Chapter: One
7. Proper and timely follow up with the customers whose bills are outstanding, both by distant
communication as well as personal visits to find out whether the delay is due to any dissatisfaction
of the customer with the quality of the goods and/or services or the after sales service rendered by
the company. This should be done regularly by ensuring that the marketing and sales personnel
are provided with the statement of outstanding receivables every month so that the matter can be
followed up with the customers during their periodic visit to them.
8. Once any customer’s profile is available as regards his outstanding bills, any further order from the
same customer should not be processed by the marketing department for sending it on to the
production department for manufacturing, especially in case the outstanding position of
receivables is not satisfactory. Thus at the very first stage, i.e., even production of goods for
customers who are defaulting would be avoided.
9. In case of large contracts, especially where the end user is not our customer and there is a clause
regarding release of 5% or 10% of the receivables after implementation of a “project” by the
ultimate end-user, try and obtain the amounts released by providing the customers with
“performance” guarantees, as mostly the retention would be due to the time necessary for being
satisfied with the performance of the goods supplied by you to the end-user through the
intermediary, who is our customer.
10. Note: In point numbers 2 and 3, it should be borne in mind that the banks while giving guarantee
do take security at least up to 25% but you still improve the cash flow to the extent of 75% of the
amount involved and the margin money given to the bank can be kept in the form of “fixed
deposit” with the bank earning “interest”, so that the overall cost of “guarantee” can be reduced.
11. Try to evolve an incentive scheme for the marketing/sales departments, by which one of the
parameters for earning the incentive is “collection of receivables” or “improvement in profile of
debtors” in the respective territories. It is observed that most of the times, incentives are given
only for booking the orders and hence there is no incentive to induce the marketing/sales
personnel to go after recovery.
12. Try to get the receivables factored by some factoring agency, like the SBI factoring company
although the cost could be higher than in the case of finance against receivables or book debts. In
fact having regard to the cost associated with “factoring”, this step is more for “liquidity” due to
the finance available from the “factor” rather than for “management of receivables”. Similar is the
case with “forfaiting” for international transactions involving “capital goods”.
Note: Factoring can be either with recourse against the drawers or without recourse. In India,
factoring is permitted only with recourse. Factoring is for short-term receivables, while forfaiting is
for medium and long-term receivables. Forfaiting internationally, is without recourse against the
drawers. However, in India, as of now, it is only with recourse. Just like “factor”, the forfaiting
agency is called “Aval” or “Avalising agent”. In India, there is “Indo Suez Aval Associates” who do
such transactions. RBI has laid down the rule that forfaiting should be registered with EXIM Bank
and that it should be backed by a bank guarantee given by the exporter’s bank.
Now let us examine the importance of “Credit policy”.

The credit policy of a company is kind of trade-off between increased credit sales and increased profits
for the company and the cost of having higher amount invested for a longer period besides the risk of
bad debts. The decision to extend credit at all, where there is none or to increase the credit period for
higher sales should weigh the additional benefit of profit from the increase in sales against the
increase in the cost with additional investment that too for a longer period. This is illustrated in the
following examples:
Example No. 11
Existing sale - Rs.200lacs
No credit on sales at present
Proposed selective credit for certain customers – 45 days
Increase in sales due to this – 24lacs per year

Chapter: One
Earnings before interest to sales – 20%
Cost of funds – 15% both from the bank and on margin
What is the additional profit from the increased sales, in case the earnings before interest and the cost
of funds is maintained, based on the assumption that on the increased sales, the bad debts is 10%.
Additional revenue before interest due to increase in sales:

Rs.24lacs X 20% = Rs.4,80,000/-
Additional investment in receivables for the credit period of 45 days, ignoring the profit margin of 20%
before interest.
(80% of 24 lacs/360) X 45 days = Rs.2,40,000/-
Interest at 15% on this = Rs.36,000/-
Loss due to bad debts = Rs.2,40,000/-
Total cost = Rs.2,76,000/-
Additional net earnings = 4,80,000/- (-) 2,76,000/- = 2,04,000/-

Hence the decision to extend credit only on new sales is quite rewarding.
Example No. 12
Existing sales: Rs.180lacs
Current credit period: 30days
Earnings before interest: 25%
Cost of funds: 18%p.a.
Contemplated increase in sales: Rs.20lacs
Contemplated increase in credit period for entire sales: 15 days
Loss due to bad debts due to new sales: 5%
Should the company go in for increased credit period?
Additional earnings before interest due to increase in sales:

20lacs x 20% = Rs.4lacs
Additional investment in receivables:
1. Additional investment on existing sales, considering the cost at 80%:
15 days x 180lacs/360 x 80% = 6,00,000/-
2. Additional investment due to new sales:
45 days x 20lacs/360 = 2,50,000/-
Total additional investment = Rs.8,50,000/-
Additional cost at 18% on the above = 8,50,000/- x 18% = 1,53,000/-
Cost of bad debt on new additional sales at 5% = 1 lac
Total additional cost = Rs.2,53.000/-
Net benefit = Additional earning (-) additional cost as above = 4lacs (-) 2.53lacs = 1.47 lacs Hence the
credit decision is welcome.

Chapter: One
Similar examples could be given even for cash discount in case there is reduction in the overall credit
period due to cash discount with or without resultant increase in sales.
Factors considered before altering credit decision and/or for credit rating
customers:
Utility of the customers to the company, in terms of existing turnover, expected increase in turnover
due to the altered credit period, efforts in promoting new products, helping in achieving the yearly
targets by agreeing to dumping and past track record regarding credit discipline.
Instruments available for credit rating and credit evaluation:
1. Bank credit reports
2. Reports in the market
3. Credit reports from independent market or credit agencies, especially in the case of international
customers
4. Customers’ published accounts in the case of limited companies.
Questions for practice and reinforcement of learning along with numerical

exercises
1. Discuss at least 4 important factors that determine the quantum of working capital required for
any business with examples.
2. From the following, determine the operating cycle in number of days and value, investment per
cycle from our side, total current assets, total current liabilities and eligible bank finance at current
ratio of 2:1. (Rupees in lacs)
♦ Raw materials - imported - annual consumption 1800 - holding 45 days
♦ Raw materials - indigenous - annual consumption 2400 - holding 20 days
♦ Packing materials - annual consumption 420 - holding 30 days
♦ Consumable stores and spares - annual consumption 360 - holding 60 days
♦ Work-in-progress - annual cost of production 6300 - holding 21 days
♦ Finished goods - annual cost of goods sold 7200 - holding 15 days
♦ Inland short-term receivables - gross sales 12720 - outstanding 2 months
♦ Other current assets - 10% of total current assets
♦ Other current liabilities - 10% of total current liabilities
3. At present you are selling Rs. 200 lacs per month.
♦ The credit period on sales is 30 days.
♦ The % of bad debts is 0.5%.
♦ The bank finance is 70% of outstanding receivables and rate of interest is 15% p.a.
♦ Your investment should earn 25% (pre-tax).
♦ Your profit margin on sales is 15% (before tax)
♦ You want to double the sales per month. The marketing department recommends an
increase of 20 days in the credit period, as the demand for your products is quite good.
The bank is willing to give you incremental credit on the same terms as at present.
However the percentage of bad debts could go up to 1.5%. Your management also wants
to earn 25% (pre-tax) on its additional investment. EBIT to sales is 22%.

Chapter: One
♦ Find out the feasibility of the proposal received from the marketing department. Show
all the steps. Do not skip any step.
4. Your company is at present doing Rs.1200 lacs sales a year. The credit period is 30 days for all
customers. You draw bank finance to the extent of 70% and the balance is the margin. Rate of
interest is 16% p.a. and the management is expecting a return of 24% on its investment. The % of
EBIT to sales is 20%. You want to expand your market and the marketing department advises you
to increase the credit period by another 30 days. The promised increase in sales is 20%. There is
no incidence of bad debts on new sales as well as old sales. Examine the issue and advise the
management suitably as to whether they should accept the recommendation and go ahead with
increasing the credit period
5. From the following determine the operating cycle in days, value of operating cycle, investment in
current assets and eligible bank borrowing.
Raw materials: 30 days – 100 lacs
Packing materials: 30 days – 30 lacs
Consumable stores and spares: 60 days – 20 lacs
Work-in-progress: 15 days – 75 lacs
Finished goods: 30 days - 200 lacs
Receivables: 45 days – Annual sales being Rs.3120 lacs
Creditors at 20 days of purchases
Profit margin – 15% on sales
Current ratio – 2:1
There are no other current liabilities
6. From the following find out the EOQ
Annual demand – 12000 units
Cost per order – Rs.1500/-
Carrying cost of inventory per unit 12% of the value of Rs.150/- per unit.
The supplier is willing to give quantity discount of 10% (reduction in Rs.150/- per unit) provided
you increase the quantum per order by 25%. If the carrying cost remains the same in value (not in
%) and the annual demand is not changed what is the revised EOQ?
Compare the total costs in both the cases (excluding the cost of material) and advise as to
whether we should go in for quantity discount?
Chapter No. 8 – Financial statements analysis
Introduction to Financial Statements and their differing objectives:
What are financial statements in a business enterprise?

The financial statements are:
Profit and Loss statement
Balance Sheet
Cash flow statement and
Funds flow statement
Objectives are:

Chapter: One
Profit and Loss statement – to know whether the enterprise is in profit or loss at the end of a
given period or not. The period would usually be one year. It could be as short a period as one
month even. However preparing the Profit and Loss Account every year is a must.
Balance Sheet – it is also referred to as statement of assets and liabilities. This is as on a
particular date. The objective is to know the financial position of the enterprise, how much it
owes to outsiders in the form of liabilities and how much it owns in the form of various assets.
Although it could be prepared on a monthly basis as at the end of every month, it is prepared
as at the end of every year – again a statutory requirement besides being a business
necessity.
Cash flow statement – as explained in the chapter on working capital management, cash flow
statement is primarily to know the cash from operations, investments and finance obtained
and manage the liquidity in the short-run. In the short-run, the objective could be financial
planning. It lists all the cash inflows and cash outflows to verify as to whether the system has
the required liquidity or not. The business should not have too little or too much cash. The
frequency of preparing it depends upon the business needs – it could even be on a weekly
basis. The minimum frequency is one month.
Funds flow statement – this is the fundamental statement used for financial planning. The
minimum period is one year. It talks of all resources, be it short-term or medium-term/long-
term and the uses to which these are put to. The objective is to ensure that proper funding
takes place in the business enterprise and that there is no diversion of working capital to
acquiring fixed assets.
Out of the above we have seen cash flow statement in the chapter on “working capital
management”. Hence the same is not repeated here. The students should take “funds flow”
statement as summary statement of sources and application for a given period; they would
realise that the format for the statement as given in the annexure to this chapter is different
from the one they are used to under “Management Accounting”.
Example no. 1 - A sample of “Profit and Loss” Account (Rupees in Lacs)

Income from operations 100
Operating expenses:
Salaries 30
Repairs and maintenance 3
Depreciation 10
Office and general expenses 10
Marketing expenses including
Commission, if any 7
Interest and other
Charges 10
Total expenses 70
Profit before tax 30
Tax at 35% 10.5
Profit after tax 19.5
Dividend 7.5
Profit retained in
Business [Retained Earnings] 12
Learning points:

Chapter: One
♦ Interest is charged to income before determining the profit of the organisation. Once the profit of
the organisation is determined, tax is paid at the stipulated rate and the dividend is paid only after
this. Thus, dividend is profit allocation.
♦ This difference between “interest” and “dividend” gives opportunity to business enterprises, to
have a mix of capital of the owners and loans taken from outside, so that they can save on tax,
through the interest charged as expense on the income. The amount of tax so saved is called “tax
shield” on the interest.
♦ In the case of profit distributed among the partners as well in the case of dividend distributed
among the shareholders, these are not taxed again in the hands of the owners.
Linkage between balance sheet and profit and loss accounts

The above statement is known as the “Profit and Loss Account”. This records the income and
expenditure for a given period and is closed as soon as the period is over. The residual profit, as it
belongs to the owners, gets transferred to the capital account in another statement, called “Balance
Sheet”.
The balance sheet tells us about the following:

How much money has the business enterprise raised?
Which are the sources for the money?
What is the use for this money?
Example no. 2
The balance sheet is also known as “Assets and Liability” statement. A sample balance sheet is shown
below:
(Rupees in lacs)
Liabilities Assets
Share capital: 100 Fixed Assets 60
Reserves: 150 Less: Depreciation 30
(Retained profits Net Fixed Assets: 30
over a period of Investments: 80
time) Current Assets:
Net worth 250 Bills Receivable 100
Bank overdraft 30 Cash and Bank 35
Creditors for expenses 10 Other current assets 60
Other current liabilities 15 Total current assets 195
Total current liabilities 55
Total Liabilities 305 Total Assets 305
Suppose profit for the year is Rs.30 lacs after paying tax and dividend. This would be transferred to
the balance sheet and the reserves at the end of the current year would be Rs.150 lacs + Rs.30 lacs =
Rs.180 lacs. Similarly the depreciation claimed on the fixed assets and shown as an operating expense
would also get transferred to the balance sheet to reduce the value of the fixed assets.
Let us assume that there is no increase in the fixed assets during the year that there are no other
changes and the depreciation for the year is Rs.10 lacs. We can construct the balance sheet for the

