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FinancialManagement

Unit1

Unit1
Structure

FinancialManagement

1.1 Introduction 1.2 1.3 MeaningAndDefinitions GoalsOfFinancialManagement 1.3.1 ProfitMaximization 1.3.2 WealthMaximization 1.4FinanceFunctions 1.4.1 InvestmentDecisions: 1.4.2 FinancingDecisions: 1.4.3 DividendDecisions 1.4.4 LiquidityDecision 1.5OrganizationOfFinanceFunction 1.5.1 InterfaceBetweenFinanceAndOtherBusinessFunctions 1.5.2 FinanceAndAccounting 1.5.3 FinanceAndMarketing 1.5.4 FinanceAndProduction(Operations) 1.5.5 FinanceAndHR 1.6 Summary TerminalQuestions AnswerstoSAQsandTQs

1.1

Introduction

Toestablishanybusiness,apersonmustfindanswerstothefollowingquestions: a) Capital investments are required to be made. Capitalinvestments are made to acquire the realassets,requiredforestablishingandrunningthebusinesssmoothly.Realassetsareland andbuildings,plantandequipmentsetc. b) Decisiontobetakenonthesourcesfromwhichthefundsrequiredforthecapitalinvestments mentionedabovecouldbeobtained,tobetaken. c) Therefore,thereare twosourcesoffundsviz.debtandequity.In whatproportionthefunds aretobeobtainedfromthesesourcesistobedecidedforformulatingthefinancingplan.

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d) Decisionontheroutineaspectsofdaytodaymanagementofcollectingmoneyduefromthe firmscustomersandmakingpaymentstothesuppliersofvariousresourcestothefirm. Thesearethecoreelementsoffinancialmanagementofafirm.

FinancialManagementofafirmisconcernedwithprocurementandeffectiveutilizationoffunds for the benefit of its stakeholders. The most admired Indian companies are Reliance, Infosys. Theyhavebeenratedwellbythefinancialanalystonmanycrucialaspectsthatenabledthemto createvalue for its share holders. Theyemploy thebest technology, producequality goodsor renderservicesattheleastcostandcontinuouslycontributetotheshareholderswealth. Allcorporatedecisionshavefinancialimplications.Therefore,financialmanagementembracesall thosemanagerialactivitiesthatarerequiredtoprocurefundsattheleastcostandtheireffective deployment.Financeisthelifebloodofallorganizations.Itoccupiesapivotalroleincorporate management. Any business which ignores the role of finance in its functioning cannot grow competitively in todays complex business world. Value maximization is the cardinal rule of efficientfinancialmanagerstoday.

LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. ThemeaningofBusinessFinance. 2. TheobjectivesofFinancialManagement. 3. Thevarious interfacesbetweenfinanceandothermanagerial functions ofafirm.


1.2MeaningAndDefinitions
The branch of knowledge that deals with the art and science of managing money is called financial management. With liberalization and globalization of Indian economy, regulatory and economicenvironmentshaveundergonedrasticchanges.ThishaschangedtheprofileofIndian financemanagerstoday.Indianfinancialmanagershavetransformedthemselvesfromlicensed raj managers to well informed dynamic proactive managers capable of taking decisions of complexnatureinthepresentglobalscenario. Traditionally, financial management was considered a branch of knowledge with focus on the procurementoffunds.Instrumentsoffinancing,formation,merger&restructuringoffirms,legal andinstitutionalframeworkinvolvedthereinoccupiedtheprimeplaceinthistraditionalapproach.

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Themodernapproachtransformedthefieldofstudyfromthetraditionalnarrowapproachtothe mostanalyticalnature.Thecoreofmodernapproachevolvedaround,procurementoftheleast costfundsanditseffectiveutilizationformaximizationofshareholderswealth.Globalizationof business and impact of information technology on financial management have added new dimensionstothescopeoffinancialmanagement.

SelfAssessmentQuestion1 1. FinancialManagementdealswithprocurementoffundsattheleastcostand______funds.

1.3GoalsOfFinancialManagement
Goals mean financial objective of afirm. Experts in financial management haveendorsed the viewthatthegoalofFinancialManagementofafirmismaximizationofeconomicwelfareofits shareholders. Maximization of economic welfare means maximization of wealth of its shareholders. Shareholders wealth maximization is reflected in the market value of the firms shares.Afirmscontributiontothesocietyismaximizedwhenitmaximizesitsvalue.Thereare twoversionsofthegoalsoffinancialmanagementofthefirm:

1.3.1 ProfitMaximization:
Inacompetitiveeconomy,profitmaximizationhasbeenconsideredasthelegitimateobjectiveof a firm because profit maximization is based on the cardinal rule of efficiency. Under perfect competition allocation of resources shall be based on the goalof profit maximization. A firms performance is evaluated in terms of profitability. Investors perception of companys performancecanbetracedtothegoalofprofitmaximization.But,thegoalofprofitmaximization hasbeencriticizedonmanyaccounts: 1. Theconceptofprofitlacksclarity.Whatdoestheprofitmean? a) Isitprofitaftertaxorbeforetax? b) Isitoperatingprofitornetprofitavailabletoshareholders?

Differences in interpretation on the concept of profit expose the weakness of the goal of profit maximization 2. Profit maximization ignores time value of money because it does not differentiate between profitsofcurrentyearwiththeprofittobeearnedinlateryears.

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3. Theconceptofprofitmaximizationfailstoconsiderthefluctuationintheprofitsearnedfrom yeartoyear.Fluctuationsmaybeattributabletothebusiness riskofthefirmbuttheconcept failstothrowlightonthisaspect. 4. Profit maximizationdoes not make clear the concept of profit as to whether itisaccounting profitoreconomicnormalprofitoreconomicsupernormalprofits. 5.Becauseofthesedeficiencies,profitmaximizationfailstomeetthestandardsstipulatedinan operationallyfeasiblecriterionformaximizingshareholderswealth.

1.3.2

WealthMaximization

Wealth Maximization has, been accepted by the finance managers, because it overcomes the limitationsofprofitmaximisation.Wealthmaximisationmeansmaximizingthenetwealthofthe Companys share holders. Wealth maximisation is possible only when the company pursues policiesthatwouldincreasethemarketvalueofsharesofthecompany. Following arguments are in support of the superiority of wealth maximisation over profit maximisation: 1. Wealthmaximisationisbasedontheconceptofcashflows.Cashflowsarearealityandnot based on any subjective interpretation. On the other hand there are many subjective elementsintheconceptofprofitmaximisation. 2. It considers time value of money. Time value of moneytranslates cash flows occurring at differentperiodsintoacomparablevalueatzeroperiod.Inthisprocess,thequalityofcash flowsisconsideredcriticallyinalldecisionsasitincorporatestheriskassociatedwiththecash flowstream.Itfinallycrystallizesintotherateofreturnthatwillmotivateinvestorstopartwith theirhardearnedsavings.Itiscalledrequiredrateofreturnorhurdleratewhichisemployed in evaluating all capital projects undertaken by the firm. Maximizing the wealth of shareholders means positive net present value of the decisions implemented. Positive net presentvaluecanbedefinedastheexcessofpresentvalueofcashinflowsof anydecision implemented over the present value of cash out flows associated with the process of implementationofthedecisionstaken.Tocomputenetpresentvalueweemploytimevalue factor.Timevaluefactorisknownastimepreferenceratei.e. thesumofriskfreerateand riskpremium.Riskfreerateistheratethataninvestorcanearnonanygovernmentsecurity forthedurationunderconsideration.Riskpremiumistheconsiderationfortheriskperceived bytheinvestorininvestinginthatassetorsecurity. X Ltdis alisted company engaged in thebusiness of FMCG (Fast Moving Consumer goods). Listedmeansthecompanyssharesareallowedtobetradedofficiallyontheportalsofthestock

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exchange.TheBoardofDirectorsofXLtdtookadecisioninoneofitsBoardmeeting,toenter into the business of power generation. When the company informs the stock exchange at the conclusion of the meeting of the decision taken, the stock market reacts unfavourably with the resultthatthenextdaysclosingofquotationwas30%lessthanthatofthepreviousday. Thequestion now is, whythe market reactedinthis manner.Investorsin this FMCG Company mighthavethoughtthattheriskprofileofthenewbusiness(power)thatthecompanywantsto takeupishighercomparedtotheriskprofileoftheexistingFMCGbusinessoftheXLtd.When theywantahigherreturn,marketvalueofcompanyssharedeclines.Thereforetheriskprofileof the company gets translated into a time value factor. The time value factor so translated

becomestherequiredrateofreturn. Requiredrateofreturnisthereturnthattheinvestorswant formakinginvestmentinthatsector. Anyprojectwhichgeneratespositivenetpresentvaluecreateswealthtothecompany.Whena companycreateswealthfromacourseofactionithasinitiatedtheshareholdersbenefitbecause suchacourseofactionwillincreasethemarketvalueofthecompanysshares.

SuperiorityofWealthMaximisationoverProfitMaximisation

1. Itisbasedoncashflow,notbasedonaccountingprofit. 2. Through the process of discounting it takes care of the quality of cash flows. Distant cash flowsareuncertain.Convertingdistantuncertaincashflowsintocomparablevaluesatbase periodfacilitatesbettercomparison ofprojects.There arevarious ways ofdealing with risk associatedwithcashflows.Theserisksareadequatelyconsidered whenpresentvaluesof cashflowsaretakentoarriveatthenetpresentvalueofanyproject. 3. In todays competitive business scenario corporates play a key role. In company form of organization,shareholdersownthecompanybutthemanagementofthecompanyrestswith the board of directors. Directors are elected by shareholders and hence agents of the shareholders.Companymanagementprocuresfundsforexpansionanddiversificationfrom Capital Markets. In the liberalized set up, the society expects corporatesto tap the capital markets effectively for their capital requirements. Therefore to keep the investors happy throughtheperformanceofvalueofsharesinthemarket,managementofthecompanymust meetthewealthmaximisationcriterion. 4. When a firm follows wealth maximisation goal, it achieves maximization of market value of share.Whenafirmpracticeswealthmaximisationgoal,itispossibleonlywhenitproduces qualitygoodsatlowcost.Onthisaccountsocietygainsbecauseofthesocietalwelfare.

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5. Maximizationofwealthdemandsonthepartofcorporatestodevelopnewproductsorrender newservicesinthemosteffectiveandefficientmanner.Thishelpstheconsumersasitwill bringtothemarkettheproductsandservicesthatconsumersneed. 6. Another notable features of the firms committed to the maximisation of wealth is that to achievethisgoaltheyareforcedtorenderefficientservicetotheircustomerswithcourtesy. Thisenhancesconsumerwelfareandhencethebenefittothesociety. 7. From thepointofevaluationofperformanceoflistedfirms,themostremarkablemeasureis that of performance of the company in the share market. Every corporate action finds its reflection on the market value of shares of the company. Therefore, shareholders wealth maximizationcouldbeconsideredasuperiorgoalcomparedtoprofitmaximisation. 8. Sincelistingensuresliquiditytothesharesheldbytheinvestors,shareholderscanreapthe benefits arising from the performance of company only when they sell their shares. Therefore,itisclearthatmaximizationofmarketvalueofshareswillleadtomaximisationof thenetwealthofshareholders. Therefore,wecanconcludethatmaximizationofwealthistheappropriateofgoaloffinancial managementintodayscontext.

SelfAssessmentQuestions2 1.Underperfectcompetition,allocationofresourcesshallbebasedonthegoalof_______. 2._____________isbasedoncashflows. 3.__________________considertimevalueofmoney.

1.4

FinanceFunctions

Financefunctionsarecloselyrelatedtofinancialdecisions.Thefunctionsperformedbyafinance manager are known as finance functions. In the course of performing these functions finance managertakesthefollowingdecisions: 1.Financingdecision 2.InvestmentDecision 3.Dividenddecision 4.Liquiditydecision.

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1.4.1

InvestmentDecisions:

To survive and grow, all organizations must be innovative. Innovation demands managerial proactiveactions.Proactiveorganizations continuouslysearchforinnovativewaysofperforming the activities of the organization. Innovation is wider in nature. It could be expansion through entering into new markets, adding new products to its product mix, performing value added activitiestoenhancethecustomersatisfaction,oradoptingnewtechnologythatwoulddrastically reduce the cost of production or rendering services or mass production at low cost or restructuring the organization to improve productivity. All these will change the profile of an organization.Thesedecisionsarestrategicbecause,theyareriskybutifexecutedsuccessfully withaclearplanofaction,theygeneratesupernormalgrowthtotheorganization. Ifthemanagementerrsinanyphaseoftakingthesedecisionsandexecutingthem,thefirmmay become bankrupt. Therefore, suchdecisions willhavetobe taken after takinginto accountall factsaffectingthedecisionsandtheirexecution. Twocriticalissuestobeconsideredinthesedecisionsare: 1. Evaluationofexpectedprofitabilityofthenewinvestments. 2. Rateofreturnrequiredontheproject. The rate of return required by investor is normally known by hurdle rate or cutoff rate or opportunitycostofcapital. Afterafirmtakesadecisiontoenterintoanybusinessorexpanditsexistingbusiness,plansto investinbuildings,machineriesetc.areconceivedandexecuted.Theprocessinvolvediscalled CapitalBudgeting.CapitalBudgetingdecisionsdemandconsiderabletime,attentionandenergy ofthemanagement.Theyarestrategicinnatureasthesuccessorfailureofanorganizationis directlyattributabletotheexecutionofcapitalbudgetingdecisionstaken. Investment decisions are also known as Capital Budgeting Decisions. Capital Budgeting decisionsleadtoinvestmentinrealassets Dividendsarepayoutstoshareholders.Dividendsarepaidtokeeptheshareholdershappy. Dividendpolicyformulationrequiresthedecisionofthemanagementastohowmuchofthe profitsearnedwillbepaidasdividend.Agrowingfirmmayretainalargeportionofprofitsas retainedearningstomeetitsneedsoffinancingcapitalprojects.Here,thefinancemanagerhas tostrikeabalancebetweentheexpectationofshareholdersondividendpaymentandtheneedto provideforfundsoutoftheprofitstomeettheorganizationsgrowth.

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1.4.2

FinancingDecisions:

Financing decisions relate to the acquisition of funds at the least cost. Here cost has two dimensionsvizexplicitcostandimplicitcost. Explicitcostreferstothecostintheformofcouponrate,costoffloatingandissuingthesecurities etc. Implicitcostisnotavisiblecostbutitmayseriouslyaffectthecompanysoperationsespecially whenitisexposedtobusinessandfinancialrisk.Forexample,implicitcostisthefailureofthe organizationtopaytoitslendersordebentureholdersloaninstallmentsonduedateonaccount of fluctuations in cash flow attributable to the firms business risk. In India if the company is unabletopayitsdebts,creditorsofthecompanymayuselegalmeanstosuethecompanyfor windingup.Thisriskisnormallyknownasriskofinsolvency.Acompanywhichemploysdebtas ameansoffinancingnormallyfacesthisriskespeciallywhenitsoperationsareexposedtohigh degreeofbusinessrisk. In all financing decisions a firm has to determine the proportion of equity and debt. The compositionofdebtandequityiscalledthecapitalstructureofthefirm. Debtischeapbecauseinterestpayableonloanisallowedasdeductionsincomputingtaxable income on which the company is liable to pay income tax to the Government of India. For example,iftheinterestrateonloantakenis12%, taxrateapplicabletothecompanyis50%, thenwhenthecompanypaysRs.12asinteresttothelender,taxableincomeofthecompanywill bereducedbyRs.12. Inotherwordswhenactualcostis12%withthetaxrateof50%theeffectivecostbecomes6% therefore, debt is cheap. But, every installment of debt brings along with it corresponding insolvencyrisk. Anotherthingnotableinthisconnectionisthatthefirmcannotavoiditsobligationtopayinterest andloaninstallmentstoitslendersanddebentures. Ontheotherhand,acompanydoesnothaveanyobligationtopaydividendtoitsshareholders. A company enjoys absolute freedom not to declare dividend even if its profitability and cash positionsarecomfortable.However,shareholdersareone ofthestakeholdersofthecompany. Theyareinrealitytheownersofthecompany.Thereforewellmanagedcompaniescannotignore the claim of shareholders for dividend. Dividend yield is an important determinant for stock prices.Dividendyieldreferstodividendpaidwithreferencetothemarketpriceofthesharesof thecompany.Aninvestorincompanysshareshastwoobjectivesforinvesting: 1. IncomefromCapitalappreciation(i.e.Capitalgainsonsaleofsharesatmarketprice) 2. Incomefromdividends.

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Itistheabilityofthecompanytogiveboththeseincomestoitsshareholdersthatdeterminesthe marketpriceofthecompanysshares. The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholdersenjoybothdividendincomeandcapitalgainsaspertheexpectationofthemarket. But,dividendisdeclaredoutoftheprofitearnedbythecompanyafterpayingincometaxtothe GovtofIndia. Forexample,letusassumethefollowingfacts: Dividend=12%onpaidupvalue Taxrateapplicabletothecompany=30% Dividendtax=10% When a Company pays Rs.12 on paid up Capital of Rs.100 as dividend, the profit that the companymustearnbeforetaxis: Since payment of dividend by an Indian Company attracts dividend tax, the company when it paysRs.12toshareholders,mustpaytotheGovtofIndia 10%ofRs.12=Rs.1.2asdividendtax.Thereforedividendanddividendtaxsumupto12+1.2 =Rs.13.2 Sincethisispaidoutoftheposttaxprofit,inthis question,thecompanymustearn: Posttaxdividendpaid 1Taxrateapplicabletothecompany=pretaxprofitrequiredtodeclareandpaythedividend 13.2 13.2

= 10.3

0.7

= Rs19approximate

Therefore,todeclareadividendof12%Companyhastoearnapretaxprofitof19%. Onthe other hand, to pay an interest of 12 % Company has to earn only 8.4 %. This leads to the conclusionthatforeveryRs.100procuredthroughdebt,itcosts8.4%whereasthesameamount procuredintheformofequity(sharecapital)costs 19 %. This confirms the established theory that equity is costly but debt is a cheap but risky sourceoffundstothecorporates. The challenge before the finance manager is to arrive at a combination of debt and equity for financingdecisionswhichwouldattainanoptimalstructureofcapital.Anoptimalstructureisone thatarrivesattheleastcoststructure,keepinginmindthefinancialriskinvolvedandtheabilityof thecompanytomanagethebusinessrisk.Besides,financingdecisioninvolvestheconsideration ofmanagerialcontrol,flexibilityandlegalaspects.Assuchitinvolves quitealotofregulatoryand managerialelementsinfinancingdecisions.

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1.4.3

DividendDecisions

Dividendyieldisanimportantdeterminantofaninvestorsattitudetowardsthesecurity(stock)in his portfolio management decisions. But dividend yield is the result of dividend decision. Dividend decision is a major decision made by a finance manager. It is the decision on formulationofdividendpolicy.Sincethegoaloffinancialmanagementismaximisationofwealth ofshareholders,dividendpolicyformulationdemandsthemanagerialattentionontheimpactof its policy on dividend on the market value of the shares. Optimum dividend policy requires decisionondividendpaymentratessoastomaximizethemarketvalueofshares.Thepayout ratiomeanswhatportionofearningspershareisgiventotheshareholdersintheformofcash dividend. In the formulation of dividend policy, management of a company must consider the relevanceofitspolicyonbonusshares. Dividendpolicyinfluencesthedividendyieldonshares.SincecompanysratingsintheCapital market have a major impact on its ability to procure funds by issuing securities in the capital markets,dividendpolicy,adeterminantofdividendyieldhastobeformulatedhavingregardtoall the crucial elements in building up the corporate image. The following need adequate considerationindecidingondividendpolicy: 1. PreferencesofshareholdersDotheywantcashdividendorCapitalgains? 2. Currentfinancialrequirementsofthecompany 3. Legalconstraintsonpayingdividends. 4. Striking an optimum balance between desires of share holders and the companys funds requirements.

1.4.4 LiquidityDecision
Liquidity decisionsare concerned withWorkingCapital Management.Itis concerned with the daytodayfinancialoperationsthatinvolvecurrentassetsandcurrentliabilities. Theimportantelementofliquiditydecisionsare: 1) Formulationofinventorypolicy 2) Policiesonreceivablemanagement. 3) Formulationofcashmanagementstrategies 4) Policiesonutilizationofspontaneousfinanceeffectively.

1.4.5

OrganizationOfFinanceFunction

Financialdecisionsarestrategicincharacterandtherefore,anefficientorganizationalstructure isrequiredtoadministerthesame.Financeislikebloodthatflowsthroughouttheorganization.

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InallorganizationsCFOsplayanimportantroleinensuringproperreportingbasedon substancetothestakeholdersofthecompany.Becauseofthecrucialrolethesefunctionsplay, financefunctionsareorganizeddirectlyunderthecontrolofBoardofDirectors.Forthesurvival ofthefirm,thereisaneedtoensurebothlongtermandshorttermfinancialsolvency. Failureto achievethiswillhaveitsimpactonallotheractivitiesofthefirm. Weakfunctionalperformancebyfinancialdepartmentwillweakenproduction,marketingandHR activitiesofthecompany.Theresultwouldbetheorganizationbecominganemic.Once anemic,unlesscrucialandeffectiveremedialmeasuresaretakenupitwillpavewayfor corporatebankruptcy. CFOreportstotheBoardofDirectors. UnderCFO,normallytwoseniorofficersmanagethe treasurerandcontrollerfunctions. ATreasurerperformsthefollowingfunction: 1. Obtainingfinance. 2. Liasoningwithtermlendingandotherfinancialinstitutions. 3. Managingworkingcapital. 4. Managinginvestmentinrealassets.

AControllerperforms: 1. AccountingandAuditing 2. Managementcontrolsystems 3. Taxationandinsurance 4. Budgetingandperformanceevaluation 5. Maintaining assets intact to ensure higher productivity of operating capital employed in the organization. In India CFOs have a legal obligation under various regulatory provisions to certify the correctnessofvariousfinancialstatementsinformationreportedtothestakeholdersintheannual reports. Listing norms, regulations on corporate governance and other notifications of Govt of IndiahaveadequatelyrecognizedtheroleoffinancefunctioninthecorporatesetupinIndia.

SelfAssessmentQuestions3 1.____________leadtoinvestmentinrealassets. 2._______________relatetotheacquisitionoffundsattheleastcost. 3.Formulationofinventorypolicyisanimportantelementof___________. 4.Obtainingfinanceisanimportantfunctionof_________.

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1.5 InterfaceBetweenFinanceAndOtherBusinessFunctions

1.5.1 FinanceAndAccounting Lookingatthehierarchyofthefinancefunctionofanorganization,thecontrollerreportstoCFO. Accountingisoneofthefunctionsthatacontrollerdischarges.Accountingandfinanceareclosely related. For computation of Return on Investment, earningsper shareand ofvarious ratiosfor financial analysis the data base will be accounting information. Without a proper accounting system, an organization cannot administer effectively function of financial management. The purposeofaccountingistoreportthefinancialperformanceofthebusinessfortheperiodunder consideration. It is historical in character. But financial management uses the historical accounting information for decision making. All the financial decisions are futuristic based on cash flow analysis. All the financial decisions consider quality of cash flows as an important elementofdecisions.Sincefinancialdecisionsarefuturistic,itistakenandputintoeffectunder conditionsofuncertainty. Assumingthedegreeofuncertaintyandincorporatingtheireffectondecisionmakinginvolveuse ofvariousstatisticalmodels.Intheselectionofthesemodels,elementofsubjectivitycreepsin.

1.5.2 FinanceAndMarketing Many marketing decisions have financial implications. Selections of channels of distribution, decidingonadvertisementpolicy,remuneratingthesalesmenetchavefinancialimplications.In fact,therecentbehaviourofrupeeagainstus$(appreciationofrupeeagainstUSdollar),affected thecashflowpositionsofexportorientedtextileunitsandBPOsandothersoftwarecompanies. Itisgenerallybelievedthatthecurrencyinwhichmarketingmanagerinvoicestheexportsdecides thecashflowconsequencesoftheorganizationifthecompanyismainlydependentonexports. Marketing cost analysis, a function of finance managers is the best example of application of principlesoffinanceontheperformanceofmarketingfunctionsbyabusinessunit.Formulation ofpolicyoncreditmanagementcannotbedoneunlesstheintegrationofmarketingwithfinanceis achieved.Decidingoncredittermstoachieveaparticularlevelofsaleshasfinancialimplication becausesanctioningliberalcreditmayresultinhugebaddebt,ontheotherhandaconservative credittermsmaydepressthesales.Credittermsalsoaffecttheinvestmentinreceivable,anarea of working capital management. There is a close relation between inventory and sales. Co ordination of stores administration with that of marketing management is required to ensure customersatisfactionandgoodwill.Butinvestmentininventoryrequiresthefinancialclearance becausefundsarelockedinandthefundssoblockedhaveopportunitycostofcapital.

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1.5.3FinanceAndProductions(Operations) Financeandoperationsmanagementarecloselyrelated.Decisionsonplantlayout,technology selection, productions / operations, process plant size, removing imbalance inthe flow of input material in the production / operation process and batch size are all operations management decisionsbuttheirformulationandexecutioncannotbedoneunlessevaluatedfromthefinancial angle. The capital budgeting decisions are closely related to production and operations management.Thesedecisionsmakeormarabusinessunit.Wehaveexamplestosubstantiate this. Failure to understand the implications of the latest technological trend on capacity expansionshascostevenbluechipcompanies.ManytextileunitsinIndiabecamesickbecause they did not provide sufficient finance for modernization of plant and machinery. Inventory management is crucial to successful operation management. But management of inventory involvesquitealotoffinancialvariables.

1.5.4 FinanceAndHR
Attractingandretainingthebestmanpowerintheindustrycannotbedoneunlesstheyarepaid salaryatcompetitiverates. Ifanorganizationformulates&implementsapolicyforattractingthe competent man power it has to pay the most competitive salary packages to them. But it improvesorganizationalcapitalandproductivity.Infosysdoesnothavephysicalassetssimilarto thatofIndianRailways.Butifbothweretocometocapitalmarketwithapublicissueofequity, InfosyswouldcommandbetterinvestorsacceptancethantheIndianRailways.Thisisbecause thevalueofhumanresourcesplaysanimportantroleinvaluingafirm.Thebetterthequalityof man power in anorganization, thehigher thevalue of the human capitaland consequentlythe highertheproductivityoftheorganization. IndianSoftwareandITenabledserviceshavebeengloballyacclaimedonlybecauseoftheman powertheypossess.Butithasacostfactori.e.thebestremunerationtothestaff.

1.6 Summary
Financial Management is concerned with the procurement of the least cost funds and its effectiveutilizationformaximizationofthenetwealthofthefirm.Thereexistsacloserelation betweenthemaximizationofnetwealthofshareholdersandthemaximizationofthenetwealth of the company. The broad areas of decision are capital budgeting, financing, dividend and working capital. Dividend decision demands the managerial attention to strike a balance betweentheinvestorsexpectationandtheorganizationsgrowth.

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TerminalQuestions 1. Whataretheobjectivesoffinancialmanagement? 2. Howdoesafinancemanagerarriveatanoptimalcapitalstructure? 3. Examinetherelationshipoffinancialmanagementwithotherfunctionalareasofafirm.

AnswersToSelfAssessmentQuestionss SelfAssessmentQuestions1: 1. Effectiveutilization

SelfAssessmentQuestions2

1. Profitmaximisation. 2. Wealth maximisation 3. Wealthmaximisation

SelfAssessmentQuestions3 1. Investmentdecisions. 2. Financingdecisions 3. Liquidity 4. Treasures

AnswerforTerminalQuestions 1. Refer1.3 2. Refer1.4.1 3. Refer1.5

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Unit2FinancialPlanning
Structure

2.1. 2.2. 2.3. 2.4. 2.5.

Introduction Stepsinfinancialplanning Factorsaffectingfinancialplan Estimationoffinancialrequirementsofafirm. Capitalizations 2.1.1 CostTheory 2.1.2 Earningstheory: 2.1.3 Overcapitalization 2.1.4 Undercapitalization

2.6

Summary TerminalQuestions AnswertoSAQsandTQs

2.1

Introduction

LiberalizationandglobalizationpoliciesinitiatedbytheGovernmenthavechangedthedimension of business environment. It has changed the dimension of competitionthat a firm faces today. Thereforeforsurvivalandgrowthafirmhastoexecuteplannedstrategysystematically. Toexecuteanystrategicplan,resourcesarerequired.Resourcesmaybemanpower,plantand machinery,building,technologyoranyintangibleasset. To acquire all these assets financial resources are essentially required. Therefore, finance managerofacompanymusthavebothlongrangeandshortrangefinancialplans.Integrationof boththeseplansisrequiredfortheeffectiveutilizationofalltheresourcesofthefirm. Thelongrangeplanmustconsider(1)Fundsrequiredtoexecutetheplannedcourseofaction. (2) Funds availableat thedisposalofthe company. (3) Determinationoffunds to be procured fromoutsidesources.

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LearningObjectives: Afterstudyingthisunityoushould

1. Explainthestepsinvolvedinfinancialplanning. 2. Explainthefactorsaffectingthefinancialplanning. 3. Listoutthecausesofovercapitation 4. Explaintheeffectsofundercapitation.


ObjectivesofFinancialPlanning FinancialPlanningisaprocessbywhichfundsrequiredforeachcourseofactionisdecided.It must consider expected business Scenario and develop appropriate courses of action. A financial plan has to consider Capital Structure, Capital expenditure and cash flow. In this connectiondecisionsonthecompositionofdebtandequitymustbetaken. Financialplanninggeneratesfinancialplan.Financialplanindicates: 1. Thequantumoffundsrequiredtoexecutebusinessplans. 2. Compositionofdebtandequity,keepinginviewtheriskprofileoftheexistingbusiness,new businesstobetakenupandthedynamicsofcapitalmarketconditions. 3. Formulationofpoliciesforgivingeffecttothefinancialplansunderconsideration. Afinancialplanisatthecoreofvaluecreationprocess. Asuccessfulvaluecreationprocesscan effectivelymeetthebenchmarksofinvestorsexpectations.

Benefitsthataccruetoafirmoutofthefinancialplanning 1. Effectiveutilizationoffunds:Shortageismanagedbyaplanthatensuresflowofcashatthe least cost. Surplusis deployed through wellplannedtreasury management. Ultimately the productivityofassetsisenhanced. 2. Flexibilityincapitalstructureisgivenadequateconsideration.Hereflexibilitymeansthefirms ability to change the composition of funds that constitute its capital structure in accordance withthechangingconditionsofcapitalmarket.Flexibilityreferstotheabilityofafirmtoobtain funds at the right time, in the right quantity and at the least cost as per requirements to financeemergingopportunities. 3. Formulation of policies and instituting procedures for elimination of all types of wastages in theprocessofexecutionofstrategicplans. 4. Maintainingtheoperatingcapabilityofthefirmthroughtheevolutionofscientificreplacement schemesforplantandmachineryandotherfixedassets.Thiswillhelpthefirminreducingits

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operatingcapital.Operatingcapitalreferstotheratioofcapitalemployedtosalesgenerated. A perusal of annual reports of Dell computers will throw light on how Dell strategically minimized the operating capital required to support sales. Such companies are admired by investingcommunity. 5. Integrationoflongrangeplanswiththeshortageplans.

Guidelinesforfinancialplanning 1. Neverignorethecoordinalprinciplethatfixedassetrequirementsbemetfromthelongterm sources. 2. Make maximum use of spontaneous source of finance to achieve highest productivity of resources. 3. Maintain the operating capital intact by providing adequately out of the current periods earnings.Dueattentiontobegiventophysicalcapitalmaintenanceoroperatingcapability. 4. Neverignoretheneedforfinancialcapitalmaintenanceinunitsofconstantpurchasingpower. 5. Employcurrentcostprinciplewhereverrequired. 6. Givedueweightagetocostandriskinusingdebtandequity. 7. Keeping the need for finance for expansion of business, formulate plough back policy of earnings. 8. Exercisethoroughcontroloveroverheads. 9. Seasonalpeakrequirementstobemetfromshorttermborrowingsfrombanks.

2.2 StepsInFinancialPlanning
1. Establish Corporate Objectives: Corporate objectives couldbegroupedinto qualitative and quantitative. Forexample, a companys mission statement may specify createeconomic valueadded.Butthisqualitativestatementhastobestatedinquantitativetermssuchasa 25%ROEora12%earningsgrowthrates.Sincebusinessenterprisesoperateinadynamic environment,thereisaneedtoformulatebothshortrunandlongrunobjectives. 2. Next stage is formulation of strategies for attaining the objectives set. In this connection corporatesdevelopoperatingplans.Operatingplansareframedwithatimehorizon.Itcould beafiveyearplanoratenyearplan. 3. Once the plans are formulated, responsibility for achieving sales target, operating targets, costmanagementbenchmarks,profittargetsetcisfixedonrespectiveexecutives. 4. Forecastthevariousfinancialvariablessuchassales,assetsrequired,flowoffunds,costto beincurredand then translate the same intofinancial statements. Suchforecastshelpthe

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finance manager to monitor the deviations of actual from the forecasts and take effective remedialmeasurestoensurethattargetssetareachievedwithoutanytimeoverrunandcost overrun. 5. Develop a detailed plan for funds required for the plan period under various heads of expenditure. 6. Fromthefundsrequiredplan,developaforecastoffundsthatcanbeobtainedfrominternal as well as external sources during the time horizon for which plans are developed. In this connectionlegalconstrainsinobtainingfundsonthebasisofcovenantsofborrowingsshould begivendueweightage.Thereisalsoaneedtocollaboratethefirmsbusinessriskwithrisk implicationsofaparticularsourceoffunds. 7. Developacontrolmechanismforallocationoffundsandtheireffectiveuse. 8. Atthetimeofformulatingtheplanscertainassumptionsneedtobemadeabouttheeconomic environment. But when plans are implemented economic environment may change. To manage such situations, there is a need to incorporate an inbuilt mechanism which would scaleuporscaledowntheoperationsaccordingly.

ForecastofIncomeStatementandBalanceSheet Therearethreemethodsofpreparingincomestatement: 1. Percentofsalesmethodorconstantratiomethod 2. Expensemethod 3. Combinationofboththesetwo

PercentofSalesmethod:Thisapproachisbasedontheassumptionsthateachelementofcost bearssomeconstantrelationshipwiththesalesrevenue. Forexample,Rawmaterialcostis40%ofsalesrevenueoftheyearended31.03.2007.Butthis methodassumesthattheratioofrawmaterialcosttosaleswillcontinuetobethesamein2008 also. Such an assumption may not hold good in most of the situations. For example, Raw materialcostincreasesby10%in2008butsellingpriceoffinishedgoodsincreasesonlyby5%. Inthiscaserawmaterialcostwillbe44/105ofthesalesrevenuein2008.Thiscanbesolvedto someextentbytakingaverageforsamerepresentativeyears.However,inflation,changeinGovt policies,wageagreements,technologicalinnovationtotallyinvalidatethisapproachonalongrun basis.

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2. BudgetedExpenseMethod:Expensesfortheplanningperiodarebudgetedonthebasisof anticipated behaviour of various items of cost and revenue. This demands effective data baseforreasonablebudgetingofexpenses. 3. Combinationofboththesemethodsisusedbecausesomeexpensescanbebudgetedbythe management taking into account the expected business environment and some other expensescouldbebasedontheirrelationshipwiththesalesrevenueexpectedtobeearned.

ForecastofBalanceSheet 1. Itemsofcertainassetsandliabilitieswhichhavea closerelationshipwiththesalesrevenue could be computed based on the forecast of sales and the historical data base of their relationshipwiththesales. 2. Determine the equity and debt mix on the basis of funds requirements and the companys policyonCapitalstructure.

Example:ThefollowingdetailshavebeenextractedfromthebooksofXLtd IncomeStatement(Rs.Inmillions) 2006 Saleslessreturns GrossProfit SellingExpenses Administration Deprecation OperatingProfit Nonoperatingincome EBIT(Earningsbeforeinterest&Tax Interest Profitbeforetax Tax Profitaftertax Dividend Retainedearnings 1000 300 100 40 60 100 20 120 15 105 30 75 38 37 2007 1300 520 120 45 75 280 40 320 18 302 100 202 100 102

BalanceSheet (Rs.Inmillion)

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Liabilities Shareholdersfund ShareCapital Equity Preference Reserves&Surplus SecuredLoans Unsecuredloans

2006

2007

Assets FixedAssets Less:Depreciation

2006 400 100 300

2007 510 120 390 50

120 50 122 100 50

120 50 224 120 60 CurrentAssets,loans &Advances CashatBank Receivables Investments

50

10 80 200 50 10

12 128 300 80 24

CurrentLiabilities TradeCrs Provisions Tax ProposedDividend 10 38 60 100 210 250

Inventories Loans&Advances Miscellaneous expenditure

760

984

700

984

Forecast the income statement and balance sheet for the year 2008 based on the following assumptions. 1. Salesfortheyear2008willincreaseby30%overthesalesvaluefor2007. 2. Use percent of sales method to forecast the values for various items of income statement usingthepercentagefortheyear2007. 3. Depreciationistochargedat25%offixedassets. 4. FixedassetswillincreasebyRs.100million. 5. InvestmentswillincreasebyRs.100million. 6. CurrentassetsandCurrentliabilitiesaretobedecidedbasedontheirrelationshiptosalesin theyear2007. 7. MiscellaneousexpenditurewillincreasebyRs.19million. 8. Securedloansin2008willbebasedonitsrelationshiptosalesintheyear2007. 9. Additionalfundsrequired,ifany,willbemetbybankborrowings. 10. Taxrateswillbe30%.

