FM Final

1 of 88
2 of 88
3 of 88
UNIT I
Q. Define Financial Management and explain its nature. Ans. Introduction : Financial management is that part of managerial process which is concerned with the planning and controlling of firms financial resources. It is concerned with the procurement of funds from most suitable sources and making the most efficient use of such funds. In the earlier stages, financial management was a branch of economics and as a separate subject it is of recent origin. The subject is of immense importance to the managers because among the most crucial decisions of the firm are those which relate to finance. Meaning of Financial Management : Financial management is a vital and an integral part of business management. It refers to that part of managerial activity which is concerned with planning and controlling of financial resources of the enterprise. It deals with raising finance for the enterprise and the efficient utilization of such finance. It includes: Investment Decisions Financing Decisions Dividend Decisions Liquidity Decisions Capital budgeting Budgetary Control
Definition of Financial Management : According to Joseph L. Massie Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. According to Wheeler Financial Management is the activity which is concerned with the acquisition and administration of capital funds in meeting the financial needs and overall objectives of business enterprise. Nature of Financial Management : (1) Financial Management is an essential part of Top Management : In the modern business management the financial manager is one of the active members of top management team and day-by-day his role is becoming more significant in solving the complex management problems. This is because almost all kinds of business activities such as production, marketing etc. directly or indirectly involve the acquisition and use of finance.
Institute of IT & Management
3
4 of 88
(2) Less Descriptive and More Analytical : Financial management is less descriptive and more analytical. Due to the development of new statistical and accounting techniques of financial analysis, the financial management chooses the best alternative out of the many possible alternatives. (3) Continuous Function : Financing is a continuous function. In addition to the raising of finance, there is a continuous need for planning and controlling the finances of an enterprise. A firm performs finance functions continuously in the normal course of the business. (4) Different from Accounting Function : There are key difference between the accounting and finance function. Accounting generates information or data whereas in the finance function the data re analysed and used for the purpose of decision making. (5) Wide Scope : There is wide scope of financial management. It is concerned not only with the raising of finance but also with the allocation and efficient use of such finance. (6) Centralised Nature : Financial management is centralized in nature. It is ne ither possible nor desirable to de centralize the financial responsibilities. (7) Measurement of Performance : Financial management is concerned with the wise use of finance. It fixes certain norms and standards against which the benefits of an investment decisions are matched. (8) Inseparable Relationship between Finance and other Activities : There exists an inseparable relationship between finance on the one hand and production, marketing and other activities on the other. All other activities are related to finance. (9) Applicable to All Types of Organisations : It is applicable to all forms of organization whether corporate or non-c orporate such as sole proprietorship and partnership firms etc. Q. Define Financial Management. Explain the Scope of Financial Management. OR Q. Define Finance Function and discuss its nature and scope Ans. Meaning of Finance : Finance is defined as the provision of money at the time when it is required. The role of finance in business enterprise needs no emphasis. Every enterprise, whether big or small, needs finance to carry on and expand its operations. Finance holds the key to all the business activities and a firms success and, in fact, its survival is dependent upon how efficiently it is able to acquire and utilize the funds.
4
5 of 88
FINANCIAL MANAGEMENT
Meaning of Financial Management : Financial management is a vital and an integral part of business management. It refers to that part of managerial activity which is concerned with planning and controlling of financial resources of the enterprise. It deals with raising finance for the enterprise and the efficient utilization of such finance. Definition of Financial Management : According to Joseph L. Massie Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. Scope of Financial Management : Financial management as an academic discipline has undergone notable changes over the years, with regard to its scope of functions. At the same time, the financial managers role also has undergone fundamental changes over the years. Study of the changes that have taken place over the years is known as Scope of Financial Management. In order to have an easy understanding and better exposition to the changes, it is necessary to divide the scope into two approaches: (A) Traditional Approach (B) Modern Approach (A) Traditional Approach : Under this approach the role of financial management was limited to the procurement of funds on suitable terms. The utilization of funds was considered out of the scope of financial management. Under this approach, a study of the following three things was made for the procurement of funds: (1) Arrangement of funds from Financial Institutions. (2) Arrangement of funds through financial Instruments like share, bonds etc. (3) Legal and accounting relationship between a business and its source of funds. The notable feature of the traditional approach was the assumption that the duty of the finance manager was only to raise funds from external parties and that he was not concerned with taking the internal financial decisions. He was not responsible for the efficient use of funds. Limitations of Traditional Approach : The traditional approach continued till mid 1950s. It has now been discarded as it suffers from the following limitations: (i) More Emphasis on Raising of Funds : This approach places more emphasis on procurement of funds from external sources and neglects the issues relating to the efficient utilization of funds. Since it is concerned with the raising of funds, it attaches more importance to the
5
6 of 88
viewpoint of external parties who provide funds to the business and completely ignores the internal persons who make financial decisions. (ii) Ignores the Financial Problems of Non-Corporate Enterprises : It places more emphasis on the problems faced by corporate enterprises in procuring the funds. The non-corporate enterprise like sole proprietorship and partnership firms are considered outside its scope. (iii Ignored Routine Problems : This approach concentrates on the financial problems on the occurrence of special events such as merger, incorporation etc, and fails to consider the day-to-day financial problems of a normal firm. (iv) Ignored Working Capital Financing : This approach gives more emphasis on the problems relating to long term financing and the problems relating to working capital financing are considered outside the purview of this approach. (B) Modern Approach : The modern approach considers the term financial management in a broad sense. According to this approach the finance function covers both acquisition of funds as well as their efficient utilization. According to this approach the financial management is concerned with the solution of three major problems relating finance: (1) What is the total volume of funds an enterprise should commit? (2) How should the funds required be raised? (3) In what specific assets the enterprise should invest its funds? Thus, in the modern approach, the financial management is responsible for taking three decisions: (1) The Investment Decision : Investment decision also known as Capital Budgeting is related to the selection of long-term assets or projects in which investments will be made by the business. Long term assets are the assets which would yield benefits over a period of time in future. (2) The Financing Decision : This function is related to raising of finance from different sources. For this purpose the financial manager is to determine the proportion of debt and equity. In other words there are two sources of finance: (i) Debt: Debt means long term loans and includes: Debentures Loan from Bank Loan from Financial Institutions Mortgage Loans
(ii) Equity: Equity refers to shareholders funds and includes: Equity Share Capital
6
7 of 88
Preference Share Capital Reserve Accumulated Profits (3) The Dividend Policy Decision: The financial management has to decide as to which portion of the profits is to be distributed as dividend among shareholders and which portion is to be retained in the business. For this purpose the financial management should take into consideration the factors of dividend stability, bonus shares and cash dividends in practice. Q: Discuss the Chief Functions of Finance OR Financial Management. Ans: Meaning of Financial Management : Financial management is a vital and an integral part of business management. It refers to that part of managerial activity which is concerned with planning and controlling of financial resources of the enterprise. It deals with raising finance for the enterprise and the efficient utilization of such finance. Definition of Financial Management : According to Joseph L. Massie Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. Functions of Finance OR Financial Management : The functions of finance are: (1) Determining the Financial Needs (2) Financing Decision (3) Investment Decision (4) Working Capital Decision (5) Dividend Policy Decision (6) Financial Control (7) Routine Functions. 1. Determining the Financial Needs : The first task of the financial management is to estimate and determine the financial requirements of the business. For this purpose, the short term and long term needs of the business are estimated separately. While determining the financial needs the financial management should take into consideration the: Nature of the Business Possibilities for future expansion Attitude of the management towards risk General economic circumstances etc.
2. Financing Decision : This function is related to raising of finance from different sources. For this purpose the financial manager is to determine
7
8 of 88
the proportion of debt and equity. In other words there are two sources of finance: (i) Debt: Debt means long term loans and includes: Debentures Loan from Bank Loan from Financial Institutions Mortgage Loans (ii) Equity: Equity refers to shareholders funds and includes: Equity Share Capital Preference Share Capital Reserve & Accumulated Profits 3. Investment Decision : Investment decision also known as Capital Budgeting is related to the selection of long-term assets or projects in which investments will be made by the business. Long term assets are the assets which would yield benefits over a period of time in future. 4. Working Capital Decision : It is concerned with the management of current assets. It is an important function of financial management. Current assets should be managed in such a way that the investment in current assets is neither inadequate nor unnecessary funds are locked up in current assets. If a firm does not have adequate working capital, that is its investment in current assets is inadequate, it may become illiquid and as a result may not be able to meet its current obligations. On the other hand, if the investment in current assets is too large, the profitability of the firm will be adversely affected because idle current assets will not earn anything. 5. Dividend Policy Decision : The financial management has to decide as to which portion of the profits is to be distributed as dividend among shareholders and which portion is to be retained in the business. For this purpose the financial management should take into consideration the factors of dividend stability, bonus shares and cash dividends in practice. 6. Financial Control : The establishment and use of financial control devices is an important function of financial management. These devices include: Budgetary Control Cost Control Ratio Analysis etc. Process of Financial Control : (i) Setting the standards (ii) Measurement of Actual Performance
8
9 of 88
(iii)Comparison of Actual Performance with standards (iv) Finding deviations and taking remedial actions. 7. Routine Functions : The routine functions are : Supervision of cash receipts and payments. Opening Bank Accounts and managing them Safeguarding of securities, insurance policies and other valuable documents Maintaining records and preparation of reports Q. What do you mean by Organisation of Finance Function? Explain the functions of Financial Manager. Ans. Organisation of Finance Function : organization of finance function means the division of functions relating to finance and to set up a sound and efficient organization for performing the finance functions. Since the financial decisions are very crucial for the survival as well as growth and development of the firm. The ultimate responsibility of carrying out the finance function lies with the top management. Hence, a department to organize and carry out the financial activities is created under the direct control of the board of directors. This department is headed by a financial manager. However, the exact nature of the organization of the finance functions differs from firm to firm depending upon many factors such as: (i) Size of the Firm (ii) Nature of its Business (iii)Type of financing operations (iv) Capabilities of firms financial officers etc. Graphic Presentation of Organisation of Finance Function : The following chart depicts the organization of the finance function of a large business firm:
Board of Directors Managing Director Production Manager Personnel Manager Financial Manager Marketing Manager
Treasurer
Controller
Cash Management
Banking Management
Credit Management Financial Accounting
Assets Management Cost Accounting
Securities Management Data Processing Internal Audit
Planning & Annual Budgeting Reports
10 of 88
Functions of Financial Manager : The financial manager is a member of top management. He is closely associated with the formulation of financial policies as well as financial decision making. He is expected to perform the following functions: (1) Financial Planning : The financial manager estimates the financial needs of the business, determines the capital structure and prepares financial plan. (2) Procurement of Funds : He arranges to acquire the funds from various sources such as shares, debentures etc.
(3) Coordination : He maintains a proper coordination among the financial needs of different departments. (4) Control : He establishes the standards of financial performance and examines whether the actual performance is according to predetermined standards. He is responsible for: Controlling the Costs Analysing the Profits Preparation of Reports (5) Business Forecasting : He keeps a close watch on the various events affecting the organization such as: Technological Changes Competition Change in Govt. Policy Change in social and business environment and studies their effect on the firm. Cash Management Banking Relations Credit Management Assets Management Securities Management Accounting Internal Auditing.
(6) Other Functions: Other functions we includes:
Functions of Treasurer : (1) Cash Management : It includes the managing of cash receipts and cash payments of the business. (2) Banking Relations : It includes banking relations, operating accounts, and managing deposits and withdrawals etc. (3) Credit Management : It includes determining the credit worthiness of the customers and arrangement for collection of credit sales.
10
bank
11 of 88
(4) Assets Management : It includes arrangement for the acquisition, disposal and insurance of various assets. (5) Securities Management : It includes the investment of surplus funds of the business. (6) Protecting Funds and Securities : It includes custody of funds and securities. Functions of Controller : (1) Planning & Budgeting : It includes profit planning, capital expenditure planning, budgeting, inventory control, sales forecasting etc. (2) Financial Accounting : He establishes a proper system of accounting, controls it and prepares financial statements such as profit & Loss Account and Balance Sheet etc. (3) Cost Accounting : He establishes a cost accounting system suitable to the business and controls it. (4) Data Processing : It includes the collection and analysis of business data. (5) Internal Auditing : He manages internal audit and internal control. (6) Annual Reports : He prepares annual reports and various other reports needed by the top management. (7) Information to Government : He prepares annual reports to be submitted to the Government under various laws. Q. What are the goals Or Objectives of Financial Management? Ans. Meaning of Financial Management : Financial management is a vital and an integral part of business management. It refers to that part of managerial activity which is concerned with planning and controlling of financial resources of the enterprise. It deals with raising finance for the enterprise and the efficient utilization of such finance. Definition of Financial Management : According to Joseph L. Massie Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. Objectives of Financial Management : It is the duty of the top management to lay down the objectives or goals which are to be achieved by the business. The main objectives are:
11
12 of 88
1. Profit Maximization : According to this approach, all activities which increase profits should be undertaken and which decrease profits should be avoided. Profit maximization implies that the financial decision making should be guided by only one test, which is, select those assets, projects and decisions which are profitable and reject those which are not. Arguments are in favour of Profit Maximization Approach : (i) Best Criterion on Decision-Making : The goal of profit maximization is regarded as the best criterion of decision-making as it provides a yardstick to judge the economic performance of the enterprises. (ii) Efficient Allocation of Resources : It leads to efficient allocation of scare resources as they tend to be diverted to those uses which, in terms of profitability, are the most desirable. (iii)Optimum Utilization : Optimum utilization of available resources is possible. (iv) Maximum Social Welfare : It ensures maximum social welfare in the form of maximum dividend to shareholder, timely payment to creditors, higher wages, better quality and lower prices, more employment opportunities to the society and maximization of capital to the owners. Criticism of Profit Maximization Approach: (i) Ambiguous : One practical difficulty with this approach is that the term profit is ambiguous. Different people take different meaning of term profit. For example: Profit may be short-term or long-term. Profit may be before tax or after tax. Profit may be total profit or rate of profit. Profit may be return on total capital employed or total assets or shareholders funds.
(ii) Ignores the Time Value of Money : This approach ignores the time value of money. It does not make a distinction between profits earned over the different years. It ignores the fact that the value of one rupee at present is greater than the value of same rupee received after one year. (iii)Ignores Risk Factor : This approach ignores the risk associated with the earnings. If the two firms have the total expected earnings, but if earnings of one firm fluctuate considerably as compared to the other, it will be more risky. It is, thus, clear that profit maximization criterion is inappropriate and unsuitable. It is not only ambiguous but fails to solve the problems of time value of money and the risk. An alternative to profit maximization, which solves these problems, is the criterion of wealth maximization.
12
13 of 88
2. Wealth Maximization : It is also termed as value maximization or Net Present worth maximization. This approach is now universally accepted as an appropriate criterion for making financial decision as it removes all the limitations of profit maximization approach. It is also known as net present value (NPV) maximization approach. According to this approach the worth of an asset is measured in terms of benefits received from its use less the cost of its acquisition. Benefits are measured in terms of cash flows received from its use rather than accounting profit which was the basis of measurement of benefits in profit maximization approach. Another important feature of this approach is that it also incorporates the time value of money. While measuring the value of future cash flows an allowance is made for time and risk factors by discounting or reducing the cash flows by a certain percentage. This percentage is known as discount rate. The difference between the present value of future cash inflows generated by an asset and its cost is known as net present value. A financial asset or a project which has a positive NPV creates wealth for shareholders and, therefore is undertaken. On the other hand, a financial asset or a project resulting in negative NPV should be rejected since it would reduce shareholders wealth. If one out of various projects is to be choosen, the one with the highest NPV is adopted. The NPV can be calculated with the help of the following formula: A1 (1+K) (1+K) A
2
W = + + + - C
1 2
(1+K)
W = Net Present Worth A1, A2,An = Stream of Cash Flows K = Appropriate discount rate to measure risk and time factors C = Initial outlay to acquire an asset or pursue a course of action. Merits of Wealth Maximization Approach : The wealth maximization approach is superior to the profit maximization approach because: 1. Wealth maximization approach uses cash flows instead of accounting profits which avoids the ambiguity regarding the exact meaning of the term profit. 2. Wealth maximization approach gives due importance to the time value of money by reducing the future cash flows by an appropriate discount or interest rate.
13
14 of 88
Q. Explain the Concept of Time value of Money. Ans. Introduction : Time value of money means that the value of a unit of money is different in different time periods. The value of a sum of money received today is more than its value received after some time. Conversely, the sum of money received in future is less valuable than it is today. In other words, the present worth of a rupee received after some time will be less than a rupee received today. The time value of money can also be referred to as time preference for money. Three reasons may be attributed to the individuals time preference for money. Risk Preference for consumption Investment opportunities. We live under risk or uncertainty. As an individual is not certain about future cash receipts, he or she prefers receiving cash now. Most people have subjective preference consumption over future consumption of goods and service either because of the urgency of their present wants or because of the risk is not being in a position to enjoy future consumption that may be caused by illness or death, Or because of inflation. Time Value of Money
Compounding or Future Value
Discounting or Present Value
(A) Compounding or Future Value Concept : Under this method of compounding, the future values of all cash inflows at the end of the time horizon at a particular rate of interest are found. Interest is compounded when the amount earned on an initial deposit becomes part of the principal at the end of the first compounding period. Example interest : If Mr. A invests Rs. 1,000 in a bank which offers him 10%
compounded annually, he as Rs. 1,100 in his account at the end of the first year. The total of the interest and principal Rs. 1,100 constitutes the principal for the next year. He thus earns Rs, 1,210 for the second year. This becomes the principal for the third year and so on. (1) Compound Value of a Single Flow (Lump Sum):- The process of calculating future value becomes very cumbersome if they have to be calculated over long maturity periods 10 to 20 years. A generalized
14
15 of 88
procedure for calculating the future value of a single cash flow compounded annually is as follows: FV = PV (1+i) PV= Initial Cash flow i= Annual rate of interest n = No. of years for which compounding is done. Example : Mr. x invests Rs. 1,000 at 10% is compounded annually for three years. Calculate value after three years. FV = PV (1+i) FV = 1000 (1+.10) FV = Rs. 1,331
n 3 n
Where, FV = Future value of the initial flow in n years
(2) Multi-period Compounding or Future Value : If the company will compounding interest half-yearly (semi-annually) instead of annually then investors will gain as he will get interest on half-yearly interest. Since interest will be compounded half-yearly, for finding out the compound value. FV = PV (1+i/m)
nx m
Where, FV = Future value of the initial flow in n years PV= Initial Cash flow i= Annual rate of interest n = No. of years for which compounding is done. m= No. of times compounding is done during a year. Example : Mr. X invests Rs. 10,000 at 10% p.a. compounded semiannually. Calculate value after three years. FV = PV (1+i/m) FV= 10,000 (1+.10/2) FV = Rs. 11,025
nx m 3x 2
(3) Compounded Value of a Series of Cash Flows : We have considered only single payment made once and its accumulation effect. An investor may be interested in investing money in installments and wish to know the value of its savings after n years. FV = A (1+i) + A (1+i) + A (1+i) + A
n 21
Where, FV = Future value of the initial flow in n years PV= Initial Cash flow i= Annual rate of interest n = No. of years for which compounding is done.
15
16 of 88
A = Amount deposit or invested. Example : Mr. X invests Rs.500, Rs.1000, Rs.1500, Rs. 2000 and Rs. 2500 at the end of each year for 5 years. Calculate the value at the end of 5 years compounded annually if the rate of interest is 5% p.a.
FV = 500 (1+0.05) 1000 (1+0.05) + 1500 (1+0.05) + 2000 (1+0.05) +2500 FV = Rs. 8020
4 +
321
(4) Compound Value of an Annuity : Annuity refers to the periodic flows of equal amounts. FV = A {(1+i) 1}/i
n
Example : Mr. X invests Rs. 2,000 at the end of each year for 5 years into his account, interest being 5% compounded annually. Determine the amount of money he will have at the end of the 5 year.
th
FV = 2000 {(1+.05) 1}/.05 FV = Rs. 11054