Chapter: One
next year without much change, excepting to accommodate these figures of depreciation and increase
in reserves.
The balance sheet as at the end of the next year would look as under:
(Rupees in Lacs)
Liabilities Assets
Share capital 100 Fixed assets 60
Reserves and surplus 180 Less: depreciation 40
Net worth 280 Net fixed assets 20
Bank overdraft 30 Investments 100
Creditors for expenses 10 Bill Receivable 120
Other current liabilities 15 Cash and Bank 35
Total current Other current assets 60
liabilities 55 Total current assets 195
Total liabilities 335 Total Assets 335
We see that between the two balance sheets, there are two
changes –
Investment has gone up by Rs.20 lacs and
Bill receivable has gone up by Rs.20 lacs.
The total is Rs.40 lacs. Where have these funds come from? This amount is the total of profit
transferred to balance sheet from the profit and loss account and depreciation added back, as it does
not involve any cash outlay. The figure is Rs.30 lacs + Rs.10 lacs = Rs.40 lacs. This figure is referred
to as “internal accruals”.
This need not be the case all the times. Where we use these funds entirely depends upon the business
priority and what we have shown is only a sample.
Learning points:
♦ The business enterprise generates funds from operations, known as “internal accruals” comprising
depreciation (which is added back, being only a book-entry) and profit after tax and dividend;
♦ Where these funds are used is entirely dependent upon business exigencies;
♦ Depreciation claimed in the books as an expense goes to reduce the value of the fixed assets in
the books, while profit after tax and dividend is shown as “Reserves” and increases the net worth
of the company.
Key pointers to balance sheet and profit and loss statements:

♦ A balance sheet represents the financial affairs of the company and is also referred to as “Assets
and Liabilities” statement and is always as on a particular date and not for a period.
♦ A profit and loss account represents the summary of financial transactions during a particular
period and depicts the profit or loss for the period along with income tax paid on the profit and
how the profit has been allocated (appropriated).

Chapter: One
♦ Net worth means total of share capital and reserves and surplus. This includes preference share
capital unlike in Accounts preference share capital is treated as a debt. For the purpose of debt to
equity ratio, the necessary adjustment has to be done by reducing preference share capital from
net worth and adding it to the debt in the numerator.
♦ Reserves and surplus represent the profit retained in business since inception of business.
“Surplus” indicates the figure carried forward from the profit and loss appropriation account to the
balance sheet, without allocating the same to any specific reserve. Hence, it is mostly called
“unallocated surplus”. The company wants to keep a portion of profit in the free form so that it is
available during the next year for appropriation without any problem. In the absence of this
arrangement during the year of inadequate profits, the company may have to write back a part of
the general reserves for which approval from the board and the general members would be
required.
♦ Secured loans represent loans taken from banks, financial institutions, debentures (either from
public or through private placement), bonds etc. for which the company has mortgaged immovable
fixed assets (land and building) and/or hypothecated movable fixed assets (at times even working
capital assets with the explicit permission of the working capital banks)
♦ Usually, debentures, bonds and loans for fixed assets are secured by fixed assets, while loans
from banks for working capital, i.e., current assets are secured by current assets. These loans
enjoy priority over unsecured loans for settlement of claims against the company.
♦ Unsecured loans represent fixed deposits taken from public (if any) as per the provisions of Section
58 (A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit
Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no security has been
offered.
♦ Such unsecured loans rank second and subsequent to secured loans for settlement of claims
against the company. There are other unsecured creditors also, forming part of current liabilities,
like, creditors for purchase of materials, provisions etc.
♦ Gross block = gross fixed assets mean the cost price of the fixed assets. Cumulative depreciation
in the books is as per the provisions of The Companies Act, 1956, Schedule XIV. It is last
cumulative depreciation till last year + depreciation claimed during the current year. Net block =
net fixed assets mean the depreciated value of fixed assets.
♦ Capital work-in-progress – This represents advances, if any, given to building contractors, value of
building yet to be completed, advances, if any, given to equipment suppliers etc. Once the
equipment is received and the building is complete, the fixed assets are capitalised in the books,
for claiming depreciation from that year onwards. Till then, it is reflected in the form of capital
work in progress.
♦ Investments – Investment made in shares/bonds/units of Unit Trust of India etc. This type of
investment should be ideally from the profits of the organisation and not from any other funds,
which are required either for working capital or capital expenditure. They are bifurcated in the
schedule, into “quoted and traded” and “unquoted and not traded” depending upon the nature of
the investment, as to whether they can be liquidated in the secondary market or not.
♦ Current assets – Both gross and net current assets (net of current liabilities) are given in the
balance sheet.
♦ Miscellaneous expenditure not written off can be one of the following –
♦ Company incorporation expenses or public issue of share capital, debenture etc. together known
as “preliminary expenses” written off over a period of 5 years as per provisions of Income Tax.
Misc. expense could also be other deferred revenue expense like product launch expenses.
♦ Other income in the profit and loss account includes income from dividend on share investment
made in other companies, interest on fixed deposits/debentures, sale proceeds of special import
licenses, profit on sale of fixed assets and any other sundry receipts.
♦ Provision for tax could include short provision made for the earlier years.
♦ Provision for tax is made after making all adjustments for the following:

Chapter: One
♦ Carried forward loss, if any;

♦ Book depreciation and depreciation as per income tax and
♦ Concessions available to a business entity, depending upon their activity (export business, S.S.I.
etc.) and location in a backward area (like Goa etc.)
♦ As per the provisions of The Companies Act, 1956, in the event of a limited company declaring
dividend, a fixed percentage of the profit after tax has to be transferred to the General Reserves of
the Company and entire PAT cannot be given as dividend.
♦ With effect from 01/04/02, dividend tax on dividends paid by the company has been withdrawn.
From that date, the shareholders are liable to pay tax on dividend income. Thus for a period of 5
years, the position was different in the sense that the company was bearing the additional tax on
dividend.
Other parts of annual statements –

♦ The Directors’ Report on the year passed and the future plans;
♦ Annexure to the Directors’ Report containing particulars regarding conservation of energy etc;
♦ Auditors’ Report as per the Manufacturing and Other Companies (Auditors’ Report) Order, 1998)
along with Annexure;
♦ Schedules to Balance Sheet and Profit and Loss Account;
♦ Accounting policies adopted by the company and notes on accounts giving details about changes
if any, in method of valuation of stocks, fixed assets, method of depreciation on fixed assets,
contingent liabilities, like guarantees given by the banks on behalf of the company, guarantees
given by the company, quantitative details regarding performance of the year passed, foreign
exchange inflow and outflow etc. and
♦ Statement of cash flows for the same period for which final accounts have been presented.
There is a significant difference between the way in which the statements of accounts are prepared as
per Schedule VI of the Companies Act and the manner in which these statements, especially, balance
sheet is analysed by a finance person or an analyst. For example, in the Schedule VI, the current
liabilities are netted off against current assets and only net current assets are shown. This is not so in
the case of financial statement analysis. Both are shown fully and separately without any netting off.
At the end of any financial year, there are certain adjustments to be made in the books of accounts to
get the proper picture of profit or loss, as the case may be, for that particular period. For example, if
stocks of raw materials are outstanding at the end of the period, the value of the same has to be
deducted from the total of the opening stock (closing stock of the previous year) and the current
year’s purchases. This alone would show the correct picture of materials consumed during the current
year.
Example no. 3
Purchases during the year: Rs.600lacs
Opening stock of raw material: Rs.100lacs
Closing stock of raw material: Rs.120lacs
Then, the quantum of raw material consumed during the year is Rs.580lacs and only this can be
booked as expenditure during the year. Consumption is always valued in this manner and cross
verified with the value of materials issued from stores during the year to compare with the previous
year;
Similarly, a second adjustment arises due to the difference between closing stocks of work-in-progress
and finished goods on one hand and opening stocks of work-in-progress and finished goods on the
other hand. Suppose the closing stocks are higher in value, the difference has to be either added to

Chapter: One
this year’s income or deducted from this year’s expense. (Different ways of presentation). Similarly in
case the closing stocks are less than the opening stocks, the difference has to be deducted from
income or added to expenses for that year. Let us study the following example.
In a company, the opening stocks were Rs.100lacs and closing stocks are Rs.120lacs. This means that
during the course of this year, the stocks on hand have gone up by Rs.20lacs from the goods produced
during this year. This does have an effect on the profit of the company. The company cannot book
expenditure incurred on producing this incremental stock of Rs.20lacs, as they have not sold the
goods. However the materials and other expenses have already been incurred and hence this value is
deducted.
The basic assumption is that the carry forward stocks have been sold during the current year while at
the end of the current year fresh stocks worth Rs.120lacs have come in for stocking. Hence, on an
ongoing basis, opening stocks are added and closing stocks are deducted. In the above example, the
effect of adding the opening stock and deducting the closing stock would be as under:
Example no. 4
Let us assume the production for the year was Rs.1000lacs
Then, sales for the year could only be Rs.980lacs derived as follows:
Production during the year: Rs.1000lacs
Add: Opening stock: Rs. 100lacs
Deduct: Closing stock: Rs. 120lacs
Sales for the year: Rs. 980lacs.
On the other hand, in case the closing stocks would have been Rs.90lacs, the sales would have been
Rs.1010lacs, more than the production value. Thus, the difference between the opening and closing
stocks of work-in-progress and finished goods affects income and thereby profit. The companies
always use this as a tool, either to increase or decrease income. In case they show more closing
stocks, income is less and thereby profit is less and tax is saved and similarly if they show less closing
stocks, income is more and profit is also more.
The principal tools of analysis are –

Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it
with the past trend. In the statements of accounts, there are several such pairs of parameters and
hence ratio analysis assumes great significance. The most important thing to remember in the case of
ratio analysis is that you can compare two units in the same industry only and other factors like the
relative ages of the units, the scales of operation etc. come into play.
Funds flow analysis – this is to understand the movement of funds (please note the difference
between cash and fund – cash means only physical cash while funds include cash and credit) during
any given period and mostly this period is 1 year. This means that during the course of the year, we
study the sources and uses of funds, starting from the funds generated from activity during the period
under review.
Let us see some of the important types of ratios and their significance:
Liquidity ratios;
Turnover ratios;
Profitability ratios;
Investment on capital/return ratios;
Leverage ratios and

Chapter: One
Coverage ratios.
Liquidity ratios:
Current ratio: Formula = Current assets/Current liabilities.
Min. Expected even for a new unit in India = 1.33:1.
Significance = Net working capital should always be positive. In short, the higher the net working
capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate
liquidity of the enterprise.
Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This
means that we are carrying either cash in large quantities or inventory in large quantities or
receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you
compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working
capital.
Range – No fixed range is possible. Unless the activity is very profitable and there are no immediate
means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an
examination of the profitability of the operations and the need for high level of current assets. Reason
= net working capital could mean that external borrowing is involved in this and hence cost goes up in
maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all
assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we
see “quick asset ratio” or “acid test ratio”.
Acid test ratio or quick asset ratio:

Quick assets = Current assets (-) Inventories which cannot be easily converted into cash. This
assumes that all other current assets like receivables can be converted into cash easily. This ratio
examines whether the quick assets are sufficient to cover all the current liabilities. Some of the
authors indicate that the entire current liabilities should not be considered for this purpose and only
quick liabilities should be considered by deducting from the current liabilities the short-term bank
borrowing, as usually for an on going company, there is no need to pay back this amount, unlike the
other current liabilities.
Significance = coverage of current liabilities by quick assets. As quick assets are a part of current
assets, this ratio would obviously be less than current ratio. This directly indicates the degree of
excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity, this
ratio is preferred. The minimum should be 1:1. This should not be too high as the opportunity cost
associated with high level of liquidity could also be high.
What is working capital gap? The difference between all the current assets known as “Gross working
capital” and all the current liabilities other than “bank borrowing”. This gap is met from one of the two
sources, namely, net working capital and bank borrowing. Net working capital is hence defined as
medium and long-term funds invested in current assets.
Turn over ratios:

Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the higher the
degree of efficiency and hence these assume significance. Further, depending upon the type of turn
over ratio, indication would either be about liquidity or profitability also. For example, inventory or
stocks turn over would give us a measure of the profitability of the operations, while receivables turn
over ratio would indicate the liquidity in the system.
Debtors turn over ratio – this indicates the efficiency of collection of receivables and contributes to
the liquidity of the system. Formula = Total credit sales/Average debtors outstanding during the year.
Hence the minimum would be 3 to 4 times, but this depends upon so many factors such as, type of
industry like capital goods, consumer goods – capital goods, this would be less and consumer goods,
this would be significantly higher;