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11. Dividendswillbe50%ofprofitaftertax. 12. Nonoperatingincomewillincreaseby10%. 13. Therewillbenochangeinthetotalamountofadministrationexpensestobespentintheyear 2008 14. Thereisnochangeinequityandpreferencecapitalin2008. 15. Interestfor2008willmaintainthesameratioasithasin2007withthesalesof2007.

IncomeStatementfortheYear2008 (Rs.Inmillion) (Forecast) Particulars a.Sales b.CostofSales c.Grossprofit d.Sellingexpenses e.Administration f.Depreciation Basis Increaseby30% Increaseby30% SalesCostofsales 30%increase Nochange %given 390+100 4 g.OperatingProfit h.NonoperatingIncome i.EarningsBefore Interest&Taxes(EBIT) j.Interest 18ofsales 1300 k.Profitbeforetax l.Tax m.Profitaftertax n.Dividends o.Retainedearnings 18x1690 1300 373 112 261 130 131 23(Decimalignored) C(D+E+F) Increaseby10% 1.1x40 352 44 396 Working 1300x1.3 780x1.3 16901014 120x1.3 Amount(Rs.) 1690 1014 676 156 45 123(Roundedoff)

BalanceSheetfortheyear2008(Rs.Inmillion) (Forecast)

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Particulars Assets FixedAssets Add:Addition

Basis

Working

Amount(Rs.)

Given

510 100 610

Depreciation 1.Netfixedassets 2.Investments 3.CurrentAssets&Loans &advances Cashatbank 12 1300 Receivables 128 1300 Inventories 300 1300 Loans&Advances 80 1300 4.Miscellaneous Expenditure Total Given

120+123

243 367 150

12x1690 1300 128x1690 1300 300x1690 1300 80x1690 1300 24+19

16(Roundedoff)

166

390

104

43 1236

Liabilities 1. ShareCapital Equity Preference 2.Reserves&Surplus Increasebycurrent yearsretained earnings 3.SecuredLoan 60 1300 Bankborrowings 60x1690 1300 78 40(Difference Balancingfigure) 355 120 50

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4. UnsecuredLoan 5. CurrentLiabilities& Provision Tradecreditors 250 1300 Provisionfortax 60 1300 ProposedDividend TotalLiabilities Currentyeargiven

60

60

250x1690 1300 60x1690 1300

325

78 130 1236

ComputerisedFinancialPlanningSystems AllcorporateforecastsuseComputerisedforecastingmodels. Additional funds required to finance the increase in sales could be ascertained using a mathematicalrelationshipbasedonthefollowing:

Additionalfunds Required

=Requiredincrease inassets

Spontaneous increasein liabilities

Increasein retained earnings

(This formula has been recommended by Engene.F.Brighaom and Michael C Ehrharte in their
th bookfinancialmanagementTheoryandPractice,10 edition.

Prof.PrasannaChandra,inhisbookFinancialManagement,hasgivenacomprehensiveformula forascertainingtheexternalfinancingrequirements: EFR=A(Ds)L(Ds)ms(1d)(D1m+SR) S Here A =Expectedincreaseinassets,bothfixedandcurrentrequiredforthe S

Sexpectedincreaseinsalesinthenextyear. L=ExpectedSpontaneousfinancingavailablefortheexpectedincreasein

X Ds

X Ds Ssales
MS1 (1d)=Itistheproductof ProfitmarginxExpectedsalesforthenextyearxRetentionRatio

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Here, retention ratio is 1 payout ratio. Payout ratio refers to the ratio of dividend paid to earningspershare D1m=Expectedchangeinthelevelofinvestmentsandmiscellaneousexpenditure SR=Itisthefirmsrepaymentliabilityontermloansanddebentureforthenextyear. Thisformulahascertainfeatures: 1. Ratiosofassetsandspontaneousliabilitiestosalesremainconstantovertheplanningperiod. 2. Dividendpayoutandprofitmarginforthenextyearcanbereasonablyplannedinadvance. 3. Since external funds requirements involve borrowings from financial institution, the formula rightlyincorporatesthemanagementsliabilityonrepayments. Example ALtdhasgiventhefollowingforecasts: Salesin2008willincreasetoRs.2000fromRs.1000in2007 ThebalancesheetofthecompanyasonDecember31,2007givesthefollowingdetails: Liabilities ShareCapital Equity(SharesofRs.10each) Reserves&Surplus Longtermloan Crsforexpensesoutstanding Tradecreditors BillsPayable 100 250 400 50 50 150 1000 1000 Rs Assets NetFixedAssets Inventories Cash BillsReceivable Rs 500 200 100 200

Ascertain the external funds requirements for the year 2008, taking into account the following information: 1. TheCompanysutilizationoffixedassetsin2007was50%ofcapacitybutitscurrentassets wereattheirproperlevels. 2. Currentassetsincreaseatthesamerateassales. 3. Companysaftertaxprofitmarginisexpectedtobe5%,anditspayoutratiowillbe60%. 4. Creditorsforexpensesarecloselyrelatedtosales(AdaptedfromIGNOUMBA)

Answers Preliminaryworkings A=Currentassets=Cash+BillsReceivables+Inventories

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=100+200+200=500 A=500=Rs.500 S1000

X Ds

X1000

L=Tradecreditors+Billspayable+Expensesoutstanding =50+150+50=Rs.250 L =250=Rs.250 1000

X Ds S
S1 =Rs.200

X1000

M(ProfitMargin)=5/100=0.05

1d=10.6=0.4or40% D1m=NIL SR=NIL Therefore:

EFR =

A Ds L ( ) - x S- mS ( - d)- ( 1 + SR D D m ) 1 1 S S

=500250(0.05x200x0.4)(0+0) =50025040(0+0) =Rs.210 Therefore, external funds requirements (additional funds required) for 2008 will be Rs.210. This additional funds requirements will be procured by the firm based on its policy on capital structure.

SelfAssessmentQuestions1 1. Corporateobjectivescouldbegroupinto________and________. 2. Controlmechanismisdevelopedfor_____________andtheireffectiveuse. 3. Seasonalpeakrequirementstobemetfrom___________________frombanks. 4. Exercisethrough_________overoverheads.

2.3FactorsAffectingFinancialPlan

1. Nature of the industry: Here, we must consider whetheritis a capitalintensive orlabour intensiveindustry.Thiswillhaveamajorimpactonthetotalassetsthatthefirmowns. 2. Size of the Company: The size of thecompany greatly influences the availability offunds from different sources. A small company normally finds it difficult to raise funds from long

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termsourcesatcompetitiveterms.Ontheotherhand,largecompanieslikeRelianceenjoy theprivilegeofobtainingfundsbothshorttermandlongtermatattractiverates. 3. Status of the company in the industry: A well established company enjoying a good market share, for its productsnormally commandsinvestors confidence. Such a company cantapthecapitalmarketforraisingfundsincompetitivetermsforimplementingnewprojects toexploitthenewopportunitiesemergingfromchangingbusinessenvironment. 4. Sources of finance available: Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with adiversified product mix may manage higher quantum of debt because the firm may manage higher financialriskwithalowerbusinessrisk.Selectionofsourcesoffinanceiscloselylinkedtothe firmscapacitytomanagetheriskexposure. 5. The Capital structure ofa company isinfluencedby the desire of theexisting management (promoters)ofthecompanytoretaincontrolovertheaffairsofthecompany.Thepromoters whodonotliketolosetheirgripovertheaffairsofthecompanynormallyobtainextrafunds forgrowthbyissuingpreferencesharesanddebenturestooutsiders. 6. Matching thesourceswith utilization: Theprudent policy ofany goodfinancialplanis to match the term of the source with the term of investment. To finance fluctuating working capitalneedsthefirmresortstoshorttermsfinance.Allfixedassetsfinancedinvestmentsare tobefinancialbylongtermsources.Itisacardinalprincipleoffinancialplanning. 7. Flexibility:Thefinancialplanofacompanyshouldpossessflexibilitysoastoeffectchanges in the composition of capital structure when ever need arises. If the capital structure of a companyisflexible,itwillnotfaceanydifficultyinchangingthesourcesoffunds.Thisfactor hasbecomeasignificantonetodaybecauseoftheglobalizationofcapitalmarket. 8. GovernmentPolicy:SEBIguidelines,financeministrycirculars,variousclausesofStandard Listing Agreement and regulatory mechanism imposed by FEMA and Department of corporate affairs (Govt of India) influence the financial plans of corporates today. ManagementofpublicissuesofsharesdemandsthecomplianceswithmanystatuesinIndia. Theyaretobecompliedwithatimeconstraint.

SelfAssessmentQuestions2: 1. ___________hasamajorimpactonthetotalassetsthatthefirmowns. 2. Sourcesoffinancecouldbegroupedinto__and_______________.

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3. ___________ofanygoodfinancialplanistomatchthetermofthesourcewiththetermof thesourcewiththetermoftheinvestment. 4. ________________referstheabilityto______________________wheneverneedarises.

2.4

EstimationOfFinancialRequirementsOfaFirm.

Theestimationofcapitalrequirementsofafirminvolvesacomplexprocess.Evenwithexpertise, managementsofsuccessfulfirmscouldnotarriveattheoptimumcapitalcompositionintermsof thequantumandthesources.Capitalrequirementsofafirmcouldbegroupedintofixedcapital andworkingcapital.Thelongtermrequirementssuchasinvestmentinfixedassetswillhaveto be metoutoffunds obtainedonlong termbasis. Variable working capital requirements which fluctuate from season to season will have to be financed only by short term sources. Any departurefromthiswellacceptednormcausesnegativeimpactsonfirmsfinances.

SelfAssessmentQuestion3: 1.Capitalrequirementofafirmcouldbegroupedinto________and__________. 2.Variableworkingcapitalwillhavetobefinancedonlyby_______________.

2.5Capitalizations Meaning:Capitalizationofafirmrefersthecompositionofitslongtermfunds.Itreferstothe capitalstructureofthefirm.Ithastwocomponentsvizdebtandequity. Afterestimatingthefinancialrequirementsofafirm,thenthenextdecisionthatthemanagement hastotakeistoarriveatthevalueatwhichthecompanyhastobecapitalized. TherearetwotheoriesofCapitalizationfornewcompanies: 1.Costtheoryand 2.Earningstheory

2.5.1CostTheory: Under this approach, the total amount of capitalization for a new company is the sum of the following: 1. Costoffixedassets. 2. Costofestablishingthebusiness. 3. Amountofworkingcapitalrequired

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Meritsofcostapproach: 1. It helps promoters to estimate the amount of capital required for incorporation of company conducting market surveys, preparing detailed project report, procuring funds, procuring assetsbothfixedandcurrent,trialproductionrunandsuccessfullyproducing,positioningand marketingofitsproductsorrenderingofservices. 2. Ifdonesystematicallyitwilllayfoundationforsuccessfulinitiationoftheworkingofthefirm. Demerits 1. Ifthefirmestablishesitsproductionfacilitiesatinflatedprices,productivityofthefirmwillbe lessthanthatoftheindustry. 2. Networthofacompanyisdecidedbytheinvestorsbytheearningsofacompany.Earnings capacitybasednetworthhelpsafirmtoarriveatthetotalcapitalintermsofindustryspecified yardstick (i,e,operating capitalbasedon bench marks in that industry) cost theoryfailsin thisrespect.

2.5.2

EarningsTheory:

Earningsareforecastandcapitalizedatarateofreturnwhichisrepresentativeoftheindustry.It involvestwosteps. 1. Estimationoftheaverageannualfutureearnings. 2. Normalearningrateoftheindustrytowhichthecompanybelongs.

Merits 1. It is superior to cost theory because there are, the least chances of neither under notover capitalization. 2. Comparisonofearningsapproachwiththatofcostapproachwillmakethemanagementtobe cautious in negotiating the technology and cost of procuring and establishing the new business.

Demerits 1. The major challenge that a new firm faces is in deciding on capitalization and its division thereofintovariousprocurementsources. 2. Arrivingatcapitalizationrateisequallyaformidabletaskbecausetheinvestorsperceptionof established companies cannot be really representative of what investors perceive of the earningpowerofnewcompany.

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Because of the problem, most of the new companies are forced to adopt the cost theory of capitalization. Ideallyeverycompanyshouldhavenormalcapitalization.Butitisanutopianwayofthinking. Changing business environment, role of international forces and dynamics of capital market conditionsforceustothinkintermsofwhatisoptimaltodayneednotbesotomorrow.Evenwith these constraints, management of every firm should continuously monitor the firms capital structuretoensuretoavoidthebadconsequencesofoverandundercapitalization.

2.5.3

Overcapitalization

Acompanyissaidtobeovercapitalized,whenitstotalcapital(bothequityanddebt)exceedsthe truevalueofitsassets.Itiswrongtoidentifyovercapitalizationwithexcessofcapitalbecause most of the overcapitalized firms suffer from the problems of liquidity. The correct indicator of overcapitalizationistheearningscapacityofthefirm.Iftheearningsofthefirmarelessthenthat ofthemarketexpectation,it willnotbeinapositiontopaydividendstoitsshareholdersasper theirexpectations.Itisasignofovercapitalization.Itisalsopossiblethatacompanyhasmore fundsthanitsrequirementsbasedoncurrentoperationlevels,andyethavelowearnings. Overcapitalizationmaybeonaccountofanyofthefollowing: 1. Acquiringassetsatinflatedrates 2. Acquiringunproductiveassets. 3. Highinitialcostofestablishingthefirm 4. Companieswhichestablishtheirnewbusinessduringboomconditionareforcedtopaymore for acquiring assets, causing a situation of overcapitalization once the boom conditions subside. 5. Totalfundsrequirementshavebeenoverestimated. 6. Unpredictablecircumstances(likechangeinimportexportpolicy,changeinmarketratesof interest,changesininternationaleconomicandpoliticalenvironment)reducesubstantiallythe earningcapacityofthefirm.Forexample,rupeeappreciationagainstU.S.dollarhasaffected earningcapacityoffirmsengagedmainlyinexportbusinessbecausetheyinvoicetheirsales inUSdollar. 7. Inadequate provisionfordepreciation adversely affects theearning capacity ofa company , leadingtoovercapitalizationofthefirm. 8. Existenceofidlefunds.

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Effectsofovercapitalization 1. Declineintheearningsofthecompany. 2. Fallindividendrates. 3. Marketvalueofcompanyssharefalls,andcompanylosesinvestorsconfidence. 4. Companymaycollapseatanytimebecauseofanemicfinancialconditionsitwillaffectits employees, society, consumers and its shareholders. Employees will lose jobs. If the companyisengagedintheproductionandmarketingofcertainessentialgoodsandservices tothesociety,thecollapseofthecompanywillcausesocialdamage.

RemediesforOvercapitalization: Restructuringthefirmistobeexecutedtoavoidthesituationofcompanybecomingsick. Itinvolves 1. Reductionofdebtburden. 2. Negotiationwithtermlendinginstitutionsforreductionininterestobligation. 3. Redemptionofpreferencesharesthroughaschemeofcapitalreduction. 4. Reducingthefacevalueandpaidupvalueofequityshares. 5. Initiating merger withwell managed profit making companiesinterestedin taking over ailing company.

2.5.4 Undercapitalization Undercapitalization is just the reverse of overcapitalization. A company is considered to be undercapitalizedwhenitsactualcapitalizationislowerthanitspropercapitalizationaswarranted byitsearningcapacity.

Symptomsofundercapitalization 1. Actualcapitalizationislessthanthatwarrantedbyitsearningcapacity. 2. Its rateof earningsis exceptionally highin relation to the returnenjoyedby similar situated companiesinthesameindustry.

Causesofundercapitalization 1. Underestimationoffutureearningsatthetimeofpromotionofthecompany. 2. Abnormalincreaseinearningsfromneweconomicandbusinessenvironment. 3. Underestimationoftotalfundsrequirements.

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4. Maintainingveryhighefficiencythroughimprovedmeansofproductionofgoodsorrendering ofservices. 5. Companieswhicharesetupduringrecessionstartmakinghigherearningcapacityassoon astherecessionisover. 6. Useoflowcapitalizationrate. 7. Companieswhichfollowconservativedividendpolicywillachieveaprocessofgraduallyrising profits. 8. Purchaseofassetsatexceptionallylow pricesduringrecession.

Effectsofundercapitalization 1. Encouragement to competition: undercapitalization encourages competition by creating a feelingthatthelineofbusinessislucrative. 2. Itencouragesthemanagementofthecompanytomanipulatethecompanysshareprices. 3. Highprofitswillattracthigheramountoftaxes. 4. High profits will make the workers demand higher wages. Such a feeling on the part of employeesleadstolabourunrest. 5. High margin of profit may create among consumers an impression that the company is charginghighpricesforitsproducts. 6. High margin of profits and the consequent dissatisfaction among its employees and consumer,mayinvitegovernmentalenquiryintothepricingmechanismofthecompany.

Remedies 1. SplittingupofthesharesThiswillreducethedividendpershare. 2. Issueofbonusshares:Thiswillreduceboththedividendpershareandearningspershare. Bothovercapitalizationandundercapitalizationaredetrimentaltotheinterestsofthesociety.

SelfAssessmentQuestion4 1.______________ofafirmreferstothecompositionofitslongtermfunds. 2.Twotheoriesofcapitalizationfornewcompaniesare________andearningstheory. 3.Acompanyissaidtobe___________,whenitstotalcapitalexceedsthetruevalueofits assets. 4.Acompanyisconsideredtobe________________whenitsactualcapitalizationislowerthan itspropercapitalizationaswarrantedbyitsearningcapacity.

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2.6

Summary

Financial planning deals with the planning, execution and monitoring of the procurement and utilizationoffunds.Financialplanningprocessgivesbirthtofinancialplan.Itcouldbethoughtof ablueprintexplainingtheproposedstrategyanditsexecution.Therearemanyfinancialplanning models. All these models forecast the future operations and then translate them into income statementsandbalancesheets.Itwillalsohelpthefinancemanagerstoascertainthefundsto be procured from outside sources. The essence of all these is to achieve a least cost capital structurewhichwouldmatchwiththeriskexposureofthecompany. Failuretofollowtheprinciple of financial planning may lead a new firm to over or undercapitalization when the economic environmentundergoesachange. Ideallyeveryfirmshouldaimatoptimumcapitalization.Other wiseitmayfaceasituationofoverorundercapitalization.Botharedetrimentaltotheinterestsof thesociety.Therearetwotheoriesofcapitalizationvizcosttheoryandearningstheory.

TerminalQuestions 1. ExplainthestepsinvolvedinFinancialPlanning. 2. ExplainthefactorsaffectingFinancialPlan 3. ListoutthecausesofOverCapitalization. 4. ExplaintheeffectsofUnderCapitalization.

AnswersToSelfAssessmentQuestions SelfAssessmentQuestions1 1. Qualitative,Quantitative. 2. Allocationoffunds 3. Shorttermborrowings

SelfAssessmentQuestion2 1. Natureoftheindustry 2. Debt,Equity 3. Theproductpolicy 4. Flexibilityincapitalstructure,effectchangesinthecompositesofcapitalstructure

SelfAssessmentQuestion3

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1. Fixedcapital,workingcapital. 2. Shorttermsources

SelfAssessmentQuestion4 1. Capitalization 2. Costtheory 3. OverCapitalized 4. Undercapitalized

AnswertoTerminalQuestions 1. Refertounit2.2 2. Refertounit 2.3 3. Refertounit 2.5.3 4. Refer tounit 2.5.4

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Unit3
Structure

TimeValueofMoney

3.1 Introduction 3.2 TimePreferenceRateandRequiredRateofReturn 3.2.1 CompoundingTechnique 3.2.2 DiscountingTechnique 3.2.3 FutureValueofaSingleFlow(Lumpsum): 3.2.4 FutureValueofSeriesofCashFlows 3.2.5 FutureValueofanAnnuity 3.2.5.1SinkingFund 3.3 PresentValue 3.3.1 DiscountingorPresentValueofaSingleFlow 3.3.2 PresentValueofaSeriesofCashFlows 3.3.2.1 PresentValueofPerpetuity 3.3.2.2 CapitalRecoveryFactor 3.4 Summary SolvedProblems TerminalQuestions AnswertoSAQsandTQs 3.1 Introduction Themainobjectiveofthisunitistoenableyoutolearnthetimevalueofmoney.Inthepreviousunit, wehavelearntthatwealthmaximizationistheprimaryobjectiveoffinancialmanagementandthatis more important than profit maximization for its superiority in the sense that it is futureoriented. A decisiontakentodaywillhavefarfetchingimplications.Forexample,afirminvestinginfixedassets willreapthebenefitsofsuchinvestmentforanumberofyears.Ifsuchassetsareprocuredthrough bankborrowingsortermloansfromfinancialinstitutions,theseinvolveanobligationtopayinterest and return of principal. Decisions are made by comparing the cash inflows (benefits/returns) and cashoutflows(outlays).Sincethesetwocomponentsoccuratdifferenttimeperiods,thereshouldbe

34

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acomparison.Inordertohavealogicalandmeaningfulcomparisonbetweencashflowsthataccrue overdifferentintervalsoftime,itisnecessarytoconverttheamountstoacommonpointoftime.This unitisdevotedforadiscussionofthetechniquesofdoingso.

LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Explainthetimevalueofmoney. 2. Understandthevaluationconcepts. 3. Calculatethepresentandfuturevaluesoflumpsumandannuityflows.


Rationale: Time Value of Money is the value of a unit of money at different time intervals. The valueof money received today is more than itsvalue received ata later date. In other words, the valueofmoneychangesoveraperiodoftime.Sincearupeereceivedtodayhasmorevalue,rational investors would prefer current receipts to future receipts. That is why this phenomenon is also referredtoasTimePreferenceofMoney.Someimportantfactorscontributingtothisare:

Investmentopportunities: Preferenceforconsumption Risk ThesefactorsremindusofthefamousEnglishsayingAbirdinhandisworthtwointhebush. Whyshouldmoneyhavetimevalue? Someofthereasonsare: Moneycanbeemployedproductivelytogeneraterealreturns.Forexample,ifwespendRs.500on materialsandRs.300onlabourandRs.200onotherexpensesandthefinishedproductissoldfor Rs.1100,wecansaythattheinvestmentofRs.1000hasfetchedusareturnof10%. Secondly,duringperiodsofinflation,arupeehasahigherpurchasingpowerthanarupeeinfuture. Thirdly, we all live under conditions of risk and uncertainty. As future is characterized by uncertainty, individuals prefer current consumption to future consumption. Most people have

35

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subjective preference for present consumption either because of their current preferences or becauseofinflationarypressures. 3.2 FutureValue: TimePreferenceRateandRequiredRateofReturn Thetimepreferenceformoneyisgenerallyexpressedbyaninterestrate.Thisratewillbepositive even in the absence of any risk. It is called the riskfree rate. For example, if an individuals time preferenceis8%,itimpliesthatheiswillingtoforegoRs.100todaytoreceiveRs.108afteraperiod ofoneyear.ThusheconsidersRs.100andRs.108areequivalentinvalue.Butinrealitythisisnot theonlyfactor he considers. There is an amount of risk involved in such investment. He therefore requiresanotherrateforcompensatinghimwiththiswhichiscalledtheriskpremium. Requiredrateofreturn=Riskfreerate+RiskPremium There are two methods by which time value of money can be calculated compounding and discounting. 3.2.1CompoundingTechnique:Underthismethodofcompounding,thefuturevaluesofallcash inflowsattheendofthetimehorizonataparticularrateofinterestarefound.Interestiscompounded when the amount earned on an initial deposit becomes part of the principal at the end of the first compoundingperiod.IfMr.AinvestsRs.1000inabankwhichoffershim5%interestcompounded annually, he has Rs. 1050 inhis account at the end of thefirst year. The total of the interest and principal Rs. 1050 constitutes the principal for the next year. He thus earns Rs. 1102.50 for the secondyear.Thisbecomestheprincipalforthethirdyear.Thiscompoundingprocedurewillcontinue for an indefinite number of years. The compounding of interest can be calculated by the following equation:
n A=P(1+i)

WhereA=Amountattheendoftheperiod P=Principalattheendoftheperiod i=rateofinterest n=numberofyears Theamount of money in theaccountattheendof various years iscalculated as under, using the equation:

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Amountattheendofyear1=Rs.1000(1+0.05)==Rs.1050 Amountattheendofyear2=Rs.1050(1+0.05)==Rs.1102.50 Amountattheendofyear3=Rs.1102.50(1+0.05)==Rs.1157.63 Year Beginningamount Interestrate Amountofinterest Beginning principal Endingprincipal 1 Rs.1000 5% 50 1000 2 5% 52.50 3 5% 55.13

Rs.1050 Rs.1102.50

Rs.1050 Rs.1102.50

Rs.1050 Rs.1102.50 Rs.1157.63

Theamountattheendofyear2canbeascertainedbysubstitutingRs.1000(1+0.05)forR. 1050,thatis,Rs.1000(1+0.05)(1+0.05)=Rs.1102.50. Similarly,theamountattheendofyear3canbeascertainedbysubstitutingRs.Rs.1000(1+0.05) (1+0.05)(1+0.05)=Rs.1157.63.


n ThusbysubstitutingtheactualfiguresfortheinvestmentorRs.1000intheformulaA=P(1+i) ,we

arriveattheresultshownaboveinTable. 3.2.2 DiscountingTechnique:Underthemethodofdiscounting,wefindthetimevalueofmoney now,thatis,attime0onthetimeline.Itisconcernedwithdeterminingthepresentvalueofafuture amount. This is in contrast to the compounding approach where we convert present amounts into futureamountsindiscountingapproachweconvertthefuturevaluetopresentsums.Forexample,if Mr.ArequirestohaveRs.1050attheendofyear1,giventherateofinterestas5%,hewouldlike toknowhowmuchheshouldinvesttodaytoearnthisamount.IfPistheunknownamountandusing theequationwegetP(1+0.5)=1050.Solvingtheequation,wegetP=Rs.1050/1.05=Rs.1000. ThusRs.1000wouldbetherequiredprincipalinvestmenttohaveRs.1050attheendofyear1at 5%interestrate.Inotherwords,thepresentvalueofRs.1050receivedoneyearfromnow,rateof interest 5%, is Rs. 1000. Thepresent value ofmoney is the reciprocal of the compounding value.
n Mathematically, we have P=A {1/(1+i) } in which P is the present value for the future sum to be

received,Aisthesumtobereceivedinfuture,iistheinterestrateandnisthenumberofyears.

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3.2.3 Future Value of a Single Flow (lump sum): The process of calculating future value will becomeverycumbersomeiftheyhavetobecalculatedoverlongmaturityperiodsof10or20years. Ageneralizedprocedureforcalculatingthefuturevalueofasinglecashflowcompoundedannually isasfollows:
n FVn =PV(1+i)

WhereFVn =Futurevalueoftheinitialflowinnyearshence PV=Initialcashflow I=Annualrateofinterest N=Lifeofinvestment


n The expression (1+i) represents thefuture value of the initial investment of Re. 1 at the end of n

numberofyearsattheinterestratei,referredtoastheFutureValueInterestFactor(FVIF).Tohelp ease in calculations, the various combinations of I and n can be referred to in the table. To
n calculate the future value of any investment, the corresponding value of (1+i) from the table is

multipliedwiththeinitialinvestment. Example:Thefixeddepositschemeofabankoffersthefollowinginterestrates: Periodofdeposit <45days 46daysto179days 180daysto365days 365daysandabove Rateperannum 9% 10% 10.5% 11%

HowmuchdoesaninvestmentofR.10000investedtodaygrowtoin3years?
n Solution:FVn=PV(1+i) orPV*FVIF(11%,3y)

=10000*1.368(fromthetables) =Rs.13680 Doublingperiod:Averycommonquestionarisinginthemindsofaninvestorishowlongwillittake for the amount invested todoublefor a given rate of interest. There are2 ways ofanswering this question.Oneiscalledruleof72.Thisrulestatesthattheperiodwithinwhichtheamountdoubles isobtainedbydividing72bytherateofinterest.Forinstance,ifthegivenrateofinterestis10%,the doublingperiodis72/10,thatis,7.2years.

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A much accurate way of calculating doubling period is the rule of 69, which is expressed as 0.35+69/interestrate.Goingbythesameexamplegivenabove,wegetthenumberofyearsas7.25 years{0.35+69/10(0.35+6.9)}. Increasedfrequencyofcompounding It has been assumed that the compounding is done annually. If a scheme is offered where compounding is done more frequently, let us see its effect on interest earned. For example, if we have deposited Rs. 10000 in a bank which offers 10% interest per annum compounded semi annually,theinterestearnedwillbeasfollows: Amountinvested Interestearnedforfirst6months 10000*10%*1/2(for6months) Amountattheendof6months Interestearnedforsecond6months 10500*10%*1/2 Amountattheendoftheyear Rs. 525 Rs. 11025 Rs. 500 Rs. 10500 Rs. 10000

Ifintheabovecasecompoundingisdoneonlyonceayeartheinterestearnedwillbe10000*10% whichisequaltoRs.1000andwewillhaveRs.11000attheendoffirstyear.Wefindthatweget moreinterestifcompoundingisdoneonamorefrequentbasis.Thegeneralizedformulaforshorter compoundingperiodsis:


m*n FVn=PV(1+i/m)

Where,FVn=Futurevalueafternyears PV=Cashflowtoday i=Nominalinterestrateperannum m=No.oftimescompoundingisdoneduringayear n=No.ofyearsforwhichcompoundingisdone. Example: Under the Andhra Banks Cash Multiplier Scheme, deposits can be made for periods rangingfrom 3 months to 5 years. Every quarter, interest isadded to theprincipal. The applicable rateofinterestis9%fordepositslessthan23monthsand10%forperiodsmorethan24months. WhatwilltheamountofRs.1000todaybeafter2years?

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Solution:
m*n FVn=PV(1+i/m) 4*2 1000(1+0.10/4) 8 1000(1+0.10/4)

Rs.1218 Effective vs. nominal rate of interest:We have just learnt that interestaccumulationbyfrequent compoundingismuchmorethantheannualcompounding.Thismeansthattherateofinterestgiven to us, that is, 10% is the nominal rate of interest per annum. If the compounding is done more frequently,saysemiannually,theprincipalamountgrowsat10.25%perannum.0.25%isknownas theEffectiveRateofInterest.Thegeneralrelationshipbetweentheeffectiveandnominalratesof interestisasfollows:
m r={(1+i/m) }1

Where, r=Effectiverateofinterest i=Nominalrateofinterest m=Frequencyofcompoundingperyear. Example:Calculatetheeffectiverateofinterestifthenominalrateofinterestis12%andinterestis compoundedquarterly. Solution:


m r={(1+i/m) }1 4 r={(1+0.12/4) }1

r=0.126or12.6%p.a. 3.2.4 FutureValueOfSeriesOfCashFlows Wehaveconsideredonlysinglepaymentmadeonceanditsaccumulationeffect.Aninvestormaybe interestedininvestingmoneyininstallmentsandwishtoknowthevalueofhissavingsafternyears. Forexample,Mr.MadaninvestsRs.500,Rs.1000,Rs.1500,Rs.2000andRs.2500attheendof eachyearfor5years.Calculatethevalueattheendof5yearscompoundedannuallyiftherateof interestis5%p.a.

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Solution: Endof year 1 2 3 4 5 Amount invested Rs.500 Rs. 1000 Rs. 1500 Rs.2000 Rs. 2500 Numberof years compounded 4 3 2 1 0 Compounded interestfactor fromtables 1.216 1.158 1.103 1.050 1.000 FVin Rs. 608 1158 1654 2100 2500 Rs. 8020

th Amountattheendof5 Year

3.2.5 FutureValueOfAnAnnuity Annuityreferstotheperiodicflowsofequalamounts.Theseflowscanbeeithertermedasreceipts or payments. For example, if you have subscribed to the Recurring Deposit Scheme of a bank requiring you to pay Rs. 5000 annually for 10 years, this stream of payouts can be called Annuities. Annuities require calculations based on regular periodic contribution of a fixed sum of money. Thefuturevalueofaregularannuityforaperiodofnyearsatirateofinterestcanbesummedupas under:
n FVAn =A{(1+i) 1}/i

WhereFVAn=Accumulationattheendofnyears i=Rateofinterest n=Timehorizonorno.ofyears A=Amountdeposit/investedattheendofeveryyearfornyears.


n The expression {(1+i) 1}/ iis called the Future Value Interest Factor for Annuity (FVIFA). This

representstheaccumulationofRe.1investedattheendofeveryyearfornnumberofyearsatirate ofinterest.Thetablesattheendofthisbookgiveusthecalculationsfordifferentcombinationsofi and n.We justhave to multiply the relevant value with A and get the accumulation in theformula givenabove.

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Example:M.RamKumardepositsRs.3000attheendofeveryyearfor5yearsintohisaccountfor 5years,interestbeing5%compoundedannually.Determinetheamountofmoneyhewillhaveatthe
th endofthe5 year.

Endof year

Amount invested

Numberof years compounded 4 3 2 1 0

Compounded interest factorfrom tables 1.216 1.158 1.103 1.050 1.000

FVinRs.

1 2 3 4 5

Rs. 2000 Rs. 2000 Rs. 2000 Rs.2000 Rs. 2000

2432 2316 2206 2100 2000 Rs.11054

th Amountattheendof5 Year

ORUsingformulaandthetableswecanfindthat: =2000FVIFA(5%,5y) =2000*5.526 =Rs.11052 Wenoticethatwecangettheaccumulationsattheendofnperiodusingthetables.Calculationsfor alongtimehorizonareeasilydonewiththehelpofreferencetables.Annuitytablesarewidelyused inthefieldofinvestmentbankingasreadyreckoners. Example: Calculate the value of an annuity flow of Rs. 5000 done on a yearly basis for 5 years, yieldinganinterestof8%p.a. Solution: =5000FVIFA(8%,5y) =5000*5.867 =Rs.29335

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3.2.5.1SinkingFund Sinkingfundisafundwhichiscreatedoutoffixedpaymentseachperiodtoaccumulatetoafuture sumafteraspecifiedperiod.Thesinkingfundfactorisusefulindeterminingtheannualamounttobe putinafundtorepaybondsordebenturesortopurchaseafixedassetorapropertyattheendofa specifiedperiod.


n A=FVA*i/{(1+i) 1} n i/{(1+i) 1}iscalledtheSinkingFundFactor.

SelfAssessmentQuestions1 1. Theimportantfactorscontributingtotimevalueofmoneyare__________,________________ and_______. 2. Duringperiodsofinflation,arupeehasa___________thanarupeeinfuture. 3. As future is characterized by uncertainty, individuals prefer _________consumption to __________consumption. 4. There are two methods by which time value of money can be calculated by _________ and _________techniques.

3.3 PresentValue Wehavesofarseenhowthecompoundingtechniquecanbeused.Theycanbeusedtocompare thecashflowsseparatedbymorethanonetimeperiod,giventheinterestrate.Withthistechnique, theamountofpresentcashcanbeconvertedintoanamountofcashofequivalentvalueinfuture. Likewise, we may be interested in converting the future cash flows into their present values. The Present Value PVof afuture cashflow is theamount of the current cash that is equivalent to the investor. The process of determining present value of a future payment or a series of future paymentsisknownasdiscounting.

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3.3.1DiscountingorPresentValueofaSingleFlow: WecandeterminethePVofafuturecashfloworastreamoffuturecashflowsusingtheformula:
n PV=FVn/(1+i)

WherePV=PresentValue FVn=Amount i=Interestrate n=Numberofyears Example:IfMs.SapnaexpectstohaveanamountofRs.1000afteroneyearwhatshouldbethe amountshehastoinvesttodayifthebankisoffering10%interestrate? Solution:


n PV=FVn/(1+i)

=1000/(1+0.10)1 =Rs.909.09 Thesamecanbecalculatedwiththehelpoftables. =1000*PVIF(10%,1y) =1000*0.909 =Rs.909 Example:AninvestorwantstofindoutthevalueofanamountofRs.100000tobereceivedafter15 years.Theinterestofferedbybankis9%.CalculatethePVofthisamount. Solution:


n PV=FVn/(1+i) or100000PVIF(9%,15y)

=100000*0.275 =Rs.27500

3.3.2PresentValueofaSeriesofCashFlows Inabusinessscenario,thebusinessmanwillreceiveperiodicamounts(annuity)foracertainnumber ofyears.Aninvestmentdonetodaywillfetchhimreturnsspreadoveraperiodoftime.Hewouldlike to know if it is worthwhile to investa certain sum now in anticipationof returns he expectsover a certainnumberofyears.Heshouldthereforeequatetheanticipatedfuturereturnstothepresentsum heiswillingtoforego.ThePVofaseriesofcashflowscanberepresentedbythefollowingformula:

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1 2 3 4 n PV=Ct/(1=i) +Ct/(1=i) +Ct/(1=i) Ct/(1=i) +..+Ct/(1=i)

Unit3

Whichreducesto:
n n PVAn=A{1+i) 1/i(1+i) } n n The expression {1+i) 1 / i(1+i) } is known as Present Value Interest Factor Annuity (PVIFA). It

representsthePVIFAofRe.1forthegivenvaluesofiandn.ThevaluesofPVIFA(I,n)canbefound outusingthetablesattheendofthebook.Itshouldbenotedthatthesevaluesaretrueonlyifthe cashflowsareequalandtheflowsoccurattheendofeveryyear.