5
(B) Discounting or Present Value Concept : As per this concept, rupee one of today is more valuable than rupee one a year later. The reason for more value of rupee today than a rupee of future is interest. Discounting is the process of determining present values of a series of future cash flows. Example : If Mr. X, depositor expects to get Rs. 100 after one year at the rate of 10%, the amount he will have to forgo at present is Rs. 90.90 at present. Thus, it is present value of Rs. 100. (1) Discounting or Present Value of a Single Flow (Lump Sum): We can determine the PV of a future cash flow using the formula: PV = FV (1+i)
n
Where, FV = Future value of the initial flow in n years PV= Present Value i= Annual rate of interest n = No. of years Example : Mr. X expects to have an amount of Rs. 1000 after one year what should be the amount he has to invest today if the bank if offering 10% interest rate? PV = 1000 (1+.10) PV = Rs. 909.09 (2) Present Value of a Series of Cash Flows : In a business situation, it is very natural that returns received by a firm are spread over a number of
16
1
17 of 88
years. To estimate the present value of future series of returns, the present value of each expected inflow will be calculated. C C C PV = + + + (1+i) (1+i) (1+i)
12n 12n
Where PV = Sum of individual present values of each cash flow C , C , C = Cash flows after periods 1,2n
1 2 n
i= Discounting Rate Example : Given the time value of money as 10% (i.e. the discounting factor). You are required to find out the present value of future cash inflows that will be received over next four years. Year Cash Flows 1 1000 2 2000 3 3000 4 4000 1000 2000 3000 4000 PV = + + + (1+.10) (1+.10) (1+.10) (1+.10)
1 2 34
= 909 + 1652 + 2253 + 2732 = Rs. 7546 (3) Present Value of an Annuity : An investor may have an opportunity to receive a constant periodic amount for a certain number of years. The present value of an annuity can be found out by using the following formula: A A A PVAn = + + ---------- + (1+i) (1+i) (1+i)
1 2 n 1 2 n
PVAn = Present value of an annuity having a duration or n periods A = Value of single installment I = Rate of interest Example : Calculate the present value of annuity of Rs. 500 received annually for four years, when discounting factor is 10%. 500 500 500 500 PVAn = + + + (1+.10) (1+.10) (1+.10) (1+.10)
1234
PVAn = 454.50 + 413.50 + 375.50 + 341.50 PVAn = Rs. 1585

17
18 of 88
UNIT II
Q. What do you mean by Investment Decisions? What are the importance and difficulties of Investment Decision? Ans. Investment Decision : The most important function of financial management is not only the procurement of external funds for the business but also to make efficient and wise allocation of these funds. The allocation of funds means the investment of funds in various assets and other activities. It is also known as Investment Decision, because a choice is to be made regarding the assets in which funds will be invested. The assets which can be acquired fall into two broad categories: (i) Short-term or Current Assets. (ii) Long-term or Fixed Assets. Accordingly, we have to take two types of investment decisions: (1) Short-term investment decisions : This type of investment decisions related to the short-term assets. These decisions are also called current assets management or Working Capital Management. (2) Long-term Investment Decisions Or Capital Budgeting Decisions : This type of investment decisions related to long-term assets. These are widely known as capital budgeting or capital expenditure decisions. Capital Budgeting is the technique of making decisions for investment in longterm assets. It is a process of deciding whether or not to invest the funds in a particular asset, the benefit of which will be available over a period of time longer than one year. Definition of Capital Budgeting : According to Milton H. Spencer Capital Budgeting involves the planning of expenditures for assets, the returns from which will be realized in future time periods. Features of Capital Budgeting Decisions : 1. Funds are invested in long-term assets. 2. Funds are invested in present times in anticipation of future profits. 3. The future profits will occur to the firm over a series of years. 4. Capital Budgeting decisions involve a high degree of risk because future benefits are not certain. Importance of Capital Budgeting Decision : 1. Such Decision affect the profitability of the Firm : Capital Budgeting decision affect the long-term profitability of a firm. They enable a firm to
18
19 of 88
produce finished goods which is ultimately sold for profit. Hence, a correct investment decision can yield large profits, whereas an incorrect decision can endanger the very survival of the firm. 2. Long-Term Effects : The consequence of capital expenditure decisions extend far into the future. To illustrate, if a company purchases a new plant to manufacture a new product, the company will have to incur a sizable amount of fixed costs, in terms of labour, supervisors salary, insurance, rent of building etc, If, in future, the product turns out to be unsuccessful, the company will have to bear the burden of heavy fixed costs. 3. Irreversible Decision : Capital Budgeting decisions, once taken, are not easily reversible without heavy financial loss to the firm. 4. Involvement of Large Amount of Funds : Capital Budgeting decisions require large amount of funds and most of the firm have limited financial resources. Hence, it is absolutely necessary to take thoughtful and correct investment decisions. 5. Risk : Capital investment proposals have different degrees of risk. 6. Most difficult to make : These decisions are among the most difficult decisions to be taken by a firm. This is, because they require an assessment of future events which are uncertain and difficult to predict. Difficulties : 1. Measurement Problems : Identifying and measuring the costs and benefits of a capital expenditure proposals tend to be difficult. This is more so when a capital expenditure has a bearing on some other activities of the firm. 2. Uncertainty : A capital expenditure decision involves costs and benefits that extend fall into the future. It is impossible to predict exactly what will happen in the future. Hence, there is usually a great deal of uncertainty characterizing the cost and benefits of a capital expenditure decision. 3. Temporal Spread : The costs and benefits associated with a capital expenditure decision are spread out over a long period of time, usually 1020 years for industrial projects and 20-50 years for infrastructural projects. Q. Explain the methods OR Techniques of Capital Budgeting? Ans. Capital Budgeting : Capital Budgeting is the technique of making decisions for investment in long-term assets. It is a process of deciding whether or not to invest the funds in a particular asset, the benefit of which will be available over a period of time longer than one year.
19
20 of 88
Methods of Capital Budgeting : There are two criterias for capital expenditure decisions: (A) Accounting Profit Criteria (B) Cash Flow Criteria Techniques of Capital Budgeting Accounting Profit Criteria 1.Average Rate of Return Method 1. Non-Discounting Methods Cash Flow Criteria 2. Discounting Methods
(i)Pay Back Method (i)Net Present Value Method (ii)Profitability Index Method (iii)Internal Rate of Return Method (A) Accounting Profit Criteria : Under accounting profit criteria, there is only one method for making capital expenditure decisions. This method is known as Average Rate of Return Method. (1) Average Rate of return Method (ARR): This method is also known as Accounting Rate of Return Method. It is based on accounting information rather than cash flows. It is calculated as follows: Average Annual Profits after Taxes ARR = X 100 Average Investment Total of after tax profits of all years Average Annual Profits after Taxes = Number of years Original investment + Salvage value Average Investment = 2 Accept-Reject Criteria : If actual ARR is higher than the predetermined rate of return .......................Project would be accepted. If actual ARR is lower than the predetermined rate of return .......................Project would be rejected.
20
21 of 88
Merits of ARR : (i) Simple : ARR method is very simple to understand and use. (ii) Entire life time of the project is considered : ARR method uses the entire profits earned during the life time of the project in calculating the projects profitability. Demerits of ARR : (i) It uses accounting income rather than cash flows : The principal shortcoming of ARR approach is that it uses accounting income instead of cash flows received from a project. Cash profits are superior than accounting income because cash profits can be reinvested during the life of the project itself. (ii) Time Value of money not considered : The second principal shortcoming of ARR approach is that it does not take into account the time value of money. Earning of all the years during the life time of the project is given equal weightage under this method. (iii)Difficult to Fix a Pre-Determined Rate : It is very difficult to fix a pre-determined rate of return with which the actual ARR is compared. (B) Cash Flow Criteria : Cash flow criteria is based on cash flows rather than accounting profit. Cash flow methods are divided into two sections: (1) Non-Discounting Methods : Under non-discounting methods only method is included: (i) Pay Back Method (PB) : The payback method is the simplest method. This method calculates the number of years required to payback the original investment in a project. There are two methods of calculating the Payback Period: First Method : This method is adopted when the project generates equal cash inflow each year. In such a case payback period is calculated as follows: Investment Payback Period (PB)= Constant Annual Cash Flow Second Method : This method is adopted when the project generates unequal cash inflow each year. Under this method, payback period is calculated by adding up the cash inflows till the time they become equal to the original investment. Formula : Amount required to equalise the investment PB = Completed Year + Amount received during the period
21
22 of 88
Accept-Reject Criteria : If the actual payback period is less than the predetermined payback period ...................... Project would be accepted. If the actual payback period is more than the predetermined payback period ...................... Project would be rejected. Merits of Pay Back Method : (i) Simple : The most significant merit of this method is that it is simple to understand and easy to calculate. (ii) Appropriate for Firms Suffering from Liquidity : This method is very appropriate for firms suffering from shortage of cash because emphasis in this method is on quick recovery of the original investment. (iii)Appropriate in case of Uncertain Conditions : This method is very suitable where the long term outlook is extremely uncertain and risky. (iv) Importance to Short-Term Earnings : This method is beneficial for firms which lay more emphasis on short-term earnings rather than the long-term growth. (v) Superior to ARR Method : It is superior to ARR method because it is based on cash flow analysis. Demerits of Pay Back Method : (i) It ignores the Cash Flows After the Pay Back Period : The major shortcoming of this method is that it completely ignores all cash inflows after the pay back period. (ii) It ignores the Time Value of Money : Another deficiency of the payback method is that it ignores the time value of money. This method treats a rupee received in the second or third year as valuable as a rupee received in the first year. (iii)It does not give the Accept-Reject Decision in case of single project : If suppose the payback period is 4 years, the method does not provide an answer as to whether the project will be accepted or rejected. (iv) It ignores cost of Capital : Cost of capital is not taken into consideration under this method. (v) It ignores the Profitability of a Project. (2) Discounting Methods : Under discounting methods we include: (I) Net Present Value (NPV) Method : This method measures the Present value of returns per rupee invested. Under this method, present value of
22
23 of 88
cash outflows and cash inflows is calculated and the present value of cash outflow is subtracted from the present value of cash inflows. The difference is called NPV. NPV= PV of Inflow PV of Outflow OR NPV = [(Cash inflow in 1 year x PVF ) + (Cash inflow in 2 year x PVF ) +(Cash inflow in 3rdyear x PVF ) +(Cash inflow in nth year X PVFn)] - [Initial cash outflow X PVF ] PVF = Present Value Factor in 1 year PVF = Present value factor in 2 year and so on.
s t 1 nd 2 3 0 1 st 2 nd
If PVF is not given, we may calculate NPV as follows: OR NPV = [Cash inflow in 1 year X 1/(1+r) ] + [Cash inflow in 2 year X 1/(1+r) ] + [Cash inflow in 3rd year X 1/(1+r) ] +[Cash inflow in nth year X 1/(1+r) ] - [Initial Cash outflow X 1/(1+r) ]
st 1 nd 2 3 n0
Accept-Reject Criteria : If NPV is positive, the project may be accepted If NPV is negative, the project may not be accepted. If NPV is zero, the project may be accepted only if non-financial benefits are there. Merits of NPV method : (i) Time value of money is taken into consideration : Because this method takes into account the time value of money, it is the best method to use for long range decisions. (ii) Full Life of the project is taken into consideration : This method takes into account the fall life of the project and not only the payback period. (iii)Wealth Maximisation : Wealth maximization object of the business is achieved by this method. By accepting the project with highest NPV, the wealth of the business is maximized. Demerits of NPV : (i) Difficult to Understand and Implement : This method is difficult to understand as well as implement in comparison to the payback and the ARR method. (ii) Difficulty in fixing the required rate of return : Required rate or discount rate is the most important in calculating the NPV because different discount rates will give different present values.
23
24 of 88
(iii)In case of two projects with unequal initial investment, this method may not give satisfactory result. (iv) In case of two projects with different lives, this method may not give satisfactory result. (II) Profitability Index OR (PI) : Second method of evaluating a project through discounted cash flows is profitability index method. This method is also called Benefit-Cost Ratio. This method is similar to NPV approach. A major drawback of the NPV method was that it does not give satisfactory results while evaluating the projects requiring different initial investments. PI method provides a solution to this problem. Present Value of Cash Inflows PI = Present Value of Cash Outflows Accept-Reject Criteria : If PI is more than one, the project will be accepted If PI is less than one, the project will be rejected. If PI is one, project may be accepted only on the basis of non-financial considerations. Merits of PI method : (i) Like the other DCF techniques, the PI method also takes into account the time value of money. (ii) It considers all cash flows during the life-time of the project (iii)PI method is a reliable method in comparison to the NPV method when the initial investment in various projects are different. Demerits of PI method : (i) This method is difficult to understand and implement (ii) Calculations under this method are complex. (III) Internal Rate of return Method (IRR) : IRR method is also known as time adjusted rate of return, marginal efficiency of capital, marginal productivity of capital and yield on investment. Like the NPV method the IRR method also takes into consideration the time value of money by discounting the cash flows. IRR is the discount rate at which present value of cash inflows is equal to the present value of cash outflows. Procedure to Find Out IRR : Step I : Calculate the fake payback period
24
25 of 88
Initial Cash Outflows Fake Payback Period = Average Cash Inflows Total Cash Inflows during the life of the project Number of year of life
Average Cash Inflows =
Step II : Locate the closest figure to fake payback period in the annuity table A-2 against the row of number of years of the project. The rate of that column will be the first discount rate. Step III : Find the NPV of the project at the first discount rate located above. If NPV is positive, determine one more discount rate which should be higher than the first discount rate so that the second NPV may be negative. Similarly, If NPV from first discount rate located above is negative, determine second rate lower than the first rate so that second NPV may be positive. Now there are two NPVs at two different rates, one is positive and other is negative. Step IV: Now, apply the following formula to find IRR: NPV at lower discount rate IRR = Lower discount rate + X Difference in discount rate NPV at lower discount rate NPV at higher discount rate
Merits of IRR Method : (i) Like the other DCF methods, IRR methods also take into consideration the time value of money. (ii) It takes into account all cash inflows and outflows occurring over the entire life time of the project. (iii) Although the calculation of IRR involves tedious calculation, its meaning is easier to understand in comparison to the concept of NPV. Demerits of IRR Method : (i) Calculation of IRR involves tedious calculations. (ii) Sometimes, this method produces more than one IRR. In such a case, it becomes difficult to accept or reject the proposal. (iii) It is assumed under the IRR method that all cash inflows of the project are reinvested at IRR rate. This assumption is not valid. Q. What do you mean by Risk Analysis in Capital Budgeting? Explain the Risk Adjusted Discount Rate Method.
25
26 of 88
Ans. Risk Analysis : Risk in an investment refers to the variability that is likely to observed between the estimated returns and the actual returns form the proposal. The greater is the variability between the two returns, the more is the risk involved in the project, and vice versa. Incorporation of the Risk in Investment Proposal : As stated earlier, risk is involved in every capital budgeting decision. As risk is involved in every capital budgeting proposal, the management of a firm must take the risk factor into account, while determining the returns or cash inflows and the profitability of a project for the purpose of capital budgeting. Techniques used for Incorporation of Risk Factor in Capital Budgeting Decision General Techniques Quantitative Techniques Risk Adjusted Discount Rate Methods Certainly Equivalent Coefficient Method Sensitivity Analysis Standard Deviation Decisio Tree
Risk Adjusted Discount Rate Method : Meaning : Under the risk adjusted discount rate method, the future cash flow from capital projects are discount at the risk adjusted discount rate and decision regarding the selection of a project is made on the basis of the net present value of the project computed at the risk adjusted discount rate. The risk adjusted discount rate is based on the assumption that investors expect a higher rate of return on more risky projects and a lower rate of return on less risky projects, and so, a higher discount rate is used for discounting the cash flows of more risky project and a lower discount rate is used for discounting the cash flows of less risky project. The risk adjusted discount rate comprises two rates, viz., (i) Risk-free rate : Risk free rate is the normal rate or the usual discount rate that takes care of time element and (ii) Risk Premium Rate : Risk Premium Rate is the surplus rate or extra rate that takes care of the risk factor. So, the risk adjusted discount rate is the usual or normal discount rate for the time factor plus the extra or additional discount rate. Merits : (1) It is easy to understand and simple to calculate.
26
27 of 88
(2) The risk premium rate included in the risk adjusted rate takes care of the risk element in the future cash flows of the project. (3) It takes into account the risk averse attitude of investors. Demerits : (1) The risk premium rates, determined under this method, are arbitrary. SO this method may not give objective results. (2) Under this method, the risk is compounded over time, since the risk premium is added to the discount rate. Which means, this method presumes that risk necessarily increases with the passage of time. But this may not happen in all situations or cases. (3) This method presumes that investors are averse to risk I i.e., investors avoid facing risk). This may not be true in all cases. There are many investors who would like to take risk and are prepared to pay premium for taking risk. Example : From the following date, state which project is preferable: Year Project A Project B 1 60000 80000 2 50000 60000 3 40000 50000 Initial Cost of 120000 120000 the Project1 Riskless discount rate is 5%. Project A is less risky as compared to project B and so, the management considers risk premium rates at 5% and 10% respectively as appropriate for discounting the cash inflow. The discount factors at 10% and 15% are: Year 10% 15% 1 0.909 0.876 2 0.826 0.756 3 0.751 0.650
27
28 of 88
Solution : First Step : Calculation of Risk-Adjusted Discount Rate For Project A: Riskless Discount Rate 5% And Risk-Premium Rate 5% Risk Adjusted Discount Rate 10% For Project B: Riskless Discount Rate 5% And Risk-Premium Rate 10% Risk Adjusted Discount Rate 15% Second Step : Calculation of Discounted Cash Inflows ( i.e, Present Value and Net Present Value of the Projects)
Year Project A Project B Discounted Cash Inflows at 10% Cash Discount Present Value Cash Discount Present Value Inflows Factor (Rs.) Inflows Factor (Rs.) (Rs) 10% (Cash Inflow x (Rs.) 15% (Cash Inflow x Discount Factor) DiscountFactor)
1 60000 .909 54540 80000 .876 70080 2 50000 .826 41300 60000 .756 45360 3 40000 .751 30040 50000 .650 32500
PV of Cash Inflow 125880 147940 Less: PV of Cash Outflow 120000 120000 Net Present Value 5880 27940
Comments : The Net Present Value of Project B is higher than that of Project A. So Project B is Preferable. Q. Explain the Certainty Equivalent Coefficient Method. Ans. Introduction : Certainty equivalent coefficient method which makes adjustment against risk in the estimates of future cash inflows for a risky capital investment project. Under this method, adjustment against risk is made in the estimates of future cash inflows of a risky capital project by adjusting to a conservative level of the
28
29 of 88
estimated cash flows of a capital investment proposal by applying a correlation factor termed as certainty equivalent coefficient. Formula for Calculating Certainty Equivalent Coefficient : The certainty equivalent coefficient is the ratio of riskless cash flow to risky cash flow. The certainty equivalent coefficient can be calculated with the help of the following formula: Riskless Cash Flow Certainty Equivalent Coefficient = Risky Cash Flow (1) Riskless Cash Flow : Riskless cash flow means the cash flow which the management expects, when there is no risk in investment proposal. (2) Risky Cash Flow : Risky cash flow means the cash flow which the management expects when there is risk in investment proposal. Example : Suppose the risky cash flow is Rs. 200000 and the riskless cash flow is Rs. 140000. 140000 The Certainty Equivalent Coefficient = = 0.7 200000 Steps Involved in Certainty Equivalent Coefficient Method : The various steps involved in the certainty equivalent coefficient method are: (1) First Step : Firstly, the certainty equivalent coefficient has to be calculated for each year of a project. (2) Second Step : Secondly, the risk-adjusted cash flow of a project for each year has to be calculated. The risk-adjusted cash flow of a year can be calculated as follows: Risk-Adjusted Cash Flow = Estimated Cash flow for the year X Certainty Equivalent Coefficient (3) Third Step : Thirdly, we have to find out the present value of the capital project. The present value of the Capital Project can be found by adopting the following procedure. First, the risk-adjusted cash flow for each year should be multiplied by the present value factor or discount factor applicable to that year to get the present value of the risk-adjusted cash flow of each year. (4) Fourth Step : Fourthly, we have to ascertain the net present value of the project. The net present value of the project will be: Present Value of the Project Less: Initial Investment on the Project Net Present Value of the Project
29
30 of 88
(5) Fifth Step : After the NPV of a project is computed, decision is taken as to the selection of the project. The selection of a project, is , usually made on the following line: (i) Generally, a project becomes acceptable, if it has a positive NPV (ii) If there are two or more mutually exclusive projects, generally, the project whose NPV is higher or highest is selected. Example : Two mutually exclusive investment proposals, X and Y under consideration before the management of a company. The initial outlay of each project is Rs. 30000. Both the projects are estimated to have a useful economic life span of 5 years. The estimates of cash inflows and their certainty equivalent coefficients are as follows:
Year Project X Project Y Estimated Cash Flows C.E.C Estimated Cash Flows C.E.C. 1 25000 0.7 30000 0.6 2 30000 0.5 35000 0.5 3 20000 0.4 25000 0.4 4 15000 0.3 12000 0.2 5 10000 0.2 10000 0.1
The cost of capital for the company is 15%. Compare the NPV of the two projects and suggest which project should be accepted by the management. The present value factor at 15% is:
Year Present Value Factor at 15% Or Discount Factor 1 0.870 2 0.750 3 0.658 4 0.572 5 0.497
30
31 of 88
Solution : Computation of the NPV of the Project X :