Chapter: One
Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and
competitive it would be less as you are forced to give credit;
Whether new enterprise or established – new enterprise would be required to give higher credit in the
initial stages while an existing business would have a more fixed credit policy evolved over the years
of business;
Hence any deterioration over a period of time assumes significance for an existing business – this
indicates change in the market conditions to the business and this could happen due to general
recession in the economy or the industry specifically due to very high capacity or could be this unit
employs outmoded technology, which is forcing them to dump stocks on its distributors and hence
realisation is coming in late etc.
Average collection period = inversely related to debtors turn over ratio. For example debtors
turn over ratio is 4. Then considering 360 days in a year, the average collection period would be 90
days. In case the debtors turn over ratio increases, the average collection period would reduce,
indicating improvement in liquidity. Formula for average collection period = 360/receivables turn over
ratio. The above points for debtors turn over ratio hold good for this also. Any significant deviation
from the past trend is of greater significance here than the absolute numbers. No minimum and no
maximum.
Inventory turn over ratio – as said earlier, this directly contributes to the profitability of the
organisation. Formula = Cost of goods sold/Average inventory held during the year. The inventory
should turn over at least 4 times in a year, even for a capital goods industry. But there are capital
goods industries with a very long production cycle and in such cases, the ratio would be low. While
receivables turn over contributes to liquidity, this contributes to profitability due to higher turn over.
The production cycle and the corporate policy of keeping high stocks affect this ratio. The less the
production cycle, the better the ratio and vice-versa. The higher the level of stocks, the lower would
be the ratio and vice-versa. Cost of goods sold = Sales – profit – Interest charges.
Current assets turn over ratio – not much of significance as the entire current assets are involved.
However, this could indicate deterioration or improvement over a period of time. Indicates operating
efficiency. Formula = Cost of goods sold/Average current assets held in business during the year.
There is no min. Or maximum. Again this depends upon the type of industry, market conditions,
management’s policy towards working capital etc.
Fixed assets turn over ratio
Not much of significance as fixed assets cannot contribute directly either to liquidity or profitability.
This is used as a very broad parameter to compare two units in the same industry and especially when
the scales of operations are quite significant. Formula = Cost of goods sold/Average value of fixed
assets in the period (book value).
Profitability ratios –
Profit in relation to sales and profit in relation to assets:
Profit in relation to sales – this indicates the margin available on sales;
Profit in relation to assets – this indicates the degree of return on the capital employed in
business that means the earning efficiency. Please appreciate that these two are totally
different.
Example no. 5
Units A and B are in the same type of business and operate at the same levels of capacities. Unit A
employs capital of 250 lacs and unit B employs capital of 200lacs. The sales and profits are as under:
Parameter Unit A Unit B

Sales 1000lacs 1000lacs

Chapter: One
Profits 100lacs 90lacs
Profit margin on sales 10% 9%
Return on capital employed 40% 45%
While Unit A has higher profit margins, Unit B has better returns on capital employed.
Profit margin on sales:

Gross profit margin on sales and net profit margin ratio –
Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of production
before selling, general, administrative expenses and interest charges. Net sales = Gross sales (-)
Excise duty. This indicates the efficiency of production and serves well to compare with another unit in
the same industry or in the same unit for comparing it with past trend. For example in Unit A and Unit
B let us assume that the sales are same at Rs.100lacs.
Example no. 6
Parameter Unit A Unit B
Sales 100lacs 100lacs

Cost of production 60lacs 5lacs
Gross profit 40lacs 35lacs
Deduct: Selling general,
Administrative expenses and interest 35lacs 30lacs
Net profit 5lacs 5lacs
While both the units have the same net profit to sales ratio, the significant difference lies in the fact
that while Unit A has less cost of production and more office and selling expenses, Unit B has more
cost of production and less of office and selling expenses. This ratio helps in controlling either
production costs if cost of production is high or selling and administration costs, in case these are high.
Net profit/sales ratio – net profit means profit after tax but before distribution in any form = Formula =
Net profit/net sales. Tax rate being the same, this ratio indicates operating efficiency directly in the
sense that a unit having higher net profitability percentage means that it has a higher operating
efficiency. In case there are tax concessions due to location in a backward area, export activity etc.
available to one unit and not available to another unit, then this comparison would not hold well.
Investment on capital ratios/Earnings ratios:

Return on net worth
Profit After Tax (PAT) / Net worth. This is the return on the shareholders’ funds including Preference
Share capital. Hence Preference Share capital is not deducted. There is no standard range for this
ratio. If it reduces it indicates less return on the net worth.
Return on equity
Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference share capital.
Although reference is equity here, all equity shareholders’ funds are taken in the denominator. Hence
Preference dividend and Preference share capital are excluded. There is no standard range for this
ratio. If it comes down over a period it means that the profitability of the organisation is suffering a
setback.

Chapter: One
Return on capital employed (pre-tax)

Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This gives
return on long-term funds employed in business in pre-tax terms. Again there is no standard range for
this ratio. If it reduces, it is a cause for concern.
Earning per share (EPS)
Dividend per share (DPS) + Retained earnings per share (REPS). Here the share refers to equity share
and not preference share. The formula is = Profit after tax (-) Preference dividend (-) Dividend tax both
on preference and equity dividend / number of equity shares. This is an important indicator about the
return to equity shareholder. In fact P/E ratio is related to this, as P/E ratio is the relationship between
“Market value” of the share and the EPS. The higher the PE the stronger is the recommendation to sell
the share and the lower the PE, the stronger is the recommendation to buy the share.
This is only indicative and by and large followed. There is something known as industry average EPS. If
the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and
growth prospects are quite good, it is the time for buying the shares, unless we know for certain that
the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than
industry average P/E, it is time for us to sell unless we expect further increase in the near future.
Leverage ratios
Leverages are of two kinds, operating leverage and financial leverage. However, we are concerned
more with financial leverage. Financial leverage is the advantage of debt over equity in a capital
structure. Capital structure indicates the relationship between medium and long-term debt on the one
hand and equity on the other hand. Equity in the beginning is the equity share capital. Over a period of
time it is net worth (-) redeemable preference share capital.
It is well known that EPS increases with increased dose of debt capital within the same capital
structure. Given the advantage of debt also, as even risk of default, i.e., non-payment of interest and
non-repayment of principal amount increases with increase in debt capital component, the market
accepts a maximum of 2:1 at present. It can be less. Formula for debt/equity ratio = Medium and long-
term loans + redeemable preference share capital / Net worth (-) Redeemable preference share
capital.
From the working capital lending banks’ point of view, all liabilities are to be included in debt. Hence
all external liabilities including current liabilities are taken into account for this ratio. We have to add
redeemable preference share capital and reduce from the net worth the same as in the previous
formula.
Coverage ratios
Interest coverage ratio
This indicates the number of times interest is covered by EBIT. Formula = EBIT / Interest payment on
all loans including short-term liabilities. Minimum acceptable is 2 to 2.5:1. Less than that is not
desirable, as after paying interest, tax has to be paid and afterwards dividend and dividend tax.
Asset coverage ratio
This indicates the number of times the medium and long-term liabilities are covered by the book value
of fixed assets.
Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities. Accepted ratio is
minimum 1.5:1. Less than that indicates inadequate coverage of the liabilities.
Debt Service coverage ratio
This indicates the ability of the business enterprise to service its borrowing, especially medium and
long-term. Servicing consists of two aspects namely, payment of interest and repayment of principal
amount. As interest is paid out of income and booked as an expense, in the formula it gets added back
to profit after tax. The assumption here is that dividend is ignored. In case dividend is paid out, the
formula gets amended to deduct from PAT dividend paid and dividend tax.

Chapter: One
Formula is:
PAT (+) Depreciation (+) Amortisation (DRE write-off) (+) Int. on med. & long-term liabilities
Interest on medium and long-term borrowing (+) Instalment on medium and long-term borrowing.
This is assuming that dividend is not paid. In the case of an existing company dividend will have to be
paid and hence in the numerator, instead of PAT, retained earnings would appear. The above ratio is
calculated for the entire period of the loan with the bank/financial institution. The minimum acceptable
average for the entire period is 1.75:1. This means that in one year this could be less but it has to be
made up in the other years to get an average of 1.75:1.
What is the objective behind analysis of financial statements?
Objective (To know about) Relevant indicator/Remarks
Net worth, i.e., share capital, reserves and

unallocated surplus in balance sheet carried
Financial position of the company down from profit and loss appropriation
account. For a healthy company, it is necessary
that there is a balance struck between dividend
paid and profit retained in business so much the
net worth keeps on increasing.
Liquidity of the company, i.e., whether the Current ratio and quick ratio or acid test ratio.
company is in a position to meet all its short- Current ratio = Current assets/current liabilities.
term liabilities (also called “current liabilities”) Quick ratio = Current assets (-) inventory/
with the help of its current assets current liabilities. Current ratio should not be
too high like 4:1 or 5:1 or too low like less than
1.5:1. This means that the company is either
too liquid thereby increasing its opportunity cost
or not liquid at all, both of which are not
desirable. Quick ratio could be at least 1:1.
Quick ratio is a better indicator of liquidity
position.
Whether the company has acquired new fixed Examination of increase in secured or
assets during the year and if so, what are the unsecured loans for this purpose. Without
sources, besides internal accruals to finance the adequate financial planning, there is always the
same? risk of diverting working capital funds for fixed
assets. This is best assessed through a funds
flow statement for the period as even net cash
accruals (Retained earnings + depreciation +
amortisation) would be available for fixed
assets.
Profitability of the company in general and Percentage of profit before tax to total income
operating profits in particular, i.e., whether the including other income, like dividend or interest
main operations of the company like income. Operating profit, i.e., profit before tax
manufacturing have been in profit or the profit (-) other income as above as a percentage of
of the company is derived from other income, income from the main operations of the
i.e., income from investment in company, be it manufacturing, trading or
shares/debentures etc. services.

Chapter: One
Relationship between the net worth of the Debt/Equity ratio, which establishes this
company and its external liabilities (both short- relationship. Formula = External liabilities +
term and long-term). What about only medium preference share capital /net worth of the
and long-term debts? company (-) preference share capital
(redeemable kind). From the lender’s point of
view, this should not exceed 3:1. Is there any
sharp deterioration in this ratio? Is so, please
be on guard, as the financial risk for the
company increases to that extent.
For only medium and long-term debts, it cannot
exceed 2:1.
Has the company’s investments in Difference between the market value of the
shares/debentures of other companies reduced investments and the purchase price, which is
in value in comparison with last year? theoretically a loss in value of the investment.
Actual loss is booked upon only selling. The
periodic reduction every year should warn us
that at the time of actual sales, there would be
substantial loss, which immediately would
reduce the net worth of the company. Banks,
Financial Institutions, Investment companies or
NBFCs would be required to declare their
investment every year in the balance sheet at
cost price or market price whichever is less.
Relationship between average debtors (bills Average debtors in the year/average creditors in
receivable) and average creditors (bills payable) the year. This should be greater than 1:1, as
during the year. bills receivable are at gross value {cost of
development (+) profit margin}, whereas;
creditors are at purchase price for software or
components, which would be much less than
the final sales value. If it is less than 1:1, it
shows that while receivable management is
quite good, the company is not paying its
creditors, which could cause problems in future.
Too high a ratio would indicate that receivable
management is very poor.
Future plans of the company, like acquisition of Directors’ report. This would reveal the
new technology, entering into new collaboration financial plans for the company, like whether
agreement, diversification programme, they are coming out with a public issue/Rights
expansion programme etc. issue etc.
Has the company revalued its fixed assets Auditors’ comments in the “Notes to Accounts”
during the year, thereby creating revaluation relevant for this. Frequent revaluation is not
reserves, without any inflow of capital into the desirable and healthy.
company, as this is just an entry passed in the
books?
Whether the company has increased its Increase in amount of investment in

investment and if so, what is the source for it? shares/debentures/Govt. securities etc. in
What is the nature of investment? Is it in comparison with last year and any investment
tradable securities or long-term within group companies? Any undue increase in
investment should put us on guard, as working
Securities, which can have a lock-in-period capital funds could have been diverted for it.
and cannot be liquidated in the near future?
Has the company during the year given any Any increase in unsecured loans. If the loans
unsecured loans substantially other than to are to group companies, then all the more