Example: Calculate the PV of anannuity of Rs.500 receivedannuallyfor 4 year, whendiscountingfactor is 10%. Endofyear 1 2 3 4 Cash inflows Rs.500 Rs.500 Rs.500 Rs.500 PVfactor 0.909 0.827 0.751 0.683 PVin Rs. 454 413 375 341

PresentValueofanannuityRs.1585. ORbydirectlylookingatthetablewecancalculate: =500*PVIFA(10%,4y) =500*3.170 =Rs.1585 Example: Find out the present value of anannuity of Rs.10000 over 3 years when discountedat 5%. Solution: =10000*PVIFA(5%,3y) =10000*2.773 =Rs.27730

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3.3.2.1PresentValueofPerpetuity Anannuityforaninfinitetimeperiodisperpetuity.Itoccursindefinitely.Apersonmayliketofindout thepresentvalueofhisinvestmentassuminghewillreceiveaconstantreturnyearafteryear.The PVofperpetuityiscalculatedasP=A/i Example: If theprincipal of a college wants to institutea scholarship of Rs.5000 to a meritorious studentinfinanceeveryyear,findoutthePVofinvestmentwhichwouldyieldRs.5000inperpetuity, discountedat10%. Solution: P=A/i =5000/0.10 =Rs.50000 ThismeansheshouldinvestRs.50000togetanannualreturnofRs.5000. Presentvalueofanunevenperiodicsum:Insomeinvestmentdecisionsofafirm,thereturnsmay notbeconstant.Insuchcases,thePViscalculatedasfollows:
2 3 4 n P=A1/(1+i)+A2/(1+i) +A3/(1+i) +A4/(1+i) ++An/(1+i)

OR PV=A1 PVIF(i,1)+A2 PVIF(i,2)+A3 PVIF(i,3)+A4 PVIF(i,4)+.+An PVIF(i,n) Example: An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000 and R. 4000 respectivelyattheendofeachof5years.Findoutthepresentvalueofthisstreamofunevencash flows,iftheinvestorsinterestrateis8%.
2 3 4 5 PV=10000/(1+0.08)+15000/(1+0.08) +8000/(1+0.08) +11000/(1+0.08) +4000/(1+0.08)

=Rs.39276 Or PV=10000PVIF(8,1)+15000PVIF(8,2)+8000PVIF(8,3)+11000PVIF(8,4)+ 4000PVIF(8,5) =10000*0.926+15000*0.857+8000*0.794+11000*0.735+4000*0.681 =Rs.39276

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3.3.2.2CapitalRecoveryFactor Capitalrecoveryistheannuityofaninvestmentforaspecifiedtimeatagivenrateofinterest.The reciprocalofthepresentvalueannuityfactoriscalledCapitalRecoveryFactor.


n n A=PVAn{i(1+i) }/(1+i) 1} n n {i(1+i) }/(1+i) 1}isknownastheCapitalRecoveryFactor.

Example:AloanofRs.100000istoberepaidin5equalannualinstallments.Iftheloancarriesa rateof14%p.a,whatistheamountofeachinstallment? Solution: Installment*PVIFA(14%,5)=100000 Installment=100000/3.433=Rs.29129 SelfAssessmentQuestions2 1. _________________iscreatedoutoffixedpaymentseachperiodtoaccumulatetoafuturesum afteraspecifiedperiod. 2. The________________ofafuturecashflowistheamountofthecurrentcashthatisequivalent totheinvestor. 3. Anannuityforaninfinitetimeperiodiscalled______________. 4. Thereciprocalofthepresentvalueannuityfactoriscalled_____________. 3.4 Summary Money has time preference. A rupee in hand today is more valuable than a rupee a year later. Individualspreferpossessionofcashnowratherthanatafuturepointoftime.Thereforecashflows occurring at different points in time cannot be compared. Interest rate gives money its value and facilitates comparison of cash flows occurring at different periods of time. Compounding and discountingaretwomethodsusedtocalculatethetimevalueofmoney. SolvedProblemsTimeValueofMoney 1. WhatisthefuturevalueofaregularannuityofRe.1.00earningarateof12%interestp.a.for5 years? Solution:1*FVIFA(12%,5y)=1*6.353=Rs.6.353

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2. IfaborrowerpromisestopayRs.20000eightyearsfromnowinreturnforaloanofRs.12550 today,whatistheannualinterestbeingoffered? Solution:20000*PVIF(k%,8y)=Rs.12550Kisapproximately6%. 3. AloanofRs.500000istoberepaidin10equalinstallments.Iftheloancarries12%interestp.a. whatisthevalueofoneinstallment? Solution:A*PVIFA(12%,10y)=500000SoA=500000/5.650=Rs.88492 4. ApersondepositsRs.25000inabankthatpays6%interesthalfyearly.Calculatetheamountat theendof3years. Solution:25000*(1+0.06)3*2=25000*1.194=Rs.29850 5. FindthepresentvalueofRs.100000receivableafter10yearsif10%isthetimepreferencefor money. Solution:100000*(0.386)=Rs.38600

TerminalQuestions
1. If you deposit Rs. 10000 today in a bank that offers 8% interest, in how many years will this amountdouble? 2. AnemployeeofabankdepositsRs.30000intohisPFA/cattheendofeachyearfor20years. What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest givenbyPFauthoritiesis9%? 3. Apersoncansave_____________annuallytoaccumulateRs.400000bytheendof10years, ifthesavingearns12%. 4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the present value of the annuityassuminghecanearninterestonhisinvestmentat10%p.a. 5. AparnainvestsRs.5000attheendofeachyearat10%interestp.a.Whatistheamountshe

willreceiveafter4years? AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Investmentopportunities,preferenceforconsumption,risk. 2. Higherpurchasingpower 3. Currentandfuture

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4. Compoundinganddiscounting SelfAssessmentQuestions2 1. Sinkingfund 2. PresentValuePV 3. Perpetuity 4. CapitalRecoveryFactor. AnswerstoTerminalQuestions 1. (Hint:Useruleof72and69) 2. 30000*FVIFA(9%,20Y)=30000*51.160=Rs.1534800 3. A*FVIFA(12%,10y)=400000whichis400000/17.549=Rs.22795 4. 20000*PVIFA(105,5y)=20000*3.791=Rs.75820 5. 5000*FVIFA(10%,5y)=5000*6.105=Rs.23205

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Unit4

Unit4
4.1 Introduction 4.2 ValuationofBonds TypesofBonds 4.2.1 IrredeemableorPerpetualBonds

ValuationOfBondsAndShares

4.2.2 RedeemableorBondswithMaturityPeriod 4.2.3 ZeroCouponBond BondyieldMeasures 4.2.1 HoldingPeriodRateofReturn 4.2.2 CurrentYield 4.2.3 YieldtoMaturity(YTM) 4.2.4 BondValueTheorems 4.3 ValuationofShares 4.3.1 ValuationofPreferenceShares 4.3.2 ValuationofOrdinaryShares 4.4 Summary SolvedProblems TerminalQuestions AnswerstoSAQsandTQs

4.1

Introduction

Valuationistheprocessoflinkingriskwithreturnstodeterminetheworthofanasset.Assetscanbe realorfinancialsecuritiesarecalledfinancialassets,physicalassetsarerealassets.Theultimate goal of any individual investor is maximization of profits. Investment management is a continuous processrequiringconstantmonitoring.Thevalueofanassetdependsonthecashflowitisexpected toprovide over the holdingperiod. Thefact thatas ondate there isno method by which prices of shares and bonds can be accurately predicted should be kept in mind by an investor before he decides to take an investment decision. The present chapter will help us to know why some

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securities are priced higher than others.We can design our investment structure by exploiting the variablestomaximizeourreturns. Ordinarysharesareriskierthanbondsordebenturesandsomesharesaremoreriskythanothers. Theinvestorwouldthereforecommitfundsonashareonlyifheisconvincedabouttherateofreturn beingcommensuratewithrisk.

LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1. KnowthemeaningofvalueasusedinFinanceTheory. 2. UnderstandthemechanicsofBondvaluation,and 3. Understandthemechanicsofvaluationofequityshares.

Concept of Intrinsic value: A security can be evaluated by the series of dividends or interest paymentsreceivableoveraperiodoftime.Inotherwords,asecuritycanbedefinedasthepresent valueofthefuturecashstreamstheintrinsicvalueofanassetisequaltothepresentvalueofthe benefits associated with it. The expected returns (cash inflows) are discounted using the required returncommensuratewiththerisk.Mathematically,itcanberepresentedby:
1 2 3 n V0=C1/(1+i) +C2/(1+i) +C3/(1+i) +Cn/(1+i) n =Cn/(1+i)

WhereV0=Valueoftheassetattimezero(t=0) P0=Presentvalueoftheasset Cn=Expectedcashflowattheendofperiodn i=Discountrateorrequiredrateofreturnonthecashflows n=Expectedlifeofanasset.

Example: Assuming a discount rateof10%and thecashflows associated with2 projectsA and Bovera3 yearperiod,determinethevalueoftheassets.

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Year 1 2 3 Solution:

Cashflows Cashflows ofA(Rs.) ofB(Rs) 20000 20000 20000 10000 20000 30000

ValueofassetA=20000PVIFA(10%,3y) =20000*2.487 =Rs.49470 ValueofassetB=10000PVIF(10%,1)+20000PVIF(10%,2)+30000PVIF(10%,3) =10000*0.909+20000*0.826+30000*0.751 =9090+16520+22530 =Rs.48140 Example: CalculatethevalueofanassetiftheannualcashinflowisRs.5000peryearforthenext6yearsand thediscountrateis16%. Solution:
n Valueoftheasset=Cn/(1+i) 6 =5000/(1+0.16)

Or

=5000PVIFA(16%,6y) =5000*3.685 =Rs.18425

4.1.1ConceptsofValue Bookvalue:Bookvalueisanaccountingconcept.Valueiswhatanassetisworthtodayintermsof theirpotentialbenefits.Assetsarerecordedathistoricalcostandthesearedepreciatedoveryears. Bookvaluemayincludeintangibleassetsatacquisitioncostminusamortizedvalue.Thebookvalue ofadebtisstatedattheoutstandingamount.Thedifferencebetweenthebookvalueofassetsand liabilities is equal to the shareholders net worth. (Net worth is the sumtotalofpaidup capital and reservesandsurplus).Bookvalueofashareiscalculatedbydividingthenetworthbythenumberof sharesoutstanding.

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Replacementvalueistheamountacompanyisrequiredtospendifitweretoreplaceitsexisting assetsinthepresentcondition.Itisdifficulttofindcostofassetspresentlyusedbythecompany. Liquidationvalueistheamountacompanycanrealizeifitsoldtheassetsafterthewindingupofits business.Itwillnotincludethevalueofintangiblesastheoperationsofthecompanywillceaseto exist. Liquidation value is generally the minimum value the company might accept if it sold its business. Going concern value is theamount a company can realize if it sells its businessasanoperating one.Thisvalueishigherthantheliquidationvalue. Marketvalueisthecurrentpriceatwhichtheassetorsecurityisbeingsoldorboughtinthemarket. Marketvaluepershareisgenerallyhigherthanthebookvaluepershareforprofitableandgrowing firms. 4.2

ValuationofBonds

Bonds are long term debt instruments issued by government agencies or big corporate houses to raiselargesumsofmoney.Bondsissuedbygovernmentagenciesaresecuredandthoseissuedby privatesectorcompaniesmaybesecuredorunsecured.Therateofinterestonbondsisfixedand theyareredeemableafteraspecificperiod.Someimportanttermsinbondvaluation: Facevalue:Alsoknownasparvalue,thisisthevaluestatedonthefaceofthebond.Itrepresents theamountthattheunitborrowswhichistoberepaidatthetimeofmaturity,afteracertainperiodof time.AbondisgenerallyissuedatvaluessuchasRs.100orRs.1000. Couponrateisthespecifiedrateofinterestinthebond.Theinterestpayableatregularintervalsis theproductoftheparvalueandthecouponratebrokendowntotherelevanttimehorizon. Maturity period refers to the number of years after which the par value becomes payable to the bondholder.Generally,corporatebondshaveamaturityperiodof710yearsandgovernmentbonds 2025years. Redemptionvalueistheamountthebondholdergetsonmaturity.Abondmayberedeemedatpar, atapremium(bondholdergetsmorethantheparvalueofthebond)oratadiscount(bondholder getslessthantheparvalueofthebond).

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Marketvalueisthepriceatwhichthebondistradedinthestockexchange.Marketpriceistheprice at which the bonds can be bought and sold and this price may be different from par value and redemptionvalue. TypesofBonds Bondsareofthreetypes:(a)IrredeemableBonds(alsocalledperpetualbonds)(b)Redeemable Bonds(i.e.,Bondswith finitematurityperiod)and(c)ZeroCouponBonds. 4.2.1 IrredeemableBondsorPerpetualBonds Bonds which will never mature are known as irredeemable or perpetual bonds. Indian Companies Actsrestrictstheissueofsuchbondsandthereforetheseareveryrarelyissuedbycorporatesthese days.Incaseofthesebondstheterminalvalueormaturityvaluedoesnotexistbecausetheyarenot redeemable.Thefacevalueisknowntheinterestreceivedonsuchbondsisconstantandreceived at regular intervals and hence the interest receipts resemble a perpetuity. The present value (the intrinsicvalue)iscalculatedas: V0=I/id IfacompanyofferstopayRs.70asinterestonabondofRs.1000parvalue,andthecurrentyieldis 8%,thevalueofthebondis70/0.08whichisequalto Rs.875 4.2.2 RedeemableBonds: There are two types viz.,bonds withannual interestpaymentsandbonds with semiannual interest payments. Bondswithannualinterestpayments BasicBondValuationModel: The holder of a bond receives a fixed annual interest for a specified number of years and a fixed principalrepaymentatthetimeofmaturity.Theintrinsicvalueorthepresentvalueofbondcanbe expressedas:
n n n V0orP0= t=1 I/(I+kd) +F/(I+kd)

Whichcanalsobestatedasfolloows V0=I*PVIFA(kd,n)+F*PVIF(kd,n) WhereV0=Intrinsicvalueofthebond

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P0=PresentValueofthebond I=AnnualInterestpayableonthebond F=Principalamount(parvalue)repayableatthematuritytime n=Maturityperiodofthebond Kd=Requiredrateofreturn Example:AbondwhosefacevalueisRs.100hasacouponrateof12%andamaturityof5years. Therequiredrateofinterestis10%.Whatisthevalueofthebond? Solution: Interestpayable=100*12%=Rs.12 PrincipalrepaymentisRs.100 Requiredrateofreturnis10% V0=I*PVIFA(kd,n)+F*PVIF(kd,n) Valueofthebond=12*PVIFA(10%,5y)+100*PVIF(10%,5y) =12*3.791+100*0.621 =45.49+62.1 =Rs.107.59 Example: Mr. Anant purchases a bond whose face value is Rs. 1000, maturity period 5 years coupledwithanominalinterestrateof8%.Therequiredrateofreturnis10%.Whatisthepricehe shouldbewillingtopaynowtopurchasethebond? Solution: Interestpayable=1000*8%=Rs.80 PrincipalrepaymentisRs.1000 Requiredrateofreturnis10% V0=I*PVIFA(kd,n)+F*PVIF(kd,n)

Valueofthebond=80*PVIFA(10%,5y)+1000*PVIF(10%,5y) =80*3.791+1000*0.621 =303.28+621 =Rs.924.28

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ThisimpliesthatthecompanyisofferingthebondatRs.1000butisworthRs.924.28attherequired rate of return of 10%. The investor may not be willing to pay more than Rs. 924.28 for the bond today. BondValueswithSemiAnnualInterestpayment: Inreality,itisquitecommontopayinterestonbondssemiannually.Withtheeffectofcompounding, the value of bonds with semiannual interest is much more than the ones with annual interest payments.Hence,thebondvaluationequationcanbemodifiedas:
n n 2n V0orP0= t=1 I/2/(I+id/2) +F/(I+id/2)

WhereV0=Intrinsicvalueofthebond P0=PresentValueofthebond I/2=SemiannualInterestpayableonthebond F=Principalamount(parvalue)repayableatthematuritytime 2n=Maturityperiodofthebondexpressedinhalfyearlyperiods kd/2=Requiredrateofreturnsemiannually. Example:AbondofRs.1000valuecarriesacouponrateof10%,maturityperiodof6years.Interest ispayablesemiannually.Iftherequiredrateofreturnis12%,calculatethevalueofthebond. Solution:


n n 2n V0orP0= t=1 (I/2)/(I+kd/2) +F/(I+kd/2) 6 6 =(100/2)/(1+0.12/2) +1000/(1+0.12/2)

=50*PVIFA(6%,12y)+1000*PVIF(6%,12y) =50*8.384+1000*0.497 =419.2+497 =Rs.916.20 Itistobekeptinmindthattherequiredrateofreturnishalved(12%/2)andtheperioddoubled(6y*2) astheinterestispaidsemiannually. 4.2.3 ValuationofZeroCouponBonds. InIndiaZerocouponbondsarealternativelyknownasDeepDiscountBonds. Forclosetoa decade,thesebondsbecameverypopularinIndiabecauseofissuanceofsuchbondsatregular intervalsbyIDBIandICICI. Zerocouponbondshavenocouponrate,i.e.thereisnointeresttobe

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paidout.Instead,thesebondsareissuedatadiscounttotheirfacevalue,andthefacevalueisthe amountpayabletotheholderoftheinstrumentonmaturity.Thedifferencebetweenthediscounted issuepriceandfacevalueiseffectiveinterestearnedbytheinvestor.Theyarecalleddeepdiscount bondsbecausethesebondsarelongtermbondswhosematurity sometimeextendsupto25to30years. Example: RiverValleyAuthorityissuedDeepDiscountBondofthefacevalueofRs.1,00,000payable25years later,atanissuepriceofRs.14,600.Whatistheeffectiveinterestrateearnedbyaninvestorfrom thisbond? Solution: Thebondinquestionisazerocouponordeepdiscountbond.Itdoesnotcarryanycouponrate. Therefore,theimpliedinterestratecouldbecomputedasfollows: Step1. PrincipalinvestedtodayisRs.14600atarateofinterestofr%over25yearstoamountto Rs.1,00,000.
n Step2. Itcanbestatedas A=P0(1+r) 25 1,00,000=14,600(1+r)

Solvingforr,weget

25 1,00,000/14600=(1+r) 25 6.849 =(1+r)

Readingthecompoundvalue(FVIF)table,horizontallyalongthe25yearline,wefindrequals8%. Therefore,bondgivesaneffectivereturnof8%perannum.

4.2.4

BondyieldMeasures

4.2.4.1 CurrentYield: Current yield measures the rate of return earned ona bond if it ispurchasedat its current market priceandthecouponinterestreceived. CurrentYield=CouponInterest/CurrentMarketPrice Example: Continuing with thesame example above calculate the CY ifthe current market price is Rs.920

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Solution: CY=CouponInterest/CurrentMarketPrice =80/920 =8.7% 4.2.4.2YieldtoMaturity(YTM) Itistherateearnedbyaninvestorwhopurchasesabondandholdsittillitsmaturity.TheYTMisthe discountrateequalingthepresentvaluesofcashflowstothecurrentmarketprice. Example:AbondhasafacevalueofRs.1000witha5yearmaturityperiod.Itscurrentmarketprice isRs.883.4.Itcarriesaninterestrateof6%.Whatshallbetherateofreturnonthisbondifitisheld tillitsmaturity?

Solution:
n n n V0orP0= t=1 I/(I+kd) +F/(I+kd)

OR V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =60*PVIFA(Kd,10)+1000*PVIF(Kd,10)=883.4 Weobtain10%forkd Example:AbondhasafacevalueofRs.1000witha9yearmaturityperiod.Itscurrentmarketprice isRs.850.Itcarriesaninterestrateof8%.Whatshallbetherateofreturnonthisbondifitisheldtill itsmaturity? Solution:


n n n V0orP0= t=1 I/(I+kd) +F/(I+kd)

OR V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =80*PVIFA(Kd%,9)+1000*PVIF(Kd%,9)=850 TofindoutthevalueofKd,trialanerrormethodistobefollowed.Letusthereforestartthevalueof Kdtobe12%andtheequationnowlookslike =80*PVIFA(12%,9)+1000*PVIF(12%,9)=850 LetusnowseeifLHSequalsRHSatthisrateof12%.LookingatthetableswegetLHSas

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80*5.328+1000*0.361=Rs.787.24 SincethisvalueislessthanthevaluerequiredontheRHS,wetakealesserdiscountrateof10%.At 10%,theequationis =80*PVIFA(10%,9)+1000*PVIF(10%,9)=850 LetusnowseeifLHSequalsRHSatthisrateof11%.LookingatthetableswegetLHSas 80*5.759+1000*0.424=Rs.884.72 WenowunderstandthatKdclearlyliesbetween10%and12%.Weshallinterpolatetofindoutthe truevalueofKd. 10%+{(884.72850)/(884.72787.24)}*(12%10%) 10%+(34.72/97.48)*2 10%+0.71 ThereforeKd=10.71% Anapproximation:ThefollowingformulamaybeusedtogetaroughideaaboutKdasTrialand ErrorMethodisaverytediousprocedureandrequireslotsoftime.Thisformulacanbeusedasa readyreferenceformula. YTM={I+(FP)/n}/{(F+P)/2} WhereYTM=YieldtoMaturity I=Annualinterestpayment F=Facevalueofthebond P=Currentmarketpriceofthebond n=Numberofyearstomaturity. Example:Acompanyissuesabondwithafacevalueof5000.ItiscurrentlytradingatRs.4500.The interestrateofferedbythecompanyis12%andthebondhasamaturityperiodof8years.Whatis YTM? Solution: YTM={I+(FP)/n}/{(F+P)/2} =600+{(50004500)/8}/{(5000+4500)/2} ={600+62.5}/4750 =13.94%

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4.2.5 BondValueTheorems Thefollowingfactorsaffectthebondvalues: Relationshipbetweentherequiredrateofinterest(Kd)andthediscountrate. Numberofyearstomaturity. YTM

Relationshipbetweentherequiredrateofinterest(Kd)andthediscountrate: WhenKdisequaltothecouponrate,theintrinsicvalueofthebondisequaltoitsfacevalue,that is,ifKd=couponrate,thenvalueofbond=facevalue. When Kd is greater than the coupon rate, the intrinsic value of the bond is less than its face value,thatis,ifKd>couponrate,thenvalueofbond<facevalue. When Kd is lesser thanthe coupon rate,the intrinsic value of thebond is greater than itsface value,thatis,ifKd<couponrate,thenvalueofbond>facevalue. Example:SugamindustrieswishestoissuebondswithRs.100asparvalue,couponrate12%an YTM5years.Whatisthevalueofthebondiftherequiredrateofreturnofaninvestoris12%,14% and10% IfKdis12%, V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =12*PVIFA(12%,5)+100*PVIF(12%,5) =12*3.605+100*0.567 =43.26+56.7 =Rs.99.96orRs.100 IfKdis14%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =12*PVIFA(14%,5)+100*PVIF(14%,5) =12*3.433+100*0.519 =41.20+51.9 =Rs.93.1 IfKdis10%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =12*PVIFA(10%,5)+100*PVIF(10%,5) =12*3.791+100*0.621 =45.49+62.1 =Rs.107.59

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Numberofyearstomaturity When Kd is greater than the coupon rate, the discount on the bond declines as maturity approaches. When Kd is less than the coupon rate, the premium on the bond declines as maturity approaches. To show the effect of the above, consider a case of a bond whose face value is Rs. 100 with a couponrateof11%andamaturityof7years. IfKdis13%,then,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =11*PVIFA(13%,7)+100*PVIF(13%,7) =11*4.423+100*0.425 =48.65+42.50 =Rs.91.15 After1year,thematurityperiodis6years,thevalueofthebondis V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =11*PVIFA(13%,6)+100*PVIF(13%,6) =11*3.998+100*0.480 =43.98+48 =Rs.91.98. Weseethatthediscountonthebondgraduallydecreasesandvalueofthebondincreaseswiththe passageoftimeatKdbeingahigherratethanthecouponrate. Continuingwiththesameexampleabove,letusseetheeffectonthebondvalueifrequiredrateis 8%. IfKdis8%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =11*PVIFA(8%,7)+100*PVIF(8%,7) =11*5.206+100*0.583 =57.27+58.3 =Rs.115.57 Oneyearlater,Kdat8%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =11*PVIFA(8%,6)+100*PVIF(8%,6) =11*4.623+100*0.630

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=50.85+63 =Rs.113.85 Forarequiredrateofreturnof8%,thebondvaluedecreaseswithpassageoftimeandpremiumon bonddeclinesasmaturityapproaches. YTM:YTMdeterminingthemarketvalueofthebond,thebondpricewillfluctuatetothechangesin marketinterestrates.AbondspricemovesinverselyproportionaltoitsYTM. 4.3

ValuationofShares

Acompanyssharesmaybecategorizedas(a)OrdinaryorEquitysharesand(b)Preferenceshares. Thereturnstheseshareholdersgetarecalleddividends.Preferenceshareholdersgetapreferential treatmentastothepaymentofdividendandrepaymentofcapitalintheeventofwindingup.Such holdersareeligibleforafixedrateofdividends.Someimportantfeaturesofpreferenceandequity shares. Dividends:Rateisfixedforpreferenceshareholders.Theycanbegivencumulativerights,that is, the dividend can be paid off after accumulation. The dividend rate is not fixed for equity shareholders.Theychangewithanincreaseordecreaseinprofits.Duringyearsofbigprofits,the management may declare a high dividend. The dividends are not cumulative for equity shareholders, that is, they cannot be accumulated and distributed in later years. Dividendsare nottaxable. Claims: In the event of the business closing down, the preference shareholders have a prior claimontheassetsofthecompany.Theirclaimsshallbesettledfirstandthebalanceifanywill be paid off to equity shareholders. Equity shareholders are residual claimants to the company incomeandassets. Redemption: Preference shares have a maturity dateon which day the company pays off the facevalueofthesharetotheholders.Preferencesharescanbeoftwotypesredeemableand irredeemable. Irredeemable preference shares are perpetual. Equity shareholders have no maturitydate. Conversion: A company can issue convertible preference shares and not vice versa. After a particular period as mentioned in the share certificate, thepreference shares canbeconverted intoordinaryshares.

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4.3.1 ValuationofPreferenceShares: Preference shares, like bonds carry a fixed rate of dividend/return. Symbolically, this can be expressedas:
n n P0=Dp/{1+Kp) }+Pn/{(1+Kp) }

OR P0= Dp*PVIFA(Kp,n)+Pn*PVIF(Kp,n) WhereP0=Priceoftheshare Dp=Dividendonpreferenceshare Kp=Requiredrateofreturnonpreferenceshare n=Numberofyearstomaturity 4.4

ValuationofOrdinaryShares

Peopleholdcommonstocksfortworeasonstoobtaindividendsinatimelymannerandtogeta higheramountwhensold.Generally,sharesarenotheldinperpetuity.Aninvestorbuystheshares, holdsthemforsometimeduringwhichhegetsdividendsandfinallysellsitofftogetcapitalgains. Thevalueofasharewhichaninvestoriswillingtopayislinkedwiththecashinflowsexpectedand risksassociatedwiththeseinflows.Intrinsicvalueofashareisassociatedwiththeearnings(past) andprofitability(future)ofthecompany,dividendspaidandexpectedandfuturedefiniteprospectsof the company. It is the economic value of a company considering its characteristics, nature of businessandinvestmentenvironment. 4.4.1 DividendCapitalizationModel Whenashareholderbuysashare,heisactuallybuyingthestreamoffuturedividends.Thereforethe valueofanordinaryshareisdeterminedbycapitalizingthefuturedividendstreamatanappropriate rate of interest. So under the dividend capitalization approach, the value of an equity share is the discountedpresentvalueofdividendsreceivedplusthepresentvalueoftheresalepriceexpected whentheshareisdisposed.Twoassumptionsaremadetoapplythisapproach: Dividendsarepaidannually. Firstpaymentofdividendismadeafteroneyeartheequityshareisbought.

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4.4.1.1 Singleperiodvaluationmodel Thismodelholdswellwhenaninvestorholdsanequityshareforoneyear.Thepriceofsuchashare willbe: P0= D1 + P1 (1+Ke)(1+Ke) WhereP0=Currentmarketpriceoftheshare D1=Expecteddividendafteroneyear P1=Expectedpriceoftheshareafteroneyear Ke=Requiredrateofreturnontheequityshare Example:GammonIndiaLtd.sshareisexpectedtotouchRs.450oneyearfromnow.Thecompany isexpectedtodeclareadividendofRs.25pershare.Whatisthepriceatwhichaninvestorwouldbe willingtobuyifhisrequiredrateofreturnis15%? Solution: P0=D1/(1+Ke)+P1/(1+Ke) {25/(1+0.15)}+{450/(1+0.15)} =21.74+391.30 =Rs.413.04isthepriceheiswillingtopaytoday

4.4.1.2 Multiperiodvaluationmodel: Anequitysharecanbeheldoranindefiniteperiodasit hasnomaturitydate,inwhichcasethevalueofapriceattimezerois:


1 2 3 P0=D1/(1+Ke) +D2/(1+Ke) +D3/(1+Ke) +..+D/(1+Ke)

Or

P0= t=1

Dn

n {(1+Ke) }

WhereP0=Currentmarketpriceoftheshare D1=Expecteddividendafteroneyear P1=Expectedpriceoftheshareafteroneyear D=Expecteddividendatinfiniteduration Ke=Requiredrateofreturnontheequityshare. Theaboveequationcanalsobemodifiedtofindthevalueofanequityshareforafiniteperiod.

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1 2 3 n P0=D1/(1+Ke) +D2/(1+Ke) +D3/(1+Ke) +..+D/(1+Ke) +Pn/(1+Ke) n n =P0= t=1Dn/{(1+Ke) }+Pn/(1+Ke)

Unit4

Wecancomeacrossthreeinstancesofdividendsincompanies: Constantdividends Constantgrowthofdividends Changinggrowthratesofdividends.

Valuation with constant dividends: If constant dividends are paid year after year, then
1 2 3 P0=D1/(1+Ke) +D2/(1+Ke) +D3/(1+Ke) +..+D/(1+Ke)

SimplifyingthiswegetP=D/Ke Valuation with constant growth in dividends: Here we assume that dividends tend to increase with time as and when businesses grow over time. If the increase in dividend is at a constant compoundrate,thenP0=D1/Keg,wheregstandsforgrowthrate. Example:Sagarautomobilesltd.sshareistradedatRs.180.Thecompanyisexpectedtogrowat 8%perannumandthedividendexpectedtobepaidoffisRs.8.Iftherateofreturnisexpectedtobe 12%,whatisthepriceoftheshareonewouldbeexpectedtopaytoday? Solution: P0=D1/Keg =8/0.120.08 =Rs.200. Example:MonicalabsisexpectedtopayRs.4asdividendpersharenextyear.Thedividendsare expected to grow perpetually@8%. Calculate the share price today if the market capitalization is 12%. Solution: P0=D1/Keg P0=4/(0.120.08) =Rs.100 Valuationwithvariablegrowthindividends:Somefirmsmaynothaveaconstantgrowthrateof dividendsindefinitely.Thereareperiodsduringwhichthedividendsmaygrowsupernormally,thatis, thegrowthrateisveryhighwhenthedemandforthecompanysproductsisveryhigh.Afteracertain periodoftime,thegrowthratemayfalltonormallevelswhenthereturnsfallduetofallindemandfor

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products(withcompetitionsettinginorduetoavailabilityofsubstitutes).Thepriceoftheequityshare ofsuchafirmisdeterminedinthefollowingmanner: Step1.Expected dividendflowsduringperiodsof supernormal growth is tobe considered and presentvalueofthisistobecomputedwiththefollowingequation:
n P0= t=1 Dn/(1+Ke)

Valueoftheshareattheendoftheinitialgrowthperiodiscalculatedas: Pn=(Dn+1)/(Kegn)(constantgrowthmodel).Thisisdiscountedtothepresentvalueandwe get:


n (Dn+1)/(Kegn)*1/(1+Ke) Add both the present value composites to find the value P0 of the share, that is, P0= t=1 n n Dn/(1+Ke) +(Dn+1)/(Kegn)*1/(1+Ke)

Example: Souparnika Pharmas currentdividend is Rs. 5.It expects to have a supernormalgrowth periodrunningto5yearsduringwhichthegrowthratewouldbe25%.Thecompanyexpectsnormal growth rate of 8% after the period of supernormal growth period. The investors required rate of returnis15%.Calculatewhatthevalueofoneshareofthiscompanyisworth. Solution:D0=5,n=5y,ga(supernormalgrowth)=25%,gn(normalgrowth)=8%,Ke=14%
n StepI:P0= t=1 Dn/(1+Ke) 1 D1=5(1.25) 2 D2=5(1.25) 3 D3=5(1.25) 4 D4=5(1.25) 5 D5=5(1.25)

Thepresentvalueofthisflowofdividendswillbe:
2 2 3 3 4 4 5 5 5(1.25)/(1.15)+5(1.25) /(1.15) +5(1.25) /(1.15) +5(1.25) /(1.15) +5(1.25) /(1.15)

5.43+5.92+6.42+6.98+7.63=32.38

StepII:Pn=(Dn+1)/(Keg) P5=D6/Kegn =D5(1+gn)/Kegn


5 ={5(1.25) (1+0.08)}/(0.150.08)

=15.26(1.08)/0.07

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=16.48/0.07 =235.42
5 Thediscountedvalueofthispriceis235.42/(1.15) =Rs.117.12 n n StepIII:P0= t=1 Dn/(1+Ke) +(Dn+1)/(Kegn)*1/(1+Ke)

ThevalueoftheshareisRs.32.38+Rs.117.12=Rs.149.50 Otherapproachestoequityvaluation In addition to thedividend valuation approachesdiscussed in the previous section, there areother approachestovaluationofsharesbasedonRatioApproach. Bookvalueapproach:Thebookvaluepershare(BVPS)isthenetworthofthecompanydividedby thenumberofoutstandingequityshares.Networthisrepresentedbythesumtotalofpaidupequity shares,reservesandsurplus.Alternatively,thiscanalsobecalculatedastheamountpershareon the sale of the assets of the company at their exact book value minus all liabilities including preferenceshares. Example: AOneLtd.hastotalassetsworthRs.500Cr.,liabilitiesworthRs.300Cr.,andpreferenceshares worthRs.50Cr.andequitysharesnumbering10lakhsTheBVPSisRs.150Cr/10lakhs=R.150 BVPS does not give a true investment picture. This relies on historical book values than the companysearningpotential. Liquidationvalue:Theliquidationvaluepershareiscalculatedas: {(Valuerealizedbyliquidatingallassets)(AmounttobepaidtoallCrsandPreSH)}divided byNumberofoutstandingshares. Intheaboveexample,iftheassetscanbeliquidatedatRs.450Cr.,theliquidationvaluepershareis (450Cr350Cr)/10lakhshareswhichisequaltoRs.1000pershare.

4.4.2 PriceEarningsRatio:Thepriceearningsratioreflectstheamountinvestorsarewillingto payforeachrupeeofearnings. Expected earning per share = (Expected PAT) (Preference dividend) / Number of outstanding shares. Expected PAT is dependent on a number of factors like sales, gross profit

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margin,depreciationandinterestandtaxrate.TheP/Eratioisalsotoconsiderfactorslikegrowth rate,stabilityofearnings,companysize,companymanagementteamanddividendpayoutratio. P/Eratio=(1b)/r(ROE*b) Where1bisdividendpayoutratio risrequiredrateofreturn ROE*bisexpectedgrowthrate. SelfAssessmentQuestions1 1. ______________________istheminimumvaluethecompanyacceptsifitsolditsbusiness. 2. ______________per share is generallyhigher than the book valueper shareforprofitableand growingfirms. 3. Bondsissuedby____________aresecuredandthoseissuedbyprivatesectorcompaniesmay be_________or___________. 4. ___________istherateearnedbyaninvestorwhopurchasesabondandholdsittillitsmaturity. 5. WhenKdislesserthanthecouponrate,thevalueofthebondis_________thanitsfacevalue. 6. ___________of a share is associated with the earnings (past) and profitability (future) of the company,dividendspaidandexpectedandfuturedefiniteprospectsofthecompany. 7. The _______________is the net worth of the company divided by the number of outstanding equityshares.

4.5

Summary

Valuationistheprocesswhichlinkstheriskandreturntoestablishtheassetworth.Thevalueofa bond or a share is the discounted value of all their future cash inflows (interest/dividend) over a periodoftime.Thediscountrateistherateofreturnwhichtheinvestorsexpectfromthesecurities. In case of bonds, the stream of cash flows consists of annual interest payment and repayment of principal(whichmaytakeplaceatpar,atapremiumoratadiscount).Thecashflowswhichoccurin eachyearisafixedamount. Cashflowsforpreferencesharearealsoafixedamountandthesesharesmayberedeemedatpar, atapremiumoratadiscount. The equity shareholders do not have a fixed rate of return. Their dividend fluctuates with profits. Thereforetheriskofholdinganequityshareishigherthanholdingapreferenceshareorabond.