Year Estimated cash Certainty Risk Adjusted Discount Present Flows Equivalent Cash Flows Factor Velue Coefficient 10%
1 25000 0.7 17500 0.870 15225 2 30000 0.5 15000 0.756 11340 3 20000 0.4 8000 0.658 5264 4 15000 0.3 4500 0.572 2574 5 10000 0.2 2000 0.497 994 Present Value of Cash Inflows 35397 Less: PV of Cash Outflow NPV of Project X Computation of the NPV of Project Y:
Year Estimated cash Certainty Risk Adjusted Discount Present Flows Equivalent Cash Flows Factor Velue Coefficient 10%
30000 5397
1 30000 0.6 18000 0.870 15660 2 35000 0.5 17500 0.756 13230 3 25000 0.4 10000 0.658 6580 4 12000 0.2 2400 0.572 1373 5 10000 0.1 1000 0.497 497
Present Value of Cash Inflows 37340 Less: PV of Cash Outflow NPV of Project Y
30000 7340
31
32 of 88
Comments : Both the projects have positive net present value. So, both are acceptable. However, the Net Present Value (NPV) of project Y is more than that of Project X. That means, Project Y is preferable. Q. What do you mean by Cost of Capital? What is its significance and what are the problems in determination of cost of capital? Ans. Meaning of Cost of Capital : Cost of capital of a firm is the minimum rate of return expected by its investors. The capital used by a firm may be in the form of equity shares, preference shares, debts and retained earnings. The cost of capital is the weighted average cost of these sources of finance used by the firms. The concept of cost of capital occupies a very important role in financial management because the investment decisions are based on it. Definition : According to Milton H. Spencer The cost of capital is the minimum rate of return which a firm requires as a condition for undertaking an investment. According to M.J. Gordon The cost of capital is the rate of return a company must earn on an investment to maintain the value of the company. Significance of the Cost of Capital : (1) Helpful in Designing the Capital Structure : The concept of cost of capital plays a vital role in designing the capital structure of a company. Capital structure of a company is the ratio of debt and equity. These sources differ from each other in terms of their respective costs. As such a company will have to design such a capital structure which minimizes cost of capital. (2) Helpful in taking capital Budgeting Decisions : Capital budgeting is the process of decision making regarding the investment of funds in long term projects of the company. The concept of cost of capital is very useful in making capital budgeting decisions because cost of capital is the minimum required rate of return on an investment project. (3) Helpful in evaluation of financial efficiency of top management :Concept of cost of capital can be used to evaluate the financial efficiency of top management. Such an evaluation will involve a comparison of projected overall cost of capital with the actual cost of capital incurred by the management. Lower the actual cost of capital is the better financial performance of the management of the firm. (4) Helpful in comparative analysis of various sources of finance : Cost of
32
33 of 88
capital to be raised from various sources goes on changing from time to time. Calculation of cost of capital is helpful in analysis of usefulness of various sources of finance. (5) Helpful in taking other financial decisions : The cost of capital concept is also useful in making other financial decisions such as: Dividend Policy Right Issue Working Capital Decisions Capitalisation of profits.
Problems in Determination of Cost of Capital : 1. Historic Cost and Future Cost : One major problem in the determination of cost of capital arises due to difference of opinion regarding the concept of cost itself. It is argued that book costs are historic costs and the calculation of cost of capital on the basis of such costs is irrelevant for decision making. 2. Problems in Computation of Cost of Equity : The computation of cost of equity capital depends upon the rate of return expected by equity shareholders. But it is very difficult to assess the expectation of equity shareholders because there are many factors which influence their expectations. 3. Problems in computation of cost of retained earnings : Sometimes it may appear that retained earning are free of cost because they have not been raised from outside. 4. Problems in Assigning Weights : Weights have to be assigned to various sources of finance to compute the weighted average cost of capital. The choice of using the book value weights or market value weights places another problem in the computation of cost of capital. Q. How will you determine the cost of capital from different sources? Ans. Meaning of Cost of Capital : Cost of capital of a firm is the minimum rate of return expected by its investors. The capital used by a firm may be in the form of equity shares, preference shares, debts and retained earnings. The cost of capital is the weighted average cost of these sources of finance used by the firms. The concept of cost of capital occupies a very important role in financial management because the investment decisions are based on it. Computation of Cost of Capital : Computation of cost of capital includes: (A) Computation of cost of specific sources of finance (B) Computation of weighted average cost of capital Computation of Cost of Specific Sources of Finance : It includes:
33
34 of 88
(1) Cost of Debt : A company may raise the debt in a number of ways. It may borrow funds from the financial institutions or public either in the form of public deposits or debentures for a specified period of time at a specified rate of interest. A debenture or bond may be issued at par, at a discount or at a premium. Debt may either be irredeemable or redeemable after a certain period. (i) Cost of Irredeemable Debt : Cost of Irredeemable Debt, before tax : cost of debt before tax is: Formula for calculating
I K = X 100 NP
db
K = Cost of debt before tax I = Annual Interest Charges NP = Net Proceeds from the issue of Debt
db
Cost of Irredeemable Debt, after tax : When a company uses debt as a source of finance then it saves a considerable amount in payment of tax because the amount of interest paid on the debts is a deductible expense in computation of tax. Formula for calculating cost of debt after tax is: I K = X 100 (1-t) NP
da
K = Cost of debt after tax I = Annual Interest Charges NP = Net Proceeds from the issue of Debt t = Rate of Tax
da
(ii) Cost of redeemable Debt : Normally a company issues a debt which is redeemable after a certain period during its life-time. Such a debt is termed as Redeemable Debt. Cost of redeemable debt may also be calculated before tax and after tax: Cost of Redeemable Debt, before tax : 1 I + (RV NP) n K = X 100
db
1 (RV +NP) 2 K = Cost of debt before tax I = Annual Interest Charges

db
34
35 of 88
NP = Net Proceeds from the issue of Debt n = Number of years in which debt is to be redeemed RV = Redeemable Value of Debt redeemed. Cost of Redeemable Debt, after tax : 1 I + (RV NP) n K = X 100 (1-t)
da
1 (RV +NP) 2 K = Cost of debt before tax I = Annual Interest Charges NP= Net Proceeds from the issue of Debt n = Number of years in which debt is to be redeemed RV = Redeemable Value of Debt t = Rate of Tax
db
(2) Cost of Preference Share Capital : A fixed rate of dividend is payable on preference shares. But, unlike debt, the dividend is payable at the discretion of the Board of Directors and there is no legal binding to pay the dividend. Preference Shares may either be irredeemable or redeemable after a certain period. (i) Cost of Irredeemable Preference Share Capital : Formula for calculating cost of Irredeemable Preference Share Capital is: D K = X 100 NP
P
K = Cost of Irredeemable Preference Share Capital D = Annual Preference Dividend NP = Net Proceeds of Preference Share Capital
P
(ii) Cost of Redeemable Preference Share Capital : Redeemable preference capital has to be returned to the preference shareholders after a stipulated period. The cost of redeemable preference share capital is calculated as follows: 1 D + (RV NP) n K = X 100 1 (RV +NP) 2
pr
35
36 of 88
K = Cost of Redeemable Preference Capital D = Annual Preference Dividend NP = Net Proceeds of Preference Share Capital n = Number of years RV = Redeemable Value of Preference Share Capital
pr
(3) Cost of Equity Share Capital : The cost of equity is the maximum rate of return that the company must earn on equity financed position of its investments in order to leave unchanged the market price of its stock. The cost of equity capital is a function of the expected return by its investors. The cost of equity share capital can be computed in the following ways: (i) Dividend Yield Method : This method is based on the assumption that when an investor invests in the equity shares of a company he expects to get a payment at least equal to the rate of return prevailing in the market. The equation is: DPS K = X 100 MP
e
Ke = Cost of Equity Capital DPS = Dividend Per Share MP = Market Price Per Share (ii) Dividend Yield Plus Growth in Dividend Method : This method is used to compute the cost of equity capital when the dividends of a firm are expected to grow at a constant rate. DPS K = X 100 + G MP
e
Ke = Cost of Equity Capital DPS = Dividend Per Share MP = Market Price Per Share G = Rate of growth in Dividend (iii) Earning Yield Method : As per this method, cost of equity capital is calculated by establishing a relationship between earning per share and the current market price of the share. The equation is : EPS K = X 100 MP
e
K = Cost of Equity Capital EPS = Earning Per Share