Chapter: One
employees of the company? reason to be cautious. Hence, where the figures

have increased, further probing is called for.
Are the company’s unsecured loans (given) not Any comments to this effect in the notes to
recoverable and very old? accounts should put us on caution. This
examination would indicate about likely impact
on the future profits of the company.
Has the company been regular in payment of its Any comments about over dues as in the “Notes
dues on account of loans or periodic interest on to Accounts” should be looked into. Any serious
its liabilities? default is likely to affect the “credit rating” of
the company with its lenders, thereby
increasing its cost of borrowing in future.
Has the company defaulted in providing for Any comments about this in the “Notes to
bonus liability, P.F. liability, E.S.I. liability, Accounts” should be looked into.
gratuity liability etc?
Whether the company is holding very huge Cash balance together with bank balance in
cash, as it is not desirable and increases the current account, if any, is very high in the
opportunity cost? current assets.
How many times the average inventory has Relationship between cost of goods sold and
turned over during the year? average inventory during the year (only where
cost of goods sold cannot be determined, net
sales can be taken as the numerator). In a
manufacturing company, which is not in capital
goods sector, this should not be less than 4:1
and for a consumer goods industry, this should
be higher even. For a capital goods industry,
this would be less.
Has the company issued fresh share capital Increase in paid-up capital in the balance sheet
during the period and what is the purpose for and share premium reserves in case the issue
which it has raised equity capital? If it was a has been at a premium.
public issue, how did it fare in the market?
Has the company issued any bonus shares Increase in paid-up capital and simultaneous
during the year? reduction in general reserves. Enquiry into the
company’s ability to keep up the dividend rate
of the immediate past.
Has the company made any rights issue in the Increase in paid-up capital and share premium
period and what is the purpose of the issue? If reserves, in case the issue has been at a
it was a public issue, how did it fare in the premium.
market?
What is the proportion of marketable Percentage of marketable investment to total

investment to total investment and whether this investment and comparison with previous year.
has decreased in comparison with the previous Any decrease should put us on guard, as it
year? reduces liquidity on one hand and increases the
risk of non-payment on due date, especially if
the investment is in its own subsidiary or group
companies, thereby forcing the company to
provide for the loss.
What is the increase in sales income over last Comparison with previous year’s sales income
year in % terms? Is it due to increase in and whether the growth has been more or less
numbers or change in product mix or increase in

Chapter: One
prices of finished products only? than the estimate.
What is the amount of provision for bad and In percentage terms, how much is it of total
doubtful debts or advances outstanding? debts outstanding and what are the reasons for
such provision in the notes to accounts by the
auditors?
What is the amount of work in progress as Is there any comment about valuation of work in
shown in the Profit and Loss Account? progress by the auditors? It can be seen that
profit from operations can be manipulated by
increase/decrease in closing stocks of both
finished goods and work in progress.
Whether the company is paying any lease Examination of expenses schedule would show
rentals and if so what is the amount of lease this. What is the comment in notes to accounts
liability outstanding? about this? Lease liability is an off-balance
sheet item and hence this examination, to
ascertain the correct external liability and to
include the lease rentals in future also in
projected income statements; otherwise, the
company may be having much less disclosed
liability and much more lease liability which is
not disclosed. This has to be taken into
consideration by an analyst while estimating
future expenses for the purpose of estimating
future profits.
Has the company changed its method of Auditors’ comments on “Accounting” policies.
depreciation on fixed assets, due to which, Change over from straight-line method to
there is an impact on the profits of the written down value method or vice-versa does
company? affect the deprecation charge for the year
thereby affecting the profits during the year of
change.
If it is a manufacturing company, whether the % Relationship between materials consumed

of materials consumed is increasing in relation during the year and the sales.
to sales?
Has the company changed its method of Auditors’ comments on “Accounting” policies.
valuation of inventory, due to which there is an
impact of the profits of the company?
Whether the % of administration and general Relationship between general and

expenses has increased during the year under administrative expenses during the year and
review? the sales. In case there is any extraordinary
increase, what are the reasons therefore?
Whether the company had sufficient income to Interest coverage ratio = earnings before
pay the interest charges? interest and tax/total interest on all short-term
and long-term liabilities. Minimum should be
3:1 and anything less than this is not
satisfactory.

Chapter: One
Whether the finance charges have gone up Relationship between interest charges and sales
disproportionately as compared with the income – whether it is consistent with the
increase in sales income during the same previous year or is there any spurt?
period?
Is there any explanation for this, like substantial
expansion or new project or diversification for
which the company has taken financial
assistance? While a benchmark % is not
available, any level in excess of 6% calls for
examination.
Whether the % of employee costs to sales has Relationship between “payment to and
increased? provision for employees” and the sales. In case
any undue increase is seen, it could be due to
expansion of activity etc. that would be included
in the Directors’ Report.
Whether the % of selling expenses in relation to Relationship between “selling and marketing”
sales has gone up? expenses and the sales. Any undue increase
could either mean that the company is in a very
competitive industry or it is aggressive to
increase its market share by adopting a
marketing strategy that would increase the
marketing expenses including offer of higher
commission to the intermediaries like agents
etc.
Whether the company had sufficient internal Debt service coverage ratio = Internal accruals
accruals {Profit after tax (-) dividend (+) any (+) interest on medium and long-term external
non-cash expenditure like depreciation, liabilities/interest on medium and long-term
preliminary expenses write-off etc.} to meet liabilities (+) repayment of medium and long-
repayment obligation of principal amount of term external liabilities. The term-lending
loans, debentures etc.? institution or bank looks for 1.75:1 on an
average for the loan period. This is a very
critical ratio to indicate the ability of the
company to take care of its obligation towards
the loans it has taken both by way of interest as
well as repayment of the principal.
Return on investment in business to compare it Earnings before interest and tax/average total
with return on similar investment elsewhere. invested capital, i.e., net worth (+) debt capital.
This should be higher than the average cost of
funds in the form of loans, i.e., interest cost on
loans/debentures etc.
Return on equity (includes reserves and surplus) Profit after tax (-) dividend on preference share
capital/net worth (-) preference share capital
(return in percentage). Anything less than 15%
means that our investment in this company is
earning less than the average return in the
market.
How much earning has our share made? (EPS) Profit after tax (-) dividend on preference share
capital/number of equity shares. In terms of
percentage anything less than 40% to 50% of
the face value of the shares would not go well
with the market sentiments.

Chapter: One
Whether the company has reduced its dividend Relationship between amount of dividend
payout in comparison with last year? payout and profit after tax last year and this
year. Is there any reason for this like liquidity
crunch that the company is experiencing or the
need for conserving cash for business activity,
like purchase of fixed assets in the immediate
future?
Is there any significant increase in the “Notes on Accounts” as given at the end of the
contingent liabilities due to any of the following? accounts.
Disputed central excise duty, customs duty, Any substantial increase especially in disputed
income tax, octroi, sales tax, contracts amount of duties should put us on guard.
remaining unexecuted, guarantees given by the
banks on behalf of the company as well as the
guarantees given by the company on behalf of
its subsidiary or associate company, letter of
credit outstanding for which goods not yet
received etc.
Has the company changed its policy of Substantial change in vendor charges, or
outsourcing its work from vendors and if so, subcontracting charges.
what are the reasons?
Is there any substantial increase in charges paid Increase in consultancy charges.

to consultants?
Has the company opened any branch office in Directors’ Report or sudden spurt in general and
the last year? administration expenses.
The principal tools of analysis are:

Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it
with the past trend. In the statements of accounts, there are several such pairs of parameters and
hence ratio analysis assumes great significance. The most important thing to remember in the case of
ratio analysis is that you can compare two units in the same industry only and other factors like the
relative ages of the units, the scales of operation etc. come into play.
Comparison with past trend within the same company is one type of analysis and comparison with the
industrial average is another analysis
While one can derive a lot of useful information from analysis of the financial statements, we have to
keep in mind some of the limitations of the financial statements. Analysis of financial statements does
indicate a definite trend, though not accurately, due to the intrinsic nature of the data itself.
Some of the limitations of the financial statements are given below.
♦ Analysis and understanding of financial statements is only one of the tools in
understanding of the company
♦ The annual statements do have great limitations in their value, as they do not speak
about the following-
♦ Management, its strength, inadequacy etc.
♦ Key personnel behind the activity and human resources in the organisation.
♦ Average key ratios in the industry in the country, of which the company is an integral
part. This information has to be obtained separately.
♦ Balance sheet is as on a particular date and hence it does not indicate about the
average for the entire year. Hence it cannot indicate the position with 100% reliability. (Link it
with fundamental analysis.)

Chapter: One
♦ The auditors’ report is based more on information given by the management, company
personnel etc.
♦ To an extent at least, there can be manipulation in the level of expenditure, level of
closing stocks and sales income to manipulate profits of the organisation, depending upon the
requirement of the management during a particular year.
♦ One cannot come to know from study of financial statements about the tax planning of
the company or the basis on which the company pays tax, as it is not mandatory under the
provisions of The Companies’ Act, 1956, to furnish details of tax paid in the annual statement
of accounts.
♦ Notwithstanding all the above, continuous study of financial statements relating to an
industry can provide the reader and analyst with an in-depth knowledge of the industry and
the trend over a period of time. This may prove invaluable as a tool in investment decision or
sale decision of shares/debentures/fixed deposits etc.
Funds flow statement – its format and construction
Financial funds flow statement is different from what the students would have learnt by this time as
“Funds flow for Management Accounting”. Financial funds flow statement bifurcates the funds into
short-term and long-term instead of working capital and funds from operations etc. It further bifurcates
the long-term funds into internal and external resources.
The purpose of this bifurcation is to ensure proper financial planning. Financial planning essentially
involves planning for resources and obtain matching resources in terms of duration, rate of interest
etc. For example, short-term resource cannot be used for fixed assets. This is called “diversion” of
funds and could land the enterprise in serious shortfall of working capital funds. Similarly long-term
funds would always be more than long-term use, as internal accruals are a part of long-term funds
along with share capital. These could be used for short-term as well as long-term purposes. Please
refer to the Chapter on “Working capital management”.
Increase in liability = source of funds; decrease in assets = source of funds
Increase in assets = use of funds; decrease in liability = use of funds
Thus a liability can reduce during a year and increase because of fresh borrowing. Let us take for
example, term loans. During the period under review, a part of the outstanding loan would have been
paid during the year and the enterprise would have taken fresh loans. Thus in the following statement,
increase in term-loans has been shown as a source of fund and decrease in term-loan has been shown
as use of fund. This is true of all medium and long-term liabilities. The student should keep this in
mind while preparing funds flow statement. He should not be tempted to adjust and
present only the net position as a source or use. For example fresh loan taken = Rs. 100 lacs
and loans repaid during the year = Rs. 30 lacs. The student may be tempted to present the net
position of Rs. 70 lacs as source of funds. This will not give the correct picture.
Chapter No. 9 – Capital structure and cost of capital
Need for a capital structure
What is a capital structure?

Capital means “funds” employed in business for a period of twelve months and above. Capital
excludes short-term funds employed in funds, i.e., working capital. Working capital is employed for a
short time and hence ignored. Capital structure gives us the various components of capital – both debt
capital and share capital. In short, capital structure tells us about how much funds have been brought
into business and in what form? It gives us the relationship between debt and equity, known as “debt
to equity” relationship.

Chapter: One
What is the need for a capital structure?

Why do we need a capital structure? Can’t we do without it? In other words, can’t we only have equity
or debt instead of both the components? We can, especially equity. One can have a business
enterprise only with equity funds without taking any loans. However, the financial risk that he will be
taking would be tremendous, without anybody to share it with. Referring to debt we cannot have a
business enterprise only with debt. It is impossible as no lender would be willing to give entire amount
by way of loan. Any lender wants the owner to put in some money by way of equity share capital so
that the balance funds can be given in the form of loans. The market norm for lending is debt to equity
not to exceed 2:1. There would be very few exceptions when this would be higher than 2:1.
To sum up, any business enterprise would have what is known as “capital structure”. It is advisable for
a business enterprise to have both debt and equity components in its capital structure although it is
possible to run the business entirely on equity. Further as we have seen in the Chapter on “leverages”,
it is beneficial to have a mix of debt and equity as it increases the “Earnings Per Share” (EPS) to the
shareholders. At the same time, having regard to increasing risk due to increasing debt, it is better to
be within the lending norms of 2:1. (Example – Rs. 100 lacs by ways of equity and Rs. 200 lacs by way
of debt).
Components of a capital structure – exclusion of current liabilities and reasons

thereof
Share capital: Equity share capital
Retained earnings
Preference share capital
Debt capital: Debentures

Loans
Fixed deposits from the public
Medium term acceptances for capital goods
Bonds
Unsecured loans from promoters, friends and relatives
Deferred Payment Guarantees
Hire Purchase Financing
Note: The above list is not exhaustive. It is only illustrative.
Exclusion of current liabilities and reasons thereof

1. They are employed in business for a short period and cannot be considered as part of capital
2. Some of them do not have any cost attached to them – advances received, provision for
outstanding expenses, provision for tax, creditors outstanding etc. whereas all the items of debt
capital have interest cost attached to them.
3. In a healthy business enterprise, they are fully covered by current assets and met out of current
assets – example creditor gets paid out of realisation of sale bill outstanding as a “debtor”. Hence
strictly speaking, current liabilities are not considered as “capital”
Factors influencing capital structure or “determinants” of capital structure

1. The profitability of the organisation – the higher the profits more the chances for debt capital
because of ability to service higher debt – both by way of interest and repayment of principal