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Solvedproblems 1. ThecurrentpriceofaAshokLeylandshareisRs.30.Thecompanyisexpectedtopayadividend of Rs. 2.50 per share which goes up annually at 6%. If an investors required rate of return is 11%,shouldhebuythisshareornot?Advise. Solution:P=D1(1+g)/Keg=2.5(1+0.06)/0.110.06=Rs.53.Theinvestorshouldcertainly buythisshareatthecurrentpriceofRs.30asthevaluationmodelsaystheshareisworthRs. 53. 2. A bond withaface value of Rs. 100 providesan annual return of8%andpays Rs. 125 at the timeofmaturity,whichis10yearsfromnow.Iftheinvestorsrequiredrateofreturnis12%,what shouldbethepriceofthebond? Solution:P=Int*PVIFA(12%,10y)+Redemptionprice*PVIF(12%,10y) =8*PVIFA(12%,10y)+125*PVIF(12%,10y) =8*5.65+125*0.322 =45.2+40.25=Rs.85.45 ThepriceofthebondshouldbeRs.85.45 3. ThebondofSiliconEnterpriseswithaparvalueofRs.500iscurrentlytradedatRs.435.The couponrateis12%withamaturityperiodof7years.Whatwillbetheyieldtomaturity? Solution:r=I+{(FP)/n}/(F+P)/2 =60+{(500435)/7}/(500+435)/2 =15.03% 4. The share of Megha Ltd is sold at Rs. 500 a share. The dividend likely to be declared by the companyisRs.25pershareafteroneyearandthepriceoneyearhenceisexpectedtobeRs. 550.Whatisthereturnattheendoftheyearonthebasisoflikelydividendandpricepershare? Solution:Holdingperiodreturn=(D1+Pricegain/loss)/purchaseprice =(25+50)/500=15% 5. AbondoffacevalueofRs.1000andamaturityof3yearspays15%interestannually.Whatis themarketpriceofthebondifYTMisalso15%? Solution:P=Int*PVIFA(15%,3y)+Redemptionvalue*PVIF(15%,3y) P=150*2.283+1000*0.658 P=342.45+658=Rs.1000.45

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1. AperpetualsharepaysanannualdividendofRs.15onafacevalueofRs.100andtherateof returnrequiredbyinvestorsonsuchinvestmentsis20%.Whatshouldbethemarketpriceofthe preferenceshare? Solution:Expectedyield=Expectedincome/currentmarketprice Expectedyield=15/0.2=Rs.75

TerminalQuestions
1. WhatshouldbepriceofabondwhichhasaparvalueofRs.1000carryingacouponrateof8% andhavingamaturityperiodof9years?Therequiredrateofreturnoftheinvestoris12%. 2. A bond of Rs.1000 value carriesa coupon rate of10% and has a maturity period of6 years. Interestispayablesemiannually.Iftherequiredrateofreturnis12%,calculatethevalueofthe bond. 3. AbondwhoseparvalueisRs.500bearingacouponrateof10%andhasamaturityof3years. Therequiredrateofreturnis8%.Whatshouldbethepriceofthebond? 4. IfthecurrentyearsdividendisRs.24,growthrateofacompanyis10%andtherequiredreturn onthestockis16%,whatistheintrinsicvalueofthestock? 5. IfastockispurchasedforRs.120andheldforoneyearduringwhichtimeRs.15dividendper shareispaidandthepricedecreasestoRs.115,whatisthenominalreturnontheshare? AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Liquidationvalue 2. Marketvalue 3. Governmentagencies,securedorunsecured 4. YieldtoMaturity 5. Greater 6. Intrinsicvalue 7. Bookvaluepershare(BVPS)

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AnswerstoTerminalQuestions 1. P=Int*PVIFA(12%,9y)+Redemptionprice*PVIF(12%,10y) 80*PVIFA(12%,9)+1000*PVIF(12%,9y) 80*5.328+1000*0.361 426.24+361=Rs.787.24 2. 50*PVIFA(6%+12y)+1000*PVIF(12%,6y) 50*8.384+1000*0.497 Rs.916.2 3. P=Int*PVIFA(8%,3y)+Redemptionprice*PVIF(6%+12y) 50*2.577+500*0.794 128.85+397=Rs.525.85 4. Intrinsicvalue=24{(1+0.1)}/0.160.1=Rs.440 5. Holdingperiodreturn=(D1+Pricegain/loss)/purchaseprice {15+(5)}/120=8.33%

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Unit5
Structure

CostofCapital

5.1 Introduction 5.2 DesignofanIdealCapitalStructure 5.3 CostofDifferentSourcesofFinance 5.3.1 CostofDebentures 5.3.2 CostofTermLoans 5.3.3 CostofPreferenceCapital 5.3.4 CostofEquitycapital 5.3.5 CostofRetainedEarnings 5.3.5.1 CapitalAssetPricingModelApproach 5.3.5.2 EarningsPriceRatioApproach 5.4 WeightedAverageCostofCapital 5.5 Summary SolvedProblems TerminalQuestions AnswerstoSAQsandTQs 5.1 Introduction Capitalstructureisthemixoflongtermsourcesoffundslikedebentures,loans,preferenceshares, equitysharesandretainedearningsindifferentratios.Itisalwaysadvisableforcompaniestoplan theircapitalstructure.Decisionstakenbynotassessingthingsinacorrectmannermayjeopardize the very existence of the company. Firms may prosper in the shortrun by not indulging in proper planningbutultimatelymayfaceproblemsinfuture.Withunplannedcapitalstructure,theymayalso failtoeconomizetheuseoftheirfundsandadapttothechangingconditions.

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LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Definecostofcapital. 2. Bringouttheimportanceofcostofcapital. 3. Explainhowtodesignanidealcapitalstructure. 4. ComputeWeightedAverageCostofCapital.


5.2 DesigninganIdealCapitalStructure Itrequiresanumberoffactorstobeconsideredsuchas: Return: The capital structure of a company should be most advantageous. It should generate maximumreturnstotheshareholdersforaconsiderableperiodoftimeandsuchreturnsshould keepincreasing. Risk:Asalreadydiscussedinthepreviouschapteronleverage,useofexcessivedebtfundsmay threatenthecompanyssurvival.Debtdoesincreaseequityholdersreturnsandthiscanbedone tillsuchtimethatnoriskisinvolved. Flexibility: The company should be able to adapt itself to situations warranting changed circumstanceswithminimumcostanddelay. Capacity:Thecapitalstructureofthecompanyshouldbewithinthedebtcapacity.Debtcapacity dependsontheabilityforfundstobegenerated.Revenuesearnedshouldbesufficientenough topaycreditorsinterests,principalandalsotoshareholderstosomeextent. Control:Anidealcapitalstructureshouldinvolveminimumriskoflossofcontroltothecompany. Dilutionofcontrolbyindulginginexcessivedebtfinancingisundesirable. Withtheabovepointsonidealcapitalstructure,raisingfundsattheappropriatetimetofinancefirms investmentactivities is an important activityof the Finance Manager. Goldenopportunities may be lost for delaying decisions to this effect. A combination of debt and equity is used to fund the activities.Whatshouldbetheproportionofdebtandequity?Thisdependsonthecostsassociated with raising various sources offunds. The costof capital is the minimum rate of returna company mustearntomeettheexpensesofthevariouscategoriesofinvestorswhohavemadeinvestmentin theformofloans,debentures,equityandpreferenceshares.Acompanynobeingabletomeetthese demands may face the risk of investors taking back their investments thus leading to bankruptcy.

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Loansanddebenturescomewithapredeterminedinterestrate,preferencesharesalsohaveafixed rate of dividend while equity holders expect a minimum return of dividend based on their risk perceptionandthecompanyspastperformanceintermsofpayoutofdividends. The following graph on riskreturn relationship of various securities summarizes the above discussion.

Error!

Requiredrateofreturn

Equity share Preference share Debt Govtbonds Riskfree security

RiskReturnrelationshipofvarioussecurities

5.3 CostofDifferentSourcesofFinance Thevarioussourcesoffinanceandtheircostsareexplainedbelow: 5.3.1 Costofdebentures Thecostofdebentureisthediscountratewhichequatesthenetproceedsfromissueofdebentures totheexpectedcashoutflowsinterestandprincipalrepayments. Kd=I(1T)+{(FP)/n} (F+P)/2 WhereKd isposttaxcostofdebenturecapital, Iistheannualinterestpaymentperunitofdebenture, Tisthecorporatetaxrate, Fistheredemptionpriceperdebenture, Pisthenetamountrealizedperdebenture,

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nismaturityperiod. Example: Lakshmi Enterprise wants to have an issue of nonconvertible debentures for Rs. 10 Cr. Each debentureisofaparvalueofRs.100havinganinterestrateof15%.Interestispayableannually andtheyareredeemableafter8yearsatapremiumof5%.Thecompanyisplanningtoissuethe NCDatadiscountof3%tohelpinquicksubscription.Ifthecorporatetaxrateis50%,whatisthe costofdebenturetothecompany? Solution: Kd= I(1T)+{(FP)/n} (F+P)/2 15(10.5)+(10597)/8 (105+97)/2 =7.5+1 101 =0.084or8.4%

5.3.2 CostofTermLoans Termloansareloanstakenfrombanksorfinancialinstitutionsforaspecifiednumberofyearsata predeterminedinterestrate.Thecostoftermloansisequaltotheinterestratemultipliedby1tax rate.Theinterestismultipliedby1taxrateasinterestontermloansisalsotaxed. Kt=I(1T) WhereIisinterest, Tistaxrate. Example: YesLtd.hastakenaloanofRs.5000000fromCanaraBankat9%interest.Whatisthecostofterm loan? Solution Kt=I(1T)=9(10.4)=5.4%

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5.3.2 CostofPreferenceCapital The cost of preference share Kp is the discountrate which equates the proceedsfrom preference capitalissuetothedividendandprincipalrepaymentswhichisexpressedas: Kp= D+{(FP)/n} (F+P)/2 WhereKpisthecostofpreferencecapital, Disthepreferencedividendpersharepayable, Fistheredemptionprice, Pisthenetproceedspershare, nisthematurityperiod. Example: C2C Ltd. has recently come out witha preference share issue to the tune of Rs. 100 lakhs. Each preference share has a face value of 100 and a dividend of 12% payable. The shares are redeemableafter10yearsatapremiumofRs.4pershare.ThecompanyhopestorealizeRs.98 persharenow.Calculatethecostofpreferencecapital. Solution Kp= D+{(FP)/n} (F+P)/2 =12+(10498)/10 (104+98)/2 = 12.6 101 Kp=0.1247or12.47% 5.3.4 CostofEquityCapital Equity shareholders do not have a fixed rate of return on their investment. There is no legal requirement(unlikeinthecaseofloansordebentureswheretheratesaregovernedbythedeed)to pay regular dividends to them. Measuring the rate of return to equity holders is a difficult and complex exercise. There are many approaches for estimating return the dividend forecast approach,capitalassetpricingapproach,realizedyieldapproach,etc.Accordingtodividendforecast

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approach,theintrinsicvalueofanequityshareisthesumofpresentvaluesofdividendsassociated withit. Ke=(D1/Pe)+g ThisequationismodifiedfromtheequationPe={D1/Keg}.Dividendscannotbeaccuratelyforecast astheymaysometimesbenilorhaveaconstantgrowthorsometimesupernormalgrowthperiods. IsEquityCapitalfreeofcost? Somepeopleareoftheopinionthatequitycapitalisfreeofcostforthereasonthatacompanyisnot legally bound to pay dividends and also the rate of equity dividend is not fixed like preference dividends. This is not a correct view as equity shareholders buy shares with the expectation of dividends and capital appreciation. Dividends enhance the market value of shares and therefore equitycapitalisnotfreeofcost. Example: SurajMetalsareexpectedtodeclareadividendofRs.5pershareandthegrowthrateindividends isexpectedtogrow@10%p.a.ThepriceofoneshareiscurrentlyatRs.110inthemarket.Whatis thecostofequitycapitaltothecompany? Solution Ke=(D1/Pe)+g =(5/110)+010 =0.1454or14.54% 5.3.5 CostofRetainedEarnings Acompanysearningscanbereinvestedinfulltofueltheeverincreasingdemandofcompanysfund requirements or they maybepaid off to equity holders infull or they may be partly heldback and invested and partly paid off. These decisions are taken keeping in mind the companys growth stages.Highgrowthcompaniesmayreinvesttheentireearningstogrowmore,companieswithno growth opportunities return the funds earned to their owners and companies with constant growth invest a little and return the rest. Shareholders of companies with high growth prospects utilizing fundsfor reinvestmentactivities havetobe compensatedforparting with their earnings. Therefore thecostofretainedearningsisthesameasthecostofshareholdersexpectedreturnfromthefirms ordinaryshares.Thatis,Kr=Ke

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5.3.5.1CapitalAssetPricingModelApproach This model establishes a relationship between the required rate of return of a security and its systematicrisksexpressedas.Accordingtothismodel, Ke=Rf+(RmRf) WhereKeistherateofreturnonshare, Rfistheriskfreerateofreturn, isthebetaofsecurity, Rmisreturnonmarketportfolio. TheCAPMmodelisbasedonsomeassumptions,someofwhichare: Investorsareriskaverse. Investorsmaketheirinvestmentdecisionsonasingleperiodhorizon. Transactioncostsarelowandthereforecanbeignored.Thistranslatestoassetsbeingbought andsoldinanyquantitydesired.Theonlyconsiderationsmatteringarethepriceandamountof moneyattheinvestorsdisposal. Allinvestorsagreeonthenatureofreturnandriskassociatedwitheachinvestment.

Example: Whatistherateofreturnforacompanyifitsis1.5,riskfreerateofreturnis8%andthemarket rateorreturnis20% Solution Ke=Rf+(RmRf) =0.08+1.5(0.20.08) =0.08+0.18 =0.26or26% 5.3.5.2 EarningsPriceRatioApproach Accordingtothisapproach,thecostofequitycanbecalculatedas: Ke=E1/PwhereE1isexpectedEPSoneyearhenceandPisthecurrentmarketpricepershare. E1iscalculatedbymultiplyingthepresentEPSwith(1+Growthrate). CostofRetainedEarningsandCostofExternalEquity

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As we have just learntthat if retainedearningsare reinvested in businessforgrowthactivities the shareholdersexpectthesameamountofreturnsandthereforeKe=Kr.Butitshouldbeborneinmind bythepolicymakersthatfloatinganewissueandpeoplesubscribingtoitwillinvolvehugeamounts of money towards floatation costs which need not be incurred if retained earnings are utilized towardsfundingactivities.Usingthedividendcapitalizationmodel,thefollowingmodelcanbeused forcalculatingcostofexternalequity. Ke={D1/P0(1f)}+g WhereKeisthecostofexternalequity, D1isthedividendexpectedattheendofyear1, P0isthecurrentmarketpricepershare, gistheconstantgrowthrateofdividends, fisthefloatationcostsasa%ofcurrentmarketprice. Thefollowingformulacanbeusedasanapproximation: Ke=ke/(1f) WhereKeisthecostofexternalequity, keistherateofreturnrequiredbyequityholders, fisthefloatationcost. Example: AlphaLtd.requiresRs.400CrtoexpanditsactivitiesinthesouthernzoneofIndia.Thecompanys CFOisplanningtogetRs.250Crthroughafreshissueofequitysharestothegeneralpublicandfor thebalanceamountheproposestouseofthereserveswhicharecurrentlytothetuneofRs.300 Cr. The equity investors expectations of returnsare 16%. The cost of procuring external equity is 4%.Whatisthecostofexternalequity? Solution WeknowthatKe=Kr,thatisKris16% CostofexternalequityisKe=ke/(1f) 0.16/(10.04)=0.1667or16.67%

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5.4 WeightedAverageCostofCapital Intheprevioussectionwehavecalculatedthecostofeachcomponentintheoverallcapitalofthe company. The term cost of capital refers to the overall composite cost of cap or the weighted average cost of each specific type of fund. The purpose of using weighted average is to consider each component in proportion of their contribution to the total fund available. Use of weighted average is preferable to simple average method for the reason that firms do not procure funds equallyfromvarioussourcesandthereforesimpleaveragemethodisnotused.Thefollowingsteps areinvolvedtocalculatetheWACC. StepI:Calculatethecostofeachspecificsourceoffund,thatofdebt,equity,preferencecapitaland termloans. StepII:Determinetheweightsassociatedwitheachsource. StepIIIMultiplythecostofeachsourcebytheappropriateweights. StepIV:WACC=WeKe+WrKr+WpKp+WdKd+WtKt Assignmentofweights Weightscanbeassignedbasedonanyofthebelowmentionedmethods: (1) Thebookvaluesofthesourcesoffundsinthecapitalstructure,(2)Presentmarket value of thefunds in the capital structure and (3) in the proportion offinancingplannedfor the capitalbudgettobeadoptedforthenextperiod. Asperthebookvalueapproach,weightsassignedwouldbeequaltoeachsourcesproportioninthe overall funds. The book value method is preferable. The market value approach uses the market values of each source and the disadvantage in this method is that these values change very frequently. Example: PrakashPackersLtd.hasthefollowingcapitalstructure: Rs.inlakhs Equitycapital(Rs.10parvalue) 14% Preference share capital Rs. 100 each Retainedearnings 12%debentures(Rs.100each) 11%TermloanfromICICIbank Total 200 100 100 300 50 750

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The market price per equity share is Rs. 32. The company is expected to declare a dividend per shareofRs.2pershareandtherewillbeagrowthof10%inthedividendsforthenext5years.The preferencesharesareredeemableatapremiumofRs.5pershareafter8yearsandarecurrently tradedatRs.84inthemarket.Debentureredemptionwilltakeplaceafter7yearsatapremiumof Rs.5perdebentureandtheircurrentmarketpriceisRs.90perunit.Thecorporatetaxrateis40%. CalculatetheWACC. Solution StepIistodeterminethecostofeachcomponent. Ke=(D1/P0)+g =(2/32)+0.1 =0.1625or16.25% Kp=[D+{(FP)/n}]/{F+P)/2} =[14+(10584)/8]/(105+84)/2 =16.625/94.5 =0.1759or17.59% Kr=Kewhichis16.25% Kd=[I(1T)+{(FP)/n}]/{F+P)/2} =[12(10.4)+(10590)/7]/(105+97)/2 =[7.2+2.14]/101 =0.092or9.2% Kt=I(1T) =0.11(10.4) =0.066or6.6% StepIIistocalculatetheweightsofeachsource. We=200/750=0.267 Wp=100/750=0.133 Wr=100/750=0.133 Wd=300/750=0.4 Wt=50/750=0.06

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Step III Multiply the costs of various sources of finance with corresponding weights and WACC calculatedbyaddingallthesecomponents. WACC=WeKe+WpKp+WrKr+WdKd+WtKt =(0.267*0.1625)+(0.133*0.1759)+(0.133*0.1625)+(0.4*0.092)+(0.06*0.066) =0.043+0.023+0.022+0.034+0.004 =0.1256or12.56% Example: JohnsonCoolAirLtdwouldliketoknowtheWACC.Thefollowinginformationismadeavailableto youinthisregard. Theaftertaxcostofcapitalare: Costofdebt9% Costofpreferenceshares15% Costofequityfunds18%

Thecapitalstructureisasfollows: DebtRs.600000 PreferencecapitalRs.400000 EquitycapitalRs.1000000

Solution Fundsource Debt Preference capital Equitycapital Total WACCis14.7% Amount Rs.600000 Rs.400000 Rs. 1000000 Rs. 2000000 Ratio 0.3 0.2 0.5 1.0 Cost 0.09 0.15 0.18 Weighted cost 0.027 0.03 0.09 0.147

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Example: ManikyamPlasticsLtd.wantstoenterintothearenaofplasticmouldsnextyearforwhichitrequires Rs.20Cr.topurchasenewequipment.TheCFOhasmadeavailablethefollowingdetailsbasedon whichyouarerequiredtocomputetheweightedmarginalcostofcapital. Theamountrequiredwillberaisedinequalproportionsbywayofdebtandequity(newissueand retainedearningsputtogetheraccountfor50%). ThecompanyexpectstoearnRs.4Crasprofitsbytheendofyearofwhichitwillretain50%and payofftheresttotheshareholders. ThedebtwillberaisedequallyfromtwosourcesloansfromIOBcosting14%andfromtheIDBI costing15%. ThecurrentmarketpriceperequityshareisRs.24anddividendpayoutoneyearhencewillbe Rs.2.40. Solution Sourceoffunds Equitycapital Retainedearnings 14%loanfromIOB 15%IDBIloan Total Ke=(D1/P0)+g =(2.40/24)=0.1or10% Kt=I(1T) =0.14(10.5)=0.07or7% Kt=I(1T) =0.15(10.5)=0.075or7.5% Example: CanaraPaintshaspaidadividendof40%onitsshareofRs.10inthecurrentyear.Thedividends aregrowing@6%p.a.Thecostofequitycapitalis16%.TheCompanystopFinanceManagersof variouszonesrecentlymettotakestockofthecompetitorsgrowthanddividendpoliciesandcame out with the following suggestions to maximize the wealth of the shareholders. As the CFO of the Weights 0.4 0.1 0.25 0.25 Aftertax cost 0.1 0.1 0.07 0.075 Weightedcost 0.04 0.01 0.0175 0.01875 0.0863or8.63%

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company you are required to analyze each suggestion and take a suitable course keeping the shareholdersinterestsinmind. Alternative1:Increasethedividendgrowthrateto7%andlowerKeto15% Alternative2:Increasethedividendgrowthrateto7%andincreaseKeto17% Alternative3:Lowerthedividendgrowthrateto4%andlowerKeto15% Alternative4:Lowerthedividendgrowthrateto4%andincreaseKeto17% Alternative5:increasethedividendgrowthrateto7%andlowerKeto14% Solution WeallknowthatP0=D1/(Keg) Presentcase=4/(0.160.06)=Rs40 Alternative1=4.28/(0.150.07)=Rs.53.5 Alternative2=4.28/(0.170.07)=Rs.42.8 Alternative3=4.16/(0.150.04)=Rs.37.8 Alternative4=4.16/(0.170.04)=Rs.32 Alternative5=4.28/(0.140.07)=Rs.61.14 Recommendation:Thelastalternativeislikelytofetchthemaximumpriceperequitysharethereby increasingtheirwealth. SelfAssessmentQuestions1 1. _________isthemixoflongtermsourcesoffundslikedebentures,loans,preferenceshares, equitysharesandretainedearningsindifferentratios. 2. Thecapitalstructureofacompanyshouldgenerate__________totheshareholders. 3. Thecapitalstructureofthecompanyshouldbewithinthe__________. 4. Anidealcapitalstructureshouldinvolve___________tothecompany. 5. ________________donothaveafixedrateofreturnontheirinvestment. 6. AccordingtoDividendForecastApproach,theintrinsicvalueofanequityshareisthesumof ______________associatedwithit.

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5.5 Summary Anyorganizationrequiresfundstorunitsbusiness.Thesefundsmaybeacquiredfromshorttermor longtermsources.Longtermfundsareraisedfromtwoimportantsourcescapital(ownersfunds) and debt. Each of these two has a cost factor, merits and demerits. Having excess debt is not desirable asdebtholders attach many conditions which may not be possiblefor the companies to adhereto.Itisthereforedesirabletohaveacombinationofbothdebtandequitywhichiscalledthe optimum capital structure. Optimum capital structure refers to the mix of different sourcesof long termfundsinthetotalcapitalofthecompany. Costofcapitalistheminimumrequiredrateofreturnneededtojustifytheuseofcapital.Acompany obtainsresourcesfromvarioussourcesissueofdebentures,availingtermloansfrombanksand financial institutions, issue of preference and equity shares or it may even withhold a portion or complete profits earned to be utilized for further activities. Retained earnings are the only internal sourcetofundthecompanysfutureplans. WeightedAverageCostofCapitalistheoverallcostofallsourcesoffinance. Thedebentures carry afixed rateof interest. Interestqualifiesfor tax deduction in determining tax liability.Thereforetheeffectivecostofdebtislessthantheactualinterestpaymentmadebythefirm. Thecostoftermloaniscomputedkeepinginmindthetaxliability. Thecostofpreferenceshareissimilartodebentureinterest.Unlikedebentureinterest,dividendsdo notqualifyfortaxdeductions. Thecalculationofcostofequityisslightlydifferentasthereturnstoequityarenotconstant. Thecostofretainedearningsisthesameasthecostofequityfunds. SolvedProblems 1. DeepaksteelhasissuednonconvertibledebenturesforRs.5Cr.Eachdebentureisofapar value of Rs. 100 carrying a coupon rate of 14%. Interest is payable annually and they are redeemableafter7yearsatapremiumof5%.ThecompanyissuedtheNCDatadiscountof 3%.Whatisthecostofdebenturetothecompany?Taxrateis40%.

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Solution Kd=I(1T)+{(FP)/n} (F+P)/2 14(10.4)+(10597)/7 (105+97)/2 =8.4+1.14 101 =0.094or9.4%

2. SupersonicindustriesLtd.hasenteredintoanagreementwithIndianOverseasBankforaloan ofRs.10Crwithaninterestrateof10%.Whatisthecostoftheloanifthetaxrateis45%? Solution Kt=I(1T)=10(10.45)=5.5% 3. Primegroupissuedpreferenceshareswithamaturitypremiumof10%andacouponrateof9%. TheshareshaveafaceavalueofRs.100.andareredeemableafter8years.Thecompanyis planningtoissuethesesharesatadiscountof3%now.Calculatethecostofpreferencecapital. Solution Kp=D+{(FP)/n} (F+P)/2 =9+(11097)/8=9+1.625=10.27% (110+97)/2 TerminalQuestions 1. Thefollowingdataisavailableinrespectofacompany: EquityRs.10lakhs,costofcapital18% DebtRs.5lakhs,costofdebt13% Calculatetheweightedaveragecostoffundstakingmarketvaluesasweightsassumingtaxrate is40%. 2. BharatChemicalshasthefollowingcapitalstructure: Rs.10facevalueequityshares Termloan@13% Rs.400000 Rs.150000 103.5

9%PreferencesharesofRs.100,currentlytraded Rs.100000 atRs.95with6yearsmaturityperiod Total Rs.650000

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The company is expected to declare a dividend of Rs. 5 next year and the growth rate of dividends is expected to be 8%. Equity shares are currently traded at Rs. 27 in the market. Assumetaxrateof50%.WhatisWACC? 3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is Rs.60lakhs.Thecostofequityanddebtare15%and12%.WhatistheWACC? 4. A company has 3 divisions X, Y and Z. Each division has a capital structure with debt, preferencesharesandequitysharesintheratio3:4:3respectively.Thecompanyisplanningto raisedebt,preferencesharesandequityforallthe3divisionstogether.Further,itisplanningto takeabankloan@12%interest.ThepreferenceshareshaveafacevalueofRs.100,dividend @12%,6yearsmaturityandcurrentlypricedatRs.88.Calculatethecostofpreferenceshares anddebtiftaxesapplicableare45% 5. Tanishk Industries issues partially convertibledebentures offace valueof is Rs.100 eachand realizes Rs. 96 per share. The debentures are redeemable after 9 years at a premium of 4%, taxesapplicableare40%.Whatisthecostofdebt? 5.8 AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Capitalstructure 2. Maximumreturns 3. Debtcapacity 4. Minimumriskoflossofcontrol 5. Equityshareholders 6. Presentvaluesofdividends AnswerstoTerminalQuestions: 1,2,3:WACC=WeKe+WpKp+WrKr+WdKd+WtKt 4.Hint:ApplytheformulaKp= D+{(FP)/n} (F+P)/2 5.Hint:ApplytheformulaKd=I(1T)+{(FP)/n} (F+P)/2

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Unit6
Structure
6.1 Introduction 6.2 OperatingLeverage 6.2.1 ApplicationofOperatingLeverage 6.3 FinancialLeverage 6.3.1 UsesofFinancialLeverage 6.4 CombinedLeverage 6.4.1 UsesofCombinedLeverage 6.5 Summary SolvedProblems TerminalQuestions AnswerstoSAQsandTQs 6.1 Introduction

Leverage

Acompanyusesdifferentsourcesoffinancingtofunditsactivities.Thesesourcescanbeclassified as those which carry a fixed rate of return and those whose returns vary. The fixed sources of financehaveabearingonthereturnonshareholders.Borrowingfundsasloanshaveanimpacton thereturnonshareholdersandthisisgreatlyaffectedbythemagnitudeofborrowinginthecapital structureofafirm.Leverageistheinfluenceofpowertoachievesomething.Theuseofanassetor sourceoffundsforwhichthecompanyhastopayafixedcostorfixedreturnistermedasleverage. Leverage is the influence of an independent financial variable on a dependent variable. It studies howthedependentvariablerespondstoaparticularchangeinindependentvariable. There are two types of leverage operating leverage and financial leverage. Leverage associatedwiththeassetpurchaseactivitiesisknownasoperatingleverage,whilethoseassociated withfinancingactivitiesiscalledasfinancialleverage.

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LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Explainthemeaningofleverage. 2. Mentionthedifferenttypesofleverage. 3. Discusstheadvantagesofleverage.


6.2 OperatingLeverage Operating leverage arises due to the presence of fixed operating expenses in the firms income flows.Acompanysoperatingcostscanbecategorizedintothreemainsections: Fixedcostsarethosewhichdonotvarywithanincreaseinproductionorsalesactivitiesfora particularperiodoftime.Theseareincurredirrespectiveoftheincomeandvolumeofsalesand generallycannotbereduced. Variable costs are those which vary in direct proportion to output and sales. An increase or decreaseinproductionorsalesactivitywillhaveadirecteffectonsuchtypesofcostsincurred. Semivariablecostsarethosewhicharepartlyfixedandpartlyvariableinnature.Thesecosts aretypicallyoffixednatureuptoacertainlevelbeyondwhichtheyvarywiththefirmsactivities. The operating leverage is the firms ability to use fixed operating costs to increase the effects of changesinsalesonitsearningsbeforeinterestandtaxes.Operatingleverageoccursanytimeafirm hasfixedcosts.Thepercentagechangeinprofitswithachangeinvolumeofsalesismorethanthe percentagechangeinvolume. Example: A firm sells a productfor Rs. 10 per unit, its variable costs are Rs.5 per unit andfixed expenses amount to R. 5000 p.a. Show the various levels of EBIT that result from sale of 1000 units, 2000 unitsand3000units. Solution Salesinunits SalesrevenueRs. Variablecost Contribution Fixedcost 1000 10000 5000 5000 5000 2000 20000 10000 10000 5000 3000 30000 15000 15000 5000

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EBIT 000 5000 10000 Ifwetake2000unitsasthenormalcourseofsales,theresultscanbesummedasunder: A50%increaseinsalesfrom2000unitsto3000unitsresultsina100%increaseinEBIT. A50%decreaseinsalesfrom2000unitsto1000unitsresultsina100%decreaseinEBIT.

Theillustrationclearlytellsusthatwhenafirmhasfixedoperatingexpenses,anincreaseinsales resultsinamoreproportionateincreaseinEBITandviceversa.Theformerisafavourableoperating leverageandthelatterisunfavourable. Another way of explaining this phenomenon is examining the effect of the degree of operating leverageDOL.TheDOLisamoreprecisemeasurement.Itexaminestheeffectofthechangeinthe quantityproducedonEBIT. DOL=%changeinEBIT/%changeinoutput Toputinadifferentway,(EBIT/EBIT) (Q/Q) EBITisQ(SV)FwhereQisquantity,Sissales,VisvariablecostandFisfixedcost. Substitutingthisweget,{Q(SV)} {Q(SV)F} Example: CalculatetheDOLofGupthaenterprises. Quantityproducedandsold 1000units Variablecost Sellingpriceperunit Fixedexpenses Solution DOL={Q(SV)} {Q(SV)F} =1000(300200) 1000(300200)20000 =100000/80000 DOL=1.25 Ifthecompanydoesnotincuranyfixedoperatingcosts,thereisnooperatingleverage. 90 Rs.100perunit Rs.300perunit Rs.20000

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Example: Salesinunits SalesrevenueRs. Variablecost Contribution Fixedcost EBIT Solution: DOL={Q(SV)} {Q(SV)F} {1000(5000)}/{1000(5000)0} =5000000/5000000 =DOL=1 Asoperatingleveragecanbefavourableorunfavourable,highrisksareattachedtohigherdegrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the operatingrisksofthecompanyandhenceahigherdegreeofoperatingleverage.Higheroperating riskscanbetakenwhenincomelevelsofcompaniesarerisingandshouldnotbeventuredintowhen revenuesmovesouthwards. 6.2.1 ApplicationofOperatingLeverage Measurement of business risk: Risk refers to the uncertain conditions in which a company performs.GreatertheDOL,moresensitiveistheEBITtoagivenchangeinunitsales.AhighDOLis ameasureofhighbusinessriskandviceversa. Production planning: A change in production method increases or decreases DOL. A firm can change its cost structure by mechanizing its operations, thereby reducing its variable costs and increasingitsfixedcosts.ThiswillhaveapositiveimpactonDOL.Thissituationcanbejustifiedonly ifthecompanyisconfidentofachievingahigheramountofsalestherebyincreasingitsearnings. 1000 10000 5000 5000 0 5000

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6.3 FinancialLeverage Financialleverageasopposedtooperatingleveragerelatestothefinancingactivitiesofafirmand measurestheeffectofEBITonEPSofthecompany.Acompanyssourcesoffundsfallundertwo categoriesthosewhichcarryafixedfinancialchargedebentures,bondsandpreferenceshares andthosewhichdonotcarryanyfixedchargeequityshares.Debenturesandbondscarryafixed rateofinterestandhavetobepaidoffirrespectiveofthefirmsrevenues.Thoughdividendsarenot contractualobligations,dividendonpreferencesharesisafixedchargeandshouldbepaidoffbefore equityshareholdersarepaidany.Theequityholdersareentitledtoonlytheresidualincomeofthe firmafterallpriorobligationsaremet. Financialleveragereferstothemixofdebtandequityinthecapitalstructureofthefirm.Thisresults fromthepresenceoffixedfinancialchargesinthecompanysincomestream.Suchexpenseshave nothing to do with the firms performance and earnings and should be paid off regardless of the amountofEBIT.Itisthefirmsabilitytousefixedfinancialchargestoincreasetheeffectsofchanges in EBIT on the EPS. It is the use of funds obtained at fixed costs to increase the returns to shareholders.Acompanyearningmorebytheuseofassetsfundedbyfixedsourcesissaidtobe havingafavourableorpositiveleverage.Unfavourableleverageoccurswhenthefirmisnotearning sufficientlytocoverthecostoffunds.FinancialleverageisalsoreferredtoasTradingonEquity. Example: TheEBITofafirmisexpectedtobeRs.10000.Thefirmhastopayinterest@5%ondebentures worth Rs. 25000. It also has preference shares worth Rs. 15000 carrying a dividend of 8%. How doesEPSchangeifEBITisRs.5000andRs.15000?Taxratemaybetakenas40%andnumberof outstandingsharesas1000. Solution: EBIT Interestondeb. EBT Tax40% EAT Preferencediv. Earningsavailable toequityholders 10000 1250 8750 3500 5250 1200 4050 5000 1250 3750 1500 2250 1200 1050 15000 1250 13750 5500 8250 1200 7050

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EPS Interpretation:

4.05

1.05

7.05

A50%increaseinEBITfromRs.10000toRs.15000resultsin74%increaseinEPS. A50%decreaseinEBITfromRs.10000toRs.5000resultsin74%decreaseinEPS.