e
36
37 of 88
MP = Market Price Per Share (iv) Earning Yield plus Growth in Earning Method : If the EPS of a company is expected to grow at a constant rate of growth, the cost of equity capital can be computed as follows: EPS K = X 100 + G
e
MP K = Cost of Equity Capital EPS = Earning Per Share MP = Market Price Per Share G = Rate of growth in EPS
e
(4) Cost of Retained Earnings : It is sometimes argued that retained earnings carry no cost since a firm is not required to pay dividend on retained earnings. However, this is not true. Though retained earnings do not have any explicit cost to the firm but they involve an opportunity cost. The cost of retained earning can be calculated as follows: Kr = Ke (1-Percentage Brokerage or Flotation Cost) Where Kr = Cost of Retained Earnings Ke = Cost of Equity Capital Q. What is meant by weighted average cost of capital OR Composite ? How is it computed? Illustrate with an example. Ans. Weighted Average Cost of Capital : Capital structure of a company consists of different sources of capital. Cost of these different sources of capital is also calculated by different methods. Hence, after the calculation of cost of capital of these different sources of capital a practical difficulty arise as to what is the cost of overall capital structure of the firm. In order to solve this problem finance managers developed the concept of Weighted Average Cost of capital. It is also known as Composite Cost or Overall Cost. Computation of Weighted Average Cost of Capital : The computation of weighted cost of capital involves the following steps: (i) Compute the cost of each source of funds. (ii) Assign weights to specific costs (iii)Multiply the cost of each of the sources by the assigned weights (iv) Divide the total weighted cost by the total weights
Formula :
S XW K = SW
w
37
38 of 88
K = Weighted Average Cost of Capital X = Cost of specific source of finance W = Weight of specific source of finance.
w
Assignment of Weights : For computing weighted average cost of capital, it is necessary to determine the proportion of each source of finance in the total capitalization. For this purpose weights will have to be assigned to various sources of finance. Weights may be assigned by any of the following methods: (i) Book Value Weights (ii) Market Value Weights (i) Book Value Weights : Book value weights are computed form the values taken from the balance sheet. The weight to be assigned to each source of finance is the book value of that source of finance divided by the book value of total sources of finance. Advantages of Book Value Weights: Book values are readily available from the published records pf the firm. Book value weights are more realistic because the firms set their capital structure targets in terms of book values rather than market values. Book value weights are not affected by the fluctuations in the capital market. In the case of those companies whose securities are not listed, only book value weights can be used. Limitations of Book Value Weights : The costs of various sources of finance are calculated using prevailing market prices. Hence weights should also be assigned according to market values. The present economic values of various sources of capital may be totally different from their book values. (ii) Market Value Weights : As per market value scheme of weighting, the weights to different sources of finance are assigned on the basis of their market values. Advantages of Market Value Weights : The costs of various sources of finance are calculated using prevailing market prices. Hence, it is proper to use market value weights Weights assigned according to market values of the sources of finance represent the true economic values of various sources of finance. Limitations of Market Value Weights : Market value weights may not be available as securities of all the
38
39 of 88
comp anies are not actively traded.

It is very difficult to use market value weights because the market prices of securities fluctuate widely and frequently.
Example : A companys after tax specific cost of capital are as follows: Cost of debt 10% Cost of Preference Shares 12% Cost of Equity Shares 15% The following is the capital structure: Source Amount Debt 3,00,000 Preference Share Capital 2,00,000 Equity Share Capital 5,00,000 ____________ 10,00,000 ____________ Calculate the weighted average cost of capital, K
w
Computation of Weighted Average Cost of Capital using Book Value Weights : Sources of Book Value Proportion or Cost (%) Weighted Funds (1) Rs. (2) Weight (3) (4) Cost (5) =(3x4) Debt 3,00,000 .3 10 3.0 Preference 2,00,000 .2 12 2.4 Share Capital Equity 5,00,000 .5 15 7.5 Share Capital Total 10,00,000 1.00 12.9 The weighted average cost using book value weights is 12.9%
39
40 of 88
UNIT III
Q. Define leverage? Explain its types & Utility. Ans. Meaning of Leverage : The dictionary meaning of the term leverage refers to an increased means of accomplishing some purpose. For example, leverage helps us in lifting heavy objects which may not be otherwise possible. However, in the area of finance it is used to describes the firms ability to used fixed cost assets or funds to magnify the returns to its owners. Leverage can be define as the employment of an assets or fund for which the firms pays a fixed cost or fixed return thus according to him, leverage result as a result of the firm employing an assets or source of funds which has a fixed cost or return. The former may be termed as fixed operating cost while the latter may be termed as fixed financial cost. It should be noted that fixed cost or return is the fulcrum of leverage. If a firm is not required to pay fixed cost or fixed return, there will be no leverage. A high degree of leverage implies that there will be a large change in the profits due to relatively small change in sales and vice- versa. Thus, the higher is the leverage, the higher is the risk and higher is the expected return. Types of Leverage : Leverage are of two types : (1) Operating Leverage (2) Financial Leverage (1) Operating Leverage : The operating leverage may be defined as the tendency of the operating profit to vary disproportional with sales. It is said to exist when a firm has to pay fixed cost regardless of volume of output or sales. The firm is said to have a high degree of operating leverage if it employs a greater amount of fixed cost and a smaller amount of variable cost. On the other hand, a firm will have a low operating leverage when it employs a greater amount of variable cost and a smaller amount of fixed cost. Thus, the degree of operating leverage depends upon the amount of fixed element in the cost structure. Operating leverage in the firm is a function of three factors : (a) The amount of fixed cost (b) The contribution margin (c) The volume of sales Formulae : Operating leverage = Contribution or C_ Operating profit OP
40
41 of 88
Utility : The operating leverage indicates the impact of change in sales on operating income. If a firm has a high degree of operating leverage, small changes in sales will have large effect on operating income. In other words, the operating profit (EBIT) of such firm will increase at a faster rate than the increase in sales. Similarly, the operating profit of such a firm will suffer a great loss as compared to reduction in its sales. (2) Financial Leverage : The financial leverage may be defined as the tendency of the residual net profit to vary disproportionately with operating profit. It indicates the change that take place in the taxable income as a result of change in the operating income. It signifies the existence of fixed interest/ fixed dividend bearing securities in the total capital structure of the company. Thus the use of fixed interest/ dividend bearing securities such as debt & capital preference along with the owners equity in the total owner capital structure of the company is described as financial leverage. Where in capital structure of the company, the fixed interest /dividend bearing securities are greater as compared to the equity capital, the leverage is said to be larger. In the reverse case the leverage will be said to be smaller. Favorable and Unfavorable financial leverage : Financial leverage may be favorable or unfavorable upon whether the earning made by the use of fixed interest or dividend bearing securities exceed the or not explicit the fixed cost, the firm has to pay for the employment of such funds. The leverage will be considered to be favorable so long the firm earns more on assets purchased with the funds than the fixed cost of there use unfavorable or negative leverage occurs when the firm does not earns as much as the fund cost. Financial leverage is also termed as trading on equity. The company resorts to trading on equity with the objective of giving the equity shareholders higher rate of return than the general rate of earning on capital employed in the company to compensate them for the risk that they have to bear. For example If a company borrows Rs. 100 @ 10% P.a. and earns a return for 12%, the balance 4% p.a. after payment of interest belongs to the shareholders and thus they can be paid a higher rate of return than the general rate of earning of company. But in case company could earn a return of only 6% on Rs. 100 employed by it, the equity shareholders loss will be Rs. 2 p.a. Thus, the financial leverage is a double edged sword. It has the potentially of increasing the return to equity shareholders. Earning before tax and Interest Formulae : Financial leverage = Profit before tax but after interest
41
42 of 88
Alternative definition of financial leverage : One of the objectives of planning an appropriate capital structure is to maximize the return on equity shareholders fund or maximize the earning per share. Some authorities have used the term financial leverage in the context that it defines the relationship between EBIT and EPS. According to Gitman financial leverage is the ability of a firm to use fixed financial charges to magnify the effects of change in EBIT on the firms earning per share. The financial leverage, therefore indicate the percentage change in earning per share in relation to a percentage change in EBIT. The degree of financial leverage can be written as follows: Percentage change in EPS Degree of financial leverage = (DFL) Percentage change in EBIT Utility : Financial leverage helps considerably the financial manager while devising the capital structure of the company. A high financial leverage means high fixed financial manager must plan the capital structure in a way that the firm is in a position to meet its fixed financial costs. Increase in fixed financial costs requires necessary increase in EBIT level. In the event of failure to do so, the company may be technically forced into liquidation. Q. Explain Net Income Approach (NI) to Capital Structure. Ans. Net Income Approach : According to the Net Income Approach, as suggested by Durand, the capital structure decision is relevant for the valuation of the firm. In other words, a change in the financial leverage (the ratio of debt to equity) will lead to a corresponding change in the value of the firm as well as the overall cost of capital. According to this approach: (i) If the ratio if debt to equity is increase, the cost of capital will decline, while the value of the firm as well as the market price of equity shares will increase. (ii) A decrease in the ratio of debt to equity will cause an increase in the overall cost of capital and a decline both in the value of the firm as well as the market price of equity shares. Hence a firm can minimize the cost of capital and increase the value of the firm as well as market price of its equity shares by using debt financing to the maximum possible extent. Assumptions : Net Income Approach is based upon the following assumptions: (i) The cost of debt is lower than the cost of equity. (ii) There are no corporate or personal income taxes. (iii)Use of debt does not change the risk perception of investors.
42
43 of 88
Explanation : (i) Net Income approach says that an increase in the proportion of debt financing in capital structure results in an increase in the proportion of a cheaper source of funds. This, in turn, results in the decrease in overall cost of capital leading to an increase in the value of the firm. The main reasons are: The assumption of cost of debt to be less than the cost of equity. The interest on debt is a deductible expense, when the company gets the tax benefits on it. (ii) With a judicious mixture of debt and equity, a firm can evolve an optimum capital structure which will be the one at which the overall cost of capital is lowest and market value of the firm is highest. At that structure, the market price per share would be maximum. Graphic Presentation of Net Income Approach : Net Income approach is explained graphically as follows:
Y
Ke Ko Kd
Degree of Leverage In the above figure, the degree of leverage is plotted along the X-axis, while the percentage rate of cost of capital is shown on Y-axis. The figure shows that K and Kd remain unchanged. But as the degree of leverage increases, cost of capital Ko decreases. K however cannot touch K as there cannot be all debt firm. The optimal capital structure is one at which K is nearest to K . At this level, the firms overall cost of capital would be lowest and the market value of the firm and market value per share is highest.
od od
Basic Terms : EBIT = Earnings before Interest and Tax S = Value of Equity B = Value of Debt V = Value of firm NI = Net Income K = Cost of Debt K = Overall Cost of Capital K = Cost of Equity
d o
e
43
44 of 88
Basic Formulas : V = S + B NI = EBIT - Interest EBIT NI K = S = VK

o e
Example : EBIT = Rs. 50,000 10% Debentures = Rs. 2,00,000 K = 12.5%

e
Solution : (a) Calculation of Value of the Firm (V) & Overall Cost of Capital : NI = EBIT Interest = 50,000 - 20,000 = 30,000 10 Interest = 2,00,000 x = 20,000 100 NI 30,000 30,000 Value of Equity (S) = = = X 100 = 2,40,000 K 12.5 % 12.5
e
Value of Debt = 2,00,000 Value of Equity = 2,40,000 Value of the Firm = S + B = 2,40,000 + 2,00,000 = 4,40,000 Calculation of Overall Cost Of Capital : EBIT 50,000 K = X 100 = X 100 = 11.36% V 4,40,000
o
Value of the Firm = 4,40,000 Overall Cost of Capital = 11.36%
(b) Calculation of Value of the Firm (V) & Overall Cost of Capital, When debt is raised to Rs, 3,00,000 When the debt is raised to Rs. 3,00,000, Then Value of Firm : NI = EBIT Interest = 50,000 - 30,000 = 20,000
44
45 of 88
10 Interest = 3,00,000 x = 30,000 100 20,000 20,000 Value of Equity (S) = = X 100 = 1,60,000 12.5 % 12.5 Value of Equity (S) = 1,60,000 Value of Debt = 3,00,000 Value of the Firm = S + B = 1,60,000 + 3,00,000 = 4,60,000 Calculation of Overall Cost Of Capital EBIT 50,000 K = X 100 = X 100 = 10.87% V 4,60,000
o
Value of The Firm = 4,60,000 Overall Cost of Capital = 10.87% Thus, the use of additional debt has caused the total value of the firm to increase and the overall cost of capitalto decrease. (c) Calculation of Value of the Firm (V) & Overall Cost of Capital, When debt is lowered to Rs, 1,00,000 When the debt is lowered to Rs. 1,00,000 , then Value of Firm: NI = EBIT Interest = 50,000 - 10,000 = 40,000 10 Interest = 1,00,000 x = 10,000 100 40,000 40,000 Value of Equity (S) = = X 100 = 3,20,000 12.5 % 12.5 Value of Equity (S) = 3,20,000 Value of Debt = 1,00,000 Value of the Firm = S + B = 3,20,000 + 1,00,000 = 4,20,000 Calculation of Overall Cost Of Capital : EBIT 50,000 K = X 100 = X 100 = 11.90% V 4,20,000
o
Value of the Firm = 4,20,00 Overall Cost of Capital = 11.90% Thus, we find that the decrease in leverage has increase the overall cost of capital and has reduced the value of the firm.
45
46 of 88
Criticism of Net Income Approach: (i) Wrong assumption of no corporate taxes. (ii) Wrong assumption of constant equity capitalization rate. (iii)Wrong assumption of constant debt capitalization rate. (iv) Wrong assumption of constant risk perception. Q. Explain Net Operating Income Approach (NOI) to Capital Structure. Ans: Net Operating Income Approach (NOI) : This is another theory of capital structure which is propounded by Durand and is just opposite to Net Income Approach. The essence of this approach is that the capital structure decision of a firm is irrelevant. Any change in leverage will not lead to any change in total value of the firm. It means that the overall cost of capital would remain same whether the debt-equity mix is 50:50 or 30: 70 or 60:40. Thus, the total value of the firm, the market price of shares as well as the overall cost of capital is independent of the degree of leverage. Assumptions of NOI Approach : (i) The cost of debt is lower than the cost of equity (ii) There are nor corporate or personal income taxes. (iii)The business risk remains constant at every level of debt & equity. Explanation : (i) The Net Operating Income approach advocates that the cost of equity increases with the increase in the financial leverage. This is due to increased risk assumed by the equity shareholders due to the use of more debt by the firm. To compensate for increased risk, shareholders would expect a higher rate of return on their investments. (ii) Therefore, the advantage of using the cheaper source of funds, i.e. the debt is exactly offset by the increased cost of equity. Consequently, the overall cost of capital remains constant at all degrees of financial leverage. Since the value of the firm is measured as a whole on the basis of overall cost of capital and since the overall cost of capital remains constant, the value of the firm also remains same at all degrees of financial leverage. Graphic Presentation of Net Operating Income Approach : Net Operating Income approach is explained graphically as follows:
Y Ke Ko
Kd X
46
Degree of Leverage
47 of 88
K = Cost of Equity K = Cost of debt K = Overall cost of capital