Chapter: One
amount. This is reflected in a very critical ratio called “Interest coverage ratio”. EBIT/I. The higher
the ratio, the more the chances of debt in the capital structure.
2. Reliable cash flows – the more they are reliable the more the lenders are willing to give debt
capital to the enterprise. Once debt is taken cash outflows get fixed for the future. Accordingly the
reliability of firm’s cash flows assumes great significance here.
3. Degree of risk associated with the enterprise – the higher the risk less the chances of debt capital
and more the chances of equity
Example – IT industry (at least in the late 90’s in India) run predominantly on equity
4. Management’s risk aversion attitude – conservative managements take less of external debt and
try to utilise internal accruals to maximum extent and equity to the extent necessary; on the
contrary aggressive managements go in for debt to a larger extent.
Examples – Sundaram group of companies in Chennai in general and Sundaram Claytons in
particular – conservative attitude towards debt and debt to equity ratio being less than 1:1. On the
contrary, Essar oils have very high debt to equity ratio – close to 3:1.
5. Whether the business enterprise enjoys tax concessions in a big way like till recently the IT
industry? Owing to high level of exports till recently the IT sector was enjoying 100% tax
concession on the exports profits. There was no difference in cost of debt (interest) and cost of
equity (primarily dividend) in the absence of taxes. Please refer to the Chapter on “Leverages”.
Such enterprises are indifferent to debt and have more of equity only.
6. Availability of different kinds of debt instruments like “deep discounted” bonds, floating rate notes
(where the rate of interest is adjusted to the market rates) etc. that are attractive to the
enterprises to go in for maximum debt within the debt to equity ratio norms specified by the
lenders or the market. These instruments have entered the market only in the 90s and hence the
debt market is getting more and more attractive and limited companies have started using them
instead of only depending upon institutional finance.
7. Attitude of the promoters towards financial and management control - if this is high, first
preference would be given for debt and then preference shares. Last preference would be given for
public equity where financial control gets diluted because of larger number of shareholders and
managerial control is likely to be affected.
8. Nature of the industry – more competitive = higher equity and less debt; more monopolistic = less
equity and more debt. Further depending upon the nature of industry the lenders do have different
lending norms. This means that the leverage ratios in a particular industry are more or less
uniform. These serve as the benchmark for determining the capital structure for any unit in the
industry
Optimal mix of debt and equity – a discussion

Is there an optimal mix of debt and equity for a business enterprise? The answer to this question has
been daunting Financial Analysts and Academicians and Theoreticians for a long time now. The perfect
answer has so far been elusive. This indicates that the best capital structure or the most suitable
capital structure for a business enterprise is still a “dream”. In the meanwhile, the business enterprise
and “Finance experts” keep trying to evolve a perfect capital structure model.
In this discussion it is better to remember that while “equity” is cushion available to a business
enterprise, debt is a “sword”. Debt has to be paid back and hence risk increases. However the
advantage of debt is that the enterprise gets exposed to professional approach of the lenders and
market; besides “external debt” would force financial discipline in the enterprise. The process of
discipline is automatic although not dramatic. The moment the firm so far in the hold of owners only
exposes itself to market, discipline improves.
The objective of optimal debt to equity mix should be to “maximise the firm value”. This involves the
following steps:
♦ Identify the economic and financial market conditions facing the firm and analyze the competitive
features of the business

Chapter: One
♦ Invest in projects that yield a return greater than the minimum acceptable hurdle rate (cost of
capital)
♦ Manage financial risks that investors cannot easily manage, to maximise the firm’s debt and
investment capacity
♦ Choose a capital structure and financing mix that minimises the hurdle rate and matches the
assets being financed
Costs associated with different components of capital structure

Is cost of debt, i.e., interest the same as cost of equity, i.e. dividend?
We have seen already that in the presence of taxes, these two are different. Let us explain through a
following example.
Example no. 1
Let us have a capital structure having Rs. 100 lacs equity share capital and Rs. 100 lacs debt capital.
Let the debt capital have interest rate of 14% p.a. and let the tax rate be 40%. Let the dividend rate on
equity share capital also be 14%.
On the face of it, we should have Rs. 14 lacs + Rs. 14 lacs = Rs. 28 lacs to be able to pay 14% interest
on debt of Rs. 100 lacs and pay dividend at 14% on Rs. 100 lacs of equity share capital. Let us
examine alternative income levels to arrive at exact level of income that is required to be able to do
both – pay interest as well as dividend.
Parameter Alternative 1 Alternative 2

Alternative 3
EBIT Rs. 28 lacs Rs. 38 lacs Rs. 37.34 lacs
Interest Rs. 14 lacs Rs. 14 lacs Rs. 14 lacs
EBT Rs. 14 lacs Rs. 24 lacs Rs. 23.34 lacs
Tax @ 40% Rs. 5.6 lacs Rs. 9.6 lacs Rs. 9.34 lacs
PAT Rs. 8.4 lacs Rs. 14.4 lacs Rs. 14 lacs
Maximum dividend
Payable assuming
100% dividend payment Rs. 8.4 lacs Rs. 14 lacs Rs. 14 lacs
(This is not permitted as leaving an
Provisions of the excess of
Companies’ Act) Rs. 0.4 lac
Thus in alternative 3, we have found the exact level of earning before interest and tax or pre-tax
earnings to be able to pay interest of Rs. 14 lacs and dividend of Rs. 14 lacs. The cost of dividend to
the dividend paying company is just not Rs. 14 lacs but the tax of Rs.9.34 lacs, the total cost being Rs.
23.34 lacs. Thus we are able to see that in the presence of taxes, dividend is costlier than interest.
The next question is: is entire tax paid by an enterprise attributable to dividend? No. Let us take the
following example.
Example no. 2
Suppose PAT = Rs. 100 lacs and tax rate is 40% and dividend is Rs. 50 lacs. It is not correct to say that
cost of dividend is Rs. 50 lacs and entire tax of Rs. 66.67 lacs that is paid by the company on its total
Profit Before Tax. [Rs. 66.67 lacs = Rs. 100 lacs post-tax = 60% (100% PBT – 40% tax rate). Hence

Chapter: One
100% = Rs. 166.67 lacs and tax is Rs. 66.67 lacs]. Hence tax attributable to Rs. 50 lacs dividend = Rs.
33.33 lacs.
Is there a formula for this conversion of post-tax to pre-tax and vice-versa?

Yes. Pre-tax to post-tax = Pre-tax rate or value (1- Tax rate in decimals) and similarly Post-tax to pre-
tax = Post-tax rate/1-Tax rate in decimals.
What is the need for this conversion?

In a given capital structure debt components have pre-tax cost while share capital components have
post-tax cost. How does one determine the weighted average cost of capital (WACC) for the capital
structure? By either converting pre-tax cost to post-tax cost and post-tax cost to pre-tax cost? The
convention is that WACC globally is expressed in terms of post-tax cost. Hence pre-tax costs are all
converted into post-tax costs.
The formula just to recap is Pre-tax rate x (1-Tax rate in decimals)
Of the various resources that constitute the capital structure of a business enterprise, for Term loans,
Acceptances of medium/long-term maturity, Deferred payment credit, Retained earnings, Privately
placed debentures, there is no cost incurred for raising the resources; whereas, in the case of any
public issue, be it equity/preference share, or debt like debenture, bond, there would always be issue
costs associated with it like the following:
Advertisement expenses;
Underwriting commission;
Fees paid to Registrar to the issues;
Brokerage to bankers/brokers to the issues;
Cost of printing prospectus, shares/debentures/bond application forms as well as share/debenture
certificates;
Conference/seminar of brokers/prospective groups of investors;
Fees paid to the manager/managers to the issue.
These costs are known as “floatation costs” and get amortized over a period of time through
preliminary expenses. Hence for the purpose of determination of cost of capital, from the amount of
the issue, the floatation costs are reduced to arrive at the net amount received under the issue and
the rate of interest/dividend actually paid is related to this net amount and not to the size of the issue.
Similarly, there could be a redemption premium at the time of repaying debenture/preference share
capital and seldom in other cases. Hence the redemption amount that is called “premium” is an
addition to the cost of that particular instrument.
Expansion for used abbreviations or symbols in the following paragraphs:
1. Kd = Cost of debt including floatation cost
2. f = floatation Costs
3. kd = cost of debt without floatation cost

4. N = number of years for maturity like in the case of preference share capital, debenture and bond
5. kp = Cost of preference share capital
6. ke = Cost of equity without floatation cost
7. Ke = Cost of equity with floatation cost

Chapter: One
8. F in the case of preference share capital = Redemption value and
9. P in the case of preference share capital = Face value
Example no. 3
Equity share capital is Rs.1000lacs;
Floatation costs are 15% of this amount. Then, the dividend outgo would relate at least for the
purpose of determination of the cost of capital to Rs.850lacs and not to Rs.1000lacs. Similarly if
redemption premium is 10% of debenture issue of Rs.200lacs, the outgo of Rs.20lacs would be a part
of cost of debenture, besides interest outgo.
Now that we have seen the adjustment required to be made due to floatation costs and redemption
premium, we will see the different costs.
Debentures:
Interest payable is pre-tax expenditure. Hence it is multiplied by (1-tax rate) to arrive at post-tax cost,
which is the measure of cost of capital. Hence, if kd is the cost of debenture, then the formula works
out as under:
Kd = {Int. outgo p.a. x (1-tax rate)} + {Redemption value of debenture (-) Amt. recd. (net of floatation
costs)}/N
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
{Redemption value of debenture (+) Amt. recd. (net of F.C.)}/2
Note No. 1:
Cost of bonds and any other instrument would be similar to this so long as the outgo is interest, which
is pre-tax and there is a likelihood of floatation cost and redemption premium.
Cost of term loans/deferred payment credit/acceptances/fixed deposits:
Annual interest outgo (1-tax rate)
------------------------------------------------------------------------------------------------------------------ X 100
Average outstanding during the year, i.e., average of opening and closing balances
Note No. 2:
In the case of fixed deposits, you incur upfront costs and the same should be taken as deduction in the
amount of fixed deposits received but there would be no redemption premium in this case.
Cost of preference share capital:
kd = D + (F– P)/N
------------------
(F + P)/2
Here for dividend rate, as it is post-tax, no conversion takes place, unlike in the case of interest.
Cost of equity capital:

(Without floatation costs)
Dividend at the end of the year

Chapter: One
ke = ------------------------------------------- +g,
Price of equity share at the beginning
Where g = constant growth rate in dividend per share (DPS).
Cost of equity capital:

(With floatation costs)
ke
Ke = -------, where ke = cost of equity without floatation costs and f = floatation cost
(1-f) in % of the equity capital amount.
Cost of retained earnings:
It is equal to cost of equity without floatation costs.
Weighted average cost of capital (WACC)

Let us calculate the WACC of the following structure
Example no. 4
Equity share capital = Rs. 1000 lacs @ 18%
Bonds = Rs. 2000 lacs @ 13%
Fixed deposits = Rs. 500 lacs @ 12.5%
Tax rate = 38.5%
(Rupees in lacs)
Name of the component in the capital structure Value
Weight Pre-tax cost Post- tax cost Cost
Equity share capital 1000 2 -- 18% 36
Bonds 2000 4 13% 8% 32
Fixed deposits 500 1 12.5% 7.69% 7.69
Total costs 75.69
Weighted average cost of capital (WACC) = total cost/number of weights = 75.69/7 = 10.82%
Note:
Conversion of 13% pre-tax to post-tax = 13% (1 – 0.385) = 8%
Similarly fixed deposit pre-tax cost of 12.5% = 7.69%
Weights are found out for all the components of a given capital structure by dividing all the amounts
with the Highest common factor (HCF). Here the HCF is Rs. 500 lacs.
Above individual costs of various components of capital structure include all costs, i.e.,
prime and additional costs.
Cost of capital and investment analysis:

Chapter: One
In theory, certain assumptions underlie the determination of cost of capital. For this, one thing that
must be understood generally is the influence of leverage (higher debt) on the firm’s valuation in the
market and accordingly the cost of debt and cost of equity are determined. Following are the
assumptions between cost of capital and finance leverage:
♦ There is no income-tax, corporate or personal;
♦ Entire earnings are paid out to share-holders in the form of dividend;
♦ Investors have identical subjective probability distribution of earnings before interest and taxes;
♦ Net operating income to remain constant at least in the short-term as well as in the medium-term;
♦ A company can change its capital structure without incurring any transaction costs.
Accordingly,
♦ Cost of debt, i.e., kd = F/B = Annual interest charge

----------------------------------
Market value of debt
♦ Cost of equity, i.e., ke, based on 100% dividend, = E/S = Equity earnings
------------------------
MV of equity
♦ Overall cost of capital = ko = O/V = Net operating income

------------------------------
MV of the firm
Where, ko = kd {B/(B+S)} + ke {S/(B+S)}
Measured by the ratio of B/S, the effect of change in the financial leverage on kd, ke & ko has to be
examined. There are different approaches, like:
1. Net income approach;
2. Net operating income approach;
3. Traditional approach and
4. Miller and Modigliani approach with three propositions.
Net income approach:
According to this approach, the cost of equity capital, i.e., k e and the cost of debt, k d remain
unchanged when B/S, the degree of leverage varies. This means that k o, the average cost of capital
measured as ko = kd{B/(B+S)} + ke{S/(B+S)} declines as B/S increases. This happens because when
B/S increases, kd, which is lower than ke, receives higher weight in the calculation of ko.
The net income approach may be illustrated with a numerical example as under:
Firm X Firm Y
Example no. 5
Nettwo
Consider operating income
firms X and Y, (O)
which are identical in all aspects2lacs 2lacs of leverage
excepting in the degree
employed by them.
Interest The following (F)
on debt is the financial data for these firms.
------- 50,000/-
Equity earnings (E) 2lacs 1.5lacs
Cost of equity capital (ke) 15% 15%
Punjab Cost of debt