This example shows that the presence of fixed interest source funds leads to a more than proportional change in EPS. The presence of such fixed sources implies the presence offinancial leverage.Thiscanbeexpressedinadifferentway.ThedegreeoffinancialleverageDFLisamore precisemeasurement.ItexaminestheeffectofthefixedsourcesoffundsonEPS. DFL=%changeinEPS %changeinEBIT DFL={EPS/EPS} {EBIT/EBIT} OrDFL= EBIT {EBITI{Dp/(1T)}} IisInterest,Dpisdividendonpreferenceshares,Tistaxrate. Example: KusumaCementsLtd.hasanEBITofRs.500000at5000unitsproductionandsales.Thecapital structureisasfollows: Capitalstructure Paidupcapital500000equitysharesof Rs.10each 12%Debentures Total Corporatetaxratemaybetakenat40% Solution: EBIT EBT 500000 452000 AmountRs. 5000000 400000 5800000

10%PreferencesharesofRs.100each 400000

LessInterestondebentures 48000

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DFL=

EBIT {EBITI{Dp/(1T)}} 500000

(50000048000{40000/(10.40)} DFL=1.30

6.3.1UseofFinancialLeverage StudyingDFLatvariouslevelsmakesfinancialdecisionmakingontheuseoffixedsourcesoffunds forfundingactivitieseasy.OnecanassesstheimpactofchangeinEBITonEPS. Likeoperatingleverage,therisksarehighathighdegreesoffinancialleverage.Highfinancialcosts areassociatedwithhighDFL.AnincreaseinfinancialcostsimplieshigherlevelofEBITtomeetthe necessaryfinancialcommitments.Afirmnotcapableofhonouringitsfinancialcommitmentsmaybe forcedtogointoliquidationbythelendersoffunds.Theexistenceofthefirmisshakyunderthese circumstances. On the one hand trading on equity improves considerably by the use of borrowed fundsandontheotherhand,thefirmhastoconstantlyworktowardshigherEBITtostayaliveinthe business.Allthesefactorsshouldbeconsideredwhileformulatingthefirmsmixofsourcesoffunds. Onemaingoaloffinancialplanningisdeviseacapitalstructureinordertoprovideahighreturnto equityholders.Butatthesametime,thisshouldnotbedonewithheavydebtfinancingwhichdrives thecompanyontothebrinkofwindingup. Impactoffinancialleverage: Highlyleveragedfirmsareconsideredveryriskyandlendersandcreditorsmayrefusetolendthem further tofuel their expansion activities. On being forced to continue lending, they may do so with theirownconditionslikeearningaminimumofX%EBITorstipulatinghigherinterestratesthanthe marketratesornofurthermortgageofsecurities.Financialleverageisconsideredtobefavourable tillsuchtimethattherateofreturnexceedstherateofreturnobtainedwhennodebtisused.This canbeexplainedwiththehelpofthefollowingexample: Followingarethebalancesheetsof2firmsAandB

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BalancesheetofA Equity 10000 capita 0 l Assets 10000 0

BalancesheetofB Equity 40000 capital Debt @ 15% 60000 Assets 10000 0

Total

10000 0

Total

10000 0

Total

10000 0

Total

10000 0

Both the companies earn an income before interest and tax of Rs. 40000. Calculate the DFL and interprettheresultsthereof. DFL=
EBIT { EBIT- I- { /( - T Dp 1 )}} 4000 = 1 40000- 0- 0 4000 = 129 . 40000- 9000- 0

CompanyA= CompanyB=

ThecompanynotusingdebttofinanceitsassetshasahigherDFL.Financialleveragedoesnotexist whenthereisnofixedchargefinancing. 6.4 TotalorCombinedLeverage Thecombinationofoperatingandfinancialleverageiscalledcombinedleverage.Operatingleverage affectsthefirmsoperatingprofitEBITandfinancialleverageaffectsPATortheEPS.Thesecause widefluctuationinEPS.Acompanyhavingahighlevelofoperatingorfinancialleveragewillfinda drasticchangeinitsEPSevenforasmallchangeinsalesvolume.Companieswhoseproductsare seasonalinnaturehavefluctuatingEPS,buttheamountofchangesinEPSduetoleveragesismore pronounced. The combined effect is quite significant for the earnings available to ordinary shareholders.CombinedleverageistheproductofDOLandDFL. DTL=
Q( - V) S Q S- V)- F- I- { /( - T ( Dp 1 )}

Example: CalculatetheDTLofM/sPoojaEnterprisesLtd.giventhefollowinginformation. Quantitysold 10000units

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Variablecostperunit Sellingpriceperunit Fixedexpenses Numberofequityshares Debt Preferenceshares Taxrate

Rs.100perunit Rs.500perunit Rs.1000000 100000 Rs.1000000@20%interest 10000sharesofRs.100each@10%dividend 50%

DTL=

Q( - V) S Q S- V)- F- I- { /( - T ( Dp 1 )}

10000 ( 500- 100 ) 10000( 500- 100 - 1000000- 200000- { ) 100000/0 5 . }

DTL=1.54 Crossverification: DOL=


{Q S- V ( )} { ( - V)- F Q S }

10000( 500- 100 ) 10000 500- 100 - 1000000 ( )

DOL=1.33 DFL=
EBIT EBIT- I- { /( - T Dp 1 )}}

3000000 3000000- 200000- { 100000/0 5 . }

DFL=1.15 DTL=DOL*DFL 1.33*1.15=1.54 6.4.1UsesofDTL DTL measures the total risk of the company as it is a combined measure of both operating and financialrisk.ItmeasuresthevariabilityofEPS.

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SelfAssessmentQuestions1 1. ________________arisesduetothepresenceoffixedoperatingexpensesinthefirmsincome flows. 2. EBITiscalculatedas_____________. 3. Higheroperatingriskscanbetakenwhen_____________ofcompaniesarerising. 4. Dividendon__________isafixedcharge. 5.Financialleverageisalsoreferredtoas____________. 6.5 Summary Leverage is the use of influence to attain something else. The advantage a company has with its currentstatusisusedtogainsomeotherbenefit.Therearethreemeasuresofleverageoperating leverage,financialleverageandtotalorcombinedleverage.Operatingleverageexaminestheeffect of change in quantity produced upon EBIT and is useful to measure business risk and production planning.FinancialleveragemeasurestheeffectofchangeinEBITontheEPSofthecompany.It also refers to the debtequity mix of a firm. Total leverage is the combination of operating and financialleverages. SolvedProblems 1. ThefollowinginformationhasbeencollectedfromtheannualreportofGardenSilks.Whatisthe degreeoffinancialleverage? TotalsalesRs.1400000 Contributionratio25% FixedexpensesRs.150000 OutstandingbankloanRs.400000@12.5% Applicabletaxrate40% Solution:DFL=EBIT/(EBITI)=200000/20000050000=1.33 EBIT=Sales*25%lessfixedexpenses 1400000*25%=350000150000=200000

2. XandYhaveprovidedthefollowinginformation.Whichfirmdoyouconsiderrisky?

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XLtd. Salesinunits Priceperunit Variablecostp.u Fixedfinancing cost Fixedfinancing cost 40000 60 20 Rs.100000 Rs.300000

YLtd. 40000 60 25 Rs.50000 Rs. 200000

Solution:DOL=Q(SV)/Q(SV)F CompanyX:40000(6020)/40000(6020)400000 1600000/1200000=1.33 CompanyY:40000(6025)/40000(6025)250000 1400000/1100000=1.22 3. CalculateEPSwiththefollowinginformation. EBITRs.1180000 InterestRs.220000 No.ofsharesoutstanding40000 Taxrateapplicable40% Solution:EBIT LessInt EBT Tax40% EAT 1180000 220000 960000 384000 576000

EPS=EAT/noofsharesoutstanding 576000/40000=Rs.14.4 4. Theleveragesofthreefirmsaregivenbelow.Whichoneofthecombinationsshouldbechosen forthecombinedleveragetobemaximumandwhataretheinferences? A Operatingleverage Financialleverage 1.14 1.27 B 1.23 1.3 C 1.33 1.33

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Solution:Weshouldcalculatethecombinedleveragetodrawinferences.Combinedleverageof Ais1.14*1.27=1.45, CombinedleverageofBis1.23*1.3=1.60, CombinedleverageofCis1.33*1.33=1.77 WefindthatthecombinedleverageishighestforfirmCandthissuggeststhatthisfirmisworking underveryhighriskysituation.

TerminalQuestions
1. MishraLtd.providesthefollowinginformation.Whatisthedegreeofoperatingleverage? Output Fixedcosts Variablecostperunit Interestonborrowedfunds Sellingpriceperunit Output Fixedcosts Variablecost Interestonborrowedfunds Sellingprice performancethroughleverage ALtd.(Rs.Inlakhs) Sales Variablecost Fixedcost EBIT Interest 1000 300 250 450 50 BLtd.(Rs.Inlakhs) 1500 600 400 500 100 100000Units Rs.15000 Rs.0.50 Rs.10000 Rs.1.50 25000units Rs.25000 Rs.2.50perunit Rs.15000 Rs.8perunit

2. XLtd.providesthefollowinginformation.Whatisthedegreeoffinancialleverage?

3. The following information is available in respect of 2 firms. Comment on their relative

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4. ABCLtd.providesthefollowinginformation.CalculatetheDFL. Output Fixedcosts Variablecost Interestonborrowedfunds Sellingpriceperunit 200000units Rs.3500 Rs.0.05perunit Nil 0.20

AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Operatingleverage 2. Q(SV)F 3. Incomelevels 4. Preferenceshares 5. TradingonEquity AnswerstoTerminalQuestions: 1.HintDOL=


{Q S- V ( )} { ( - V)- F Q S } EBIT { EBIT- I- { /( - T Dp 1 )}}

2.HintDFL=

3. HintcalculateDFL

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Unit7

CapitalStructure

Structure 7.1 Introduction 7.2 FeaturesofIdealCapitalStructure 7.3 FactorsAffectingCapitalStructure 7.4 TheoriesofCapitalStructure 7.4.1 NetIncomeApproach 7.4.2 NetOperatingIncomeApproach 7.4.3 TraditionalApproach 7.4.4 MillerandModiglianiApproach 7.4.4.1CriticismofMillerandModiglianiApproach 7.5 Summary TerminalQuestions AnswerstoSAQsandTQs 7.1 Introduction Thecapitalstructureofacompanyreferstothemixoflongtermfinancesusedbythefirm.Inshort,it isthefinancingplanofthecompany.Withtheobjectiveofmaximizingthevalueoftheequityshares, the choice should be that pattern of using debt and equity in a proportion that will lead towards achievementofthefirmsobjective.Thecapitalstructureshouldaddvaluetothefirm.Financingmix decisionsareinvestmentdecisionsandhavenoimpactontheoperatingearningsofthefirm.Such decisionsinfluencethefirmsvaluethroughtheearningsavailabletotheshareholders. Thevalueofafirmisdependentonitsexpectedfutureearningsandtherequiredrateofreturn.The objectiveofanycompanyistohaveanidealmixofpermanentsourcesoffundsinamannerthatwill maximize the companys market price. The proper mix of funds is referred to as Optimal Capital Structure. Thecapitalstructuredecisionsincludedebtequitymixanddividenddecisions.Boththesehavean effectontheEPS.

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LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Explainthefeaturesofidealcapitalstructure. 2. Namethefactorsaffectingthecapitalstructure. 3. Mentionthevarioustheoriesofcapitalstructure.


7.2 FeaturesofanIdealCapitalStructure Profitability:Thefirmshouldmakemaximumuseofleverageatminimumcost. Flexibility:Itshouldbeflexibleenoughtoadapttochangingconditions.Itshouldbeinaposition toraisefundsattheshortestpossibletimeandalsorepaythemoneysitborrowed,iftheyappear tobeexpensive.Thisispossibleonlyifthecompanyslendershavenotputforthanyconditions likerestrictingthecompanyfromtakingfurtherloans,norestrictionsplacedontheassetsusage orlayingarestrictiononearlyrepayments.Inotherwords,thefinanceauthoritiesshouldhavethe powertotakedecisionsonthebasisofthecircumstanceswarrant. Control:Thestructureshouldhaveminimumdilutionofcontrol. Solvency:Useofexcessivedebtthreatenstheveryexistenceofthecompany.Additionaldebt involveshuge repayments. Loans with high interest rates are to be avoided however attractive someinvestmentproposalslook.Somecompaniesresorttoissueofequitysharestorepaytheir debtforequityholdersdonothaveafixedrateofdividend. 7.3 FactorsAffectingCapitalStructure Leverage:Theuseoffixedchargessourcesoffundssuchaspreferenceshares,loansfrombanks and financial institutions and debentures in the capital structure is known as trading on equity or financial leverage. Creditors insist ona debt equity ratio of 2:1for medium sized and large sized companies, while they insist on 3:1 ratio for SSI. Debt equity ratio is an indicator of the relative contribution of creditors and owners. The debt component includes both long term and short term debtandthisisrepresentedasDebt/Equity.Adebtequityratioof2:1indicatesthatforevery1unitof equity,thecompanycanraise2unitsofdebt.Bynormalstandards,2:1isconsideredahealthyratio, but it is not always a hard and fast rule that this standard is insisted upon. A ratio of 1.5:1 is considered good for a manufacturing company while a ratio of 3:1 is good for heavy engineering

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companies.Itisgenerallyperceivedthatlowertheratio,higheristheelementofuncertaintyinthe mindsoflenders. Increaseduseofleverageincreasescommitmentsofthecompany,theoutflowsbeinginthenature of higher interestand principal repayments, thereby increasing the risk of the equity shareholders. Theotherfactorstobeconsideredbeforedecidingonanidealcapitalstructureare: Cost of capital High cost funds should be avoided however attractive an investment propositionmaylooklike,fortheprofitsearnedmaybeeatenawaybyinterestrepayments. CashflowprojectionsofthecompanyDecisionsshouldbetakeninthelightofcashflows projected for the next 35 years. The company officials should not get carried away at the immediateresultsexpected.Consistentlesserprofitsareanywaypreferablethanhighprofitsin thebeginningandnotbeingabletogetanyafter2years. Sizeofthecompany DilutionofcontrolThetopmanagementshouldhavetheentireflexibilitytotakeappropriate decisionsattherighttime.Thecapitalstructureplannedshouldbeoneinthisdirection. Floatation costs A company desiring to increase its capital by way of debt or equity will definitelyincurfloatationcosts.Effectively,theamountofmoneyraisedbyanyissuewillbelower than the amount expected because of the presence of floatation costs. Such costs should be comparedwiththeprofitsandrightdecisionstaken. 7.4 TheoriesofCapitalStructure Asweareaware,equityanddebtarethetwoimportantsourcesoflongtermsourcesoffinanceofa firm.Theproportionofdebtandequityinafirmscapitalstructurehastobeindependentlydecided case to case. A proposal though not being favourable to lenders may be taken up if they are convincedwiththeearningpotentialandlongtermbenefits.Manytheorieshavebeenpropoundedto understandtherelationshipbetweenfinancialleverageandfirmvalue. Assumptions Thefollowingaresomecommonassumptionsmade: Thefirmhasonlytwosourcesoffundsdebtandordinaryshares. Therearenotaxesbothcorporateandpersonal.

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Thefirmsdividendpayoutratiois100%,thatis,thefirmpaysofftheentireearningstoitsequity holdersandretainedearningsarezero.

Theinvestmentdecisionsofacompanyareconstant,thatis,thefirmdoesnotinvestanyfurther initsassets.

TheoperatingprofitsEBITarenotexpectedtoincreaseordecline. AllinvestorsshallhaveidenticalsubjectiveprobabilitydistributionofthefutureexpectedEBIT. A firm can change its capital structure at a short notice without the occurrence of transaction costs.

Thelifeofthefirmisindefinite.

Basedontheabove,wederivethefollowing: 1. Debtcapitalbeingconstant,Kdisthecostofdebtwhichisthediscountrateatwhichdiscounted futureconstantinterestpaymentsareequaltothemarketvalueofdebt,thatis,Kd=I/Bwhere,I referstototalinterestpaymentsandBisthetotalmarketvalueofdebt. ThereforevalueofthedebtB=I/Kd 2. Cost of equity capital Ke = (D1/P0) + g where D1 is dividendafter one year, P0 is the current marketpriceandgistheexpectedgrowthrate. 3. Retainedearningsbeingzero,g=brwhereristherateofreturnonequitysharesandbisthe retentionrate,thereforegiszero.NowweknowKe=E1/P0+gandgbeingzero,soKe=NI/S whereNIisthenetincometoequityholdersandSismarketvalueofequityshares. 4. Thenetoperatingincomebeingconstant,overallcostofcapitalisrepresentedasK0=W1K1+ W2K2. Thatis,K0=(B/V)K1+(S/V)K2whereBisthetotalmarketvalueofthedebt,Smarketvalueof equity and V total market value of the firm (B+S). The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, ( K1 being the debt component and Ke being the equity component)whichcanbeexpressedasK0=I+NI/VorEBIT/Vorinotherwords,netoperating income/marketvalueoffirm. 7.4.1 NetIncomeApproach ThistheoryissuggestedbyDurandandheisoftheviewthatcapitalstructuredecisionisrelevantto thevaluationofthefirm.Anychangeinthefinancialleveragewillhaveacorrespondingchangein theoverallcostofcapitalandalsothetotalvalueofthefirm.Astheratioofdebttoequityincreases, theWACCdeclinesandmarketvalueoffirmincreases.TheNIapproachisbasedon3assumptions 104

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notaxes,costofdebtlessthancostofequityanduseofdebtdoesnotchangetheriskperception ofinvestors. WeknowthatK0=[B/(B+S)]Kd+[S/(B+S)]Ke Thefollowinggraphicalrepresentationofnetincomeapproachmayhelpusunderstandthisbetter.

Percentagecost

Ke

K0 Kd

LeverageB/S

Example: Given below are two firms A and B, which are identical in all aspects except the degree of leverageemployedbythem.Whatistheaveragecostofcapitalofbothfirms? FirmA NetoperatingincomeEBIT InterestondebenturesI EquityearningsE CostofequityKe CostofdebenturesKd MarketvalueofequityS=E/Ke MarketvalueofdebtB TotalvalueoffirmV AverageCostofcapitaloffirmA is: 10%*0/Rs.666667+15%*666667/666667whichis15% Rs.100000 Nil Rs.100000 15% 10% Rs.666667 Nil Rs.666667 FirmB Rs.100000 Rs.25000 Rs.80000 15% 10% Rs.533333 Rs.250000 Rs.783333

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AverageCostofcapitaloffirmBis: 10%*25000/783333+15%*533333/783333whichis10.53% Interpretation:Theuseofdebthascausedthetotalvalueofthefirmtoincreaseandtheoverallcost ofcapitaltodecrease. 7.4.2 NetOperatingIncomeApproach ThistheoryisagainpropoundedbyDurandandistotallyoppositeoftheNetIncomeApproach.He saysanychangeinleveragewillnotleadtoanychangeinthetotalvalueofthefirm,marketpriceof shares and overall cost of capital. The overall capitalization rate is the same for all degrees of leverage.Weknowthat: K0=[B/(B+S)]Kd+[S/(B+S)]Ke AspertheNOIapproachtheoverallcapitalizationrateremainsconstantforalldegreesofleverage. The market values the firm as a whole and the split in the capitalization rates between debt and equityisnotverysignificant. Theincreaseintheratioofdebtinthecapitalstructureincreasesthefinancialriskofequity shareholdersandtocompensatethis,theyexpectahigherreturnontheirinvestments.Thusthecost ofequityis Ke=Ko+[(KoKd)(B/S)] Costofdebt:Thecostofdebthastwopartsexplicitcostandimplicitcost.Explicitcostisthegiven rateofinterest.Thefirmisassumedtoborrowirrespectiveofthedegreeofleverage.Thiscanmean that the increasing proportion of debt does not affect the financial risk of lenders and they do not chargehigherinterest.ImplicitcostisincreaseinKeattributabletoKd.Thustheadvantageofuseof debtiscompletelyneutralizedbytheimplicitcostresultinginKeandKdbeingthesame. Graphicallythisisrepresentedas:

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Percentagecost

Ko

Kd

LeverageB/S

Example: Givenbeloware twofirms Xand Y which are similar in all aspects except the degree of leverage employed. FirmA NetoperatingincomeEBIT OverallcapitalizationrateKo TotalmarketvalueV=EBIT/Ko InterestondebtI DebtcapitalizationrateKd MarketvalueofdebtB=I/Kd MarketvalueofequityS=VB Rs.10000 18% 55555 Rs.1000 11% Rs.9091 Rs.46464 FirmB Rs.10000 18% 55555 Rs.2000 11% Rs.18181 Rs.37374 0.2140

LeverageB/S 0.1956 Theequitycapitalizationratesare FirmA=9000/46464whichis19.36% FirmB=8000/37374whichis21.40%

Theequitycapitalizationratescanalsobecalculatedwiththeformula Ke=Ko+[(KoKd)(B/S)] FirmA=0.18+[(0.180.11)(0.1956)]=19.36% FirmB=0.18+[(0.180.11)(0.4865)]=21.40%

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7.4.3 TraditionalApproach:TheTraditionalApproachhasthefollowingpropositions: Kdremainsconstantuntilacertaindegreeofleverageandthereafterrisesatanincreasingrate. Keremainsconstantorrisesgraduallyuntilacertaindegreeofleverageandthereafterrisesvery sharply. Asasequencetotheabove2propositions,Kodecreasestillacertainlevel,remainsconstantfor moderateincreasesinleverageandrisesbeyondacertainpoint. Graphically,wecanrepresenttheseasunder:

Ke Percentagecost

Ko

Kd

LeverageB/S

7.4.4MillerandModiglianiApproach Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up to a reasonable limit and Ko being constant atall degreesof leverage. They state that the relationship between leverage and cost of capital is elucidated as in NOI approach. The assumptions for their analysisare: Perfect capital markets: Securities can befreely traded, that is, investors arefree to buy and sellsecurities(bothsharesanddebtinstruments),therearenohindrancesontheborrowings,no presenceoftransactioncosts,securitiesinfinitelydivisible,availabilityofallrequiredinformation atalltimes. Investorsbehaverationally,thatis,theychoosethatcombinationofriskandreturnthatismost advantageoustothem.

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Homogeneity of investors risk perception, that is, all investors have the same perception of businessriskandreturns.

Taxes:Thereisnocorporateorpersonalincometax. Dividendpayoutis100%,thatis,thefirmsdonotretainearningsforfutureactivities.

Basic propositions: The following three propositions can be derived based on the above assumptions: Proposition I: The market value of the firm is equal to the total market value of equity and total marketvalueofdebtandisindependentofthedegreeofleverage.Itcanbeexpressedas: ExpectedNOI Expectedoverallcapitalizationrate V+(S+D)whichisequaltoO/KowhichisequaltoNOI/Ko V+(S+D)=O/Ko=NOI/Ko WhereVisthemarketvalueofthefirm, Sisthemarketvalueofthefirmsequity, Disthemarketvalueofthedebt, Oisthenetoperatingincome, Koisthecapitalizationrateoftheriskclassofthefirm. Error!

Costofcapital

Ko

Ke

LeverageD/V

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The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage mechanism.Arbitrageistheprocessofbuyingasecurityatlowerpriceinonemarketandsellingitin another market at a higher price bringing about equilibrium. This is a balancing act. Miller and Modigliani perceive that the investors of a firm whose value is higher will sell their shares and in returnbuysharesofthefirmwhosevalueislower.Theywillearnthesamereturnatloweroutlayand lowerperceivedrisk.Suchbehavioursareexpectedtoincreasethesharepriceswhosesharesare beingpurchasedandloweringthesharepricesofthosesharewhicharebeingsold.Thisswitching operationwillcontinuetillthemarketpricesofidenticalfirmsbecomeidentical. PropositionII:Theexpectedyieldonequityisequaltodiscountrate(capitalizationrate)applicable plusapremium. Ke=Ko+[(KoKd)D/S] PropositionIII:Theaveragecostofcapitalisnotaffectedbythefinancingdecisionsasinvestment andfinancingdecisionsareindependent. 7.4.4.1 CriticismsofMMProposition Riskperception:Theassumptionthatrisksaresimilariswrongandtheriskperceptionsofinvestors arepersonalandcorporateleverageisdifferent.Thepresenceoflimitedliabilityoffirmsincontrast tounlimitedliabilityofindividualsputsfirmsandinvestorsonadifferentfooting.Allinvestorsloseifa leveredfirmbecomesbankruptbutaninvestorlosesnotonlyhissharesinacompanybutwouldalso beliabletorepaythemoneyheborrowed.Arbitrageprocessisonewayofreducingrisks.Itismore riskytocreatepersonalleverageandinvestinunleveredfirmthaninvestinginleveredfirms. Convenience: Investors find personal leverage inconvenient. This is so because it is the firms responsibility to observe corporate formalities and procedures whereas it is the investors responsibilitytotakecareofpersonalleverage.Investorsprefertheformerratherthantakingonthe responsibilityandthustheperfectsubstitutabilityissubjecttoquestion. Transactioncosts:Anothercostthatinterferesinthesystemofbalancingwitharbitrageprocessis thepresenceoftransactioncosts.Duetothepresenceofsuchcostsinbuyingandsellingsecurities, itisnecessarytoinvestahigheramounttoearnthesameamountofreturn. Taxes: When personal taxes are considered along with corporate taxes, the Miller and Modigliani approachfailstoexplainthefinancingdecisionandfirmsvalue.

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Agency costs: A firm requiring loan approach creditors and creditors may sometimes impose protectivecovenantstoprotecttheirpositions.Suchrestrictionmaybeinthenatureofobtainingprior approvalofcreditorsforfurtherloans,appointmentofkeypersons,restrictionondividendpayouts, limitingfurtherissueofcapital,limitingnewinvestmentsorexpansionschemesetc. SelfAssessmentQuestions1 1. Financingmixdecisionsare_______________andhavenoimpactonthe_____________ofthe firm. 2. Thevalueofafirmisdependentonits_____________andthe________. 3. _________and_______aretwoimportantsourcesoflongtermsourcesoffinanceofafirm. 4. Astheratioofdebttoequityincreases,the________declinesand_____________offirm increases. 5. AspertheNOIapproachthe____________remainsconstantforalldegreesofleverage. 6. ________istheprocessofbuyingasecurityatlowerpriceinonemarketandsellingitinanother marketatahigherpricebringingabout_______. 7.5

Summary

AccordingtotheNIApproach,overallcostofcapitalcontinuouslydecreasesasandwhendebtgoes upinthecapitalstructure.Optimalcapitalstructureexistswhenthefirmborrowsmaximum. NOIApproachbelievesthatcapitalstructureisnotrelevant.Koisdependentbusinessriskwhichis assumedtobeconstant. TraditionalApproachtellsusthatKodecreaseswithleverageinthebeginning,reachesitsmaximum pointandfurtherincreases. MillerandModiglianiApproachalsobelievesthatcapitalstructureisnotrelevant. TerminalQuestions 1. WhataretheassumptionsofMMapproach? 2. Thefollowingdataareavailableinrespectof2firms.Whatistheaveragecostofcapital? FirmA Netoperatingincome Interestondebt Equityearnings Rs.500000 Nil Rs.500000 FirmB Rs.500000 Rs.50000 Rs.450000 111

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Costofequitycapital Costofdebt Marketvalueofequityshares Marketvalueofdebt Totalvalueoffirm

15% Nil Rs.2000000 Nil Rs.2000000

15% 10% Rs.1400000 Rs.400000 Rs.1800000

3. Twocompaniesareidenticalinallrespectsinallaspectsexceptthedebtequityprofile.Company X has 14% debentures worth Rs. 2500000 whereas company Y doesnot haveanydebt.Both companiesearn20%beforeinterestandtaxesontheirtotalassetsofRs.5000000.Assuminga taxrateof40%,andcostofequitycapitaltobe22%,whatisthevalueofthecompanyXandY usingNetoperatingincomeapproach? 4. ThemarketvalueofdebtandequityofafirmareRs.10crandRs.20Cr.respectivelyandtheir respective costs are 12% and 14%. The overall capital is 13%. Assuming the company has a 100% dividend payout ratio and there are no taxes, calculate the net operating income of the firm. 5. If a company has equity worth Rs. 300 lakhs, debentures worth Rs. 400 lakhs and term loan worthRs.50lakhs,calculatetheWACC. AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions 1. Investmentdecisions,operatingearnings 2. Expectedfutureearnings,requiredrateofreturn 3. Equitydebt 4. WACCmarketvalue 5. Overallcapitalizationrate 6. Arbitrageequilibrium AnswerstoTerminalQuestions:

1. Referto6.4.4
2,3,4.K0=[B/(B+S)]Kd+[S/(B+S)]Ke 5.WACC= WeKe+WpKp+WrKr+WdKd+WtKt Hint:W e=0.4W d=0.533W t=0.067

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Unit8
Structure

CapitalBudgeting

8.1. 8.2. 8.3. 8.4. 8.5. 8.6. 8.7.

Introduction ImportanceofCapitalbudgeting ComplexitiesinvolvedinCapitalbudgetingdecisions PhasesofCapitalexpendituredecisions Identificationofinvestmentopportunities RationaleofCapitalbudgetingproposals CapitalBudgetingprocess 8.7.1 Technicalappraisal 8.7.2 EconomicAppraisal

8.8. 8.9.

InvestmentEvaluation Appraisalcriteria 8.9.1 Traditionaltechniques 8.9.2 Discountedpaybackperiod

8.10. Summary TerminalQuestions AnswertoSAQsandTQs

8.1 Introduction HDFCBanktakesoverCenturionBankofPunjab.ICICIBanktookoverBankofMadurai.The motivebehindall these mergers is to grow becauseinthisera of globalization theneedof the hour is to grow as big as possible. In all these, one could observe that the desire of the managementtocreatevalueforshareholdersisthemotivatingforce. Another way of growing is through branch expansion, expanding the product mixand reducing cost through improved technology for deeper penetration into the market for the companys products.Forexample,abankwhichisurbanbased,forexpansiontakesoverabankwithrural network. HereurbanbasedbankcanopenmoreurbanbranchesonlywhenitmeetstheReserve BankofIndiaguidelineofhavingaminimumnumberofruralbranches.Thisisthemotiveforthe mergerofurbanbasedbankofICICIwiththeruralbasedBankofMadurai.

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In this competitive arena proactive organization makes attempts to convert challenges into opportunities.Indianeconomyisgrowingat9%.Ithasfarreachingimplications.Newlinesof businesssuchas retailing, investment advisory servicesandprivatebankingareemerging. All theseinvolveinvestmentdecisions.Theseinvestmentdecisionsthatcorporatestaketoreapthe benefits arising out of the emerging business opportunities are known as Capital Budgeting decisions.Capitalbudgetingdecisionsinvolveevaluationofspecificinvestmentproposals.Here the word capital refers to the operating assets used in production of goods or rendering of services. Budgeting involves formulating a plan of the expected cash flows during the future period.When wecombineCapital withbudgetwegetCapitalbudget.Capitalbudgetisablue printofplannedinvestmentsinoperatingassets.Therefore,Capitalbudgetingistheprocessof evaluatingtheprofitabilityoftheprojectsunderconsiderationanddecidingontheproposaltobe includedintheCapitalbudgetforimplementation.Capitalbudgetingdecisionsinvolveinvestment ofcurrentfundsinanticipationofcashflowsoccurringoveraseriesofyearsinfuture.Allthese decisions are Strategic because they change the profile of the organizations. Successful organizations have created wealth for their shareholders through Capital budgeting decisions. Investmentofcurrentfundsinlongtermassetsforgenerationofcashflowsinfutureoveraseries ofyearscharacterizesthenatureofCapitalBudgetingdecisions.

LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1. Explaintheconceptofcapitalbudgeting. 2. Bringouttheimportanceofcapitalbudgeting. 3. Examinethecomplexityofcapitalbudgetingprocedures. 4. Discussthevarioustechniquesofappraisalmethods. 5. Evaluatecapitalbudgetingdecision

8.2 ImportanceofCapitalbudgeting
CapitalbudgetingdecisionsarethemostimportantdecisionsinCorporatefinancialmanagement. Thesedecisionsmakeormarabusinessorganization.Thesedecisionscommitafirmtoinvest itscurrentfundsintheoperatingassets(i,elongtermassets)withthehopeofemployingthem mostefficientlytogenerateaseriesofcashflowsinfuture. Thesedecisionscouldbegroupedinto

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1. Replacement decisions: These decisions may be decision to replace the equipments for maintenanceofcurrentlevelofbusinessordecisionsaimingatcostreductions. 2. Decisions on expenditure for increasing the present operating level or expansion through improvednetworkofdistribution. 3. Decisionsforproductsofnewgoodsorrenderingofnewservices. 4. Decisionsonpenetrating intonewgeographicalarea. 5. Decisions to comply with the regulatory structure affecting the operations of the company. InvestmentsinassetstocomplywiththeconditionsimposedbyEnvironmentalProtectionAct comeunderthiscategory. 6. Decisions on investment to build township for providing residential accommodation to employeesworkinginamanufacturingplant.

Therearemanyreasonsthat maketheCapitalbudgetingdecisionsthemostcrucialforfinance managers 1. Thesedecisionsinvolvelargeoutlayoffundsnowinanticipationofcashflowsinfuture.For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables.Themostcrucialvariableisthesalesforecast. a. For example, Metal Box spent large sums of money on expansion of its production facilitiesbasedonitsownsalesforecast.Duringthisperiod,hugeinvestmentsinR&Din packaging industry brought about new packaging medium totally replacing metal as an importantcomponentofpackingboxes.AttheendoftheexpansionMetalBoxLtdfound itself that the marketforitsmetal boxes had declineddrastically. The end resultis that Metal Box became a sick company from the position it enjoyed earlier prior to the executionofexpansionasabluechip.Employeeslosttheirjobs.Itaffectedthestandard ofliningandcashflowpositionofitsemployees. Thishighlightstheelementofriskinvolvedinthesetypeofdecisions. b. Equally we have empirical evidence of companies which took decisions on expansion throughtheadditionofnewproductsandadoptionofthelatesttechnologycreatingwealth forshareholders.ThebestexampleistheReliancegroup. c. Any seriouserrorinforecastingSales andhence the amountof capital expenditurecan significantlyaffectthefirm.Anupwardbiasmayleadtoasituationofthefirmcreatingidle capacity,layingthepathforthecancerofsickness.

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d. Anydownwardbiasinforecastingmayleadthefirmtoasituationoflosingitsmarkettoits competitors.Bothareriskyfraughtwithgraveconsequences.

2. Alongterminvestmentoffundssometimesmaychangetheriskprofileofthefirm.AFMCG companywithitscorecompetenciesinthebusinessdecidedtoenterintoanewbusinessof power generation. This decision will totally alter the risk profile of the business of the company.Investorsperceptionofriskofthenewbusinesstobetakenupbythecompany willchangehisrequiredrateofreturntoinvestinthecompany.Inthisconnectionitistobe noted that the power pricing is a politically sensitive area affecting the profitability of the organization. Therefore, Capital budgeting decisions change the risk dimensions of the companyandhencetherequiredrateofreturnthattheinvestorswant. 3. MostoftheCapitalbudgetingdecisionsinvolvehugeoutlay.Thefundsrequirementsduring thephaseofexecutionmustbesynchronized withtheflowoffunds.Failuretoachievethe requiredcoordinationbetweentheinflowandoutflowmaycausetimeoverrunandcostover run. These two problems of time over run and cost over run have to be prevented from occurring in the beginning of execution of the project. Quite a lot empirical examples are thereinpublicsectorinIndiainsupportofthisargumentthatcostoverrunandtimeoverrun can make a companys operations unproductive. But the major challenge that the management of a firm faces in managing the uncertain future cash inflows and out flows associatedwiththeplanandexecutionofCapitalbudgetingdecisions. 4. Capital budgeting decisions involve assessment of market for companys products and services, deciding on the scale of operations, selection of relevant technology and finally procurementofcostlyequipment.Ifafirmweretorealizeaftercommittingitselfconsiderable sumsofmoneyintheprocessofimplementingtheCapitalbudgetingdecisionstakenthatthe decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipmentswillbespecializedcostlyequipments.Therefore,Capitalbudgetingdecisionsare irreversible. 5. ThemostdifficultaspectofCapitalbudgetingdecisionsistheinfluenceoftime.Afirmincurs Capitalexpendituretobuildupcapacityinanticipationoftheexpectedboominthedemand foritsproducts.ThetimingoftheCapitalexpendituredecisionmustmatchwiththeexpected boomindemandforcompanysproducts.Ifitplansinadvanceitmayeffectivelymanagethe

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timingandthequalityofassetacquisition.Butmanyfirmssufferfromitsinabilitytoforecast the future operations and formulate strategic decision to acquire the required assets in advanceatthecompetitiverates. 6. All Capital budgeting decisions have three strategic elements. These three elements are cost,quality and timing. Decisions must betaken at the right time which wouldenablethe firmtoprocuretheassetsattheleastcostforproducingtheproductsofrequiredqualityfor customer.Anylapseonthepartofthefirminunderstandingtheeffectoftheseelementson implementation of Capital expenditure decision taken will strategically affect the firms profitability. 7. Liberalization and globalization gave birth to economic institutions like World Trade organization.GeneralElectricalcanexpanditsmarketintoIndiasnatchingthesharealready enjoyedbyfirmslikeBajajElectricalsorKirloskarElectricCompany.AbilityofGEtosellits products in India at a rate less than the rate at which Indian Companies sell cannot be ignored. Therefore, the growth and survival of any firm in todays business environment demandsafirmtobeproactive.Proactivefirmscannotavoidtheriskoftakingchallenging Capitalbudgetingdecisionsforgrowth. Therefore,Capitalbudgetingdecisionsforgrowthhavebecomeanessentialcharacteristicsof successfulfirmstoday. 8. Thesocial,political,economicandtechnologicalforcesgeneratehighlevelofuncertaintyin futurecashflowsstreamsassociatedwithCapitalbudgetingdecisions.Thesefactors make thesedecisionshighlycomplex. 9. Capital expenditure decisions are very expensive. To implement these decisions firms will havetotaptheCapitalmarketforfunds.Thecompositionofdebtandequitymustbeoptimal keepinginviewtheexpectationofinvestorsandriskprofileoftheselectedproject.

SelfAssessmentQuestions1 1. ______________makeormarabusiness. 2. _____decisionsinvolvelargeoutlayoffundsnowinanticipationofcashinflowsinfuture. 3. Social, political, economic and technological forces make capital budgeting decisions ________________. 4. ________areveryexpensive.

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8.3 ComplexitiesinvolvedinCapitalbudgetingdecisions
Capitalexpendituredecisioninvolvesforecastingoffutureoperatingcashflows.Suchforecasting suffersfromuncertaintybecausethefutureishighlyuncertain.Forecastingthefuturecashflows demandsthenecessitytomakecertainassumptionsaboutthebehaviourofcostsandrevenues infuture.Fastchangingenvironmentmakesthetechnologyconsideredforimplementationmany timesobsolete.Forexample,thearrivalofmobilerevolutiontotallymadethepagertechnology obsolete.Thefirmswhichinvestedinpagersfacedtheproblemofpagerslosingitsrelevanceas a means of communication. The firms with the ability to adapt the new knowhow in mobile technology could survive the effect of this phase of technological obsolescence. Others who could not manage the effect of change in technology had a natural death and so most Capital expenditure decisions are irreversible. Estimation of future cash flows of Capital budgeting decisionsisreally complex and difficult commitment offunds onlong termbasis along with the associated problem of irreversibility of decisions and difficulty in estimating cash flows makes Capitalexpendituredecisionscomplexinnature.

SelfAssessmentQuestions2 1. Capitalexpendituredecisionsare____________. 2. Forecasting of future operating cash flows suffers from ____ because the future is ____________________.