e d o
In the above figure, the degree of leverage is plotted along the X-axis, while the percentage rate of cost of capital is shown on Y-axis. The figure shows that K and K remain unchanged. as the degree of leverage is increased. But with the increase in the leverage the cost of equity rises in such a manner so as to offset the advantage of using cheaper debt. As a result, K and the value of firm (V) remain unchanged by the increase in the financial leverage.
do o
Basic Terms : EBIT = Earnings before Interest and Tax S = Value of Equity B = Value of Debt V = Value of firm NI = Net Income K = Cost of Debt K = Overall Cost of Capital K = Cost of Equity
d o
e
Basic Formulas : V = S + B NI = EBIT Interest EBIT EBIT -I EBIT V = K = X 100 K K S V

e
o
= X 100
Example : EBIT = 50,000 10% Debentures = 2,00000 Overall Cost of Capital (K ) = 12.5%
o
Solution : (a) Calculation of Value of the Firm : EBIT = 50,000 Ko = 12.5% EBIT 50,000 50,000 V = = = X 100 = 4,00,000 Ko 12.5% 12.5 V = S + B S = V-B S = 4,00,000 2,00,000 = 2,00,000 50,000 -20,000 K = X 100 = 15% 2,00,000
e
47
48 of 88
Calculation of Overall Cost Of Capital : EBIT 50,000 K = X 100 K = X 100 = 12.5% V 4,00,000
o
o
Value of the Firm = 4,00,000 Overall Cost of Capital = 12.5% (b) Calculation of Value of the Firm (V) & Overall Cost of Capital, When debt is raised to Rs, 3,00,000 EBIT = 50,000 Ko = 12.5% 50,000 V = = 4,00,000 Value of the firm = 4,00,000 12,5% S = 4,00,000- 3,00,000 = 1,00,000 Value of Equity = 1,00,000 50,000 -30,000 K = X 100 = 20% Cost of Equity = 20% 1,00,000
e
Calculation of Overall Cost Of Capital : EBIT 50,000 K = X 100 = X 100 = 12.5%

o
V 4,00,000 Value of the Firm = 4,00,000 Overall Cost of Capital = 12.5% Thus, the value of the firm and overall cost of capital remains unchanged but the cost of equity increases (c) Calculation of Value of the Firm (V) & Overall Cost of Capital, When debt is lowered to Rs, 1,00,000 EBIT = 50,000 Ko = 12.5% 50,000 V = = 4,00,000 Value of the firm = 4,00,000 12,5% S = 4,00,000- 1,00,000 = 3,00,000 Value of Equity = 3,00,000
48
49 of 88
50,000 -10,000 K = X 100 = 13.33% Cost of Equity = 3.33% 3,00,000

e
Calculation of Overall Cost Of Capital : EBIT 50,000 K = X 100 = = 12.5% V 4,00,000

o
Value of the Firm = 4,00,000 Overall Cost of Capital = 12.5% Thus, the value of the firm and overall cost of capital remains unchanged but the cost of equity decreased. Criticism : (i) Irrelevant assumption of constant NOI. (ii) Wrong assumption of constant interest rate. (iii)Wrong assumption of business risk. Q. What is Traditional Approach of capital Structure? Explain its various stages. Ans. Traditional Approach : The traditional approach establishes a midway between the Net Income approach and the Net Operating Income Approach. It resembles Net Income approach in arguing that overall cost of capital and the value of the firm are both affected by capital structure decision. But it does not subscribe to the view of NI approach that use of debt in capital structure to any extent will necessarily decrease the overall cost of capital and increase the value of the firm. It resembles Net Operating Income approach that beyond a certain degree of leverage, the cost of equity increases. But it differs from the NOI approach that overall cost of capital and the value of the firm are constant for all degrees of leverage. Stages of Traditional Approach: According to the traditional approach, the manner in which the overall cost of capital and the value of the firm reacts to changes in the degree of financial leverage can be divided into three stages: (1) First Stage : In the first stage, increase in financial leverage, i.e., the use of increased debt in the capital structure results in decrease in the overall cost of capital (k) and increase in the value of the firm. This is because, a relatively cheaper source of funds debt replaces a relatively costlier source of funds equity. In this stage, cost of equity(k ) and cost of debt (k ) remains constant.
o ed
(2) Second Stage : Once the firm has reached a certain degree of financial leverage, increase in leverage does not affect the overall cost of capital and
49
50 of 88
the value of the firm. This because the increase in the cost of equity due to added financial risk completely offsets the advantage of using cheaper debt. With in that range, the overall cost of capital will be minimum and the value of the firm will be maximum. This range represents optimum capital structure. (3) Third Stage : In the third stage, the further increase in debt will lead to increase in overall cost of capital and will reduce the value of the firm. This happens due to two factors: (i) Owing to increased financial risk, K will rise sharply and (ii) K would also rise because the lenders will also raise the rate of interest as they may require compensation for higher risk.
e d
Ke Y Ko Kd Stage I Stage II Stage III
RRX Degree of Leverage

e
Figure depicts that cost of equity (k ) rises negligibly in the initial stage but starts rising sharply in the later stage. Cost of debt remains constant upto a certain degree of leverage and thereafter it also starts rising. The overall cost of capital (k ) curve is saucer-shaper with a horizontal range RR. The optimum capital structure of the firm is represented by range RR because in this stage the overall cost of capital (k ) is minimum and the value of firm is maximum.
o o
Q. Explain the Modigliani and Miller Approach (M-M)of Capital Structure. What are its limitations? Ans. Modigliani and Miller Approach : The Modigliani-Miller approach is similar to the net operating income approach when taxes are ignored. However, when corporate taxes are assumed to exist, their hypothesis is similar to the Net Income approach. (1) The Modigliani-Miller Approach-When the taxes are ignored : The theory propounds that a change in capital structure does not affect the overall cost of capital and the total value of the firm. The reason behind the theory is that although the debt is cheaper to equity, with the increased
50
51 of 88
use of debt as a source of finance, the cost of equity increases and this increase in the cost of equity offsets the advantage of the low cost of debt. Thus, although the change in the debt-equity ratio affects the cost of equity, the overall cost of capital remains constant. The theory further propounds that beyond a certain limit of debt, the cost of debt increases but the cost of equity falls thereby again keeping the overall cost of capital constant. Graphic Presentation :
Y
Ko
Degree of Leverage
Assumptions : MM approach is based on the following assumptions: (i) Securities are traded in a perfect capital market situation. (ii) There are no corporate taxes (iii)All the investors have same expectations about the net operating income of the firm. (iv) The cut-off rate of investment in a firm is the capitalization rate. (v) All the earnings are distributed to the shareholders (vi) Firms can be grouped into homogeneous risk classes. Arbitrage Process : The fundamental theory of the MM approach, if we ignore the taxes, is that the total value of a firm must be constant irrespective of the degree of leverage. In other words, the basic preposition of the MM approach is that the capital structure decision is irrelevant. MM approach provides behavioural justification for the irrelevance of the capital structure decision and are not content with merely stating the preposition. The justification lies in the arbitrage process. Arbitrage process involves buying and selling of those securities whose prices are lower (undervalued securities) and selling those securities whose prices are higher (overvalued securities). Buying the undervalued securities will increase their demand and will result in raising their prices and the selling of overvalued securities will increase their supply thereby bringing down their prices. This will continue till the equilibrium is restored. The arbitrage process
51
52 of 88
ensures that the securities of two identical firms cannot sell at different prices for long. Example : The following is the data regarding two companies X and Y belonging to the same risk class: Company X Company Y Number of Ordinary Shares 90,000 1,50,000 Market price per share 1.20 1.00 6% Debentures 60,000 EBIT 18,000 18,000 All profits after debentures interest are distributed as dividends. Explain how under Modigliani and Miller approach an investor holding 10% shares in company X will be better off in switching his holding to Company Y. Solution : (a) Investors current position in company X with 10% equity holdings: Investments ( 9000 shares X Rs. 1.20) Rs. 10,800 Dividend Income 10% of (18000-6%of 60,000) 1,440 (b) Investor sells his holdings in X for Rs. 10,800 He creates a personal leverage by borrowing Rs. 6,000. Thus, The total amount available with him is Rs. 16,800 (c) He purchases 10% equity holding of Y for Rs. 15,000 (15,000 shares X re 1) for which he pays as follows: From Borrowed funds From Own funds (15,000-6,000) 9,000 (d) His dividend income is 10% of 18,000 1,800 Less: Interest on personal borrowings 6% on Rs. 6000 360 Net Income Thus, he gets the same income of Rs, 1,440 from switching over to Y. But, in the process he reduces his investment outlay by Rs. 1800(10,800-9,000). Therefore, he is better off by investing in company Y. (2) The Modigliani-Miller Approach-When corporate taxes are assumed to exist : Modigliani and Miller agree that the value of the firm will increase and cost capital will decline with the use of debt if corporate taxes are considered. Since interest on debt is tax-deductible, the effective cost of borrowing will be less than the rate of interest. Hence, the value of the levered firm would exceed that of the unlevered firm by an amount equal to the levered firms debts multiplied by the tax rate. Value of the levered firm can be calculated on the basis of the following equation: V =V +D
L u t
6,000
1,440
52
53 of 88
V = Value of Levered Firm V D = Amount of Debt t = Tax Rate

L
= Value of Unlevered Firm
Equation implies that the value of the levered firm equals the value of an unlevered firm plus tax saving resulting from the use of debt. Example : Two firm U and L are identical in every respect, except that U is unlevered and L is levered. L has Rs. 20 Lakh of 8% debt outstanding. The net operating income of both the firms is identical.i.e., Rs. 6 Lakh. The corporate tax rate is 35% and equity capitalization rate for U is 10%. Find out the value of each firm according to the MM Approach. Solution : (i) Value of Unlevered Firm U : EBIT 6,00,000 Less : Interest Nil _________ Earning before tax 6,00,000 Less : Tax @ 35% 2,10,000 _________ Earning After Tax 3,90,000 __________ Cost of Equity(K ) 10%
e
__________
EBIT (1-t) Value of the firm = K

e
3,90,000 Value of the firm (Vu) = = 39,00,000 10% (ii) Value of Levered Firm L V V V V
L L
=V +D
u
= 39,00,000 + 20,00,000 (.35) = 39,00,000 + 7,00,000 = 46,00,000
Limitations or Criticism of MM Approach : (1) Risk Perceptions of personal and corporate leverages are different : It is incorrect to assume that personal leverage is a perfect substitute for corporate leverage. Liability of an investor is limited in corporate
53
54 of 88
enterprises whereas the liability of an individual borrower is unlimited as even his personal property is liable to be used for payment to lenders. Hence, the risk to the individual borrower is higher. (2) Difference in cost of borrowing by the firm and individuals : The assumption that firms and individuals can borrow at the same rate of interests does not hold good in practice. (3) Convenience : The corporate borrowing is more convenient to the investor because the formalities and procedures in borrowing are to be observed by corporates. (4) Institutional Restrictions : Institutional restrictions stand in the way of a smooth operation of arbitrage process. Q. Define Dividend. Explain various factors determining Dividend Policy. Ans: Dividend : Dividend refers to that part of net profits of a company which is distributed among shareholders as a return on their investment in the company. Dividend is paid on preference as well as equity shares of the company. On preference shares, dividend is paid at a predetermined fixed rate. But decision of dividend on equity shares, dividend is taken for each year separately. A settled approach for the payment of dividend is known as dividend policy. Thus, the dividend policy divide the net profits or earnings after taxes into two parts: (1) Earnings to be distributed as dividend (2) Earnings retained in the business. Factors Determining Dividend Policy : (1) Financial Needs of the Firm : Financial needs of a firm are directly related to the investment opportunities available to it. If a firm has abundant profitable investment opportunities, it will adopt a policy of distributing lower dividends. On the other hand, if the firm has little or no investment opportunities, it should retain only a small portion of its earnings and should distribute the rest as dividends. (2) Stability of Dividends : Investors always prefer a stable dividend policy. They expect that they should get a fixed amount as dividends which should increase gradually over the years. (3) Legal Restrictions : The firms dividend policy has to be formulated within the legal provisions and restrictions. For instance, section 205 of the Indian Companies Act provides that dividend shall be paid only out of the current profits or past profits after providing for depreciation. (4) Restrictions in Loan Agreement : Lenders, mostly the financial institutions, put certain restrictions on payment of dividend to safeguard their interests. The following restrictions may be:
54
55 of 88
A loan agreement may prohibit the payment of any dividend as long as the firms current ratio is less than, say, 2:1 A loan agreement may prohibit the payment of any dividend as long as the firms Debt-Equity ratio is more than, say, 1.5:1 They may prohibit the payment of dividends in excess of a certain percentage, say, 10%. When such restrictions are put, the company will have to keep a low dividend payout ratio. (5) Liquidity : Payment of dividend causes sufficient outflow of cash. Although a firm may have adequate profits, it may not have enough cash to pay the dividends. Thus, the cash position is a significant factor in determining the size of dividends. Higher the cash and overall liquidity position of a firm, higher will be its ability to pay the dividends. (6) Access to Capital Market : A company which is not sufficiently liquid can still pay dividends if it has easy accessibility to the capital market. In other words, if a company is able to raise debt or equity in the capital market, it will be able to pay dividends even if its liquid position is not good. (7) Stability of Earnings : Stability of earnings also has a significant effect on the dividend policy of a firm. Normally, the greater the stability of earnings, greater will be the dividend payout ratio. (8) Objectives of Maintaining Control : Sometimes the present management employs dividend policy to retain control of the company in its own hands. When a company pays larger dividends, its liquidity position adversely affected and it may have to issue new shares to raise funds to finance its investment opportunities. If the existing shareholders do not want purchase the new share, their control over the company will be diluted. Under such circumstances, the management will declare lower dividends and earnings will be retained to finance the investment opportunities. (9) Effect on Earning Per Share : As discussed above, higher dividend payout ratio affects the liquidity position adversely and may necessitate the issue of new equity shares in the near future, causing an increase in the number of equity shares and ultimately the earning per share may reduce. On the other hand, by keeping a low dividend payout ratio the firm can retain earnings resulting in increase in future earnings and thereby an increase in earning per share. (10) Firms Expected Rate of Return : If the firms expected rate of return would be less than the rate which could be earned by the shareholders themselves from external investment of their funds, the firm should retain smaller part of its earnings and should opt for a higher dividend payout ratio.
55
56 of 88
(11) Inflation : Inflation may also act as a constraint on paying larger dividends. Depreciation is charged on the original cost of the asset and as a result, when there is an increase in price level, funds generated from depreciation become inadequate to replace the obsolete assets. Consequently, companies will have to retain more of its earnings to provide funds to replace the assets and hence their dividend payout ratio will be low during periods of inflation. (12) General State of Economy : Earnings of a firm are subject to general economic conditions of the country. If the future economic conditions are uncertain, it may lead to retention of larger part of the earnings of a firm to absorb any eventuality. Likewise, in the event of depression, when the level of business activity is very low, the management may reduce the dividend payout ratio of preserve its liquidity position. All the above factors must be carefully considered before formulating a dividend policy. Q. Explain the Walters dividend model. Discuss its assumptions and limitations. Ans. Walters Model : Walters model supports the doctrine that the dividend policy is relevant for the value of the firm. According to Walter, the investment policy of the firm and its dividend policy are interlinked. The main proposition of the Walter approach is the relationship between the following two factors: (i) the return on firms investment or its internal rate of return (r) and (ii) Its cost of capital or the required rate of return (ke) According to Walter approach optimum dividend policy of the firm shall be determined by the relationship between r and Ke. (i) When Internal Rate of Return is greater than Cost of Capital ( r > Ke) : If the firms return on investment is more than the cost of capital, the firm should retain the earnings rather than distributing it to the shareholders because of the reason that the money is earning more profits in the hands of the firm than it would if it was paid to the shareholders. (ii) When Internal Rate of Return is less than Cost of Capital ( r < Ke) : On the other hand, if r is less than Ke, the firm should pay off the money to the shareholders in the form of dividends because of the reason that the shareholders can earn higher return by investing it elsewhere. (iii) If Internal Rate of Return is equal to Cost of Capital (r = Ke) : Lastly, if r is equal to Ke, it is a matter of indifference whether the earnings are retained or distributed. For such firms, there is no optimum dividend policy.
56
57 of 88
The Walters model, thus relates the question of distributing the dividends and retaining the earnings to the investment opportunities that are available with the firm. (i) If a firm has adequate profitable investment opportunities, it will be able to earn more than what the investors expect as r> Ke i.e. return on investment is more than the cost of capital. Such firms are called the growth firms. For growth firms, the optimum dividend policy would be given by Dividend Payout Ratio of zero, .i.e. they would retain their entire earnings. The market value of the shares will be maximized as a result. (ii) On the contrary, if a firm does not have profitable investment opportunities, i.e. when r is less than Ke, the shareholders will be better off if the earnings are paid out to them so that they are able to earn a higher return by investing the funds elsewhere. In such a case, the market price of shares will be maximised by the distribution of the entire earnings as dividend. For such firms the optimum dividend policy would be given by Dividend Payout Ratio of 100%. Assumptions : 1. Constant Return and Cost of Capital : The Walter model assumes that the firms rate of return and its cost of capital are constant. 2. Internal Financing : All financing is done through the retained earnings; that is, external sources of funds like debt or new equity capital are not used. 3. 100% Payout or Retention : All earnings are either distributed as dividends or reinvested internally immediately. 4. Constant Earnings per share and Constant Dividends per share : There is no change in key variables, namely, beginning earnings per share and dividend per share. 5. Infinite Time : The firm has a very long life. Walters Formula for determining the value of a share : r D + (E-D) K P = K
e e
Where P = Market price per share D = Dividend per share E = Earnings per share r = Internal Rate of Return K = Cost of Equity Capital or Capitalisation Rate
e
Example : The following information is available in respect of a firm:

57
58 of 88
Capitalisation Rate (Ke) = 10% Earning Per Share (E) = Rs. 8 Calculate the market price of share under Walters Model by assuming Rate of Return (i) 15% (ii) 10% (iii) 5% and Dividend Payout Ratio (i) 0% (ii) 25% (iii) 50% (iv) 75% (v) 100% Solution : DIVIDEND POLICY AND THE VALUE OF SHARE ( WALTERS MODEL) Sr. r > K No. r = K r < K
r= 0.15 r= 0.10 r= 0.05 K = 0 .10 K = 0 .10 K E = Rs. 8 E = Rs. 8 E = Rs. 8

e e
= 0 .10
(i) D/P Ratio = 0% D/P Ratio = 0% D/P Ratio=0% (Dividend per (Dividend per (Dividend per share = Rs.0) share =Rs.0) share = Rs.0) 0.15 0.10 0.05 0 + (8-0) 0 + (8-0) 0 + (8-0) 0.10 0.10 0.10 P = P = P = 0.10 0.10 0.10 P = 120 P = 80 P = 40
(ii) D/P Ratio = 25% D/P Ratio = 25% D/P Ratio=25% (Dividend per (Dividend per (Dividend per share = Rs.2) share =Rs.2) share = Rs.2) 0.15 0.10 0.05 2 + (8-2) 2 + (8-2) 2 + (8-2) 0.10 0.10 0.10 P = P = P = 0.10 0.10 0.10 P = 110 P = 80 P = 50
58
59 of 88
(iii) D/P Ratio = 50% D/P Ratio = 50% D/P Ratio=50% (Dividend per (Dividend per (Dividend per share = Rs.4) share =Rs.4) share = Rs.4) 0.15 0.10 0.05 4 + (8-4) 4 + (8-4) 4 + (8-4) 0.10 0.10 0.10 P = P = P = 0.10 0.10 0.10 P = 100 P = 80 P = 40
(iv) D/P Ratio = 75% D/P Ratio = 75%
D/P Ratio=75%
(Dividend per (Dividend per (Dividend per share = Rs.6) share =Rs.6) share = Rs.6) 0.15 0.10 0.05 6 + (8-6) 6 + (8-6) 4 + (8-6) 0.10 0.10 0.10 P = P = P = 0.10 0.10 0.10 P = 90 `P = 80 P = 70
(v) D/P Ratio = 100% D/P Ratio = 100%
D/P Ratio=100%
(Dividend per (Dividend per (Dividend per share = Rs.8) share =Rs.8) share = Rs.8) 0.15 0.10 0.05 8 + (8-8) 8 + (8-8) 8 + (8-8) 0.10 0.10 0.10 P = P = P = 0.10 0.10 0.10 P = 80 P = 80 P = 80 Criticism of Walters Model : (i) No External Financing : Walter model assumes that the firms investment are financed exclusively by retained earnings and no external financing is used. If it was so then the model would be applicable to only those firms in which equity was the only source of finance. (ii) Constant Rate of Return : The model assumes that r is constant. This is
59
60 of 88
not a realistic assumption because when increased investments are made by the firm, r also changes. (iii) Constant Equity Capitalisation Rate (Ke) : The model assumes that equity capitalization rate remains constant. This is also not a realistic assumption because equity capitalization rate changes directly with the change in risk complexion of the firm. Q. Explain the Gordons dividend model. Discuss its assumptions and limitations. Ans. Gordons Model : Gordons model is another theory which contends that dividend policy is relevant for the value of the firm. In other words, the dividend decision of the firm affects the value of the firm. Assumptions : (i) No External Financing : Gordons model assumes that no external financing is available and retained earnings are the only source of finance. (ii) All-Equity Firm : This model assumes that the firm is an all equity firm and it has absolutely no debt. (iii) No Taxes : Corporate taxes do not exist (iv) Perpetual earnings : it is assumed that the firm has perpetual life and its stream of earnings are also perpetual. (v) Constant Internal Rate of Return : The internal rate of return of the firm is assumed to be constant. (vi) Constant Cost of Capital : The cost of capital of the firm is assumed to be constant. (vii) Constant Retention Ratio : The retention ratio once decided upon is constant. (viii) Cost of capital greater than growth rate : It is assumed that the firms cost of capital is greater than the growth rate. Explanation : The implications of Gordons basic valuation may be as below: (1) When the rate of return of the firm on its investment is greater than the cost of capital, the price per share increases as the dividend payout ratio decrease. Thus, the growth firm should distribute smaller dividends and should retain maximum earnings. (2) When the rate of return is equal to the cost of capital, than the price per share remains unchanged and is not affected by dividend policy. Thus, for a normal firm there is nor optimum dividend policy. (3) When the rate of return is less than the cost of capital, the price per share increases as the dividend payout increases. Thus, the shareholders of
60
61 of 88
declining firm stand to gain if the firm distributes its earnings for such firms. (4) According to Gordon, the market value of the share is equal to the present value of future stream of dividends. Thus, D D D P = + + + (1+K) (1+K) (1+K)
1 2 t 12n
P = Market Price per share K = Appropriate discount rate to measure risk and time factors Gordons Formula for determining the value of a share : P=E (1-b) D x OR P = K -b
e r
K -g
e
Where P = Market Price per share E = Earnings Per Share r = Firms rate of return b = retention ratio br = g = Growth rate (1-b) = D/P ratio Ke = Cost of Capital Example : The following is the information is available : Rate of Return : (i) 15% (ii) 10% (iii)8% Cost of Capital (Ke) = 10% Earning per share (E) = Rs. 10 Calculate the dividend policy and the value of the firm using Gordons Model when D/P Ratio Retention Ratio (a) 40% 60% (b) 60% 40% (c) 90% 10%
61
62 of 88
Solution : DIVIDEND POLICY AND THE VALUE OF SHARE (GORDONS MODEL) Sr. r > K No. r = K
e
r < K
r= 0.15 r= 0.10 r= 0.08 K = 0 .10 K E = Rs. 10 E = Rs. 10 E = Rs. 10

e
= 0 .10 K
= 0 .10
(i)
D/P Ratio (I-b) = 40% D/P Ratio (I-b) = 40% D/P Ratio (I-b) = 40% Retention ration(b)=60% Retention ration(b)=60% Retention ration(b)=60%
g=br=0.6.15=0.09 g=br=0.6.10=0.06 g=br=0.6.08=0.048 10(1-0.6) 10(1-0.6) 10(1-0.6) P = P = P = 0.10-0.09 0.10-0.06 0.10-0.048 P = 400 P = 100 P = 77 (ii)
g=br=0.4.15=0.06 g=br=0.4.10=0.04 g=br=0.4.08=0.032 10(1-0.4) 10(1-0.4) 10(1-0.4) P = P = P = 0.10-0.06 0.10-0.04 0.10-0.032 P = 150 P = 100 P = 88 (iii)
g=br=0.1.15=0.015 g=br=0.1.10=0.01 g=br=0.1.08=0.008 10(1-0.1) 10(1-0.1) 10(1-0.1) P = P = P = 0.10-0.015 0.10-0.01 0.10-0.008 P = 106 P = 100 P = 98 Q. Discuss the Modigliani and Miller Approach of irrelevance of dividends. What are its limitations? Ans. Modigliani and Miller Approach (MM Model) : The most prominent theory in support of irrelevance of dividends and value of the firm is provided by Modigliani and Miller. The crux of the hypothesis is that the dividend policy of a
62
63 of 88
firm is a passive decision which does not affect the value of the firm. The dividend policy is a residual decision which depends upon the availability of investment opportunities to the firm. There are two situations: (i) If a firm has sufficient investment opportunities, it will not pay dividends and retain the earnings to finance them. (ii) On the contrary, if there are inadequate investments opportunities, dividends will be declared to distribute the earnings. Assumptions of MM Hypothesis : (i) There are perfect capital markets. (ii) Investors behave rationally. (iii) Information about the company is available to all without any cost (iv) There are no floatation and transaction costs (v) No investor is large enough to influence the market price of shares. (vi) There are no taxes (vii) The firm has rigid investment policy (viii) There is no risk or uncertainty in regard to the future profits of the firm. The Argument of MM : The argument given by MM in support of their hypothesis is that whatever increase in the value of the firm results from the payment of dividend will be exactly off set by the decline in the market price of shares because of external financing and there will be no change in the total wealth of the shareholders. For example, if a company having investment opportunities, distributes all its earnings among the shareholders, it will have to raise additional funds from external sources. To be more specific, the market price of a share in the beginning of a period is equal to the present value of dividends paid at the end of the period plus the market price of the shares at the end of the period. MM Hypothesis can be explain by following steps : Step I : Calculation of the Value of the firm : D +P P = 1+K
1 1 o e
= Market Price per share at the beginning of the period or prevailing market price of share. D = Dividend to be received at the end of year 1 P = Market price of shares at the end of year 1 K = Cost of equity capital or rate of capitalization.
o 1 1
Calculation of P1 : The value of P1 can be derived by the above equation: P1 = Po (1 + Ke) D1