Technical capitalOnline
University, (kdVirtual
) Campus 16% 16% 98
Market value of equity E/ke (S) 13.33lacs 10lacs

Market value of debt (B) ------ 3.13lacs
Total value of firm (V) 13.33lacs 13.13lacs
Chapter: One
The average cost of capital for firm X:

16% x 0/13.33lacs + 15% x 13.33/13.33 = 15%
The average cost of capital for firm Y:
16% x 3.13/13.13 + 15% x 10/13.13 = 11.43%
Net operating income approach:

According to this approach, the overall capitalization rate and the cost of debt remains constant for all
degrees of leverage. Therefore, in the following equation, ko and kd are constant for all degrees of
leverage.
ko = kd {B/(B+S)} + ke {S/(B+S)}
Therefore, the cost of equity can be expressed as:
ke = ko + {(ko – kd) x (B/S)}

David Durand has advocated this approach. According to him, the market value of a firm depends on
its net operating income and business risk. The change in the degree of leverage employed by a firm
cannot change these underlying factors. Changes take place in the distribution of income and risk
between debt and equity without affecting the total income and risk, which influence the market value
of the firm. Hence the degree of leverage cannot influence the market value or the overall cost of
capital of the firm.
The critical assumption in this approach is that k o is constant irrespective of the debt/equity
relationship. The market capitalises the value of the firm as a whole and is indifferent to debt/equity.
An increase in the leverage, which reduces the cost of capital, is offset by the increase in the equity
return as expected by the prospective investors in view of the increased risk associated with the firm
due to higher leverage. As the cost of the firm k o cannot be altered through leverage, this theory
implies that there is no optimal capital structure.
Traditional approach:
The traditional approach has the following propositions:
1. The cost of debt capital kd remains more or less constant up to a certain degree of leverage
but rises thereafter at an increasing rate.
2. The cost of equity capital, ke, remains more or less constant or rises only gradually up to a
certain degree of leverage and rises sharply thereafter.
3. The average cost of capital, ko, as a consequence of the above behaviour of kd and ke
(a) Decreases up to a certain point with the increase in leverage;

Chapter: One
(b) Remains more or less unchanged for moderate increase in leverage thereafter and
(c) Rises beyond a certain point.
Note No. 3:
The principal implication of this approach is that the overall cost of capital is dependent on the capital
structure and there is an optimal capital structure, which minimizes the cost of capital. At point of
optimal capital structure, the real marginal cost of debt and equity is the same. Before the optimal
point, the real marginal cost of debt is less than the real marginal cost of equity. Beyond the optimal
point, the real marginal cost of debt is more than the real marginal cost of equity.
Miller and Modigliani approach:

Their proposition is that the net operating income approach in terms of three basic propositions best
explains the relationship between leverage and the cost of capital. They argue against the traditional
approach by offering behavioural justification for having the cost of capital, ko, remain constant
throughout all degrees of leverage. It is essential to spell out the assumptions underlying their
proposition:
♦ Capital markets are perfect. Information is costless and readily available to all investors. There
are no transaction costs and all securities are infinitely divisible;
♦ Investors are assumed to be rational and behave accordingly, i.e., choose a combination of risk
and return that is most advantageous to them;
♦ The average expected future operating earnings of a firm are subject by random variables. It is
assumed that the expected probability distribution values of all the investors are the same. The
MM theory implies that the expected probability distribution values of expected operating earnings
for all future periods are the same as present operating earnings;
♦ Firms can be grouped into “equivalent return” classes on the basis of their business risks. As firms
falling into one class have the same degree of business risk;
♦ There is no corporate or personal income tax.
Basic propositions:
Proposition 1:
The total market value of the firm which is equal to the total market value of debt and market value of
equity is independent of the degree of leverage and is equal to its expected to its expected operating
incomes discounted at the rate appropriate to its risk class.
Symbolically, it is represented as:
Vj = Sj + Bj = Oj /pk,
Where, Vj = total market value of the firm j
Sj = market value of the equity of the firm j
Bj = market value of the debt of the firm j
Oj = expected operating income of the firm j
pk = discount rate applicable to the risk class k to which the firm belongs.

Chapter: One
Proposition 2:
The expected yield on equity, ij is equal to pk plus a premium, which is equal to the debt/equity ratio,
times the difference between pk and the yield on debt r. Symbolically, it is represented by the
following equation:
Ij = pk + (pk – r)Bj/Sj
Proposition 3:
The manner in which an investment is financed does not affect the cut-off rate for the investment
decision making for a firm in a given risk class. The proposition emphasises the point that average
cost of capital is not affected by the financing decisions as both investment and financing decisions are
independent.
Proof of the above propositions – The Arbitrage Mechanism

Let us consider two firms A and B in the same risk class. The expected operating incomes are also the
same but the two firms have varying financial leverages.
Consider the case wherein the unlevered firm A has a market value, which is, less than that of the
levered firm B. Now if an investor holds equity shares in the firm B, he can sell these shares and
purchase shares in the firm A. By this, the market value of the firm B comes down while that of the
firm A increases. This means that any difference between the values of unlevered and levered firms is
negated by the availability of arbitrage opportunity to the individual investor, who takes advantage of
his personal leverage to buy equity in firm A.
Similarly, an investor could sell his investment in the equity of the firm A and purchase some equity in
the firm B, in case the market value of the unlevered firm A is greater than that of the levered firm B.
Here again, because of his selling the equity in firm A, the firm’s market value depresses and the
market value of firm B increases. This position continues till there is no further arbitrage opportunity,
i.e., equality between the values of the firms is established. This means that investors are able to
reconstitute their individual portfolios by offsetting changes in the corporate leverage with changes in
personal leverage.
Criticism of the MM position:

Assumptions underlying the MM position do not hold in most of the markets, like, absence of taxes,
both corporate and personal, imperfection in the capital markets and because of this, bankruptcy costs
exist for any firm, which drastically could alter the market values of the firm, be it debt or equity, more
so in the case of equity. These imperfections in the assumptions could be overcome.
Conclusion:
Thus, there is a traditional approach, which states that there exists an optimal capital structure and
the MM position that financial leverages do not affect the overall value of the firm in the market.
However, there are certain imperfections in the underlying assumptions in the MM position, which if
overcome by necessary correction, would render the altered MM position quite acceptable.
The imperfections in the underlying assumptions in the MM position could be overcome by

incorporating the personal and corporate tax in the determination of cost of capital. The basic premise
here is that while interest on debt-capital is a tax-deductible expenditure, dividend on the share capital
is not. In the first step, only the corporate tax is considered. Accordingly, the following example is
constructed.

Chapter: One
Example no. 6
Consider two firms A and B having an expected net operating income of Rs.5lacs and which are similar
in all respects except in the degree of leverage employed by them. Firm “A” employs no debt capital
whereas Firm “B” has Rs.20lacs in debt capital on which it pays 12% interest. The corporate tax rate
applicable to both the firms is 50%. The income to stockholders and debt-holders of both the firms is
shown below.
Firm A Firm B
Net operating income 5,00,000/- 5,00,000/-
Interest on debt ------ 2,40,000/-
Profit before taxes 5,00,000/- 2,60,000/-
Taxes 2,50,000/- 1,30,000/-
Profit after tax (income available 2,50,000/- 1,30,000/-
To shareholders)
Combined income of debt-holders 2,50,000/- 3,70,000/-
And shareholders
This is because of the less amount of tax paid in the case of Firm B, which is again due to the interest
charge of Rs.2,40,000/-. This saving in tax due to a tax-deductible expenditure is called “Tax shield”.
Tax shield is calculated at the rate of corporate tax on any tax-deductible expenditure. It should be
borne in mind that due to the presence of tax shield, the value of the firm also increases, unlike in the
classical theory, in which, the firm enjoying higher leverage, i.e., debt has its market value diminished
due to the higher incidence of risk on account of higher level of debt. The best way to combine these
two is that, while, in the presence of corporate taxes and availability of “tax shield” on interest on
debt capital, the value of the firm having higher debt capital increases initially up to a certain point,
beyond this point, the advantage of “leverage” diminishes and the market value of the firm starts
declining.
In general, when corporate taxes are considered the value of the firm that is levered would be equal to
value of the unlevered firm added by the tax shield associated with debt, i.e.,
V = O (1 - corporate tax rate, tc)
------------------------------------------ + tc B
k
where, “O” is the operating income of the firm as reduced by the tax rate to convert it into a post-tax
return and discounted by a rate of return expectation by the share holder, namely, “k” and t c B is the
present value of the “tax shield” on the interest on debt capital, enjoyed by the firm B in our example.
It is assumed here, that the debt capital is perpetual and the rate of interest is constant and hence, it
is taken that the present value of tax shield on the interest outflows is equal to the present value of
the borrowing as multiplied by (1-tax rate) which is tc
Corporate taxes and personal taxes:

Chapter: One
At present in India, the dividend income is not taxed with effect from 01/04/97 and hence, from the
point of view of the shareholder, he would prefer to have dividend income rather than income from
interest which is taxable. Hence, incorporation of personal tax into the scene together with corporate
tax does not alter the situation and if at all it alters, it alters in favour of the firm, which is having
higher leverage, wherein the EPS could be higher along with the dividend pay out. Let us incorporate
the corporate tax to the debt holder in the above example and compare the two firms A and B again.
Example no. 7
Firm A Firm B
Income available to the shareholders 2,50,000 1,30,000
Personal tax on dividend ---------- ----------
Net income after tax to the shareholders 2,50,000 1,30,000
Income to debt holders ------------- 2,40,000
Less Corporate tax @ 35% ------------- 84,000
Net income on debt after tax ------------- 1,56,000
Combined income to shareholders and 2,50,000 2,86,000
Debt holders
From the above it is clear that the advantage of “leverage” for the firm B is reflected in its combined
income to the shareholders and the debt holders, post-tax.
Existence of “bankruptcy” costs:

Capital market, when perfect, has no “bankruptcy” costs. However, capital markets in most of the
countries or economies are far from perfect and more so, in India. Hence, “bankruptcy” costs do exist.
It can be seen that in the case of a firm in “distress”, the assets to be sold for cash would not fetch the
market value but much less than that, in which case, the bankruptcy costs do matter to a very great
extent. It would be further appreciated that these costs affect firms with “higher” leverage more than
those firms, which are “equity” oriented.
Difference between Corporate and Personal Leverage:

In the classical theory, it has been assumed that any advantage available to a firm due to higher
leverage is negated by the availability of an “arbitrage” opportunity, available to an investor who has a
portfolio, which is interchangeable. However, it is well known that the rate of interest on borrowing for
an individual investor is quite different from that of a corporate borrower. In most of the cases, the
rate of interest on personal loans is higher. Further, the individual is saddled with personal liability
towards the lender also whereas, in the case of corporates, the individual liability of the promoters or
the shareholders is absent.
Agency costs:
Credit monitoring costs of lending agencies could be high, especially in the case of high debt/equity
ratio and hence cannot be ignored. To the extent of credit monitoring costs, the cost of debt capital
gets enhanced which is absent in the case of equity capital, while in the case of equity public issue,
floatation costs are incurred.
Net Income Approach:

Example no. 8
A company’s expected annual net operating income (EBIT) is Rs.2,00,000/-. The company has
Rs.8,00,000/-, 10% debentures. The equity capitalisation rate (ke) of the company is 12.5%. No taxes.
Step No. 1 – Determine the value of the firm

Chapter: One
Net operating income (EBIT) Rs.200000/-
Less interest on 10% debenture (I) Rs.80000/-
----------------
Earnings available to equity holders (NI) Rs.120000/-
Equity capitalisation rate 0.125
Market value of equity (Earnings available/ECR) Rs.960000/-
Market value of debt Rs.800000/-
Total value of the firm Rs.1760000/-
Step No. 2 Determine the overall cost of capital of the firm

Overall cost of capital = ko = EBIT/Total value of the firm –
Rs.2lacs
----------------- = 0.1136 = 11.36% app.
Rs.17.6lacs
Alternatively:
ko = kd (B/(B+S) + ke (S/(B+S) = {10.0% x 8lacs/17.6lacs} + {12.5% x 9.6lacs/17.6lacs} = 11.36%
Alternative 2
Suppose we increase the amount of debenture to Rs.12lacs and pay off the shareholders, assuming
that it is possible. The kd and ke would remain unaffected as per the “Net operating income” approach
theory. Hence in the new situation, let us see the value of the firm and overall cost of capital for the
firm.
----------------

Rs.2lacs
----------------- = 0.1087 = 10.87% app.
Rs.18.4lacs
Alternatively:
ko = kd (B/(B+S) + ke (S/(B+S) = {10.0% x 12lacs/18.4lacs} + {12.5% x 6.40lacs/18.4lacs}