8.4 PhasesofCapitalexpendituredecisions: ThefollowingstepsareinvolvedinCapitalbudgetingdecisions: 1. Identificationofinvestmentopportunities. 2. Evaluationofeachinvestmentproposal. 3. Examinetheinvestmentsrequiredforeachinvestmentproposal. 4. PreparethestatementsofCostsandbenefitsofinvestmentproposals. 5. Estimate and compare the net present values of the investment proposals that have been clearedbythemanagementonthebasisofscreeningcriteria. 6. Examine the government policiesand regulatory guidelinesto be observedfor execution of each investment proposal screened and cleared based on the criteria stipulated by the management. 7. Budgetingforcapitalexpenditureforapprovalbythemanagement. 8. Implementation. 9. Post_completionaudit.

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SelfAssessmentQuestions3 1. Postcompletionauditis_____inthephasesofcapitalbudgetingdecisions. 2. Identification of investment opportunities is the ______ in the phases of capital budgeting decisions.

8.5 Identificationofinvestmentopportunities:
Afirmisinapositiontoidentifyinvestmentproposalonly whenitisresponsivetotheideasfor capital projects emergingfromvariouslevelsoftheorganization. The proposal may beadding newproductstothecompanysproductline,expansionofcapacitytomeettheemergingmarket atdemandforcompanysproductstomeettheemergingmarketdemandforcompanysproduct ornewtechnologybasedprocessofmanufacturethatwillreducethecostofproduction. Forexample,asalesmanagermaycomewithaproposaltoproduceanewproductasperthe requirements of companys consumers. Marketing manager, based on the sales managers proposal may conducta market survey todetermine the expected demandforthe new product under consideration. Once the marketing manager is convinced of the market potential for proposednewproducttheproposalgoestotheengineerstoexaminethesamewithallaspects of production process. Then the proposal goes to the cost accountant to translate the entire gamutoftheproposalintocostsandrevenuesintermsofincrementalcashflowsbothoutflows and inflows. The costbenefit statement generated by cost accountant shall include all incremental costs and benefits that the firm will incur and derive on commercialization of the proposal under consideration. Therefore, generation of ideas with the feasibility to convert the same into investment proposals occupies a crucial place in the Capital budgeting decisions. Proactiveorganizations encourage a continuous flow of investment proposals from alllevels in theorganization. Inthisconnectionfollowingdeservestobeconsidered: 1. MarketCharacteristics: Analysingthedemandandsupplyconditionsofthemarketforthe companysproductcouldbeafertilesourceofpotentialinvestmentproposals. 2. Various reports submitted by production engineers coupled with the information obtained throughmarketsurveysoncustomersperceptionofcompanysproductcouldbeapotential investmentproposaltoredefinethecompanysproductsintermsofcustomersexpectations. 3. CompanieswhichinvestinResearchandDevelopmentconstantlygetexposuretothebenefit of adapting the new technology quite relevant to keep the firm competitive in the most dynamic businessenvironment. Reports emergingfrom R& D section couldbe a potential sourceofinvestmentproposal.

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4. Economic growth of the country and the emerging middle class endowed with purchasing power could generate new business opportunities to existing firms. These new business opportunitiescouldbepotentialinvestmentideas. 5. Public awarenessof their rights compels many firms toinitiateprojectsfrom environmental protection angle. If ignored, the firm may have to face the public wrath through PILs entertainedattheSupremecourtandHighcourts. Therefore, project ideas that would improve the competitiveness of the firm by constantly improving the production process with the sole objective of cost reduction and costumer welfareareacceptedbywellmanagedfirms. Therefore,generationofideasforcapitalprojectsandscreeningthesamecanbeconsidered themostcrucialphaseofCapitalbudgetingdecisions.

SelfAssessmentQuestions4 1. Analyzingthedemandandsupplyconditionsofthemarketforthecompanysproductscould be________ofpotentialinvestmentproposal. 2. Generationofideasforcapitalbudgetsandscreeningthesamecanbeconsidered __________ofcapitalbudgetarydecisions.

8.6RationaleofCapitalbudgetingproposals:
Theinvestorsandstakeholdersexpectafirmtofunctionefficientlytosatisfytheirexpectations. Through the stake holders expectation of the performance of the company may clash among themselves,theonethattouchesallthesestakeholdersexpectationcouldbevisualizedinterms of the firms obligation to reduce the operating costs on a continuous basis and increasing its revenues. These twin obligations of a firm form the basis of all Capital budgeting decisions. Therefore,Capitalbudgetingdecisionscouldbegroupedintotwocategories: 1. Decisionsoncostreductionprogrammes. 2. Decisionsonrevenuegenerationthroughexpansionofinstalledcapacity.

SelfAssessmentQuestions5 1._________decisionscouldbegroupedintotwocategories. 2.____________andrevenuegenerationarethetwoimportantcategriesofcapitalbudgeting.

8.7CapitalBudgetingprocess:Oncethescreeningofproposalsforpotentialinvolvementis overthenext.ThecompanyshouldtakeupthefollowingaspectsofCapitalBudgetingprocess.

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1. Commercial: A proposal should be commercially viable. The following aspects are examinedtoascertainthecommercialviabilityofanyinvestmentproposal. a. Marketfortheproduct b. Availabilityofrawmaterials c. Sourcesofrawmaterials d. Theelementsthatinfluencethelocationofaplanti,e,thefactorstobeconsideredinthesite selection. 2. Infrastructural facilities such as roads, communications facilities, financial services such as banking,publictransportservices. Amongtheaspectsmentionedabovethecrucialoneistheneedtoascertainthedemandfor the productor services. Itis done by marketappraisal. Inappraisalof marketfor thenew product,thefollowingdetailsarecompiledandanalyzed. a. Consumptiontrends. b. Competitionandplayersinthemarket c. Availabilityofsubstitutes d. Purchasingpowerofconsumers e. RegulationsstipulatedbyGovernmentonpricingtheproposedproductsorservices f. Production constraints: Relevant forecasting technologies are employed to get a realistic picture of the potential demand for the proposed product or service. Many projects fail to achieve the planned targets on profitability and cash flows if the firm could not succeed in forecastingthedemandfortheproductonarealisticbasis.

8.7.1 Technicalappraisal: Thisappraisalisdonetoensurethatalltechnicalaspectsofthe implementationoftheprojectareconsidered. Thetechnicalexaminationoftheprojectconsidersthefollowing: a. Selectionofprocessknowhow b. Decisionondeterminationofplantcapacity c. Selectionofplantandequipmentandscaleofoperation d. Plantdesignandlayout e. Generallayoutandmaternalflow f. Constructionschedule

8.7.2 Economic Appraisal: This appraisal examines the project from the social point of view.Itisalsoknownassocialcostbenefitanalysis.Itexamines:

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g. Theimpactoftheprojectontheenvironment h. Theimpactoftheprojectontheincomedistributioninthesociety. i. The impact of the project on fulfillment of certain social objective like generation of employment,attainmentofselfsufficiencyetc. j. Willitmateriallyalterthelevelofsavingsandinvestmentinthesociety?

3. Financial appraisal: This appraisalis to examine the financial viability of the project. It assesses the risk and returns at various stages of project execution. Besides, it examines whether the risk adjusted return from the project exceeds the cost of financing the project. Thefollowingaspectsareexaminedintheprocessofevaluatingaprojectinfinanciallyterms. a. Costoftheproject b. Investmentoutlay c. Meansoffinancingandthecostofcapital d. Expectedprofitability e. Expectedincrementalcashflowsfromtheproject f. Breakevenpoint g. Cashbreakevenpoint h. Riskdimensionsoftheproject i. Willtheprojectmateriallyaltertheriskprofileofthecompany? j. Iftheprojectisfinancedbydebt,expectedDebtServiceCoverageRatio k. Taxholidaybenefits,ifany

SelfAssessmentQuestions6 1. ______________examinestheprojectfromthesocialpointview. 2. Alltechnicalaspectsoftheimplementationoftheprojectareconsideredin_____. 3. ___ofaprojectisexaminedbyfinancialappraisal. 4. Among the elements that are to be examined under commernal appraised the most crucial oneisthe_________________. 8.8 InvestmentEvaluation: followingstepsareinvolvedintheevaluationofanyinvestment proposal: 1. EstimatesofCashflowsbothinflowsandoutflowsoccurringatdifferentstagesofprojectlife cycle. 2. Examinationoftheriskprofileoftheprojecttobetakenupandarrivingattherequiredrateof return

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3. Formulatingthedecisioncriteria.

Estimation of Cash flows: Estimating the cash flows associated with the project under considerationisthemostdifficultandcrucialstepintheevaluationofaninvestmentproposal.It istheresultoftheteamworkofmanyprofessionalsinanorganization. 1. Capital outlays are estimated by engineering departments after examining all aspects of productionprocess. 2. Marketing department on the basis of market survey forecasts the expected sales revenue duringtheperiodofaccrualofbenefitsfromprojectexecutions. 3. Operatingcostsareestimatedbycostaccountantsandproductionengineers 4. Incrementalcashflowsandcashoutflowstatementispreparedbythecostaccountantonthe basisofthedetailsgeneratedintheabovesteps.Theabilityofthefirmtoforecastthecash flows with reasonableaccuracy liesat the rootofthe successof theimplementationofany capitalexpendituredecision. Investment (Capital budgeting) decision required the estimation of incremental cash flow stream over the life of the investment. Incremental cash flows are estimated on after tax basis. Incrementalcashflowsstreamofacapitalexpendituredecisionhasthreecomponents. 1. InitialCashoutlay(Initialinvestment):Initialcashoutlaytobeincurredisdeterminedafter consideringanyposttaxcashinflowsifany,Inreplacementdecisionsexistingoldmachinery is disposed of and a new machinery incorporating the latest technology is installed in its place.Ondisposalofexistingoldmachinerythefirmhasacashinflow.Thiscashinflowhas tobecomputedonposttaxbasis.Thenetcashoutflow(totalcashrequiredforinvestmentin capitalassetsminusposttaxcashinflowondisposaloftheoldmachinerybeingreplacedby anewone)thereforeistheincrementalcashoutflow.Additionalnetworkingcapitalrequired onimplementationofnewprojectistobeaddedtoinitialinvestment. 2. OperatingCashinflows:OperatingCashinflowsareestimatedfortheentireeconomiclifeof investment(project).Operatingcashinflowsconstitute astreamofinflowsandoutflowsover the life of the project. Here also incremental inflows and outflows attributable to operating activitiesareconsidered.Anysavingsincostoninstallationofanewmachineryintheplace of the old machinery will have to be accounted to on post tax basis. In this connection incrementalcashflowsrefertothechangeincashflowsonimplementationofanewproposal overtheexistingpositions.

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3. TerminalCashinflows: Attheendoftheeconomiclifeoftheproject,theoperatingassets installednowwillbedisposedoff.Itisnormallyknownassalvagevalueofequipments.This terminalcashinflowsiscomputedonposttaxbasis. Prof. Prasanna Chandra in his book Financial Management has identified certain basic principlesofcashflow estimation. The knowledge oftheseprinciples will help a studentin understandingthebasisofcomputingincrementalcashflows. Theseprinciples,asgivenbyProf.PrasannaChandraare: a. Separationprinciple b. Incrementalprinciple c. Posttaxprinciple d. Consistencyprinciple a. Separationprinciple: Theessenceofthisprincipleisthenecessitytotreatinvestment element of the project separately (i,e independently) from that of financing element. The financing costis computed by the cost of capital. Cost ofcapitalisthe cutoff rate and rate of returnexpectedonimplementationoftheprojectiscomparedwiththecostofcapital.Therefore, we compute separately cost offundsforexecutionofproject throughthefinancing mode. The rateofreturnexpectedonimplementationiftheprojectisarrivedatbytheinvestmentprofileof theprojects.Therefore,interestondebtisignoredwhilearrivingatoperatingcashinflows. Thefollowingformulaeisusedtocalculateprofitaftertax. IncrementalPAT=IncrementalEBIT(1t) (Incremental)(Incremental) EBIT=Earnings(Profit)beforeinterestandtaxes. t=taxrate EBITinfactrepresentsincrementalearningsbeforeinterestandtax Whendepreciationchargesoncomputingincrementalposttaxprofitisaddedbacktoincremental profitaftertax,wegetincrementaloperatingcashinflow.

b. Incrementalprinciple:Incrementalprinciplesaysthatthecashflowsofaprojectareto beconsideredinincrementalterms.Incrementalcashflowsarethechangesinthefirms totalcashflowsarisingdirectlyfromtheimplementationoftheproject. Thefollowingaretobekeptinmindindeterminingincrementalcashflows. 1. IgnoreSunkcosts: Asunkcostmeansanoutlayalreadyincurred.Itisnotarelevantcost for the project decisions to be taken now. It is ignored when the decisions on project now underconsiderationistobetaken.

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2. OpportunityCosts: Ifthefirmalreadyownsanassetorresourcewhichcouldbeusedinthe execution of the project under consideration theasset or resource has an opportunity cost. Theopportunityofcostofsuchresourceswillhavetobetakenintoaccountintheevaluation oftheprojectfor acceptanceor rejection. For example,thefirm wants to openabranchin Chennai for expansion of its market in Tamil Nadu. The firm already owns a building in Chennai. The building in Chennai is let out to some other firm on an annual rent of Rs.1 Crore.ThefirmtakesadecisiontoopenabrandsatChennai.Foropeningthebranchat Chennaithefirmusesthebuildingitownsbysacrificingtherentalincome whichitreceives now. The opportunity cost of the building at Chennai is Rs.1 crores. This will have to be considered in arriving at the operating cash flows associated with the decision to open a branchatChennai. 3. Need to takeintoaccount all incident effect:Effectsof aproject on the workingof other parts of a firm also known as externalities must be taken into account. For example, expansion or establishment of a branch at a new place may increase the profitability of existing branches because the branch at the new place has a complementary relationship withtheotherexistingbranchesorreducetheprofitabilityofexistingbranchesbecausethe branchatthenewplacecompeteswiththebusinessofotherexistingbranchesortakesaway somebusinessactivitiesfromtheexistingbranches. Cannibalization: Another problem that a firm faces on introduction of a new product is the reductioninthesaleofanexistingproduct.Thisiscalledcannibalization.Themostchallenging task is the handling of problems of cannibalization. Depending on the companys position with that of the competitors in the market, appropriate strategy has to follow. Correspondingly the costofcannibalizationwillhavetobetreatedeitherasrevelentcostofthedecisionorignored. Productcannibalization willaffectthe companys sales if thefirm is marketingitsproducts in a marketcharacterizedbyseverecompetition,withoutanyentrybarriers. In this case costs are not relevant for decision. On the other hand if the firms sales are not affected by competitors activities due to certain unique protection that it enjoys on account of brand positioning or patent protection the costs of cannibalization cannot be ignored in taking decisions c.PostTaxPrinciple: allcashflowsshouldbecomputedonposttaxbasis d. Consistencyprinciple: cashflowsanddiscountratesusedinprojectevaluationneedto consistentwiththeinvestorgroupandinflation.

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In capital budgeting, the cash flows applicable to all investors (i.e equity, preference share holders anddebt holders) and weightedaverage cost of capital areconsidered. Nominal cash flowsandnominaldiscountsareconsideredincapitalbudgetingdecision. Example(illustration) Afirmconsideringreplacementofitsexistingmachinebyanewmachine.Thenewmachinewill costRs1,60,000andhavealifeoffiveyears.Thenewmachinewillyieldannualcashrevenue of Rs 2,50,000 andincur annual cashexpensesof Rs 1,30,000. The estimated salvage ofthe newmachineattheendofitseconomiclifeisRs8,000.Theexistingmachinehasabookvalue ofRs40,000andcanbesoldforRs20,000.Theexistingmachine,ifusedforthenextfiveyears is expected to generate annual cash revenue of Rs 2,00,000 and to involve annual cash expensesofRs1,40,000.Ifsoldafterfiveyears,thesalvagevalueoftheexistingmachinewill benegligible. Thecompanypaystaxat30%.Itwritesoffdepreciationact25%onthewrittendownvalue.The companyslostofcapitalis20% Computetheincrementalcashflowsofreplacementdecisions.

Solution: InitialInvestment: Grossinvestmentforthenewmachine Less:Cashreceivedfromthesaleof Existingmachine Netcashoutlay 20,000 (1,40,000) (1,60,000)

AnnualCashflowsfromoperations Incrementalcashflowsfromrevenue50,000 Incrementaldecreaseinexpenditure(10,000) IncrementalDepreciationSchedule

Year

Depreciation (NewMachine(Rs.)

Depreciation (OldMachine) 10,000 7,500 5,625

Incremental Depreciation(Rs.) 35,000 26,250 19,687

1 2 3

45,000 33,750 25,312

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4 5

18,984 14,238

4,219 3,164

14,765 11,074

Depreciationiscalculatedasunder BookValue Add:Costofnewmachine 40,000 1,60,000 2,00,000 Less:SaleproceedsofOldMachine 20,000 1,80,000 DepreciationforIyear25% 45,000 1,35,000 DepreciationforIIyear25% 33,750 1,01,250 DepreciationforIIIyear25% 25,312 75,938 DepreciationforIVyear25% 18,984 56,954 DepreciationforVyear25% Bookvalueafter5years 14,238 42,716

StatementofincrementalCashflows Particulars 0Rs 1.Investmentinnew machine 2.Aftertaxsalvagevalue ofoldmachine 3.NetCashOutlay (1,40,000) 20,000 (1,60,000) 1Rs Year 2Rs 3Rs 4Rs 5Rs

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4.Increaseinrevenue 5.Decreaseinexpenses 6.Increaseindepreciation 7.IncreaseinEBIT 8.EBIT(1T) 9.IncrementalCashflows fromoperation(8+6) 10.Salvagevalueofnew machine 11.IncrementalCash flows (1,40,000) negative

50,000 10,000 35,000 25,000 17,500 52,500

50,000 10,000 26,250 33,750 23,625 49,875

50,000 10,000 19,687 40,313 28,219 47,906

50,000 10,000 14,765 45,235 31,665 46,430

50,000 10,000 11,074 48,926 34,248 45,322

8,000

52,500

49,875

47,906

46,430

53,322

Thefollowingpointstobekeptindecidingontheappraisaltechnique: 1. Appraisaltechniqueshouldmeasuretheeconomicworthoftheproject. 2. Wealthmaximizationofshareholdersshallbetheguidingprinciple. 3. Itshallconsiderallcashflowsovertheentirelifeoftheprojecttoascertaintheprofitabilityof theproject. 4. Itshallranktheprojectsonascientificbasis. 5. It should ensure an accepted criterion when faced with the need to select fromamong the projectswhicharemutuallyexclusivesoastomakeacorrectchoice. 6. Itshouldrecognizethefactthatinitialhighercashflowsaretobepreferredtosmallerones. 7. Earliercashflowsarepreferredtothatoccurringlater.

SelfAssessmentQuestions7 1. Formulating_isthethirdstepintheevaluationofinvestmentproposal. 2. A_____________isnotarelevantcostfortheprojectdecision. 3. Effectofaprojectontheworkingofotherpartsofafirmisknowas________. 4. Theessenceofseparationprincipleisthenecessitytotreat________ofaprojectseparately fromthatof________. 5. Paybackperiod________timevalueofmoney. 6. IRRgivesarateofreturnthatreflectsthe__theproject.

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8.9 Appraisal Criteria: The methodsof appraising aninvestmentproposal can be grouped into 1. Traditionalmethods. 2. Modernmethods. TraditionalMethodare: i. Paybackmethod. ii. AccountingRateofReturn. Moderntechniquesare: a. Netpresentvalue. b. InternalRateofRate. c. Modifiedinternalrateofreturn. d. Profitabilityindex.

8.9.1TraditionalTechniques: a. Payback method: payback period is defined as the length of time required to recover the initialcashoutlay. Example:ThefollowingdetailsareavailableinrespectofthecashflowsoftwoprojectsA&B

Year

ProjectA Cashflows(Rs.)

ProjectB Cashflows(Rs.) (5,00,000) 1,00,000 2,00,000 3,00,000 4,00,000 2,00,000

0 1 2 3 4 5

(4,00,000) 2,00,000 1,75,000 25,000 2,00,000 1,50,000

ComputepaybackperiodforAandB Solution: Year ProjectA Cashflows(Rs.) Cumulative Cashflows 1 2 2,00,000 1,75,000 2,00,000 3,75,000 1,00,000 2,00,000 ProjectB Cashflows(Rs.) Cumulative Cashflows 1,00,000 3,00,000

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3 4 5

25,000 2,00,000 1,50,000

4,00,000 6,00,000 7,50,000

3,00,000 4,00,000 2,00,000

6,00,000 10,00,000 12,00,000

From the cumulative cash flows column project A recovers the initial cash outlay of Rs 4,00,000attheendofthethirdyear.Therefore,paybackperiodofprojectAis3years. FromthecumulativecashflowcolumntheinitialcashoutlayofRs5,00,000liesbetween
nd rd 2 yearand3 yearinrespectofprojectB.Therefore,paybackperiodforprojectBis:

5,00,0003,00,000

2+
=2.67years

3,00,000

Evaluationofpaybackperiod: Merits: 1. Simpleinconceptandapplication. 2. Since emphasis is on recovery of initial cash outlay it is the best method for evaluation of projectswithveryhighuncertainty. 3. Withrespecttoacceptorrejectcriterionpaybackmethodfavorsaprojectwhichislessthan orequaltothestandardpaybacksetbythemanagement.Inthisprocessearlycashflows getduerecognition thanlatercashflows.Therefore,paybackperiodcouldbeusedasatool todealwiththerankingofprojectsonthebasisofriskcriterion. 4. Forfirmswithshortagefundsthisispreferredbecauseitmeasuresliquidityoftheproject. Demerits: 1. Itignorestimevalueofmoney. 2. Itdoesnotconsiderthecashflowsthatoccurafterthepaybackperiod. 3. Itdoesnotmeasuretheprofitabilityoftheproject. 4. Itdoesnotthrowanylightonthefirmsliquiditypositionbutjusttellsabouttheabilityofthe projecttoreturnthecashoutlayoriginallymade. 5. Project selected on the basis of pay back criterion may be in conflict with the wealth maximizationgoalofthefirm. Acceptorrejectcriterion: a. Ifprojectsaremutuallyexclusive,selecttheprojectwhichhastheleastpaybackperiod. b. Inrespectofotherprojects,selecttheprojectwhichhavepaybackperiodlessthanorequal tothestandardpaybackstipulatedbythemanagement. Illustration:

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Followingdetailsareavailable Paybackperiod: ProjectA=3years ProjectB=2.5years Standardsetupbymanagement=3years Ifprojectsaremutuallyexclusive,acceptprojectBwhichhastheleastpaybackperiod. Ifprojectsarenotmutuallyexclusive,acceptboththeprojectbecausebothhavepaybackperiod lessthanorequaltooriginaltothestandardpaybackperiodsetbythemanagement Paybackperiod formula YearPriortofullrecovery Ofinitialoutlay + Balanceofinitialoutlaytoberecovered atthebeginningoftheyearinwhichfull Recoverytakesplace Cashinflowoftheyearinwhichfullrecovery takesplace

8.9.2 DiscountedPayBackPeriod: Thelengthinyearsrequiredtorecovertheinitialcashoutlayonthepresentvaluebasisiscalled thediscounted pay back period. The opportunity cost of capitalis usedfor calculatingpresent valuesofcashinflows. Discounted pay back period for a project will be always higher than simple pay back period becausethecalculationofdiscountedpaybackperiodisbasedondiscountedcashflows.

Forexample: Year ProjectA Cashflows 0 1 2 3 4 5 (4,00,000) 2,00,000 1,75,000 25,000 2,00,000 1,50,000 PVfactorat10 % 1 0.909 0.826 0.751 0.683 0.621 PVofCash flows (4,00,000) 1,81,800 1,44,550 18,775 1,36,600 93,150 Cumulativepositive Cashflows 1,81,800 3,26,350 3,45,125 4,81,725 5,74,875

DiscountedPaybackperiod:

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4,00,0003,45,125

3+

1,36,600

=3.4years

Accountingrateofreturns: ARR measures the profitability of investment (project) using information taken from financial statements: Averageincome

ARR=

Averageinvestment

Averageofposttaxoperatingprofits Averageinvestment

Averageinvestment=

Bookvalueoftheinvestment Inthebeginning

Bookvalueofinvestmentattheendof thelifeoftheprojectorinvestment

2 Illustration: Thefollowingparticularrefertotwoprojects: X Cost Estimatedlife Salvagevalue Estimateincome Aftertax Rs 1 2 3 4 5 Total Average 3,000 4,000 7,000 6,000 8,000 28,000 5,600 Rs 10,000 8,000 2,000 6,000 5,000 31,000 6,200 40,000 5years Rs.3,000 Y 60,000 5years Rs.3,000

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Averageinvestment21,50031,500 ARR 5,600 21,500 6,200 31,500

=26%

19.7%

MeritsofAccountingrateofreturn: 1. Itisbasedonaccountinginformation. 2. Simpletounderstand. 3. Itconsiderstheprofitsofentireeconomiclifeoftheproject. 4. Since it is based on accounting information the business executives familiar with the accountinginformationunderstandthistechnique. Demerits: 1. Itisbasedonaccountingincomeandnotbasedoncashflows,asthecashflowapproachis consideredsuperiortoaccountinginformationbasedapproach. 2. Itdoesnotconsiderthetimevalueofmoney. 3. Different investment proposals which require different amounts of investment may have the same accounting rate of return. The ARR fails to differentiate projects on the basis of the amountrequiredforinvestment. 4. ARRisbasedontheinvestmentrequiredfortheproject.Therearemanyapproachesforthe calculation of denominator of average investment. Existence of more than one basis for arriving at the denominator of average investment may result in adoption of many arbitary bases. BecauseofthisthereliabilityofARRasatechniqueofappraisalisreducedwhentwoprojects withthesameARRbutwithdifferinginvestmentamountsaretobeevaluated. Acceptorrejectcriterion: AnyprojectwhichhasanARRmoretheminimumratefixedbythemanagementisaccepted.If actual ARR is less than the cuff rate (minimum rate specified by the management ) then that projectisrejected).Whenprojectsaretoberankedfordecidingontheallocationofcapitalon accountoftheneedforcapitalrationing,projectwithhigherARRarepreferredtotheoneswith lowerARR.

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Discountedcashflowmethod: Discountedcashflowmethodortimeadjustedtechniqueisanimprovementoverthetraditional techniques. In evaluation ofthe projects theneed to give weight age to the timing of returnis effectively considered in all DCF methods. DCF methods are cash flow based and take the cognizanceofboththeinterestfactorsandcashflowafterthepaybackperiod. DCFtechniqueinvolvesthefollowing. 1. Estimation of cash flows, both inflows and outflows of a project over the entire life of the project. 2. Discountingthecashflowsbyanappropriateinterestfactor(discountfactor). 3. Sumofthepresentvalueofcashoutflowsisdeductedfromthesumofpresentvalueofcash inflows to arrive at net present value of cash flows, the most popular techniques of DCF methods. DCFmethodsareof3types: 1. Thenetpresentvalue. 2. Theinternalrateofreturn. 3. Profitabilityindex.

Thenetpresentvalue: NPVmethodrecognizesthetimevalueofmoney.Itcorrectlyadmitsthatcashflowsoccurringat differenttimeperiodsdifferinvalue.Therefore,thereistheneedtofindoutthepresentvaluesof allcashflows. NPVmethodisthemostwidelyusedtechniqueamongtheDCFmethods. StepsinvolvedinNPVmethod: 1. Forecast the cash flows, both inflows and outflows of the projects to be taken up for execution. 2. Decisionsondiscountfactororinterestfactor.Theappropriatediscountrateisthefirmscost ofcapitalorrequiredrateofreturnexpectedbytheinvestors. 3. Computethepresentvalueofcashinflowsandoutflowsusingthediscountfactorselected. 4. NPV is calculated by subtracting the PV of cash outflows from the present value of cash inflows.

Acceptorrejectcriterion: If NPV is positive, the project should be accepted. If NPV is negative the project should be rejected.

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Acceptorrejectcriterioncanbesummarizedasgivenbelow: 1. NPV>Zero=accept 2. NPV<Zero=reject NPV method canbe used to select between mutually exclusive projects by examining whether incrementalinvestmentgeneratesapositivenetpresentvalue. MeritsofNPVmethod: 1. Ittakesintoaccountthetimevalueofmoney. 2. Itconsiderscashflowsoccurringovertheentirelifeoftheproject. 3. NPVmethodisconsistentthegoalofmaximizingthenetwealthofthecompany. 4. Itanalysesthemeritsofrelativecapitalinvestments. 5. Sincecostofcapitalofthefirmisthehurdlerate,theNPVensuresthattheprojectgenerates profitsfromtheinvestmentmadeforit. Demerits: 1. Forecasting of cash flows in difficult as it involves dealing with the effect of elements of uncertaintiesonoperatingactivitiesofthefirm. 2. Todecideonthediscountingfactor,thereistheneedtoassesstheinvestorsrequiredrateof returnButitisnotpossibletocomputethediscountrateprecisely. 3. Therearepracticalproblemsassociatedwiththeevaluationofprojectswithunequallivesor underfundsconstraints. For ranking of projects under NPV approach the project with the highest positive NPV is preferredtothatwithlowerNPV.

Example:AprojecttcostsRs.25000andisexpectedtogeneratecashinflowsas Year 1 2 3 Cashinflows 10,000 8,000 9,000

46,000 5 7,000

Thecostofcapitalis12%.Thepresentvaluefactorsare: Year 1 2 3 PVfactorat12% 0.893 0.797 0.712

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40.636 5 0.567

ComputetheNPVoftheproject Solution: Year Cashflows PVfactorat12 % 1 2 3 4 5 10,000 8,000 9,000 6,000 7,000 0.893 0.797 0.712 0.636 0.567 PVofCash flows 8,930 6,376 6,408 3,816 3,969 29,499

Sumofthepresentvalueofcashinflows Less:Sumofthepresentvalueofcashoutflows NPV 25,500 4,499

TheprojectgeneratesapositiveNPVofRs.4499.Therefore,projectshouldbeaccepted.

Problem: A company is evaluating two alternatives for distribution within the plant. Two alternativesare 1. Csystemwithahighinitialcostbutlowannualoperatingcosts. 2. Fsystemwhichcostslessbuthaveconsiderablyhigheroperatingcosts. The decision to construct the plant has already been made, and the choice here will have no effect on the overall revenues of the project. The cost of capital of the plant is 12% and the projectsexpectednetcostsarelistedbelow: Year ExpectedNetCashCosts CSystems 0 1 2 3 4 5 (3,00,000) (66,000) (66,000) (66,000) (66,000) (66,000) FSystems (1,20,000) (96,000) (96,000) (96,000) (96,000) (96,000)

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Whatisthepresentvalueofcostsofeachalternative? Whichmethodshouldbechosen.? Solution:Computationofpresentvalue

Year CSystems 1 2 3 4 5 (66,000) (66,000) (66,000) (66,000) (66,000) FSystemsIncremental (96,000) (96,000) (96,000) (96,000) (96,000) 30,000 30,000 30,000 30,000 30,000

Presentvalueofincrementalsavings=30,0000xPVIFA(12%,5) =30,000x3.605=1,08,150 Incrementalcashoutlay= 1,80,000 (71,850)

SincethepresentvalueofincrementalnetcashinflowsofCsystemoverFsystemisnegative.C systemisnotrecommended. Therefore,Fsystemisrecommended. PropertiesoftheNPV 1. NPVsareadditive.IftwoprojectsAandBhaveNPV(A)andNPV(B)thenbyadditiverule thenetpresentvalueofthecombinedinvestmentisNPV(A+B) 2. Intermediatecashinflowsarereinvestedatarateofreturnequaltothecostofcapital. DemeritsofNPV: 1. NPVexpressestheabsolutepositiveornegativepresentvalueofnetcashflows.Therefore, itfailstocapturethescaleofinvestment. 2. In the application of NPV rule in the evaluation of mutually exclusive projects with different lives,biasoccursinfavourofthelongtermprojects.

InternalRateofReturn: Itistherateofreturn(i,ediscountrate)whichmakestheNPVofany projectequaltozero.IRRistherateofinterestwhichequatesthePVofcashinflowswiththePV ofcashflows. IRR is also called yield on investment, managerial efficiency of capital, marginal productivity of capital,rateofreturn,timeadjustedrateofreturn.IRRistherateofreturnthataprojectearns.

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EvaluationofIRR: 1. IRRtakesintoaccountthetimevalueofmoney 2. IRR calculates the rate of return of the project, taking into account the cash flows over the entirelifeoftheproject. 3. Itgivesarateofreturnthatreflectstheprofitabilityoftheproject. 4. Itisconsistentwiththegoaloffinancialmanagementi,emaximizationofnetwealthofshare holders 5. IRRcanbecomparedwiththefirmscostofcapital. 6. TocalculatetheNPVthediscountratenormallyusediscostofcapital.ButtocalculateIRR, there is no need to calculate and employ the cost of capital for discounting because the projectisevaluatedattherateofreturngeneratedbytheproject.Therateofreturnisinternal totheproject.

Demerits: 1. IRRdoesnotsatisfytheadditiveprinciple. 2. Multipleratesofreturnorabsenceofauniquerateofreturnincertainprojectswillaffectthe utilityofthistechniquesasatoolofdecisionmakinginprojectevaluation. 3. Inprojectevaluation,theprojectswiththehighestIRRaregivenpreferencetotheoneswith lowinternalrates. Applicationofthiscriteriontomutuallyexclusiveprojectsmayleadundercertainsituationsto acceptanceofprojectsoflowprofitabilityatthecostofhighprofitabilityprojects. 4. IRRcomputationisquitetedious.

AcceptorRejectCriterion: Iftheprojectsinternalrateofreturnisgreaterthanthefirmscostofcapital,accepttheproposal. Otherwiserejecttheproposal. IRRcanbedeterminedbysolvingthefollowingequationforr=

CF0 =

Ct
t (1+r)

wheret=1ton

CF0 =Investment Sumofthepresentvaluesofcashinflowsattherateofinterestofr: Ct (1+r)


t

wheret=1ton

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Example: A project requires an initial out lay of Rs.1,00,000. It is expected to generate the followingcashinflows: Year 1 2 3 4 Cashinflows 50,000 50,000 30,000 40,000

WhatistheIRRoftheproject? StepI Computetheaverageofannualcashinflows Year 1 2 3 4 Total Cashinflows 50,000 50,000 30,000 40,000 1,70,000

Average=1,70,000=Rs.42,500 4 StepII:Dividetheinitialinvestmentbytheaverageofannualcashinflows: =1,00,000=2.35 42,500 StepIII:FromthePVIFAtablefor4years,theannuityfactorverynear2.35is25%.Therefore thefirstinitialrateis25% Year Cashflows PVfactorat25 % 1 2 3 4 50,000 50,000 30,000 40,000 0.800 0.640 0.512 0.410 Total PVofCash flows 40,000 32,000 15,360 16,400 1,03,760

SincetheinitialinvestmentofRs.1,00,000islessthanthecomputedvalueat25%ofRs.1,03,760 thenexttrialrateis26%.

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Year

Cashflows

PVfactorat26 %

PVofCash flows 39,685 31,495 14,997 15,872 1,02,049

1 2 3 4

50,000 50,000 30,000 40,000

0.7937 0.6299 0.4999 0.3968 Total

Thenexttrialrateis27% Year Cashflows PVfactorat27 % 1 2 3 4 50,000 50,000 30,000 40,000 0.7874 0.6200 0.4882 0.3844 Total PVofCash flows 39,370 31,000 14,646 15,376 1,00,392

Thenexttrialrateis28% Year Cashflows PVfactorat26 % 1 2 3 4 50,000 50,000 30,000 40,000 0.7813 0.6104 0.4768 0.3725 Total PVofCash flows 39,065 30,520 14,3047 14,900 98,789

SinceinitialinvestmentofRs.1,00,000liesbetween98789(28%)and1,00,392(27%)theIRRby interpolation. 1,00,3921,00,000

27+
.

1,00,39298,789

X1

392

27+

1603

X1

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=27+0.2445 =27.2445=27.24%

ModifiedInternalRateofReturn: MIRRisadistinctimprovementovertheIRR.ManagersfindIRRintuitivelymoreappealingthan the rupees of NPV because IRRisexpressedona percentage rates ofreturn. MIRR modifies IRR.MIRRisabetterindicatorofrelativeprofitabilityoftheprojects. MIRRisdefinedas PVofCosts=PVofterminalvalue TV

PVC= n (1+MIRR)
PVC=PVofcosts TocalculatePVC,thediscountrateusedisthecostofcapital. Tocalculatetheterminalvalue,thefuturevaluefactorisbasedonthecostofcapital ThenobtainMIRRonsolvingthefollowingequation. TV

PVofCosts=

n (1+MIRR)

SuperiorityofMIRRoverIRR 1. MIRRassumesthatcashflowsfromtheprojectarereinvestedatthecostofcapital.The IRRassumesthatthecashflowsfromtheprojectarereinvestedattheprojectsownIRR. Since reinvestment at the cost of capital is considered realistic and correct, the MIRR measurestheprojectstrueprofitability 2. MIRRdoesnothavetheproblemofmultiplerateswhichwecomeacrossinIRR.

Illustration: Year Cashflows (Rsinmillion) 0 1 2 3 4 5 6

(100)(100)306090120130

CostofCapital is12% Presentvalueofcost=100+100 1.12 =100+89.29=189.29

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Terminalvalueofcashflows:
4 3 2 =30(1.12) +60(1.12) +90(1.12) +120(1.12)+130

=30x1.5735+60x1.4049+90x1.2544+120x1.12+130 =47.205+84.294+112.896+134.4+130 =508.80 MIRRisobtainedonsolvingthefollowingequation 508.80


6 189.29= (1+MIRR)

508.80

(1+MIRR) =
(1+MIRR) =2.6879 MIRR=17.9%
6

189.29

ProfitabilityIndex:itisalsoknownasBenefitcostratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay.The discountfactorbasedontherequiredrateofreturnisusedtodiscountthecashinflows.