63
64 of 88
Step II : Calculation of Number of shares to be issued, when firm requires additional funds: I ( E-nD1) m = P1 m = Number of Shares to be issued I = Total amount required for investment E = Earning of the firm during the year nD1 = Total Dividends to be paid. Step III : Further calculation of the value of the firm with the help of following formula: ( n + m) P1 I + E nPo = 1 + Ke m = Number of shares to be issued E = Total earnings of the firm during the period I = Investment Required P1 = Market price per share at the end of the period Ke = Cost of equity n = number of shares outstanding at the beginning of period nPo = Value of the firm D = Dividend to be received at the end of year 1
1
Example : MM Foam Company currently has 5,000 outstanding shares selling at Rs. 100 each. The firm expects to have a net earning of Rs. 50,000 and contemplating a dividend of Rs. 6 per share at the end of the current financial year. There is a proposal for making new investment of Rs. 1,00,000. Assuming 10% cost of capital show that under MM hypothesis, the payment of dividend does not affect the value of the firm. Solution : (1) Calculation of the value of firm when dividends are paid : (i) Price of the share at the end of current financial year : P = Po (1 + Ke) D1 P = 100 (1+.10) 6
11
= Rs. 104
(ii) Number of shares to be issued : I ( E-nD1) 1,00,000 (50,000 5,000 x 6) 80,000 m = = = P1 104 104
64
65 of 88
(iii) Value of the firm : ( n + m) P1 I + E nPo = 1 + Ke ( 5,000 + 80,000/104) 104 1,00,000 + 50,000 nPo = 1 + .10 6,00,000 -50,000 nPo = = Rs. 5,00,000 1.10 (2) Value of the Firm when dividends are not paid (i) Price of the share at the end of current financial year : P = Po (1 + Ke) D1 P = 100 (1+.10) 0
11
= Rs. 110
(ii) Number of shares to be issued : I ( E-nD1) 1,00,000 (50,000 5,000 x 0) 50,000 m = = - = P1 110 110 (iii) Value of the firm : ( n + m) P1 I + E nPo = 1 + Ke ( 5,000 + 50,000/110) 110 1,00,000 + 50,000 nPo = 1 + .10 6,00,000 -50,000 nPo = = Rs. 5,00,000 1.10 Conclusion : Hence, whether dividends are paid or not, the value of the firm remains the same Rs. 5,00,000
65
66 of 88
UNIT IV
Q. Define Working Capital. Ans. Introduction : Working capital plays the same role in the business as the role of heart in the human body. Just like heart gets blood and circulates the same in the body, in the same way in working capital, funds are generated and then circulated in the business. As and when this circulation stops the business becomes lifeless. Thus, prudent management of Working capital is necessary for the success of a business. Meaning of Working Capital : Working capital management is an important aspect of financial management. In business, money is required for fixed assets and working capital. Fixed assets include land and building, plant and machinery, furniture and fittings etc. Fixed assets are acquired to be retained in the business for a long period and yield returns over the life of such assets. The main objective of working capital management is to determine the optimum amount of working capital required. Generally, management of working capital means management of current assets. Concepts Of Working Capital : There are two concepts of working capital(1) Gross Working Capital Concept (2) Net Working Capital Concept. 1. Gross working capital : Gross working capital; refers to firms investment in current assets. Current assets are the assets which can be converted into cash within an accounting year and include cash, shortterm securities, debtors, bill receivables and stock. According to this concept, working capital means Gross working Capital which is the total of all current assets of a business. It can be represented by the following equation: Gross Working Capital = Total Current Assets According to Bonneville and Dewey : Any acquisition of funds which increases the current assets increases working capital, for they are one and the same. 2. Net Working Capital Concept : Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors, bills payables, and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed
66
67 of 88
current liabilities. A negative Net working capital occurs when current liabilities are in excess of current assets. Net Working Capital = Current Assets - Current Liabilities According to Lawrence. J. Gitmen : The most common definition of net working capital is the difference of firms current assets and current liabilities. Q. What is the need of Working Capital? Ans. Meaning of Working Capital : Working capital management is an important aspect of financial management. In business, money is required for fixed assets and working capital. Fixed assets include land and building, plant and machinery, furniture and fittings etc. Fixed assets are acquired to be retained in the business for a long period and yield returns over the life of such assets. The main objective of working capital management is to determine the optimum amount of working capital required. Generally, management of working capital means management of current assets. NEED FOR WORKING CAPITAL : Along with the fixed capital almost every Small-Scale industries requires working capital though the extent of working capital requirement differs in different businesses. Working capital is needed for running the day-to-day business activities. The need for working capital can also be explained with the help of operating cycle. Operating cycle of a manufacturing concern involves five phases: Conversion of cash into raw material Conversion of raw material into work-in-progress Conversion of work-in-progress into finished goods Conversion of finished goods into debtors by credit sales Conversion of debtors into cash by realising cash from them. Cash Debtors and Bills Receivables Raw Materials
Finished Goods Work-in-progress Diagram : Operating Cycle Working capital in a business is needed because of operating cycle. But the need for working capital does not come to an end after the cycle if completed. Since the operating cycle is a continuous process, there remains
67
68 of 88
a need for continuous supply of working capital. However, the amount of working capital required is not constant throughout the year, but keeps fluctuating. On the basis of this concept, working capital is classified into two types:(i) Permanent Working Capital : The need for working capital fluctuates from time to time. However, to carry on day-to-day operations of the business without any obstacles, a certain minimum level of raw materials, work-in-progress, finished goods and cash must be maintained on a continuous basis. The amount needed to maintain current assets on this minimum level is called permanent or regular working capital. (ii) Temporary or Variable Working Capital : Any amount over and above the permanent level of working capital is called temporary, fluctuating or variable working capital. The distinction between permanent and temporary working capital is illustrated in the following diagram:SHOWING PERMANENT AND TEMPORARY WORKING CAPITAL: Y Temporary Working Capital Permanent Working Capital OX Time
SHOWING PERMANENT AND TEMPORARY WORKING CAPIRAL IN A GROWING CONCERN: Y Temporary Working Capital
Permanent Working Capital O Time X
Q. What is the meaning of Working Capital? Explain the factors affecting the working capital requirements of a business. Ans. Meaning of Working Capital : Working capital management is an important aspect of financial management. In business, money is required for
68
69 of 88
fixed assets and working capital. Fixed assets include land and building, plant and machinery, furniture and fittings etc. Fixed assets are acquired to be retained in the business for a long period and yield returns over the life of such assets. The main objective of working capital management is to determine the optimum amount of working capital required. Generally, management of working capital means management of current assets Determinants of Working Capital : The working capital requirement is determined by a large number of factors but, in general, the following factors influence the working capital needs of an enterprise: (1) Nature of Business : Working capital requirements of an enterprise are largely influenced by the nature of its business. For instance, public utilities such as railways, transport, water, electricity etc. have a very limited need for working capital because they have invested fairly large amounts in fixed assets. Their working capital need is minimal because they get immediate payment for their services and do not have to maintain big inventories. On the other extreme are the trading and financial enterprises which have to invest fewer amounts in fixed assets and a large amount in working capital. This is so because the nature of their business is such that they have to maintain a sufficient amount of cash, inventories and debtors. Working capital needs of most of the manufacturing enterprises fall between these two extremes, that is, between public utilities and trading concerns. (2) Size of Business : Larger the size of the business enterprise, greater would be the need for working capital. The size of a business may be measured in terms of scale of its business operations. (3) Growth and Expansion : As a business enterprise grows, it is logical to expect that a larger amount of working capital will be required. Growing industries require more working capital than those that are static. (4) Production cycle:- Production cycle means the time-span between the purchase of raw materials and its conversion into finished goods. The longer the production cycle, the larger will be the need for working capital because the funds will be tied up for a longer period in work in process. If the production cycle is small, the need for working capital will also be small. (5) Business Fluctuations : Business fluctuations may be in the direction of boom and depression. During boom period the firm will have to operate at full capacity to meet the increased demand which in turn, leads to increase in the level of inventories and book debts. Hence, the need for working capital in boom conditions is bound to increase. The depression phase of business fluctuations has exactly an opposite effect on the level of working capital requirement.
69
70 of 88
(6) Production Policy : The need for working capital is also determined by production policy. The demand for certain products (such as woolen garments) is seasonal. Two types of production policies may be adopted for such products. Firstly, the goods may be produced in the months of demand and secondly, the goods may be produced throughout the year. If the second alternative is adopted, the stock of finished goods will accumulate progressively upto the season of demand which requires an increasing amount of working capital that remains tied up in the stock of finished goods for some months. (7) Credit Policy Relating to Sales : If a firm adopts liberal credit policy in respect of sales, the amount tied up in debtors will also be higher. Obviously, higher book debts mean more working capital. On the other hand, if the firm follows tight credit policy, the magnitude of working capital will decrease. (8) Credit Policy Relating to Purchase : If a firm purchases more goods on credit, the requirement for working capital will be less. In other words, if liberal credit terms are available from the suppliers of goods (i.e., creditors), the requirement for working capital will be reduced and vice versa. (9) Availability of Raw Material : If the raw material required by the firm is available easily on a continuous basis, there will be no need to keep a large inventory of such materials and hence the requirement of working capital will be less. On the other hand, if the supply of raw material is irregular, the firm will be compelled to keep an excessive inventory of such raw materials which will result in high level of working capital. Also, some raw materials are available only during a particular season such as oil seeds, cotton, etc. They would have to be necessarily purchased in that season and have to be kept in stock for a period when supplies are lean. This will require more working capital. (10) Availability of Credit from Banks : If a firm can get easy bank facility in case of need, it will operate with less working capital. On the other hand, if such facility is not available, it will have to keep large amount of working capital. (11) Volume of Profit : The net profit is a source of working capital to the extent it has been earned in cash. Higher net profit would generate more internal funds thereby contributing the working capital pool. (12) Level of Taxes : Full amount of cash profit is not available for working capital purpose. Taxes have to be paid out of profits. Higher the amount of taxes less will be the profits available for working capital. (13) Dividend Policy : Dividend policy is a significant element in determining the level of working capital in an enterprise. The payment of dividend
70
71 of 88
reduces the cash and, thereby, affects the working capital to that extent. On the contrary, if the company does not pay dividend but retains the profits, more would be the contribution of profits towards capital pool. (14) Depreciation Policy : Although depreciation does not result in outflow of cash, it affects the working capital indirectly. In the first place, since depreciation is allowable expenditure in calculating net profits, it affects the tax liability. In the second place, higher depreciation also means lower disposable profits and, in turn, a lower dividend payment. Thus, outgo of cash is restricted to that extent. (15) Price Level Changes : Changes in price level also affect the working capital requirements. If the price level is rising, more funds will be required to maintain the existing level of production. Same level of current assets will need increased investment when prices are increasing. However, companies that can immediately revise their product prices with rising price levels will not face a severe working capital problem. Thus, it is possible that some companies may not be affected by rising prices while others may be badly hit. (16) Efficiency of Management : Efficiency of management is also a significant factor to determine the level of working capital. Management can reduce the need for working capital by the efficient utilization of resources. It can accelerate the pace of cash cycle and thereby use the same amount working capital again and again very quickly. Q. Give the Classification of Working Capital. Ans. Classification of Working Capital : Working Capital can be classified in two ways, firstly, on the basis of concept, and secondly, on the basis of its need. (1) On the Basis of Concept : On this basis working capital may be of two types: (i) Gross Working Capital (ii) Net Working Capital (2) On the Basis of Need : On this basis also working capital may be of two types: (i) Permanent Working Capital (ii) Temporary Working Capital. Q. Define Working Capital. Briefly explain the techniques used in making working capital forecast or Estimating Working Capital Requirements Ans:- Meaning of Working Capital : Working capital management is an important aspect of financial management. In business, money is required for fixed assets and working capital. Fixed assets include land and building, plant
71
72 of 88
and machinery, furniture and fittings etc. Fixed assets are acquired to be retained in the business for a long period and yield returns over the life of such assets. The main objective of working capital management is to determine the optimum amount of working capital required. Generally, management of working capital means management of current assets. Working Capital Forecasting Techniques Capital : Or Computation Of Working
A number of methods are used to determine working capital needs of a business. The important among them are: (1) Operating Cycle Method : Operating cycle is the time span the firm requires in the purchase of raw materials, conversion of raw materials into work in progress and finished goods, conversion of finished goods into sales and in collecting cash from debtors. Larger the time span of operating cycle, larger the investment in current assets. Hence, time period of each stage of operating cycle is estimated and then working capital needed in each stage is computed on the basis of cost of each item. A certain percentage for contingencies may also be added to the above estimates to determine the working capital requirement. On the basis of operating cycle, the working capital can be forecasted in the following way: STATEMENT SHOWING WORKING CAPITAL REQUIREMENT Current Assets : Stock of Raw-Materials : Average Inventory holding period Cost of yearly consumption (weeks/months) Of raw material x = 52 weeks / 12 months
Work in Progress : Average time span of work in process Cost of yearly consumption (weeks/months) Of raw material x 52 weeks/ 12 months
72
73 of 88
Average time span of work in process 50 (weeks/months) + Yearly wages x x 100 52 weeks/ 12 months + Yearly manufacturing and administrative overheads (excluding dep.) Average time span of work in process 50 (weeks/ months) x x = 100 52 weeks/ 12 months Stock of Finished Goods : Cost of goods produced (i.e., yearly cost of raw materials +Wages + manufacturing & administrative overheads(excluding depreciation) Average finished goods holding period (weeks / months) x = 52 weeks/ 12 months Debtors : Working Capital tied up in debtors should be estimated on the basis of cost of sales (excluding depreciation): Average debt collection period Cost of goods produces (i.e., raw materials + wages manufacturing, administrative & selling overhead)
(weeks / months) x = 52 weeks/ 12 months
Cash and Bank Balance : (i.e., minimum cash balance required to be maintained = Total Current Assets (A) Less: Current Liabilities _______
73
74 of 88
Trade Creditors : Credit period allowed by creditors Cost of yearly consumption (weeks/ months) Of raw material x = 52 weeks/ 12 months Wages : Average time lag in payment of wages (weeks/ months) Yearly wages x = 52 weeks/ 12 months Overheads: Average time lag in payment of overheads Yearly Overheads(other (weeks/ months) Than Depreciation) x = 52 weeks/ 12 months
____________ Total Current Liabilities (B) -------------____________ Working Capital (A) (B) -------------Add: Provision for Contingencies -------------____________ Estimated Working Capital Requirement -------------____________ (2) Forecasting of Current Assets and Current Liabilities Method : According to this method, an estimate is made of forthcoming periods current assets and current liabilities on the basis of factors like past experience, credit policy, stock policy and payment policy of the previous years. First of all, such estimate is made for each current asset on the basis of each month and then monthly requirements are converted into yearly requirement of current assets. The estimated amount of current liabilities is deducted from this amount in order to estimate the
74
75 of 88
requirement of working capital. A certain percentage for contingencies may also be added to this amount. (3) Cash Forecasting Method : Under this method, an estimate is made of cash receipts and payments for the next period. Estimated cash receipts are added to the amount of working capital which exists at the beginning of the year and estimated cash payments are deducted from this amount. The difference will be the amount of working capital. (4) Percentage of Sales Method : Under this method, certain key ratios based on past years information are established. These ratios can be ratio of sales to raw material stock, ratio of sales to semi-finished goods stock, ratio of sales to finished goods stock, ratio of sales to debtors, ratio of sales to cash balance etc. After this, sales for the next year will be estimated and the requirement of working capital will be determined on the basis of these ratios. (5) Projected Balance Sheet Method : Under this method, an estimate is made of assets and liabilities for a future date and a projected balance sheet is prepared for that future date. The difference in current assets and current liabilities shown in projected balance sheet will be the amount of working capital. Q. What do you mean by Cash? What are the motives of holding cash? Explain the Objectives of Cash Management? Ans. Cash : For the purpose of cash management, the term cash not only includes coins, currency, notes, cheques, bank drafts, demand deposits with banks but also the near-cash assets like marketable securities and time deposits with banks because they can be readily converted into cash. For the purpose of cash management, near-cash assets are also included under cash because surplus cash is required to be invested in near-cash assets for the time being. Motives of Holding Cash : In every business assets are kept because they generate profit. But cash is an asset which does not generate any profit itself, yet in every business sufficient cash balance is maintained. There are four primary motives or causes for maintaining cash balances: (1) Transaction Motive : A number of transactions take place in every business. Some transactions result in cash outflow such as payment for purchases, wages, operating expenses, financial charges like interest, taxes, dividends etc. Similarly, some transactions result in cash inflow such as receipt from sales, receipt from investment, other incomes etc. But the cash outflows and inflows do not perfectly match with each other. At times, inflows exceed outflows while, at other times outflows exceed inflows. To meet the shortage of cash in situation when cash outflows exceed cash inflows, the business must have an adequate cash balance.
75
76 of 88
(2) Precautionary Motive : In every business, some cash balance is kept as a precautionary measure to meet any unexpected contingency. These contingencies may contingencies may include the following: (i) Floods, strikes and failure of important customers. (ii) Unexpected slow down in collection from debtors. (iii)Cancellation of orders by customers. (3) Speculative Motive : In business, some cash is kept in reserve to take advantage of profitable opportunities which may arise from time to time. These opportunities are: (i) Opportunity to purchase raw material at low prices on payment of immediate cash. (ii) Opportunity to purchase other assets for the business when their prices are low. (4) Compensative Motive: - Banks provide a number of services to the business such as clearance of cheques, supply of credit information about other customers, transfer of fund and so on. Bank charge commission or fee for some of these services. For other services, banks do not charge any commission or fee they require indirect compensation. For this purpose, bank requires the client to maintain a minimum balance in their accounts in the bank. Therefore, cash is also kept at the bank to compensate for free services by banks to the business. Objectives of Cash Management : (i) To maintain Optimum Cash Balance : The main objective of cash management is to determine the optimum cash balance required in the business and to maintain the cash balance at that level. It is necessary to bring equilibrium between liquidity and profitability of business to determine the optimum cash balance. (ii) To Keep the optimum cash balance requirement at minimum level : The second main objective of cash management is to minimize the optimum cash requirement because cash is a non-earning asset. Q. What is Cash Management? Cash Management? What are the Methods OR Devices of
Ans. Cash Management : Cash management includes maintaining optimum cash balance and efficient collection and disbursement of cash. Methods or Devices of Cash Management : The following are the methods of cash management: (1) Cash Budget
76
77 of 88