Chapter: One
= 10.87%
Thus it can be seen, that by increasing the debt, i.e., the leverage, the firm is able to increase the
market value and simultaneously reduce the overall cost of capital. The opposite would be the effect if
we reduce the debt component.
Alternative 2
Decrease the amount of debenture from Rs.8lacs to Rs.6lacs and all other factors remain unchanged:
----------------

Rs.2lacs
----------------- = 0.1162 = 11.62% app.
Rs.17.2lacs
Alternatively:
ko = kd (B/(B+S) + ke (S/(B+S) = {10.0% x 6lacs/17.2lacs} + {12.5% x 11.20lacs/17.2lacs}
= 11.62%
Net operating income approach (NOI)
Example no. 9
Operating income Rs.150000/-; debt at 10%; outstanding debt Rs.6lacs; overall capitalisation rate
12.5%; total value of the firm and equity capitalisation rate to be found out.
Overall capitalisation rate 0.125
Total market value of the firm (V) = EBIT/ko Rs.1200000/-
Market value of debt (B) Rs.600000/-
Market value of equity (S) Rs.600000/-
Equity capitalisation rate, ke = {EBIT (-) I}/S
Earning available to equity holders
-------------------------------------------------------- ke= {150000 (-) 60000}/600000 = 15%
Total market value of equity shares

Chapter: One
Alternatively,
ke = ko + {(ko – kd) x B/S} = 12.5% + {(12.5% - 10%) x 6lacs/6lacs} = 15%
Now let us examine the effect of changes in the debt as in the case of net income approach, i.e., in the
first instance, the debt goes up to Rs. 8lacs and in the second instance, it reduces to Rs. 5lacs.
Alternative 1

-------------------------------------------------------- ke = {150000 (-) 80000}/400000 = 17.5%

Alternatively,
ke = ko + {(ko – kd) x B/S} = 12.5% + {(12.5% - 10%) x 8lacs/4lacs} = 17.5%
Alternative 2


-------------------------------------------------------- ke = {150000 (-) 50000}/700000 = 14.28%

Alternatively,
ke = ko + {(ko – kd) x B/S} = 12.5% + {(12.5% - 10%) x 5lacs/7lacs} = 14.28%
Chapter No. 11 – Capital Budgeting
Capital budgets as opposed to revenue budgets

Chapter: One
The assumption here is that the students understand the significance of the term “budgets”. To recap,
“budgets” are essentially meant for:
♦ Allocation of scarce resources and
♦ Control and monitoring of expenses
The budgets are of various kinds, depending upon the objectives in the organisation. The two major
finance budgets that a business enterprise usually prepare are:
♦ Revenue budget – prepared on an annual basis with monthly break-up. Purpose is to control
revenue expenses related to different activities in an organisation. There is a review process. The
frequency of break-up could be less say a quarter. The frequency of review process and the period
for which break-up is given like month or quarter synchronise with each other. If there is a monthly
break-up of expenses, the review is also done on a monthly basis.
♦ Capital budget – prepared on an annual basis with once in a year review process. This budget is
more meant for capital expenses for which the enterprise will be required to manage within its
internal accruals and not depend upon external finance. External finance and shareholders’ capital
are warranted only for major capital expenditure like expansion, diversification, modernisation etc.
The students will appreciate that there is a difference between capital expenditure on routine
items like say copier machine, furniture and fixtures, EPABX (telephone exchange) etc. which do
not give any return unlike industrial projects. Industrial projects require a lot of funds and in turn,
give positive cash flows (net cash flows being positive – difference between cash outflows and cash
inflows)
In this chapter we are going to learn about capital budgeting, a process of selection of projects and
decision on alternative investment opportunities available to a business enterprise.
Different kinds of capital budgets – non-productive assets, improving operating

efficiency and capital projects
Just to link this point with what we have seen in the previous paragraph, we may state that there could
be different kinds of capital budgets in an organisation like:
1. Budgets for projects that involve huge capital outlays (cash outflows) but also bring in substantial
net cash inflows
2. Budgets for replacement of assets that bring in improved operating efficiency resulting in cost
reduction that is indirectly cash inflow – this is different from the first one in requirement of funds
also. Further this is done on an on going basis unlike industrial projects that happen once in a
while
3. Budgets for routine items that are fairly regular (examples given in the preceding paragraph) and
involve only capital expenditure from internal accruals.
We can see that the parameters for all the above three would be different for planning, resource
mobilisation, resource allocation, monitoring and control. Let us see the differences in the following
lines.
1. Budgets for projects require in-depth and detailed planning like project report including report on
marketing feasibility, technical feasibility, technological feasibility, financial feasibility etc.
Resource mobilisation will be partly from equity of promoters and major portion will be in the form
of debts like project loans, debentures etc. There will be a separate committee constituted in
professionally run organisations called, “project committee” that takes the responsibility for the
entire project. The committee is associated with the project right from the conception of the
project till its completion and commercial production. One of the major functions of the committee
is “project review, monitoring and control”. Lenders go in depth into the risks associated with the
projects and have a detailed appraisal before sanctioning the loans etc. The repayment of the
external loans is spread over a fairly long period.
2. Budgets for replacement may or may not be supported by external assistance. If the requirement
is substantial due to a number of machines being replaced, although in a phased manner, external
assistance may be called for in the form of loans; otherwise the resources could be “internal
accruals”. If external loan is warranted, the planning process will be very much involved, although

Chapter: One
it will not be elaborate. The resource mobilisation will be fairly easy, easier than in the case of
projects. The repayment period will be shorter than for projects in point no. 1 above. The resource
allocation, monitoring and control will also be fairly simple.
3. Budgets for routine items have to be met only from internal accruals. Rarely external assistance
will be available for this as incremental income will be absent. Hence a lot of internal control is
called for in this case. There will be constant demand from various departments within the
organisation for funds and budgetary process is very much indicated here. Budget is for resource
allocation, monitoring and control. Not much of planning is required and resources are available
internally.
Choosing capital projects – Conventional and Discounted Cash Flow techniques

Basis for project cash flows and capital expenditure on projects
A project owner wants return from the project higher than the cost of debt (borrowing) and the cost of
equity (his own contribution). Please refer to the chapters on “time value of money” as well as “cost of
capital”. He also wants the recovery of capital (total of equity and debt) within a period that he is
comfortable with. This period is known as “pay back period”. Thus from the project owner’s point of
view he has definite ideas on:
♦ The period for capital recovery and
♦ The rate of return from the project
The finance manager or the consultant as the case may be proceeds to prepare the project cash flows
based on certain assumptions that are central to the working of the project. Some of the assumptions
are:
♦ The cost of the project and means of financing them
♦ The cost of all inputs like materials, power etc. and the selling prices of outputs
♦ The weighted average cost of capital
♦ The rates of depreciation on the fixed assets
♦ The requirement of working capital for the project
♦ The installed capacity (in terms of 100% production) of the plant
♦ The capacity utilisation in terms of % of the installed capacity
♦ The rate of corporate taxes that the business will be paying
♦ The repayment or redemption period for various loans, debentures or bonds
♦ The number of days working for the project
♦ The number of shifts on which the production will be done
♦ The cost of imported materials, components if any and the foreign exchange fluctuation if any etc.
Note: As usual, this list is not exhaustive. These are some of the better-known assumptions for the
project working. The success of the project lies in the assumptions being as close to reality as possible.
Methods of financial evaluation of the project:

The methods take into account the following considerations from the project owners’ and project
lenders’ points of view:

Chapter: One
1. Whether the project is earning a return that is higher then its cost of capital?
2. Whether the project’s earnings recover the capital investment in the desired period called “pay
back period”?
3. Whether the objective of the project in creating assets is achieved through “wealth maximisation”
– by adding further wealth?
Broad classification of the methods of financial evaluation of projects –
Conventional methods – these methods do not consider the timing of the future cash flows. Let us see
the following example to understand this.
Example no. 1
We invest in a project Rs. 300 lacs. The projected cash flows at the end of three years is as under:
Year 1 = Rs. 150 lacs
Total = Rs. 325 lacs. In the conventional method the fact that cash flows occur at different periods is
ignored. This is perhaps due to the fact that the importance of time value of money was not
appreciated in the past.
Conventional methods are:
Payback period31
This is defined as the period in which the original capital investment is recovered. In case there is more
than one project with the same amount of investment to choose from, based on payback period
method, the project having less payback period will be chosen.
Example no. 2
Let us repeat the figures as per Example no. 1.
Cash flow at T0 = (Rs. 300 lacs)32
Cash flow at T1 = Rs. 150 lacs

At the end of two years, the capital recovery is Rs. 250 lacs. Remaining amount to the recovered = Rs.
50 lacs. We will have to find out in how many months, this stands recovered in the third year. This is
based on the assumption that the cash flows occur uniformly in the project.33
(50/75) x 12 months = 8 months
Thus payback period for this project is = 2 years + 8 months = 2.67 years
Without this calculation, on the first reading of the figures of cash flows it can be seen that the pay
back period lies between the second and the third year of the project.
Merits:
♦ Easy to calculate
31
The second method – Accounting Rate of Return is omitted here as it is practically not used even by those who
are not initiated into “finance”
32
Figures within brackets indicate that there is cash out flow rather than inflow. This is because of the investment
into fixed assets at the beginning of the project.
33
In fact this assumption goes for all the methods of evaluation, both conventional and discounting cash flow
methods.

Chapter: One
♦ Gives an idea of capital recovery

Demerits:
1. Does not consider the time value of money or timing of the cash flows. For example if Rs. 100 lacs
were to be the cash flows at year 1 and year 3, both are considered to be equal. We know after
going through the chapter on “Time value of money” that due to inflation these two are not equal
to each other.
2. Reliability as an evaluation method is very limited as the cash flows after the pay back period are
ignored.
Note: The shortcoming in this method can be overcome by discounting the future
cash flows at a suitable rate of discount and then determine the payback period.
This is called “adjusted” or “discounted” payback method. As we apply the
concept of “time value of money” the adjusted or discounted payback method
more belongs the DCF techniques as discussed below.
Modern methods or “Discounted Cash flow Techniques” are:

1. Net Present Value
2. Internal Rate of Return
3. Profitability Index
Net Present value method
Example no. 3
Consider the following 3 alternative projects. Assumptions are also given below:
♦ The initial investment for all the projects is Rs.500 lacs;
♦ The period of working is 5 years from the year Zero, i.e., the time of investment;
♦ Although the scale of operations for all the projects is the same, the projects have different future
earnings or returns; and
♦ The rate of discount is 15% p.a., which is the rate of return expected from the project by the
promoters. The future earning (at the end of the1st year) is discounted by (1.15), (1.15)2 for the
second year, (1.15)3 for the third year and so on. The present value equivalent of the future
earning or return is also known as the discounted value.
(Rupees in Lacs)
Project 1 Project 2 Project 3
Year Future Disc. Future Future

Disc. Value Disc. Value
No. Earnings Value Earnings Earnings

Chapter: One
1 100 86.96 150 130.44 175 152.18
2 120 90.73 150 113.42 150 113.42
3 200 131.5 150 98.63 180 118.35
4 250 142.95 200 114.36 225 128.66
5 250 124.3 200 99.44 250 124.3
Total 576.44 556.29 636.91
Note: As Project 3 has the highest present value it would be selected. Net present value is equal to
present value (-) original investment value, i.e., Rs.500 lacs. Accordingly, the net present values for
the three projects would be:
On the basis of net present value, project 3 would get selected.
Merits:
1. Takes into consideration the project cash flows for the entire economic life of the project.
2. Applies time value of money – timing of the cash flows is the basis of evaluation.
3. Net present value truly represents the addition to the wealth of the shareholders.
4. Reliable as a method of evaluation of alternative projects.
Demerits:
1. It is not an easy exercise to estimate the discounting rate that is linked to “hurdle rate”34
2. In real life situations, alternative investment projects with the same amount of capital investment
are non-existent practically
Internal Rate of Return method (IRR)

Internal Rate of Return for an investment proposal is the discount rate that equates the present value
of the expected net cash flows (CFs) with the initial cash outflow. If the initial cash outflow or cost
occurs at time “zero”, it is represented by that rate, IRR such that
Initial cash outflow (ICO) = CF1 CF2 CF3 CF4
CFn
34
Hurdle rate = the minimum rate of return that should be had from any investment, especially in a project