Presentvalueofcashinflows

PI=

InitialCashoutlay

AcceptorRejectCriterion: 1. AccepttheprojectifPIisgreaterthan1 2. RejecttheprojectifPIislessthan1

If profitability indexis 1 then the management may accept the project because the sum of the presentvalue of cash inflowsis equal to the sum ofpresentvalueofcash outflows. It neither addsnorreducestheexistingwealthofthecompany. MeritsofPI: 1. Ittakesintoaccountthetimevalueofmoney 2. Itisconsistentwiththeprincipleofmaximizationofshareholderswealth. 3. Itmeasurestherelativeprofitability.

Demerits: 1. Estimationofcashflowsanddiscountratecannotbedoneaccuratelywithcertainty.

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2. A conflict may arise between NPV and profitability index if a choice between mutually exclusiveprojectshastobemade.

Example X PVofCashinflows Initialcashoutlay NPV ProfitabilityIndex 4,00,000 2,00,000 2,00,000 2 Y 2,00,000 80,000 1,20,000 2.5

AsperNPVmethodprojectXshouldbeaccepted.AsperprofitabilityindexprojectYshouldbe accepted.Thisleadstoaconflictingsituation.TheNPVmethodistobepreferredtoprofitability indexbecausetheNPVrepresentsthenetincreaseinthefirmswealth.

Example: AfirmisconsideringaninvestmentproposalwhichrequiresanintialcashoutlayofRs 8lakhnowandRs2lakhattheendofthethirdyear.Itisexpectedtogeneratecashflowsas under: Year 1 2 3 Cashinflows 3,50,000 8,00,000 2,50,000

Applythediscountrateof12%calculateprofitabilityindex Solution: PresentValueofCashoutflows

Year

PVfactorat12 % 1

Cashoutflows

PVofCash flows

Rs.8lakhs

Rs.8lakhs

2 3 0.712 2lakhs Total 1.424lakhs 9.424lakhs

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PresentValueofCashinflows Year PVIF(12%) Cashinflows PVofCash flows 1 2 4 0.893 0.797 0.636 3,50,000 8,00,000 2,50,000 Total 3.1255lakhs 6.376lakhs 1.5900lakhs 11.0915lakhs

PI=Totalofpresentvalueofcashinflows Totalofpresentvalueofcashoutflows =11.0915 9.424 ForeveryRe.1investedtheprojectisexpectedtogiveacashinflowofRs.1.177i,eforevery rupeeinvestedaprofitofRs.0.177isobtained. =1.177

8.10 Summary Capital investment proposals involve current outlay of funds in the expectation of a stream of cashinflowinfuture.Varioustechniquesareavailableforevaluatinginvestmentprojects.They aregroupedintotraditionalandmoderntechniques.Themajortraditionaltechniquesarepayback period and accounting rate of return. The important discounting criteria are net present value, internalrateofreturnandprofitabilityindex.Amajordeficiencyofpaybackperiodisthatitdoes not take into account the time value of money. DCF techniques overcome this limitation. Each methodhasbothpositiveandnegativeaspect.Themostpopularmethodforlargeprojectisthe internal rate of return. Payback period and accounting rate of return are popular for evaluating smallprojects.

TerminalQuestions
1. Examinetheimportanceofcapitalbudgeting. 2. Briefly examine the significance of identification of investment opportunities in capital budgetingprocess. 3. Criticallyexaminethepaybackperiodasatechniqueofapprovalofprojects. 4. SummariesthefeaturesofDCFtechniques.

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AnswerforSelfAssessmentQuestions SelfAssessmentQuestions1 1. Capitalbudgeting 2. Capitalbudgeting 3. Highlycomplex 4. Capitalbudgetingdecisions

SelfAssessmentQuestions2 1. Irreversible. 2. Uncertainty,highlyuncertain.

SelfAssessmentQuestions3 1. Finalstep. 2. Firststep SelfAssessmentQuestions4 1. Afertilesource 2. Themostcrucialphase

SelfAssessmentQuestions5 1. Capitalbudgeting 2. Costreduction.

SelfAssessmentQuestions6 1. Economicappraisal 2. Technicalappraisal 3. Financialviability 4. Demandfortheproductorservice.

SelfAssessmentQuestions7 1. Decisioncriteria 2. Sunkcost 3. Externalities. 4. Investmentelement. 5. Ignores.

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6. Profitabilityof

AnswerforTerminalQuestions. 1. Refertounit8.2 2. Refertounit8.5 3. Refertounit8.8.1 4. Refertounit8.8.2

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Unit9
Structure
9.1 Introduction

RiskAnalysisinCapitalBudgeting

9.2 TypesandsourcesofRiskincapitalBudgeting 9.3 RiskAdjustedDiscountRate 9.4 CertaintyEquivalent 9.5 SensitivityAnalysis 9.6 ProbabilityDistributionApproach: 9.7 Decisiontreeapproach 9.8 Summary: TerminalQuestions AnswertoSAQsandTQs

9.1 Introduction
Inthepreviouschapteroncapitalbudgetingtheprojectappraisaltechniqueswereappliedonthe assumptionthattheprojectwillgenerateagivensetofcashflows. ItisquiteobviousthatoneofthelimitationsofDCFtechniquesisthedifficultyinestimating cash flowswithcertaindegreeofcertainty.Certainprojectswhentakenupbythefirmwillchangethe businessriskcomplexionofthefirm. Thisbusinessriskcomplexionofthefirminfluencestherequiredrateofreturnoftheinvestors. Suppliersofcapitaltothefirmtendtoberiskaverseandtheacceptanceofaprojectthatchanges theriskprofileofthefirmmaychangetheirperceptionofrequiredratesofreturnforinvestingin firmsproject. Generallytheprojectsthatgeneratehighreturnsarerisky.Thiswillnaturallyalterthebusiness risk of thefirm. Becauseof thishigh riskperception associated with the new project a firmis forced to asses the impact of the risk on the firms cash flows and the discount factor to be employedintheprocessofevaluation. DefinitionofRisk:Riskmaybedefined asthevariationofactualcashflowsfrom theexpected cashflows.Thetermriskincapitalbudgetingdecisionsmaybedefinedasthevariabilitythatis likelytooccurinfuturebetweentheestimatedandtheactualreturns.Riskexistsonaccountof theinabilityofthefirmtomakeperfectforecastsofcashflows.

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Riskarisesinprojectevaluationbecausethefirmcannotpredicttheoccurrenceofpossiblefuture events with certainty and hence, cannot make any correct forecast about the cash flows. The uncertaineconomicconditionsarethesourcesofuncertaintyinthecashflows. For example, a company wants to produce and market a new product to their prospective customers.Thedemandisaffectedbythegeneraleconomicconditions.Demandmaybevery highifthecountryexperienceshighereconomicgrowth.Ontheotherhandeconomiceventslike weakeningofUSdollar,subprimecrisesmaytriggereconomicslowdown.Thismaycreatea pessimisticdemanddrasticallybringingdowntheestimateofcashflows. Riskisassociatedwiththevariabilityoffuturereturnsofaproject.Thegreaterthevariabilityof theexpectedreturns,theriskiertheproject. Everybusinessdecisioninvolvesrisk.Riskarisesoutoftheuncertainconditionsunderwhicha firmhastooperateitsactivities. Becauseoftheinabilityoffirmstoforecastaccuratelycashflows of future operations thefirmsfacethe risks of operations. The capitalbudgeting proposals are notbasedonperfectforecastofcostsand revenuesbecausetheassumptionsaboutthefuture behaviourofcostsandrevenuemaychange.Decisionshavetobemadeinadvanceassuming certainfutureeconomicconditions. ThereareManyfactorsthataffectforecastsofinvestment,costandrevenue. 1) Thebusinessisaffectedbychangesinpoliticalsituations,monetarypolicies,taxation,interest rates,policiesofthecentralbankofthecountryonlendingbybanksetc. 2) Industry specific factors influence the demand for the products of the industry to which the firmbelongs. 3) Company specific factors like change in management, wage negotiations with the workers, strikesorlockoutsaffectcompanyscostandrevenuepositions. Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management. Thebestbusinessdecisionsmaynotyieldthedesiredresultsbecausetheuncertainconditions likelytoemergeinfuturecanmateriallyalterthefortunesofthecompany. Every change gives birth to new challenges. New challenges are the source of new opportunities.Aproactivefirmwillconverteveryproblemintosuccessfulenterpriseopportunities. Afirmwhich avoids new opportunitiesfor theinherent risk associatedwith it, will stagnate and degenerate.Successfulfirmshaveempiricalhistoryofsuccessfulmanagementofrisks. Therefore,analysingtherisksoftheprojecttoreducetheelementofuncertaintyinexecutionhas becomeanessential aspectoftodayscorporateprojectmanagement.

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LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1. Defineriskincapitalbudgeting. 2. Examinetheimportanceofriskanalysisincapitalbudgeting. 3. Methodsofincorporatingtheriskfactorincapitalbudgetingdecision. 4. Understandthetypesandsourcesofriskincapitalbudgetingdescision

9.2TypesandsourcesofRiskincapitalBudgeting
Risksinaprojectaremany.Itispossibletoidentifythreeseparateanddistincttypesofriskin anyproject. 1) Standalonerisk:itismeasuredbythevariabilityofexpectedreturnsoftheproject. 2) Portfoliorisk: Afirmcanbeviewedasportfolioofprojectshavingascertaindegreeofrisk. Whennewprojectaddedtotheexistingportfolioofprojecttheriskprofilethefirm willalter. Thedegreeofthechangeintheriskdependonthecovarianceofreturnfromthenewproject andthereturnfromtheexistingportfoliooftheprojects.Ifthereturnfromthenewprojectis negativelycorrelatedwiththereturnfromportfolio,theriskofthefirmwillbefurtherdiversified away. 3) Marketorbetarisk:Itismeasuredbytheeffectoftheprojectonthebetaofthefirm.The marketriskforaprojectisdifficulttoestimate. Standaloneriskistheriskofaprojectwhentheprojectisconsideredinisolation.Corporate riskistheprojectsriskstotheriskofthefirm.Marketriskissystematicrisk.Themarketrisk isthemostimportantriskbecauseofthedirectinfluenceithasonstockprices. Sourcesofrisk:Thesourcesofrisksare 1. Projectspecificrisk 2. CompetitiveorCompetitionrisk 3. Industryspecificrisk 4. Internationalrisk 5. Marketrisk 1. Projectspecificrisk:Thesourcesofthisriskcouldbetracedtosomethingquitespecific to the project. Managerial deficiencies or error in estimationof cashflows or discount rate mayleadtoasituationofactualcashflowsrealisedbeinglessthanthatprojected. 2. Competitive risk or Competition risk: unanticipated actions of a firms competitors will materially affect the cash flows expected from a project. Because of this theactual cash flowsfromaprojectwillbelessthanthatoftheforecast.

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3. Industryspecific:industryspecificrisksarethosethataffectallthefirmsintheindustry. Itcouldbeagaingroupedintotechnologicalrisk,commodityriskandlegalrisk.Alltheserisks willaffecttheearningsandcashflowsoftheproject.Thechangesintechnologyaffectallthe firmsnotcapableofadaptingthemselvestoemergingnewtechnology. The best example is the case of firms manufacturing motor cycles with two strokes engines. Whentechnologicalinnovationsreplacedthetwostrokeenginesbythefourstrokeenginesthose firmswhichcouldnotadapttonewtechnologyhadtoshutdowntheiroperations. Commodity risk is the risk arising from the effect of price changes on goods produced and marketed. Legalriskarisesfromchangesinlawsandregulationsapplicabletotheindustrytowhichthefirm belongs.ThebestexampleistheimpositionofservicetaxonapartmentsbytheGovernmentof India when the total number of apartments built by a firm engaged in that industry exceeds a prescribedlimit.SimilarlychangesinImportExportpolicyoftheGovernmentofIndiahaveled totheclosureofsomefirmsorsicknessofsomefirms. 4. InternationalRisk: thesetypesofrisksarefacedbyfirmswhosebusinessconsistsmainly of exports or those who procure their main raw material from international markets. For example,rupeedollarcrisisaffectedthesoftwareandBPOsbecauseitdrasticallyreduced their profitability. Another best example is that of the textile units in Tirupur in Tamilnadu, exporting their major part of the garments produced. Rupee gaining and dollar Weakening reduced their competitiveness in the global markets. The surging Crude oil prices coupled with the governments delay in taking decision on pricing of petro products eroded the profitabilityofoilmarketingCompaniesinpublicsectorlikeHindustanPetroleumCorporation Limited.AnotherexampleistheimpactofUSsubprimecrisisoncertainsegmentsofIndian economy. Thechangesininternationalpoliticalscenarioalsoaffecttheoperationsofcertainfirms. 5. MarketRisk: Factorslikeinflation,changesininterestrates,andchanginggeneraleconomic conditionsaffectallfirmsandallindustries. Firmscannotdiversifythisriskinthenormalcourseofbusiness. Techniquesusedforincorporationofriskfactorincapitalbudgetingdecisions There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology so farasincorporationof riskintheevaluationprocessisconcerned. Conventionaltechniques PayBackPeriod

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The oldest and commonlyused method of recognisingrisk associated with a capital budgeting proposalispaybackperiod.Underthismethod,shorterpaybackperiodisgivenpreferenceto longer ones. Firms establish guidelines for acceptance or rejections of projects based on standardsofpaybackperiods. Paybackperiodprefersprojectsofshorttermpaybackstothatoflongtermpaybacks.The emphasisisontheliquidityofthefirmthroughrecoveryofcapital.TraditionallyIndianbusiness communityemploysthistechniqueinevaluatingprojectswithveryhighlevelofuncertainty.The changingtrendsinfashionmakethefashionbusiness,oneofhighriskandtherefore,payback period has been endorsed by tradition in India to take decisions on acceptance or rejectionof suchprojects.Theusualriskinbusinessismoreconcernedwiththeforecastofcashflows.Itis thedownsideriskoflowercashflowsarisingfromlowersalesandhighercostsofoperationthat mattersinformulatingstandardsofpayback. Paybackperiodignorestimevalueofmany(cashflows).Forexample,thefollowingdetailsare availableinrespectoftwoprojects. Particulars Initialcashoutlay Cashflows Year1 Year2 Year3 Year4 ProjectA(Rs) 10lakhs 5lakhs 3lakhs 1lakhs 1lakhs ProjectB(Rs) 10lakhs 2lakhs 2lakhs 3lakhs 3lakhs

Boththeprojectshaveapaybackperiodof4years.TheprojectBisriskierthantheProjectA becauseProjectArecovers80%ofinitialcashoutlayinthefirsttwoyearsofitsoperationwhere as Project B generates higher Cash inflows only in the latter half of the payback period. This underminestheutilityofpaybackperiodasatechniqueofincorporatingriskinprojectevaluation. This method considers only time related risks and ignores all other risks of the project under consideration.

SelfAssessmentQuestions2 1. _____________ismeasuredbythevariabilityofexpectedreturnsoftheproject. 2. Marketriskismeasuredbytheeffectoftheprojectonthe____ofthefirm. 3. Firmscannot____marketriskinthenormalcourseofbusiness. 4. Impact of U.S sub prime crisis on certain segments of Indian economy is and example of _______________________.

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9.3RiskAdjustedDiscountRate
Thebasisofthisapproachisthatthereshouldbeadequaterewardintheformofreturntofirms whichdecidetoexecuteriskybusinessprojects.Manbynatureisriskaverseandtriestoavoid risk. Tomotivatefirmstotakeupriskyprojectsreturnsexpectedfromtheprojectshallhavetobe adequate,keepinginviewtheexpectationsoftheinvestors.Thereforeriskpremiumneedtobe incorporatedindiscountrateintheevaluationofriskyprojectproposals. Thereforethediscountrateforappraisalofprojectshastwocomponents. Thosecomponentsare 1. Risk freerateandriskpremium RiskAdjustedDiscountrate=Riskfreerate+Riskpremium Riskfreerateiscomputedbasedonthereturnongovernmentsecurities. Risk premium is the additional return that investors require as compensation for assuming the additionalriskassociatedwiththeprojecttobetakenupforexecution. The more uncertain the returns of the project the higher the risk. Higher the risk greater the premium. Therefore, risk adjusted Discount rate is a composite rate of risk free rate and risk premiumoftheproject. Example:AninvestmentwillhaveaninitialoutlayofRs100,000.Itisexpectedtogeneratecash inflowsasunder: Year 1 2 3 4 Cashinflows 40,000 50,000 15,000 30,000

Riskfreerateofinterestis10%.Riskpremiumis10%(theriskcharacterisingtheproject) (a) (b) computetheNPVusingriskfreerate ComputeNPVusingriskadjusteddiscountrate

Solutions=(a)usingriskfreerate

Year 1 2 3 4

Cashflows(inflows)Rs 40,000 50,000 15,000 30,000 PVofcashinflows

PVFactorat10% 0.909 0.826 0.751 0.683

PVofCashflows(inflows) 36,360 41,300 11,265 20,490 1,09,415

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PVofCashoutflows NPV

1,00,000 9,415

(b) Usingriskadjusteddiscountrate Year 1 2 3 4 CashinflowsRs 40,000 50,000 15,000 30,000 PVofCashinflows PVofCashoutflows NPV PVfactorat20% 0.833 0.694 0.579 0.482 PVofcashinflows 33,320 34,700 8,685 14,460 91,165 100,000 (8,835)

Theprojectwouldbeacceptablewhennoallowanceismadeforrisk. Butitwillnotbeacceptableifriskpremiumisaddedtotheriskfreerate.Itmovesfrompositive NPVtonegativeNPV. Ifthefirmweretousetheinternalrateofreturn,thentheprojectwouldbeacceptedwhenIRRis greaterthantheriskadjusteddiscountrate. EvaluationofRiskadjusteddiscountrate: Advantages: 1. Itissimpleandeasytounderstand. 2. Riskpremiumtakescareoftheriskelementinfuturecashflows. 3. Itsatisfiesthebusinessmenwhoarerisk averse.

Limitations: 1. There are no objective basesof arriving at the risk premium. In this process the premium ratescomputedbecomearbitrary. 2. Theassumptionthatinvestorsareriskaversemaynotbetrueinrespectofcertaininvestors whoarewillingtotakerisks.Tosuchinvestors,asthelevelofriskincreases,thediscount ratewouldbereduced. 3. Cashflowsarenotadaptedtoincorporatetheriskadjustmentfornetcashinflows. SelfAssessmentQuestions2 1.Riskpremiumisthe__________________thattheinvestorsrequireascompensationfor

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assumptionofadditionalrisksofproject. 2.RADRisthesumof______________and______________. 3.Highertherisk__________________thepremium. 4.Manbynatureisriskaverseandtriestoavoidrisk.

9.4 CertaintyEquivalent: Underthismethodtheriskinguncertain,expectedfuturecashflowsareconvertedintocashflows with certainty. Here we multiply uncertain future cash flows by the certainty equivalent coefficient to convert uncertain cash flows into certain cash flows. The certainty equivalent coefficient is also known as the risk adjustment factor. Risk adjustment factor is normally denotedbyt(Alpha).Itistheratioofcertainnetcashflowtoriskynetcashflow =CertaintyEquivalent=CertainCashflow RiskyCashflow

Thediscountfactortobeusedistheriskfreerateofinterest.Certaintyequivalentcoefficientis between0and1.Thisriskadjustmentfactorvariesinverselywithrisk.Ifriskishighalower valueisusedforriskadjustment.Ifriskislowahighercoefficientofcertaintyequivalentis used Illustration(Example) AprojectcostsRs50,000.Itisexpectedtogeneratecashinflowsasunder Year 1 2 3 4 Cashinflows 32,000 27,000 20,000 10,000 CertaintyEquivalent 0.9 0.6 0.5 0.3

Riskfreediscountrateis10%computeNPV Answer: Year Uncertaincash inflows 1 2 3 4 32,000 27,000 20,000 10,000 0.9 0.6 0.5 0.3 CE Certaincash flows 28,800 16,200 10,000 3,000 PVFactorat PVofcertaincash 10% 0.909 0.826 0.751 0.683 inflows 26,179 13,381 7,510 2,049

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PVofcertaincashin flows Initialcashoutlay NPV

49,119

50,000 (881)negative

TheprojecthasanegativeNPV. Therefore,itisrejected. IfIRRisusedtherateofdiscountatwhichNPVisequaltozeroiscomputedandthencompared withtheminimum(required)riskfreerate.IfIRRisgreaterthanspecifiedminimumriskfreerate, theprojectisaccepted,otherwiserejected. Evaluation: Itrecognisesrisk.Recognitionofriskbyriskadjustmentfactorfacilitatestheconversionofrisky cashflowsintocertaincashflows.Buttherearechancesofbeinginconsistentintheprocedure employedfromoneprojecttoanother. Whenforecastspassthroughmanylayersofmanagement,originalforecastsmaybecomehighly conservative. Becauseofhighconservationinthisprocessonlygoodprojectsarelikelytobeclearedwhenthis methodisemployed. Certainty equivalentapproachisconsideredtobetheoreticallysuperiortotherisk adjusted discountrate. SelfAssessmentQuestions3 1.CEcoefficientisthe_______. 2.DiscountfactorstobeusedunderCEapproachis_____________. 3.Becauseofhigh______________CEclearsonlygoodprojects. 4.___________isconsideredtobesuperiortoRADR 9.5 SensitivityAnalysis: There are many variables like sales, cost of sales, investments, tax rates etc which affect the NPV and IRR ofa project. Analysing the change in the projects NPVor IRR on account ofa givenchangeinoneofthevariablesiscalledSensitivityAnalysis.Itisatechniquethatshowsthe changeinNPVgivenachangeinoneofthevariablesthatdeterminecashflowsofaproject.It measuresthesensitivityofNPVofaprojectinrespecttoachangeinoneoftheinputvariablesof NPV.

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The reliability of the NPV depends on the reliability of cash flows. If fore casts go wrong on account of changes in assumed economic environments, reliability of NPV & IRR is lost. Therefore,forecastsaremadeunderdifferenteconomicconditionsvizpessimistic,expectedand optimistic.NPVisarrivedatforallthethreeassumptions. FollowingstepsareinvolvedinSensitivityanalysis: 1. IdentificationofvariablesthatinfluencetheNPV&IRRoftheproject. 2. Examininganddefiningthemathematicalrelationshipbetweenthevariables. 3. AnalysisoftheeffectofthechangeineachofthevariablesontheNPVoftheproject. Example: A company has two mutuallyexclusive projects under considerationviz project A & projectB. EachprojectrequiresaninitialcashoutlayofRs3,00,000andhasaneffectivelifeof10years. The companys cost of capital is 12%. The following fore cast of cashflows are made by the management.

Economic Environment Pessimistic Expected Optimistic

ProjectA Annualcashinflows 65,000 75,000 90,000

ProjectB Annualcashinflows 25,000 75,000 1,00,000

WhatistheNPVoftheproject? Whichprojectshouldthemanagementconsider? GivenPVIFA=5.650 Answer/Solutions NPVofprojectA

Economic Environment

Project cashinflows at

PVIFA 12% 10

PVofcashinflows

NPV

years Pessimistic Expected Optimistic 65,000 75,000 90,000 5.650 5.650 5.650 3,67,250 4,23,750 5,08,500 67,250 1,23,750 2,08,500

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NPVofProjectB Pessimistic Expected Optimistic 25,000 75,000 1,00,000 5.650 5.650 5.650 1,41,250 4,23,750 5,65,000 (1,58,750) 1,23,750 2,65,000

Decision 1. UnderpessimisticconditionsprojectAgivesapositiveNPVofRs67,250andProjectBhasa negativeNPVofRs1,58,750ProjectAisaccepted. 2. Under expected conditions,both gave some positive NPV ofRs 1,23,000. Any one of two maybeaccepted. 3. UnderoptimisticconditionsProjectBhasahigherNPVofRs2,65,000comparedtothat of AsNPVofRs2,08,500. 4. Difference between optimistic and pessimistic NPV for Project A is Rs 1,41,250 and for ProjectBthedifferenceisRs4,23,750. 5. ProjectBisriskycomparedtoProjectAbecausetheNPVrangeisoflargedifferences. StatisticalTechniques: Statisticaltechniquesuseanalyticaltoolsforassessingrisksofinvestments. SelfAssessmentQuestions4 1._____________analysisthechangesintheprojectNPVonaccountofagivenchangeinone oftheinputvariablesoftheproject. 2. Examining and defining the mathematical relation between the variable of the NPV is _________________________. 3.Forecastsundersensitivityanalysisaremadeunder__________.

9.6 ProbabilityDistributionApproach: When we incorporatethe chances ofoccurrences ofvariouseconomicenvironments computed NPV becomes more reliable. The chances of occurrences are expressed in the form of probability.Probabilityisthelikelihoodofoccurrenceofaparticulareconomicenvironment.After assigningprobabilitiestofuturecashflowsexpectednetpresentvalueiscomputed. Illustration: A company has identified aproject with an initial cash outlay of Rs 50,000. The followingdistributionofcashflowisgivenbelowforthelifeoftheprojectof3years.

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Year1 Cashinflow 15,000 18,000 35,000 32,000 Probability 0.2 0.1 0.4 0.3

Year2 Cashinflow 20,000 15,000 15,000 30,000 Probability 0.3 0.2 0.2 0.2

Year3 Cashinflow 25,000 20,000 20,000 45,000 Probability 0.4 0.3 0.3 0.1

Discountrateis10% Year1 =15,000x0.2+18,000x0.1+35,000x0.4+32,000x0.300 3,000+1,800+14,000+9,600=28,400 Year2 20,000x0.3+15,000x0.2+30,000x0.3+30,000x0.2 =6,000+3,000+9,000+6,000=24,000 Year3 25,000x0.4+20,000x0.3+40,000x0.2+5,000x0.1= 10,000+6,000+8,000+4,500==28,500

Year 1 2 3

Expectedcashinflows 28,400 24,000 28,500 PVofexpectedcashinflows PVofinitialcashoutlay ExpectedNPV

PVfactorat10% 0.909 0.826 0.751

PVofexpected cashinflows 25,816 19,824 21,403 67,043 50,000 17,043

Variance: A study of dispersion of cash flows of projects will help the management in assessing the risk associated with the investment proposal. Dispersion is computed by variance or standard deviation. Variance measures the deviation of each possible cash flow from the expected. Squarerootofvarianceisstandarddeviation. Example:Followingdetailsareavailableinrespectofaprojectwhichrequiresaninitialcostof Rs5,00,000.

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Year 1

EconomicConditions Highgrowth Averagegrowth Nogrowth

Cashflows 2,00,000 1,50,000 40,000 3,00,00 2,00,000 5,00,000 4,00,000 2,50,000 30,000

Probability 0.3 0.6 0.1 0.3 0.5 0.2 0.2 0.6 0.2

Highgrowth Averagegrowth Nogrowth

Highgrowth Averagegrowth Nogrowth

Discountrateis10% Solution: Year1 EconomicCondition 1 Highgrowth Averagegrowth Nogrowth Cashinflow 2 2,00,000 1,50,000 40,000 Probability 3 0.3 0.6 0.1 ExpectedValue 60,000 90,000 4,000 1,54,000 ExpectedvalueofCashinflow

Year2 EconomicCondition Highgrowth Averagegrowth Nogrowth Cashinflow 3,00,000 2,00,000 50,000 Probability 0.3 0.5 0.2 ExpectedValue ExpectedvalueofCashinflow 90,000 1,00,000 10,000 2,00,000

Year3 EconomicCondition Highgrowth Averagegrowth Nogrowth Cashinflow 4,00,000 2,50,000 30,000 Probability 0.2 0.6 0.2 ExpectedvalueofCashinflow 80,000 1,50,000 6,000

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ExpectedValueof Cashinflows 1,54,0002,00,000 2,36,000


3 + (1.10)

2,36,000

ExpectedNPV= 1.10(110) + 2

5,00,000

=1,40,000+1,65,289+1,77,3105,00,000=(17,401)negativeNPV

StandardDeviationforIyear Cashinflow C 2,00,000 1,50,000 40,000 ExpectedValue E 1,54,000 1,54,000 1,54,000


2 (46,000) 2 (4000) 2 (1,14,000) 2 (46,000) x0.3=634800000 2 (4,000) x0.3=9600000 2 (1,14,000) x0.3=1299600000 2 (CE) 2 (CE) xprob

Total

1944000000

StandarddeviationofCashflowsforIyear=44091
nd For2 year 2 (CE) 2 (CE) xprob

Cashinflow C 3,00,000 2,00,000 50,000

ExpectedValue E 2,00,000 2,00,000 2,00,000

2 (1,00,000) 2 (0) 2 (1,50,000)

2 (1,00,000) x0.3=3000000000 2 (0) x0.5=0 2 (1,50,000) x0.2=4500000000

Total
nd VarianceofCashflowsfor2 year=7500000000 nd StandardDeviationofcashflowsfor2 year=8660

750000000

Forthethirdyear Cashinflow C 4,00,000 2,50,000 30,000 ExpectedValue E 2,36,000 2,36,000 2,36,000


2 (1,64,000) 2 (14,000) 2 (2,00,000) 2 (1,64,000) x0.2=5379200 000 2 (14,000) x0.6=117600000 2 (2,00,000) x0.2=8000000000 2 (CE) 2 (CE) xprob

Total

13496800000

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rd VarianceofCashflowsfor3 year=13496800000 rd StandardDeviationofcashflowsfor3 year=116175

Unit9

StandardDeviationofNPV
2 (44091) 2 (8660) 2 (116175)

sNPV =

2 (1.10)

4 (1.10)

6 (1.10)

= 1606625026+51223004+7618496131 = 9276344161 =96314 Heretheassumptionisthatthereisnorelationshipbetweencashflowsfromoneperiodto another.Underthisassumptionthestandarddeviation ofNPV isRs96,314. On the other hand, if cash flows are perfectly correlated, cash flows of all years have linearcorrelationtooneanother,then

440918660116175

sNPV =

1.10

2 + (1.10)

+ (1.10) 3

=40083+7157+87284=134524 The standard deviation of NPV when cash flows are perfectly correlated will be higher thanthatunderthesituationofindependentcashflows. SelfAssessmentQuestions.5 1. Probability distribution approach incorporates the probability of occurrences of various economicenvironment,tomaketheNPV________. 2._______islikelihoodofoccurrenceofaparticulareconomicenvironment.

9.7 Decisiontreeapproach: Manyprojectdecisionsarecomplexinvestmentdecisions.Suchcomplexinvestmentdecisions involveasequenceofdecisionsovertime.Decisionstreecanhandlethesequentialdecisionsof complex investment proposals. The decision of taking up an investment project is broken into differentstages.Ateachstagetheproposalisexaminedtodecidewhethertogoaheadornot. The multi stages approach can be handled effectively with the help of decision trees. A decisiontreepresentsgraphicallytherelationshipbetweenapresentdecisionandfutureevents, futuredecisionsandtheconsequencesofsuchdecisions.

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Example R&Dsectionofacompanyhasdevelopedanelectricmoped.Thefirmisreadyforpilot productionandtest marketing. This will cost Rs 20 millionand take six months. Management believesthatthereisa70%chancethatthepilotproductionandtestmarketingwillbesuccessful. IfsuccessfulthecompanycanbuildaplantcostingRs200million. TheplantwillgenerateannualcashinflowofRs50millionfor20yearsifthedemandishighor anannualcashinflowor20millionifthedemandislow. Highdemandhasaprobabilityof0.6andlowdemandhasaprobabilityof0.4.Costofcapitalis 12%. Suggest the optimal course of action using decision tree analysis (Bangalore University MBA, adapted).
D21 Investment Rs.200million D11 Carryoutpilot Production AndMarket test(20million) C11 Success D2 D22 Stop D3
C12

C2

HighDemand Probability 0.6 C21 AnnualCashinflow Rs.50million AnnualCashinflow Rs.20million C22 LowDemand Probability 0.4

0.7
C1 failure Probability0.3

D31 Stop

D12 DoNothing

WorkingNotes:Fromrighthandsideofthedecisiontree I step: ComputationofExpected Monetary Valueatpoint C2. HereEMV representsexpected NPV.

Cashinflow 50 20

Probability 0.6 0.4 EMV

Expectedvalueofcashinflows 30 8 38

PresentValueofEMV=ExpectedvalueofcashinflowxPVIFA(12%20) 38x7.469=Rs283.82million

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Step2: ComputationofEMVatdecisionpointD2. Decisiontaken D2 D22 Consequences InvestRs200million Stop TheresultingEMVatthislevel 283.8220083.82million 0

HerethedecisioncriterionisselecttheEMVwiththehighestvalue. Stage3: ThereforeEMVwithRs83.82millionwillbeconsideredthereforeweselectthedecisiontakenat D2, Stage4: ComputationofEMVatthepointC, EMV 83.82 0 Probability 0.7 0.3 EMVatthisstage ExpectedValue 58.67 0 58.67

Step5: ComputeEMVatdecisionspointD, Decisiontaken Consequences TheresultingEmatthis level D11carry outpilot productionandmarkettest D12Donothing Invest 20million 0 EMVatthisstage 0 38.67Million (ApplytheEMVcriterion)i.e selecttheEMVwiththe highestvalue 58.6720=Rs38.67Million

Thereforeoptimalstrategyis 1. Carryoutpilotproductionandmarkettest. 2. If the result ofpilotproduction and market test is successful, go ahead with theinvestment decisionofRs200millioninestablishingaplant. 3. Iftheresultofpilotproductionandmarkettestisfuture,stop.

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EvaluationofDecisiontreeapproach: 1. Itportraysinterrelated,sequential andcriticalmultidimensionalelementsofmajorproject decisions. 2. Adequateattentionisgiventothecriticalaspectsinaninvestmentdecisionwhichspreadover atimesequence. 3. Complex projects involve huge out lay and hence risky. There is the need to define and evaluate scientifically the complex managerial problems arising out of the sequence of interrelateddecisionswithconsequentialoutcomesofhighrisk.Itiseffectivelyansweredby decisiontreeapproach. 4. Structuringa complexproject decision with many sequentialinvestment decisionsdemands effectiveprojectriskmanagement.Thisispossibleonlywiththehelpofananalyticaltoollike decisiontreeapproach. 5. Able to eliminateunprofitableoutcomes andhelps in arriving at optimumdecisionstagesin timesequence.

SelfAssessmentQuestions6 1.Decisiontreecanhandlethe_____________ofcomplexinvestmentproposals. 2._____portraysinterrelated,sequentialandcriticalmultidimensionalelementsofmajorproject decisions. 3. Adequate attention is given to the ______ in an investment decision under decision tree approachs. 4.____________areeffectivelyhandledbydecisiontreeapproachs.

9.8Summary Riskinprojectevaluationarisesonaccountoftheinabilityofthefirmtopredicttheperformance ofthefirm with certainty. Riskincapitalbudgeting decision may be defined as thevariabilityof actual returns from the expected. There are many factors that affect forecasts of investment, costsandrevenuesofaproject.Itispossibletoidentifythreetypeofriskinanyproject,vizstand alonerisk,corporateriskandmarketrisk.Thesourcesofrisksare: a. Project b. Competition c. Industry d. Internationalfactorsand e. Market

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Thetechniquesforincorporationofriskfactorincapitalbudgetingdecisioncouldbegroupedinto conventionaltechniquesandstatisticaltechniques.

TerminalQuestions 1. Definerisk.Examinetheneedforassessingtherisksinaproject. 2. Examinethetypeandsourcesofriskincapitalbudgeting. 3. Examine risk adjusted discount rate as a technique of incorporating risk factor in capital budgeting. 4. Examinethestepsinvolvedinsensitivityanalysis. 5. ExaminethefeaturesofDecisiontreeapproaches.

AnswerforSelfAssessmentQuestions SelfAssessmentQuestions1 1. Standalonerisk. 2. Beta 3. Diversify 4. Internationalrisk

SelfAssessmentQuestion2 1. Additionalreturn 2. Riskfreerate,riskpremium. 3. Greater.

SelfAssessmentQuestion3 1. Riskadjustmentfactor 2. Riskfreerateofinterest. 3. Conservation. 4. CE

SelfAssessmentQuestion4 1. Sensitivityanalysis 2. Oneofthestepsofsensitivityanalysis 3. Differenteconomicconditions

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SelfAssessmentQuestion5 1. Morereliable 2. Probability

SelfAssessmentQuestion6 1. Sequentialdecisions 2. Decisiontree. 3. Criticalaspects 4. Complexprojects.

AnswerforTerminalQuestions 1. Refertounits9.1 2. Refertounits9.2 3. Refertounits9.3 4. Refertounit9.5 5. Refertounit9.7

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Unit10
Structure

CapitalRationing

10.1 10.2 10.3 10.4

Introduction MeaningofCapitalRationing StepsinvolvedinCapitalRationing Summary TerminalQuestions AnswertoSAQsandTQs

10.1 Introduction: Capital budgeting decisions involve huge outlay offunds. Funds availablefor projects may be limited. Therefore, a firm has to prioritize the projects on the basis of availability of funds and economiccompulsionofthefirm.Itisnotpossibleforacompanytotakeupalltheprojectsata time.Thereistheneedtorankthemonthebasisofstrategiccompulsionandfundsavailability. Sincecompanieswillhavetochooseonefromamongmanycompetinginvestmentproposalthe needtodevelopcriteriaforCapitalrationingcannotbeignored.Thecompaniesmayhavemany profitable and viable proposals but cannot execute because of shortage of funds. Another constraintisthatthefirmsmaynotbeabletogenerateadditionalfundsfortheexecutionofallthe projects.Whenafirmimposesconstraintsonthetotalsizeoffirmscapitalbudget,itisrequires CapitalRationing.WhenCapitalisrationedthereisaneedtodevelopamethodofselectingthe projects that could beexecuted with the companys resources yetgivethehighest possiblenet presentvalue. LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1.Explainthemeaningofcapitalrationing. 2.Explaintheneedforcapitalrationing. 3.Explaintheprocessofcapitalrationing. 4.Explainthevariousapproachestocapitalrationing.