(2) Cash Flow Statements (3) Cash Flow Ratios (4) Cash Management Model or Baumol Model. (1) Cash Budget : A cash budget is an estimate of cash receipts and cash payments for a future period of time. It is prepared to forecast the cash requirements for a given period and indicates the surplus or shortage of cash during the budget period. There are two parts of cash budget: (i) Cash Receipts : Cash is mainly received from cash sales, collection from debtors, income from investments etc. (ii) Cash Payments : Cash is mainly paid for cash purchases, payment to creditors, payment for expenses etc. By estimating the cash receipts and cash payments for a future period it can be estimated that in which months there will be surplus cash and in which months there will be deficiency of cash resources. (2) Cash Flow Statement : This is another method of cash management. A cash flow statement is a statement showing inflows and outflows of cash during a particular period. In other words, it is a summary of sources and applications of cash during a particular span of time. It analyses the reasons for changes in balance of cash between the two balance sheet dates. (3) Cash Flow Ratios : Cash Flow Ratios are another device of cash management. Some important cash flow ratios are: (i) Cash Turnover Ratio : Sales Per Period Cash Turnover Ratio = Cash Balance Higher cash turnover ratio indicates that a given level of sales, cash balance requirement is less. (ii) Cash Coverage Ratio : Cash Coverage Ratio = Annual Cash Flow Before Interest and Taxes Interest + Principal Payments ( 1/1-tax rate)
Higher the cash coverage ratio, higher will be the credit worthiness of the firm because the lender risk will be lower in such a case. (iii)Cash to average Daily Purchase Ratio : Cash to Average Daily Purchase Ratio = Cash Balance Average Daily Purchase
77
78 of 88
Purchases during the period Average Daily Purchase = Days during the period (iv) Days of Cash Available: Average Cash Balance Days of Cash Available = Average Daily Outflows (v) Cash Break-Even Point: Cash Break-Even Point = Cash Fixed Costs Contribution Per Unit
Contribution Per Unit = Selling price per unit Variable Cost Per Unit. (4) Baumol Model : Baumol model is a device of cash management which is used to determine optimum cash balance. Optimum cash balance is determined by establishing a balance between liquidity and profitability. Higher liquidity or higher cash balance means excessive cash is kept in business which results in loss of interest which can be earned by investing this excessive cash in marketable securities. On the contrary, lower liquidity or a very low cash balance means no idle cash and interest is being earned by investing the excess cash into securities. But in this case also, additional costs are incurred such as brokerage of converting securities into cash, accounting costs of securities, cost of registration of securities etc. Therefore two types of costs are involved in keeping cash balance in a business(i) Opportunity Cost (ii) Transaction Cost When cash balance increases, opportunity cost increases but transaction cost decreases. On the other hand, when cash balance is less, opportunity cost decreases but transaction cost increases. Optimum cash balance is that level of cash at which the opportunity cost and transaction cost becomes equal. In other words, total cost of keeping cash balance will be minimum if both of its component namely opportunity cost and transaction cost are equal. Assumptions : The Baumol Model is based on the following assumptions:78
79 of 88
(i) The cash needs of the firm are known with certainty (ii) The cash disbursements of the firm occurs uniformly over a period of time and is known with certainty (iii)The opportunity cost of holding cash is known and it remains constant. (iv) The transaction cost of converting securities into cash is known and remains constant. Baumol model is in the form of following formula : 2U X P C = ________________ S Where C = Optimum Cash Balance U = Cash disbursement of a year (or month) P = Fixed cost per transaction S = Opportunity cost of one rupee p.a. (per month) Example : Monthly cash requirements according to cash budget Rs. 50,000 Fixed cost per transaction Rs. 10 Interest Rate 12% p.a. Calculate optimum cash balance Solution : 2 X 50,000 X 10 C = ______________________ = Rs. 10,000 .01 Therefore, optimum cash balance= Rs. 10,000 Q. Define Inventory. What are the benefits and costs of holding inventory? Ans. Inventory : Every enterprise needs inventory for smooth running of its activities. The term inventory refers to stock of goods kept for sale by the firm. Kinds of Inventories:(A) In Trading Concern. (B) In Manufacturing Concern. (A) In Trading Concern : In case of trading concerns, it includes only finished goods. (B) Manufacturing Concern : In case of manufacturing concern, inventory may include:Institute of IT & Management
79
80 of 88
(i) Inventory of Raw Materials (ii) Inventory of Work-in-progress (iii)Consumables (iv) Inventory of Finished Goods Benefits of Holding Inventories : (1) Timing of Demand and Supply : Need to hold inventory of raw materials arises because it is not possible for a firm to procure raw materials whenever it is needed. If the firm is assured of supply of raw material without delay, at the rate it is used in its manufacturing process, it need not to hold stock of raw materials. But in actual practice, a time lag exists between demand of raw materials in manufacturing process and its supply. Supply of raw material to the firm mat also be delayed because of such factors as strike, transport problems, short supply etc. Therefore, the firm should maintain adequate inventory of raw material to run its manufacturing process regularly. Similarly, need to hold inventory of finished goods arises because the rate of manufacturing and the rate of sale do not match. A firm cannot manufacture the goods immediately on demand by customers. (2) Quantity Discounts : Raw materials are required as and when production process is run. But instead of procuring raw materials in small quantities at the time of each production run, firm may purchase large quantities of raw material in advance to obtain quantity discounts of bulk purchasing. This results in a significant saving in costs. (3) Anticipation of Price Rise : Anticipation of price rise may also necessitate purchasing and holding of raw material inventories. (4) Reducing Ordering Cost : These cost include the cost of preparing purchase orders, transporting cost, receiving costs, inspecting costs etc. These cost increase in proportion to number of order placed. Therefore, a firm may purchase raw materials in excess of its immediate needs by placing one bulk order to reduce the ordering costs. This also results in accumulation of raw material inventory. Cost of Holding Inventories : The holding of inventories involves blocking of a firms funds. The various risks and costs in holding inventories are as below: (1) Capital Costs : Maintaining of inventories results in blocking of the firms financial resources. The firm has, therefore, to arrange additional funds to meet the cost of inventories. The funds may be arranged from own resources or from outsiders. But in both cases, the firm incurs a cost. In the former case, there is an opportunity cost of investment while in the later case, the firm has to pay interest to outsiders. (2) Storage and Handling Costs : Holding of inventories also involves costs
80
81 of 88
on storage as well as handling of materials. The storage costs includes: (i) Rent of the Godown (ii) Insurance charges etc. (3) Risk of Price Decline : There is always a risk of reduction in the prices of inventories by the suppliers on holding inventories. This may be due to increased market supplies, competition or general depression in the market. (4) Risk of Obsolescence : The inventories may become obsolete due to improved technology, change in requirements, change in customers tastes, etc. (5) Risk Deterioration in Quality : The quality of the materials may also deteriorate while the inventories are kept in stores. Q. What are the Objectives and techniques of Inventory Management? Ans. Objectives of Inventory Management : The objectives of Inventory Management are: (i) To maintain a sufficient large size of inventory to meet the demand of finished goods and to meet the demand of raw material by production department. (ii) To keep the investment in inventory at minimum level by efficiently organizing the purchase and sales operations. (iii) To maintain sufficient inventory of raw materials in period of short supply. (iv) To minimize the carrying cost of inventory namely cost of godown, insurance expenses etc. (v) To control investment in inventory and keep it at an optimum level. Tools and Techniques of Inventory Management : Effective inventory management requires an effective control system for inventories. A proper inventory control not only helps in solving the problems of liquidity but also increases profits and causes substantial reduction in the working capital of the concern. The following are the important tools and techniques of inventory management and control: (1) Re-order point. (2) Economic Order Quantity (EOQ) (3) ABC Analysis. (4) Inventory Turnover Ratios. (1) Re-order point: - The re-order point is that inventory level at which an order should be placed. Both the excessive and inadequate level of inventory are not favourable for business. Therefore, re-order level should not be set up very high or very low. Re-order point is calculated by the following formula: Re-order Level/Point = Lead Time X Average Usage
81
82 of 88
Lead Time : Lead time is the time period between the date of placing order and the date of receiving delivery. Lead time may also be called procurement of inventory. Average Usage : Average usage means the quantity of inventory consumed daily. Therefore, re-order point can be identified as the inventory level which should be maintained for consumption during the lead time. For Example : Lead time in a business is 15 days and average daily usage of inventory is 2,000 units. Re-order point of the business will be: Re-Order Point = 15 days X 2000 units = 30000 units. Safety Stock : in determining re-order point, we have assumed that lead time and average usage rate have been correctly estimated. But in actual practice, both of these factors are difficult to predict accurately. Receipt of raw materials may be delayed beyond the estimated lead time due to strike, floods, transport problems etc. In such situation, the re-order point will be: Re-order Point = Lead Time X Average Usage + Safety Stock. (2) Economic Order Quantity (EOQ) : Economic order quantity is that quantity of material for which each order should be placed. Purchasing large quantities at one time and keeping the same as stock, increases carrying cost of inventories but reducing ordering cost of inventories. On the other hand, small orders reduce the average inventory level thereby reducing the carrying cost of inventories but increasing the ordering costs bec ause of incre ased nu mber of purc hase orders . Therefore, determination of economic order quantity is a trade-off between two types of inventory costs: (i) Ordering costs : Ordering costs includes costs of placing orders and cost of receiving delivery of goods such as clerical expenses in preparing a purchase order, transportation expenses, receiving expenses, inspection expenses and recording expenses of goods received. (ii) Carrying Cost : Carrying cost include costs of maintaining or carrying inventory, such as godown rent, insurance expenses etc. These costs vary with inventory size. The sum of ordering costs and carrying costs represents the total costs of inventory. Economic order quantity is that order quantity at which the total of ordering and carrying cost is minimum. Economic order quantity can be explained with the help of following diagram:
82
83 of 88
Minium Total Cost Carrting Cost
Ordering Cost Order Size (in units)
Formula : EOQ can be determined by the following formula: EOQ= 2xRxO ---------------C
EOQ = Economic Order Quantity R = Annual purchase Requirements in units O = Ordering cost per order C = Carrying cot per unit. Example : Compute the Economic Order Quantity from the following details: Annual Inventory Requirements = 4,00,000 units Cost of placing each order = Rs. 20 Carrying cost for one year = Rs. 4 per unit. EOQ = 2 x R x O C EOQ = 2 x 4, 00,000 x 20 4 (3) ABC Analysis:- ABC Analysis is a technique of controlling different items of inventory. Usually a firm has to maintain several different items as inventory. All these items are not equally important. Therefore, it is not desirable to keep same degree of control on all these items. The firm should give more attention to those items whose value is higher in comparison to others.
= 2,000 units
83
84 of 88
Under this analysis all the items of inventory are classified into three categories:(i) In category A those items are included which are small in number, say, 15 percent of the total items but they are quite valuable, the value being 70 per cent of the total value of the inventory. (ii) Category B stands midway and consists of items which are 30 percent in number and 20 percent of the total value. (iii) In category C those items are included which are quite large in number, say, 55 percent of the total items but carrying little value, say, 10 percent of the total value of inventory. Thereby, all the items can be classified as follows: Class Number of Items Inventory Value (In terms of their % of (In terms of their % of total items) total value) A 15 70 B 30 20 C 55 10 TOTAL 100 100
(4) Inventory Turnover Ratio : Certain items of inventory are slow moving. It means that their consumption is quite slow and capital remains locked up in such items for along period. As a result, carrying costs continue to incur on such items. Slow moving items can be identified with the help of inventory turnover ratios. Cost of Goods Sold Inventory Turnover Ratio (in times) = Average Stock Q. What do you mean by Receivables Management? What are the motives and cost of maintaining Receivables? Also explain the objectives of Receivable Management. Ans. Receivable Management : The term receivables refers to debt owed to the firm by the customers resulting from sale of goods or services in the ordinary course of business. These are the funds blocked due to credit sales. Receivables are also called as trade receivables, accounts receivables, book debts, sundry debtors and bills receivables etc. Management of receivables is also known as management of trade credit.
84
85 of 88
Motives of Maintaining Receivables : (i) Sales Growth Motives : The main objectives of credit sales is to increase the total sales of the business. On being given the facility of credit, customers have shortage of cash may also purchase the goods. Therefore, the prime motive for investment in receivables is sales growth. (ii) Increased profit Motive : Due to credit sales, the total sales of business increases. Thus, in turn, results in increase in profits of the business. (iii) Meeting Competition Motive : In business, goods are sold on credit to protect the current sales against emerging competition. If goods are not sold on credit, the customers may shift to the competitors who allow credit facility to them. Costs of Investment in Receivables : When a firm sells goods or services on credit, it has to bear several types of costs. These costs are as follows:(i) Administrative Cost : To record the credit sale and collections from customers, a separate credit department with additional staff, accounting records, stationery etc is needed. Expenses have also to be incurred on acquiring information about the credit worthiness of the customers. (ii) Capital Cost : There is a time lag between sale of goods and its collection from customers. In that time period, the firm has to pay for purchases, wages, salary and other expenses. Therefore, the firm needs additional funds which may arrange either from external sources or from retained earnings. Both of these sources involve cost. If funds are arranged from external sources, interest has to be paid. On the other hand, if retained earnings are used for this purpose, the firm has to bear opportunity cost. Opportunity cost means the income which could have been earned by investing this amount elsewhere. (iii) Collection Cost : These are the expenses incurred by the firm on collection from the customers after expiry of the credit period. (iv) Default Cost : Despite all efforts by the management, the firm may not be able to recover full amount due from the customers. Such dues are known as bad debts or default cost. Objectives of Receivable Management : (i) To obtain optimum (not maximum) volume of sales. (ii) To minimize cost of credit sales. (iii)To optimize investment in receivables. Q. Explain briefly the aspects or Scope of receivables management. Ans. Receivable Management:- The term receivables refers to debt owed to the firm by the customers resulting from sale of goods or services in the ordinary course of business. These are the funds blocked due to credit sales. Receivables
85
86 of 88
are also called as trade receivables, accounts receivables, book debts, sundry debtors and bills receivables etc. Management of receivables is also known as management of trade credit. Scope or Aspects or Receivables Management : Scope of receivables management is quite wide. It includes the following aspects: (A) Formulation of Optimum Credit Policy. (B) Determination of Credit Terms. (C) Formulation of Collection Policy. (D) Evaluation of Credit Policy. (A) Formulation of Optimum Credit Policy : A firm needs a clear policy regarding as to whether the credit should be allowed to a customer and if yes, to what extent. Credit standards are set for making such decisions. Therefore, a credit policy has two dimensions: (1) Credit Standards (2) Credit Analysis. (1) Credit Standards : Credit standards are the basic criteria set for extension of credit to customers. Decision of credit to customers are taken on the basis of their credit rating, security provided by them, average collection period of the firm and financial ratios. Standards are set for all these factors. A firm can control its credits by setting the credit standards accordingly. If credit standards are liberal, more credit will be extended. On the other hand, if standards are tight, less credit will be extended. Factors for which standards are set can be classified into two broad categories namely: a) Qualitative Factors : Qualitative factors such as willingness and ability of the customers to pay for purchase, public image of the customer and other social factor are included. b) Quantitative Factors : Quantitative factors such as average collection period and financial ratios. (2) Credit Analysis : Credit Analysis is made to evaluate the credit worthiness of the customers before making credit sales. Decision of sale on credit is taken only on the basis of credit analysis. The firm need not follow the policy of treating all the customers equal for allowing credit. Each customer may be fully examined before offering credit terms to him. Credit evaluation involves two steps: a. Obtaining Credit Information : Credit Information concerning each customer is gathered from different sources. Gathering credit information involves cost. Cost of collecting information should be less than the expected profit accruing from it. Credit information can be obtained from internal as well as external sources.
86
87 of 88
Internal Sources : As internal sources of credit information, firm can require its customers to fill up forms giving details about their financial activities. They may also be asked to furnish trade references with whom the firm can have contact to obtain the required information. External Sources : Credit information can also be obtained externally from: (i) Financial Statements : Financial statements, that is , Balance Sheet and profit & loss a/c are major source of credit information. (ii) Bank References : Bank of the customer is also a useful source of credit information about the customer. Firms obtain credit information from customers bank with the help of its own bank. Information such as normal balance of customer, loan taken by him, any default in repaying such loan etc. can obtain from the bank of the customer. (iii)Reports of Credit Rating Agencies : Credit rating agencies collect information about the financial and managerial aspects of large number of business concerns from various sources such as market, newspapers, private investigation etc. (iv) Bazaar Reports : Credit information about the customer can also be maintained from the business concerns in the same trade or industry. (v) Other Sources : Other sources from where credit information can be obtained are trade directories, journals, government revenue records such as income tax returns, sales tax returns etc. b. Analysis of Credit Information : After obtaining the desired information from various source, the information is analysed to determine the credit worthiness of the customer. (B) Determination of Credit Terms : The second aspect of receivable management, after setting the credit standards and assessment of credit worthiness of the customers, is the determination of the terms on which credit will be given. Credit terms are the terms which relate to the repayment of the amount of credit sale. There are three components of credit terms namely:(i) Credit Period : Credit period is the time period for which credit is extended to the customers and after which they have to make the payment. (ii) Cash Discount : To encourage the customers for prompt payment, cash discount may be offered by the firm. Customers can take advantage of cash discount by paying amount within the period of cash discount.
87
88 of 88
(iii)Cash Discount Period : It is the duration within which cash discount is available. (C) Formulation of Collection Policy : The third aspect of the receivable management is to formulate a collection policy. Collection policy is required because all the customers do not pay in time. Some customers pay after the due date and some do not pay at all. If collection is delayed, additional funds are needed during the meantime to pay for purchase, wages etc. Delay in collection also increases risk of bad-debts. Collection policy Lays down the collection procedure followed to collect the amounts from the customers who do not pay within credit period allowed to them. After the expiry of credit period, the firm should initiate collection procedures to make collection from debtors. The efforts should be polite in the beginning but, with the passage of time, they should be made strict. The efforts usually made by the firm include: (i) Reminder Letters (ii) Telephone Calls (iii)Personal Visits (iv) Engaging collection agencies. (v) Settlement at extended payment period. (vi) Legal Action. (D) Evaluation of Credit Policy : A credit policy is formulated to maintain the investment in receivables at optimum level. Receivable Turnover Ratio can be used:Net Credit Sales Receivable Turnover Ratio= Average Debtors + Average Bills Receivables If this ratio comes to 6, it means that the collection from receivables is being made after 12/6= 2 months. Similarly, if the ratio comes to 3, it means that the collection is being made after 12/3 = 4 months. Average Collection Period= Months or days in a period Receivables Turnover Ratio
88

FM Final

Загружено:

Сведения о документе

Исходное описание:

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

FM Final

Загружено:

Авторское право:

Доступные форматы

1 of 88

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Credit Management Financial Accounting

Assets Management Cost Accounting

Securities Management Data Processing Internal Audit

Planning & Annual Budgeting Reports

Institute of IT & Management

Institute of IT & Management

(6) Other Functions: Other functions we includes:

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Compounding or Future Value

Discounting or Present Value

Institute of IT & Management

Where, FV = Future value of the initial flow in n years

Institute of IT & Management

FV = 2000 {(1+.05) 1}/.05 FV = Rs. 11054

Institute of IT & Management

PVAn = 454.50 + 413.50 + 375.50 + 341.50 PVAn = Rs. 1585

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Average Cash Inflows =

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Solution : Computation of the NPV of the Project X :

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

1 (RV +NP) 2 K = Cost of debt before tax I = Annual Interest Charges

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

K = Cost of Equity Capital EPS = Earning Per Share

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

comp anies are not actively traded.

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management

Institute of IT & Management