Chapter: One
------------- + -------------- + --------------- + -------------- +
………. + --------------- (1+IRR)1 (1+ IRR)2 (1+IRR)3
(1+IRR)4 (1+IRR)n
This means that the Net present value in the case of IRR = “zero” or Present value of project cash
flows = original investment at the beginning of the project.
How do you get IRR by calculation?
IRR is obtained by “trial and error” method. Suppose we are given a set of cash flows, both outflow at
the beginning and inflows over a period of time in future. We start with some rate as the discounting
rate and start determining the NPV till we get NPV= zero. In case the rate lies between two rates, we
fix the range and mention that the IRR lies in this range. Let us illustrate this with an example.
Example no. 4
Let us take project 2 in our Example no. 3. The present value is the closest to our original investment
of Rs. 500 lacs. The discounting rate is 15%. p.a. our target present value is Rs. 500 lacs. How do we
get to this figure? By increasing the rate of discount or reducing the rate of discount? As the present
value is inversely related to the rate of discount, we have to increase the rate. Let us try it out for 20%.
Year Future Present

no. value of value @
cash flow 20%
1 100 82.0
2 120 80.76
3 200 110.8
4 250 114
5 250 94.25
Total 481.81
This means that the discounting rate of 20% is high and has to be reduced so as to reach the target
present value of Rs. 500 lacs. Le us try it out at 19% and redo the exercise.
Year Future Present

cash flow 19%
1 100 82.80
2 120 82.32
3 200 114
4 250 118.75
5 250 99.00
Total 496.87
This means that we have to reduce the rate of discount to 18%. The IRR lies between 18% and 19%.
This is called the “trial and error” method. However if we want to find out the exact IRR, we will have
to adopt the following steps further:

Chapter: One
1. Find out the Present value by @ 18% discount rate
2. Employ the “method of interpolation”
Let us do this exercise so that the students will be familiar with determining accurate IRR.
Year Future Present

cash flow 18%
1 100 83.60
2 120 84.0
3 200 117.40
4 250 123.50
5 250 104.0
Total 512.50
Compare the present values @ 19% and 18% discount rates. It clearly shows that the IRR is closer to
19% than to 18%. Let us now adopt the method of interpolation35 and determine the exact IRR.
At 18% discounting, PV = Rs. 512.50 lacs
At 19% discounting, PV = Rs. 496.87 lacs and
Our target PV = Rs. 500 lacs
By employing the method of interpolation we find that the IRR =
18% + 512.5 – 500____ = 18.80%
512.5 – 496.87
This vindicates what we have mentioned in the previous paragraph – we have mentioned that IRR is
closer to 19% rather than 18%. How do we take the values in this method?
1. In the denominator, the values at the extremes of the given range are taken and difference is the
denominator
2. One may start from the lower rate in which case in the numerator, the values taken are the target
value and the value corresponding to the lower rate
3. On the other hand, if we want to go from the higher rate, the equation will be =
19% (-) 500 – 496.87____ = 18.80%
512.5 – 496.87
Thus whether we go up from the lower rate or come down from the higher rate, there is no difference
in the end result. The above example tells us clearly how to adopt the trial and error method to fix the
range of interest rates within which our IRR lies and then proceed to adopt “interpolation method” to
determine the exact IRR.
When we employ IRR method of financial evaluation of more than one project, that project
with the higher IRR is chosen.
Merits:
35
Method of interpolation is just the opposite of method of extrapolation. This is adopted whenever the target
parameter (in this case the discount rate) lies between a range of values. In the given example, the target discount
rate (IRR) lies between 18% and 19%.

Chapter: One
1. It tells us the rate at which the project should get a return taking into consideration the risks
associated with the project
2. It takes into consideration the time value of money and hence reliable as a tool for evaluation of
projects
3. It is very useful to a lender who is always interested in NPV = zero at a given rate and in a given
period.
Demerits:
1. It takes a long time to calculate
2. Based on this comparison cannot be made between projects of unequal size. A smaller project
could get selected because of higher IRR as against a project in which wealth maximisation is very
good (NPV being very high) only because its IRR is less than the previous one.
3. Multiple IRRs (more than one IRR) will be the outcome in case there is a negative sign in the
project cash flows in the future. This means that should it happen that in one-year project cash
inflow is negative (cash outflows being more than cash inflows) it will give rise to more than one
IRR.
Profitability Index (PI)

The profitability index or benefit-cost ratio of a project is the ratio of present value of future net cash
flows to the initial cash outflow. It can be expressed as
Present value as per NPV and IRR methods
Initial investment in the project
Example no. 5
In our above example the present value of future cash flows at 15% was Rs. 556.29 lacs in the case of
project no. 2 as against original investment of Rs. 500 lacs. Hence PI = 556.29/500 = 1.113
This is more often employed in social projects like infrastructure projects undertaken by the
governments or public sector and less employed in commercial projects.
The merits and demerits are the same as for the NPV method as above.
IRR vs. NPV and ranking problems of alternative investment proposals

So far we have seen that when we have projects that have equal investment at the beginning and
equal economic life, the different methods give us a tool in selection of the best project. These can be
referred to as “independent projects”, as execution of the projects does not depend upon other
factors. However, there could be “dependent” projects that are dependent upon other factors like
required civil construction etc Further, as already listed under demerits even in the case of “modern
methods”, projects that are equal in scale of investment or have equal economic life are rare to come
by simultaneously. In reality, most of the times we have projects that are not equal with each other.
We do encounter problems while applying the “DCF” techniques to such projects in ranking them
properly.
A mutually exclusive project is one whose acceptance precludes the acceptance of one or more
alternative proposals. For example, if the firm is considering investment in one of two computer
systems, acceptance of one system will rule out the acceptance of the other. Two mutually exclusive
proposals cannot both be accepted simultaneously. Ranking such projects based on IRR or NPV may
give contradictory results. The conflict in rankings will be due to one or a combination of the following
differences:
1. Scale of investment – cost of projects differ
2. Cash flow pattern – timing of cash flows differs. For example, the cash flows of one project increase
over time while those of another decrease.
3. Project life – projects have unequal economic lives.

Chapter: One
It is important to note that one or more of the above constitute a necessary but not sufficient condition
for a conflict in rankings. Thus it is possible that mutually exclusive projects could differ on all these
dimensions (scale, pattern and life) and still not show any conflict between rankings under the IRR and
NPV methods.
Scale differences
Example no. 6
------------------------------------------------------------------------------
Net cash flows
------------------------------------------
End of year Project 1 Project 2
____________________________________________________
0 - 1 lac - 100 lacs
1 0 0
2 4 lacs 156.25 lacs
-------------------------------------------------------------------------------
Suppose the required rate of return is 10%, we can tabulate the IRR and NPV values as under:
-------------------------------------------------------------------------------
IRR NPV @ 10%
-------------------------------------------
Project 1 100% 2.31 lacs
Project 2 25% 29.13 lacs
-------------------------------------------------------------------------------
Can we see the conflict? If we adopt IRR, we will reject the second project whereas the first project is
rejected by the NPV method.
This is because of the fact that in the case of IRR method, the results are expressed as a %, the scale
of investment is ignored in the above case. This could be a serious limitation in applying the IRR
method.
Cash flow pattern differences

Example no. 7
------------------------------------------------------------------------------
Net cash flows
------------------------------------------
____________________________________________________
0 - 12 lacs - 12 lacs
1 10 lacs 1 lac
2 5 lacs 6 lacs
3 1 lac 10.80 lacs
-------------------------------------------------------------------------------

Chapter: One
IRR for project 1 = 23% and IRR for project 2 = 17%. For every discount rate greater than 10%, project
1’s net present value will be larger than for project 2. If we assume a required rate of return of 10%,
each project will have identical net present value of 1,98,000/- . Using these results to determine
project rankings we find the following:
------------------------------------------------------------------------------
r < 10% r > 10%
------------------------------------------------------
Ranking IRR NPV IRR NPV
____________________________________________________
1 Project 1P 2 P1 P1
2 Project 2P 1 P2 P2
-------------------------------------------------------------------------------
Project Life Differences
Example no. 8
------------------------------------------------------------------------------
Net cash flows
------------------------------------------
____________________________________________________
0 - 10 lacs - 10 lacs
1 0 20 lacs
2 0 0
3 13.75 lacs 0
-------------------------------------------------------------------------------
Ranking the projects based on IRR and NPV criteria, we find that:
------------------------------------------------------------------------------
Ranking IRR NPV @ 10%
____________________________________________________
1 Project 2 (100%) P 1 (NPV = 1,53,600)
2 Project 1 (50%) P 2 (NPV = 81,800)
-------------------------------------------------------------------------------
With all the above examples, it is hoped that the concepts of IRR and NPV are clear to the students.
To sum up, we can say that:
1. Both the methods are quite reliable
2. NPV represents wealth maximisation
3. IRR indicates the rate of return from investment
4. In case there is any conflict, the scale of investment and the cash flow timing difference have to be
considered
5. It is wise not to compare two projects with unequal life

Chapter: One
6. IRR is readily suitable for a finance product like lease, hire purchase or term loan as the lender will
decide to invest only based on rate of return.
Incremental cash flow principle for evaluation of replacement decisions

As discussed in the initial paragraphs to this chapter, incremental cash flow principle is the basis on
which decisions are taken for replacing one machine with another. This is nothing but the cost benefit
analysis. The steps involved are:
1. The investment at the beginning is net of the salvage value of the existing machine
2. While considering depreciation, only the differential should be taken into account, i.e., the
difference between depreciation on the new machine and depreciation on the existing machine for
the remainder of its economic life at least (the remainder of economic life of the existing machine
is bound to be shorter than for a new machine)
3. There could be additional investment by way of incremental working capital at the beginning
besides capital cost.
4. The salvage value of the existing machine at the end also should be taken as cash inflow along
with the withdrawal of additional working capital as at point no. 3
5. The incremental value in the cash flow could be due to increase in revenues (very little chances for
this) or due to reduction in cost (this is more likely to happen – replacing increasing the operating
efficiency)
6. Construct the cash flows and on net cash inflow apply the chosen discounting rate
7. Cash flow = Net inflow after tax + differential depreciation added back
8. In case the cash inflow is negative, do not calculate tax on that and carry forward the loss to the
next year and deduct the same from the next year’s net cash inflow before paying taxes.

i
Merchant banker controls the Primary market and is fully responsible for the issue of public
securities like equity shares, debentures, bonds etc. the capital market instruments. He is the
principal operator and controls and monitors all the other operators in the capital market. He is
fully accountable to SEBI for the smooth conduct of the operations in the capital markets. He has
to ensure 100% conformity with SCRA rules and regulations as well as SEBI rules and regulations.
ii
Underwriting in the capital market means giving an undertaking to invest money in securities
issued to public should the issue fail to collect the required amounts as per SEBI rules and
regulations. Underwriting as such does not involve any funds and hence is referred to as “fee
based activity”. However once the issue fails to collect the required amount, the underwriter is
expected to make good the deficit amount to the extent undertaken by him.
iii
At present, we have two depositories operating at the national level – National Securities
Depositories Limited (NSDL – owned by the National Stock Exchange) and Central Depository
Services Limited (CDSL – owned by the Bombay Stock Exchange). As per capital market
regulations, in the secondary market, the securities can be sold only in the “demat” or electronic
form and not in the physical form. Accordingly under the national level depositories, depository
participants operate at the retail level. They maintain the individual demat accounts on behalf of
the shareholders and investors of other securities. These demat accounts are often referred to as
“Electronic Share Accounts”. The DPs transfer the data from the retail level to the national level
depositories who in turn collate information about ownership of securities and submit data to the
signatory companies with whom they have signed contracts.

Financial Management

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Financial Management

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Subject: Financial Management

Some of the key finance functions are:

Let us examine briefly the above functions with some examples.

Mobilisation of financial resources

Adequate supply in time etc.

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Management of cash in the organisation

Management of risk in foreign exchange etc.

Difference between finance function and accounts function

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Short-term and long-term objectives of Financial Management

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Financial system in India

Constituents of the Indian Financial System

The financial markets

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Segments of capital markets: GOI bonds

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The financial intermediaries

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Agents operating in different segments of the financial markets

Secondary market: Stock Exchanges – controlled and regulated by SEBI

Chapter No. 10 – Dividend policy

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Measures of Dividend Policy

Different kinds of dividend policies – factors influencing dividend policy

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Theories on dividend policy

Theory no. 1 - Dividend irrelevance theory – Miller and Modigliani

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Relevant issue out of this theory is “growth rate”

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Theory no. 3 – Gordon’s model – “ a bird in the hand” theory

To determine growth rate, g = ke – (D1/P0),

To determine P0 = D1/(ke – g) and

The balanced viewpoint

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Statement of Management Beliefs Agree No Opinion Disagree

3.The market uses dividend announcements as information for

4.Investors have different perceptions of the relative riskiness

5.Investors are basically indifferent with regard to returns from

6. A stockholder is attracted to firms that have dividend

7. Management should be responsive to shareholders'

Determining growth rate based on return on equity

Equity valuation based on dividend declared and growth rate

Certain issues relating to dividend at present in India

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Chapter No. 2 - Time Value of Money

Concept of “Inflation” – Wholesale Price Index and Consumer Price Index

Wholesale price and not the retail price

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Concept of Interest as compensation for loss of purchasing power due to “inflation”:

Four tier structure for rates of interest in any economy

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Why discuss about a loan here?

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Future value of Re.1 - Process of compounding

Can we have a formula for this process of compounding?

Future value = Present investment x (1 + r/200) n x 2

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Present value of a future rupee – Process of discounting

Future value at T1, Rs.108/- = PV at T0 (to be determined) x (1.08)