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10.2 MeaningofCapitalRationing:
Because of the limited financial resources, firms may have to make a choice from among profitableinvestmentopportunities.Capitalrationingreferstoasituationinwhichthefirmisunder aconstraintoffunds,limitingitscapacitytotakeupandexecutealltheprofitableprojects.Sucha situationmaybeduetoexternalfactorsorduetotheneedtoimposeinternalconstraints,keeping inviewoftheneedtoexercisebetterfinancialcontrol.

WhyCapitalRationing ReasonsforCapitalRationing: CapitalRationingmaybedueto a.Externalfactors b.Internalconstraintsimposedbymanagement

External Capital Rationing: External Capital Rationing is due to the imperfections of capital marketsImperfectionmaybecausedby: a. Deficienciesinmarketinformation b. RigiditiesthathampertheforceflowofCapitalbetweenfirms. Whencapitalmarketsarenotfavourabletothecompanythefirmcannottapthecapitalmarketfor executingnewprojectseventhoughtheprojectshavepositivenetpresentvalues.Thefollowing reasonsattributetotheexternalcapitalrationing: 1. Inabilityofthefirmtoprocurerequiredfundsfrom Capitalmarketbecausethefirmdoesnot commandtherequiredinvestorsconfidence. 2. Nationalandinternationaleconomicfactorsmaymakethemarkethighlyvolatileandinstable. 3. Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the marketforfunds. 4. HighCostofissueofSecuritiesI,eHighfloatationcost.Smallerfirmssmallerfirmsmayhave toincurhighcostsofissueofsecurities.Thisdiscouragessmallfirmsfromtappingthecapital marketsforfunds.

InternalCapitalRationing:Impositionsofrestrictionsbyafirmonthefundsallocatedforfresh investmentiscalledinternalcapitalrationing.Thisdecisionmaybetheresultofaconservative policy pursued byafirm. Restriction maybe imposed on divisionalheads onthe totalamount thattheycancommitonnewprojects. AnotherinternalrestrictionforCapitalbudgetingdecisionmaybeimposedbyafirmbasedonthe need to generate a minimum rate of return. Under this criterion only projects capable of

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generatingthemanagementsexpectationontherateofreturnwillbecleared.Generallyinternal capitalrationingisusedbyafirmasameansoffinancialcontrol.

SelfAssessmentQuestions1 1. When a firm imposes constraints on the total size of its capital budget, it is known as _____________. 2.Internalcapitalrationingisusedbyafirmasa______________________. 3.Rigiditiesthataffectthefreeflowofcapitalbetweenfirmscause_________________. 4.Inabilityofafirmtosatisfytheregularitynormsforissueofequitysharesfortappingthemarket forfundscauses__________________.

10.3 StepsinvolvedinCapitalRationing StepsinvolvedinCapitalRationingare: 1. Rankingofdifferentinvestmentproposals 2. Selectionofthemostprofitableinvestmentproposal

Rankingofdifferentinvestmentproposals Thevariousinvestmentproposalsshouldberankedonthebasisoftheirprofitability.Rankingis doneonthebasisofNPV,ProfitabilityindexorIRRinthedescendingorder. ProfitabilityindexasthebasisofCapitalRationing Thefollowingdetailsareavailable: CashInflows Project A B C CostofCapitalis15% ComputationofNPV Year Cashinflows PVfactorat15% PVofCashin flows 1 2 3 60,000 50,000 40,000 0.870 0.756 0.658 52,200 37,800 26,320 InitialCashoutlay 1,00,000 50,000 50,000 Year1 60,000 20,000 20,000 Year2 50,000 40,000 30,000 Year3 40,000 20,000 30,000

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PVofCashinflow InitialCashoutlay NPV

1,16,320 1,00,000 16,320

PVofCashinflows

Profitabilityindex= PVofCashoutflows
1,16,320

= 1,00,000
ProjectB

=1.1632

Year

Cashinflows

PVfactorat15%

PVofCashin flows

1 2 3

20,000 40,000 20,000

0.870 0.756 0.658 PVofCashinflow InitialCashoutlay NPV

17,400 30,240 13,160 60,800 50,000 10,800

Profitabilityindex=60,800=1.216 50,000 ProjectC Year Cashinflows PVfactorat15% PVofCashin flows 1 2 3 20,000 30,000 30,000 0.870 0.756 0.658 PVofCashinflow InitialCashoutlay NPV 17,400 22,680 19,740 59,820 50,000 9,820

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Profitabilityindex=59,820=1.1964 50,000 RankingofProjects Project Absolute A B C 16320 10800 9820 NPV Rank 1 2 3 ProfitabilityIndex Absolute 1.1632 1.216 1.1964 Rank 3 1 2

If the firm has sufficient funds and no capital rationing restriction, then all the projects can be acceptedbecauseallofthemhavepositiveNPVs. Let us assume that the firm is forced to resort to capital rationing because the total funds availableforexecutionofprojectisonlyRs.1,00,000. InthiscaseonthebasisofNPVCriterion,projectAwillbecleared.Itincursaninitialcashoutlay ofRs.1,00,000.AfterallocatingRs.1,00,000toprojectA,leftoverfundsisnil.Therefore,onthe basisofNPVcriterionotherprojectsi,eB&Ccannotbetakenupforexecutionbythefirm.Itwill increasethenetwealthofthefirmbyRs.16,320. On the other hand on the basis of profitability index, project B and C can be executed with Rs.1,00,000 because both of them incur individually an initial cash outlay of Rs.50,000. Therefore,withtheexecutionofprojectsBandC,increaseinnetwealthofthefirmwillbe10800 +9820=Rs20620 The objective is to maximize NPV per rupee of Capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis ranks assigned by profitabilityindex.

Evaluation: 1. PIruleofselectingprojectsunderCapitalrationingmaynotyieldsatisfactoryresultbecause of project indivisibility. When projects involving high investment is accepted many small projectswillhavetobeexcluded.ButthesumoftheNPVsofsmallprojectstobeaccepted maybehigherthantheNPVofsinglelargeproject. 2. ItalsosuffersfromthemultiperiodCapitalconstraints. Programmingapproach:TherearemanyprogrammingtechniquestoCapitalrationing.Among themare:

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1. LinearProgramming:LPapproachtoCapitalrationingtriestoachievemaximumNPVsubject tomanyconstraints.HeretheobjectivefunctionismaximisationofsumoftheNPVsofthe projects. Here the constraints matrix incorporates all the restrictions associated with Capital rationing imposedbythefirm. 2. IntegerProgramming:LPmaygiveanoptimalmixofprojectsinwhichtheremaybeneedto accept fraction of a project. Accepting fraction of a project is not feasible. Therefore, optimummaynotbeattainable.Theactualimplementationofprojectsmaybesuboptimal. Whenprojectsarenotdivisible,integerprogrammingcanbeemployedtoavoidthechancesof acceptingfractionofprojects. Theadvantageofprogrammingapproachisthatitprovidesinformationondualvariables.Italso givesinformationonshadowpricesofbudgetconstraints.Dualvariablesprovideinformationfor decisionontransferoffundsfromoneyeartoanotheryear

Thedemeritsofprogrammingapproachisthat a. Costlytousewhenlarge,indivisibleprojectsarebeingexamined. b. They are deterministic models. But variables of Capital budgeting are subject to change makingtheassumptionofdeterministichighlyinvalid.

SelfAssessmentQuestions2 1. Thetwostepsinvolvedincapitalrationingare__________and__________________. 2. Projectindivisibilitycanleadtosuboptimalresultwhen____________isusedforcapital rationing. 3. Objectivefunctionunderlinearprograminingapproachis___________. 4. Whenprojectarenotdivisible______________canbeemployedtoavoidthechangesof acceptingfractionofaproject.

10.4Summary
Oftenfirmsareforcedtorationthefundsamongtheeligibleprojectsthatthefirmwantstotake up.Theinabilityofthefirminfindingadequatefundsforexecutionoftheprojectscouldbedueto manyfactors.Itmaybeduetoexternalfactorsorinternalconstraintsimposedbythe management.Externalcapitalrationingoccursmainlybecauseofimperfectionsincapital markets.Internalcapitalrationingiscausedbyrestrictionsimposedbythemanagements.

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TerminalQuestions 1. Examinetheneedforcapitalrationing. 2. Examinethereasonsforexternalcapitalrationing. 3. InternalcapitalrationingisusesbyfirmsforexercisingfinancialcontrolHowdoesafirm achievethis? 4. Briefexplaintheprocessofcapitalrationing.

AnswertoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Capitalrationing. 2. Meansoffinancialcontrol. 3. Externalcapitalrationing. 4. Externalcapitalrationing.

SelfAssessmentQuestions2 1. Rankingtheproject,selectionofthemostprofitableinvestmentproposal 2. Profitabilityindex 3. MaximisationofsumofNPVsoftheprojects. 4. Integerprogramming

AnswerforTerminalQuestions 1. Refertounit10.1 2. Refertounit10.1 3. Refertounit10.1 4. Refertounit10.3

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Unit11
Structure

WorkingCapitalManagement

11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 11.9

Introduction ComponentsofCurrentAssetsandCurrentLiabilities ConceptsofWorkingCapital ObjectiveofWorkingCapitalManagement NeedforworkingCapital OperatingCycle DeterminantsofWorkingCapital EstimationofWorkingCapital Summary TerminalQuestions AnswertoSAQsandTQs

11.1

Introduction

SoundworkingCapitalManagementhasbecomeanecessityinaneraofinformationtechnology foracompanytosucceed.ThebestexampletosupportthisargumentistheperformanceofDell computersasreportedinoneoftherecentFortunearticle. AperusalofthearticlewillgiveusaninsightintohowDellcouldusetechnologyforimprovingthe performanceofcomponentsofworkingcapital. 1. Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and dealers. 2. Outsourcinganoperationsifthefirmscorecompetencedoesnotpermittheperformanceof theoperationeffectively. 3. Traintheemployeestoacceptchange. 4. Introductionofinternetbusiness 5. Releasing Capital by reduction in investment in inventory for improving the profitability of operatingcapital. Afinancialmangerspendsalargepartofhistimeinmanagingworkingcapital. Therearetwoimportantelementsofworkingcapitalmanagement.

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1. Decisionsontheamountofcurrentassetstobeheldbyafirmforefficientoperationsofits business. 2. Decisionsonfinancingworkingcapitalrequirement. Inadequacy or mismanagement of Working Capital is the leading cause of many business failures. Working Capital is that portion of asset of a business which are used in current operations. They are used in the operating cycle of the firm. It is defined as the excess of CurrentAssetsoverCurrentLiabilitiesandprovisions.

LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1. Explainthemeaning,definitionandconceptsofWorkingCapital 2. StatetheobjectivesofWorkingCapitalmanagement. 3. BringouttheimportanceofWorkingCapitalmanagement. 4. ExplaintheprocessofestimationofWorkingCapital.

11.2

ComponentsofCurrentAssetsandCurrentLiabilities
1)Inventories 2)SundryDebtors3)BillsReceivables

11.2.1 CurrentAssetsare:

4)CashandBankBalances5)Shortterminvestments 6) Advances such as advances for purchase of raw materials, components and consumablestores,prepaidexpensesetc. 11.2.2 CurrentLiabilitiesare: 1)SundryCreditors2)BillsPayable3)Creditorsforoutstandingexpenses 4)Provisionfortax5)Otherprovisionsagainsttheliabilitiespayablewithinaperiodof 12months. Working Capital Management is concerned with managing the different components of current assets and current liabilities. A firm must have adequate Working Capital neither excess nor shortage.MaintainingadequateWorkingCapitalatthesatisfactoryleveliscrucialformaintaining thecompetitivenessofafirm. Anylapseofafirmonthisaccountmayleadafirmtothestateofinsolvency.

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SelfAssessmentQuestions1 1. Maintaining adequate working capital at the satisfactory level is crucial for ______________the_____________ofafirm. 2. Prepaidexpensesare____________. 3. Provisionfortaxis______________. 4. Afirmmust___________________neitherexcessnorshortage.

11.3

ConceptsofWorkingCapital

TherearetwoimportantconceptsofWorkingCapitalgrossandnet Gross Working Capital: Gross Working Capital refers to the amounts invested in the various componentsofcurrentassets.Thisconcepthasthefollowingpracticalrelevance. a. ManagementofcurrentassetsisthecrucialaspectofWorkingCapitalManagement. b. Itisanimportantcomponentofoperatingcapital.Therefore,forimprovingtheprofitabilityon itsinvestmentafinancemanagerofacompanymustgivetopprioritytoefficientmanagement ofcurrentassets. c. The need to plan and monitor the utilization of funds of a firm demands working capital managementasappliedtocurrentassets. d. Ithelpsinthefixationofvariousareasoffinancialresponsibility.

NetWorkingCapital NetWorkingCapitalis theexcessof current assets over currentliabilitiesand provisions. Net Working Capital is positive. when current assets exceed current liabilities and negative when currentliabilitiesexceedcurrentassets.Thisconcepthasthefollowingpracticalrelevance. 1. Itindicatestheabilityofthefirmtoeffectivelyusethespontaneousfinanceinmanagingthe firmsWorkingCapitalrequirements. 2. A firms short term solvency is measured through the net Working Capital position it commands.

PermanentWorkingCapital PermanentWorkingCapitalistheminimumamountofinvestmentrequiredtobemadeincurrent assetsatalltimestocarryonthedaytodayoperationoffirmsbusiness.Thisminimumlevelof currentassethasbeengiven thename of corecurrentassetsby the Tandon Committee. It is alsoknownasfixedWorkingCapital.

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TemporaryWorkingCapital It is also known as Variable Working Capital orfluctuating Working Capital. The firms working capital requirementsvary depending upon theseasonaland cyclical changesindemandsfor a firms products. The extra Working Capital required as per the changing production and sales levelsofafirmisknownasTemporaryWorkingCapital.

SelfAssessmentQuestion2 1._______________referstotheamountsinvestedincurrentassets. 2.To_______and monitorthe________________________________to(currentassets)isto begiventoppriority. 3.Whencurrentassetsexceedcurrentliabilitiesthenetworkingcapitalis_____. 4.Permanentworkingiscalled____workingcapital.

11.4 ObjectiveofWorkingCapitalManagement Thebasicobjectiveoffinancialmanagementismaximizingthenetwealthofshareholders.Afirm mustearnsufficientreturnsfromitsoperationstoensuretherealizationofthisobjective.There exists a positive correlation between sales and firms return on its investment. The amount of earnings that a firm earns dependsupon the volume of sales achieved. There is the need to ensure adequate investment in current assets, keeping pace with accelerating sales volume. Firmsmakesalesoncredit.Thereisalwaysatimegapbetweensaleofgoodsoncreditandthe realizationofproceedsofsalesfromthefirmscustomers.Financemangerofafirmisrequired to finance the operation during this time gap. Therefore, objective of Working Capital Managementisto ensure smoothfunctioning ofthenormalbusiness operationsofafirm. The firmhastodecideontheamountofWorkingCapitaltobeemployed. The firm may have a conservative policy of holding large quantum of current assets to ensure largermarketshareandtopreventthecompetitorsfromsnatchinganymarketfortheirproducts. Butsuchapolicywillaffectthefirmsreturnonitsinvestment.Thefirmwillhavehigherthanthe requiredamountofinvestmentincurrentasset.Thisexcessfundslockedincurrentassetswill reducethefirmsprofitabilityonoperatingcapital. Ontheotherhandafirmmayhaveanaggressivepolicyofdependingonspontaneousfinanceto the maximum extent. Credit obtained by a firm from its suppliers is known as spontaneous finance.Hereafirmwilltrytoreduceitsinvestmentsincurrentassetsasmuchaspossiblebut withoutaffectingthefirmsabilitytomeetworkingcapitalneedsforsalesgrowthtargets.Sucha policy will ensure higher return on its investment as the firm will not be locking in any excess

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fundsin currentassets. However,anyerror inforecasting canaffect the operationsof thefirm unfavorablyiftheerrorisfraughtwiththedownsiderisk.Thereisalsoanotherriskoffirmlosing onmaintainingitsliquidityposition. Objective of working capital management is achieving a trade off between liquidity and profitability ofoperationsforthesmoothconductofnormalbusinessoperationsofthefirm.

SelfAssessmentsQuestions3 1. Objective of working capital management is achieving a trade off between ______ and ________. 2.Creditobtainedbyfirmfromitssuppliersisknowas_________. 3. An aggressive policy of working capital management means depending on ____________________tothemaximumextent. 4.Topreventthecompetitorsfromsnatchinganymarketfortheirproductsthefirmmayhavea ________________policyofholding__________ofcurrentassets.

11.5 NeedforworkingCapital Theneedforworkingcapitalarisesonaccountoftworeasons: a. Tofinanceoperationsduringthetimegapbetweensaleofgoodsoncreditandrealization ofmoneyfromcustomersofthefirm. b. Tofinanceinvestmentsincurrentassetsforachievingthegrowthtargetinsales. Thereforefinancetheoperationsinoperatingcycleofafirmworkingcapitalisrequired.

SelfAssessmentQuestions4 1.Tofinancetheoperationsin_______ofafirmworkingcapitalisrequired. 2.Tofinanceoperationsduringthetimegapbetween______and____________workingcapital isrequired.

11.6OperatingCycle Operatingcycleofafirmhasthefollowingelements. 1. Acquisitionofresourcesfromsuppliers. 2. Makingpaymentstosuppliers. 3. Conversionofrawmaterialsintofinishedproducts. 4. Saleoffinishedproductstocustomers. 5. Collectionofcashfromcustomersforthegoodssold.

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Thetimegapbetweenacquisitionofresourcesandcollectionofcashfromcustomersisknownas theoperatingcycle.Thesefivephasesoccuronacontinuousbasis.Thereisnosynchronization between the activities in operating cycle. Cashout flows occur before the occurrences of cash inflows in operating cycle cash out flows are certain. On the other hand cash in flows are uncertain because of uncertainty associated.With effecting salesasper the salesforecastand ultimatetimelycollectionofamountduefromthecustomerstowhomthefirmhassolditsgoods. Sincecashinflowsdonotmatchwithcashoutflows,firmhastoinvestinvariouscurrentassets toensuresmoothconductofdaytodaybusinessoperations.Therefore,thefirmhastoassess the operating cycle time of its operation for providing adequately for its working capital requirements. Operatingcycle=ICperiod+RCperiod ICperiod=Inventoryconversionperiod RCperiod=Receivablesconversionperiod Inventory conversion period is the average length of time required to produce and sell the product.

1. InventoryConversionperiod=AverageInventory x365 Annualcostofgoodssold

2. Receivablesconversionperiod=AverageAccountsReceivables x365 AnnualSales

Accountspayablesperiodisalsoknownaspayablesdeferralperiod. 3. Accountspayablesperiod= (Payablesdeferralperiod) Purchasesperday Averagecreditors purchasesperday =TotalPurchasesforyear 365 Receivablesconversionperiodistheaveragelengthoftimerequiredtoconvertthefirms receivablesintocash.

4. CashConversionCycle:Isthelengthoftimebetweenthefirmsactualcashexpenditure anditsowncashreceipt.Thecashconversioncycleistheaveragelengthoftimearupee istiedupincurrentassets. CashConversionCycleis

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CCC=ICP+RCPPDP CCC=CashConversionCycle ICP=InventoryConversionPeriod RCP=ReceivablesConversionPeriod PDP=Payablesdeferralperiod

Example: ThefollowingdetailsareavailableforXYZLtdfortheyearended31.03.08 Sales Costofgoods 80,000 56,000 Inventory 31.03.07 31.03.08 AccountsReceivables 31.03.07 31.03.08 AccountsPayable 31.03.07 31.03.08 7,000 10,000 12,000 16,000 9,000 12,000

Whatisthelengthoftheoperatingcycle? Whatisthecashcycle? Assume365daysintheyear(MBAAdopted) Answer OperatingCycle=InventoryConversionPeriod+AccountsReceivablesconversionPeriod

InventoryConversionPeriod AverageInventory (9000+12000)/2

AnnualCostofgoodssold56000 10500x365 56000

X365

X365

=68.4days
AverageAccountsReceivables

ReceivablesConversionPeriod=

X365

Annualsales

(12000+16000)/2x365 80000

=63.9days

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AverageAccountsPayables

ReceivablesConversionPeriod=
(7000+10000)/2x365 56000

AnnualCostofgoodssold

X365

=63.9days

8500x365 56000

=55.4days

OperatingCycle=ICP+RCP =68.4+63.9=132.3days CashConversioncycle =OCPDP =132.355.4=76.9days The Cash conversion cycle shows the time interval over which additional non spontaneous sourcesofworkingcapitalfinancingmustbeobtainedtocarryoutfirmsactivities.Anincreasein the length of operating cycle, without a corresponding increase in payables deferral period, increasesthecashconversioncycle.Anyincreaseincashconversioncycleleadstoadditional workingcapitalneedsofthefirm.

SelfAssessmentQuestion5 1. The time gap between acquisition of resources from suppliers and collection of cash from customersisknownas______. 2.__________istheaveragelengthoftimerequiredtoproduceandselltheproduct. 3. ______________ is the average lenth of time required to concept the firms receivables into cash. 4. _______________ is conversion cycle is the length of time between firms actual cash expenditureanditsownreceipt.

11.7 DeterminantsofWorkingCapital A large numberof factors influence Working Capital needs of a firm. The basic objective of a firmsWorkingCapitalmanagementistoensurethatthefirmhasadequateworkingcapitalforits operations,neithertoomuchnottoolittle.Investingheavilyincurrentassetswilldrainthefirms earningsandinadequateinvestmentincurrentassetswillreducethefirmscredibilityasitaffects

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the firms liquidity. Therefore, the need to strike a balance between liquidity and profitability cannotbeignored.Thefollowingfactorsdetermineafirmsworkingcapitalrequirements. 1. Natureofbusiness:WorkingCapitalrequirementsarebasicallyinfluencedbythenatureof businessofthefirm.Tradingorganizationsareforcedtocarrylargestocksoffinishedgoods, accounts receivables and accounts payables. Public utilities require lesser investment in workingcapital. 2. SizeofBusinessOperation:Sizeismeasuredintermsofascaleofoperation.Afirmwith largescaleofoperationnormallyrequiresmoreWorkingCapitalthanafirmwithalowscaleof operation. 3. Manufacturing Cycle: Capital intensive industries with longer manufacturing process will havehigherrequirementsofWorkingCapitalbecauseoftheneedtoruntheirsophisticated andlongproductionprocess. 4. ProductsPolicy:Productionscheduleofafirminfluencestheinvestmentsininventories.A firm,exposedtoseasonalchangesindemandwhenfollowingasteadyproductionpolicywill havetofacethecostsandrisksassociatedwithinventoryaccumulationduringtheoffseason periods. On the other hand a firm with a variable production policy will be facing different dimensions of management of working capital. Such afirmmay have to effectively handle problem of production planning and control associated with utilization of installed plant capacityunderconditionsofvaryingvolumesofproductionofproductsofseasonaldemand. 5. Volumeofsales:Thereisapositivedirectcorrelationbetweenthevolumeofsalesandthe sizeofworkingcapitalofafirm. 6. Term of Purchase and Sales: Afirm which allows liberal credit to its customers willneed more working capital than thatof afirm with strict creditpolicy. A firm whichenjoysliberal creditfacilitiesfromitssuppliersrequiresloweramountofworkingcapitalwhencomparedtoa firmwhichdoesnothavesuchafacility. 7. Operating efficiency: The firm with high efficiency in operation can bring down the total investmentinworkingcapitaltolowerlevels.Hereeffectiveutilizationofresourceshelpsthe firminbringingdowntheinvestmentinworkingcapital. 8. Price levelchanges: Inflation affects the working capital levelsin afirm. To maintain the operating efficiency under an inflationary set upa firm should examine the maintenance of working capital position under constant price level. The financial capital maintenance demands afirm to maintainhigheramountof working capital keeping pace with risingprice levels. Under inflationary conditions same levels of inventory will require increased

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investment.Theabilityofafirmtoreviseitsproductspriceswithrisingpricelevelswilldecide theadditionalinvestmenttobemadetomaintaintheworkingcapitalintact. 9. BusinessCycle: Duringboom,salesriseasbusinessexpands.Depressionismarkedbya decline in sale. During boom, expansion of business can be achieved only by augmenting investmentinvariousassetsthatconstituteworkingcapitalofafirm.Whenthereadeclinein business on account of depression in economy, inventory glut forces a firm to maintain workingcapitalatalevelfarinexcessoftherequirementsundernormalconditions. 10. Processing technology: Longer the manufacturing cycle the larger the investment in working capital when raw materialpasses through several stagesintheproductionprocess workinprocessinventorywillincreasecorrespondingly. 11. Fluctuationsinthesupplyofrawmaterials: Companieswhichuserawmaterialsavailable onlyfromoneortwosourcesareforcedtomaintainbufferstockofrawmaterialstomeetthe requirementsofuncertaintyinleadtime Suchfirmsnormallycarrymoreinventorythanitwouldhave,hadthematerialsbeenavailable innormalmarketconditions.

SelfAssessmentQuestions6 1.Capitalintensiveindustriesrequired___amountofworkingcapital. 2. There is a _______________between volume of sales and the size of working capital of a firm. 3.Underinflationingconditionssamelevelofinventorywillrequire____________investmentin workingcapital 4.Longerthemanufacturingcyclethe_theinvestmentinworkingcapital.

11.8 EstimationofWorkingCapital Thebestapproachtoestimateisbasedonoperatingcycle.Therefore,thetwocomponentsof working capital are current assets and current liabilities. This approach is based on the assumption that production and sales occur on a continuous basis and all costs occur accordingly. EstimationofCurrentAssets. 1. Rawmaterialsinventory:Averageinvestmentinrawmaterialisestimated. 2. Averageinvestmentinworkinprogressinventoryisestimated. 3. Averageinvestmentinfinishedgoodsinventoryisestimated.

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4. Average investment in receivables (i,e both in debtors and bills receivables) is estimated basedoncreditpolicythatthefirmwishestopursue. 5. Basedonthefirmsattitudetowardsrisk,accesstoborrowingsources,pastexperienceand natureofbusiness,firmsdecideonthepolicyofmaintainingtheminimumcashbalances.

EstimationofCurrentLiabilities: 1. Trade Creditors: Based on production budget, raw material consumption, credit period enjoyedfromsuppliersaverageamountoffinancingavailabletothefirmisestimated. 2. Directwages: Based onproductionbudget,direct labour cost perunit,average timelagin paymentofwagesestimationismadeontotalwagestobepaidonanaveragebasis. 3. Overheads: Based on production budget, overhead cost per unit and average timelag in paymentofoverheadanestimationonanaveragebasisoftheamountoutstandingtobepaid tocreditorsforoverhead.

Example:AProformacostsheetofacompanyprovidesthefollowingdata CostsperUnit RawMaterial DirectLabout Overheads TotalCost Profit SellingPrice 19.50 39.00 110.50 19.50 130.00 52.00

Thefollowingadditionalinformationisavailable: a. Averagerawmaterialinstock:Onemonth b. Averagematerialsinprocess:Halfamonth c. CreditallowedbySuppliers:Onemonth d. Creditallowedtodebtors:Twomonths e. Timelaginpaymentofwages:oneandahalfweeks f. Timelaginpaymentofoverheadsonemonth g. Onefourthofsalesoncashbasis h. CashbalanceexpectedtobemaintainedisRs.1,20,000 Youarerequiredtoprepareastatementshowingtheworkingcapitalrequiredtofinancealevelof activityof70,000unitsofoutput.Youmayassume thatproductioniscarriedonevenlythrough

SikkimManipalUniversity

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out the year and wages and overheads occur similarly. Assume 360 days in a year (MBA adapted) Solution: EstimationofWorkingCapital a. Investmentininventory 1. Rawmaterial RMC = 70000x52

360360 2. Workinprocessinventory COP 360

XRMCP

X30=303333.33

= 70000x110.5

XWIPCP

360

X15=322291.67

3. Finishedgoodsinventory COS = 70000x110.5x30644583.33

3603601270208.33

XFGCP

b. Investmentindebtors CostofCreditSales 360 52500x110.5

XDCP

360

X60=966875.00

c. Cashbalance d. TotalcurrentAsset(A+B+C) e. CurrentLiabilities 1. Creditors PurchaseofrawmaterialsxPDP 360 70000x52x30=303333.33 360 2. Wages 70000x19.5x10=37916.67 360 3. Overheads 70000x39x30=227500.00 360

120000 2357083.33

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f. TotalCurrentLiabilities568750.00 g. NetworkingCapital(DF)1788958.33

Examples2:ThefollowingannualfiguresrelatetoXYZ: Sales(attwomonthscredit) Materialsconsumed (Suppliersextendtwomonthscredit) 900000 WagesPaid(monthlyinarrears) Manufacturingexpensesoutstanding attheendoftheyear (Cashexpensesarepaidone monthinarrears) Totaladministrativeexpenses paid,asabove Salespromotionexpenses, Paidquarterlyinadvance 120000 240000 80000 720000 3600000

Thecompanysellsitsproductsongrossprofitof25%countingdepreciationaspartofthecostof production. It keeps one months stock each of raw materials and finished goods, and a cash balanceofRs.100000. Assumea20percentsafetymargin.Calculatetheworkingcapitalrequirementsofthecompany oncashcostbasis.Ignoreworkinprocess. [CAFinalAdapted]

Solution WorkingNotes: Computationofmanufacturingexpenses Sales Less:grossprofitat25% Totalmanufacturingcost Less:Materials900000 Wages720000 1620000 3600000 900000 2700000

Manufacturingexpenses

1080000

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Cashmanufacturingexpenses Depreciation:

960000

Totalmanufacturingexpenses Cashmanufacturingexpenses 1080000960000=Rs.120000 Totalcashcost Totalmanufacturingcost Less:Depreciation Cashmanufacturingcost Totalmanufacturingexpenses SalesPromotionexpenses Totalcashcost 2700000 120000 2580000 240000 120000 2940000

Statementofworkingcapitalrequiredcurrentassets:

RawMaterialsstock MaterialCost 12 Finishedgoodsstock Cashmanufacturingcost x 1 12 2580000x=215000 Debtors: Totalcashcostofsalesx2/12 =2940000x2/12= Salespromotionexpenses =120000x1/4 Cashrequired (A)TotalAssets CurrentLiabilities 100000 910000 490000 30000 90000x1=75000

X1

12

SundryCreditors MaterialCost 12

X2

90000x2=150000 12

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Wagesoutstanding=720000x1/12=60000 Manufacturingexpensesoutstanding=80000 Totaladministrativeexpenses Outstanding 240000/12= (B)TotalcurrentLiabilities WorkingCapital AB Add20%safetymargin WorkingCapitalrequired 600000 120000 720000 20000 310000

SelfAssessmentQuestions7 1. ________________isusedtoestimateworkingcapitalrequirementsofafirm. 2. Operatingcycleapproachisbasedontheassumptionthatproductionand salesoccurona _____________.

11.9 Summary Allcompaniesarerequiredtomaintainaminimumlevelofcurrentassetsatallpointoftime.This leveliscalledcoreorpermanentworking.Capitalofthecompany.Workingcapitalmanagement isconcernedwiththedeterminationofoptimumlevelofworkingcapitalanditseffectiveutilization. Toassetstheworkingcapitalrequiredforaformtoconductitsoperationssmoothly,firmuse operatingcycleconceptandcomputeeachcomponentofworkingcapital.

TerminalQuestions 1. ExaminetheComponentsofworkingcapital. 2. Explaintheconceptsofworkingcapital 3. Whataretheobjectivesofworkingcapitalmanagement? 4. Brieflyexplainthevariouselementsofoperatingcycle.

AnswerforSelfAssessmentQuestions SelfAssessmentQuestions1 1. Maintaining,Competitiveness. 2. Currentassets. 3. CurrentLiabilities 4. Adequateworkingcapital

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SelfAssessmentQuestions2 1. Grossworkingcapital 2. Plan,utilizationoffundsofafirmworkingcapitalmanagementasapplied. 3. Positive 4. Fixed SelfAssessmentQuestions3 1. Liquidity,Profitability. 2. Spontaneousfinance. 3. Spontaneousfinance. 4. Conservative,Largequantum. SelfAssessmentQuestions4 1.Operatingcycle 2.Salesofgoodsoncredit,realizationofmoneyfromcustomers. SelfAssessmentQuestions5 1. Operatingcycle 2. Inventoryconversionperiod 3. Receivables conversionperiod 4. CashConversioncycle SelfAssessmentQuestions6 1. Higher 2. Positivedirectcorrelation. 3. Increased 4. Larger SelfAssessmentQuestions7 1. Operatingcycle 2. Continuousbases AnswerforTerminalQuestions 1. Refertounit11.2 2. Refertounit11.3 3. Refertounit11.4 4. Refertounit11.6

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Unit12
Structure

CashManagement

12.1 Introduction 12.1.1MeaningofCash 12.2 Meaningandimportanceofcashmanagement 12.3Motivesforholdingcashbalances 12.4 ObjectivesofCashManagement 12.5 DeterminingtheCashNeedsModelsforDeterminingOptimalCash 12.5.1 12.5.2 12.5.3 12.5.4 BaumolModel MillerOrrmodel CashPlanning CashForecastingandBudgeting

12.6 Summary TerminalQuestions AnswerstoTQsandSAQs.

12.1

Introduction

Cash is the most important current asset for a business operation. It is the energy that drives business activities and also the ultimate output expected by the owners. The firm should keep sufficient cash at all times. Excessive cash will not contribute to the firms profits and shortage of cashwilldisruptitsmanufacturingoperations. 12.1.1 MeaningofCash Thetermcashcanbeusedintwosensesinanarrowsenseitmeansthecurrencyandothercash equivalentssuchascheques,draftsanddemanddepositsinbanks.Inabroadersense,itincludes nearcashassetslikemarketablesecuritiesandtimedepositsinbanks.Thedistinguishingnatureof thiskindofassetisthattheycanbeconvertedintocashveryquickly.Cashinitsownformisanidle asset.Unlessemployedinsomeformoranother,itdoesnotearnanyrevenue.

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LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Meaningofcashandnearcashassets 2. Theimportanceofcashmanagementinafirm 3. Thedifferentmodelsofdeterminingtheoptimalcashbalances 4. Techniquesforforecastingthecashinflowsandoutflows.

12.2

MeaningandimportanceofCashManagement

Cashmanagementisconcernedwith(a)managementofcashflowsintoandoutofthefirm,(b)cash managementwithinthefirmand(c)managementofcashbalancesheldbythefirmdeficitfinancing orinvestingsurpluscash.Cashmanagementtriestoaccomplishataminimumcostthevarioustasks ofcashcollection,paymentofoutstandingsandarrangingfordeficitfundingorsurplusinvestment.It is very difficult to predict cash flows accurately. Generally, there is no correlation between inflows and outflows. At some points of time, cash inflows may be lower than outflows because of the seasonal nature of product sale thus prompting the firm to resort to borrowings and sometimes outflows may be lesser than inflows resulting in surplus cash. There is always an element of uncertainty about the inflows and outflows. The firm should therefore evolve strategies to manage cashinthebestpossibleway.Thesecanbebroadlysummarizedas: Cash planning: Cashflows should beappropriatelyplannedtoavoidexcessiveor shortageof cash.Cashbudgetscanbepreparedtoaidthisactivity Managingcashflows:Theflowofcashshouldbeproperlymanaged.Stepstospeedupcash collectionandinflowsshouldbeimplementedwhilecashoutflowsshouldbesloweddown. Optimumcashlevel:Thefirmshoulddecideontheappropriatelevelofcashbalance.Balance shouldbestruckbetweenexcesscashandcashdeficientstage. Investing surplus cash: The surplus cash should be properly invested to earn profits. Many investmentavenuestoinvestsurpluscashareavailableinthemarketsuchas,bankshortterm deposits,TBills,intercorporatelendingetc.

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The ideal cash management system will depend on a number of issues like, firms product, competition,collectionprogram,delayinpayments,availabilityofcashatlowratesofinterestsand investmentopportunitiesavailable.

12.3 MotivesofHoldingCash Therearefourmotivesofholdingcash.Theyare: Transaction motive: This refers to a firm holding cash to meet its routine expenses which are incurredintheordinarycourseofbusiness.Afirmwillneedfinancestomeetaplethoraofpayments likewages,salaries,rent,sellingexpenses,taxes,interests,etc.Thenecessitytoholdcashwillnot arise if there were a perfect coordination between the inflows and outflows. These two never coincide.At times, receipts may exceedoutflows and at other times,paymentsoutrun inflows. For suchperiodswhenpaymentsexceedinflowsthefirmshouldmaintainsufficientbalancestobeable to make the required payments. For transactions motive, a firm may invest its cash in marketable securities. Generally, they purchase such securities whose maturity will coincide with payment obligations. Precautionarymotive:Thisreferstotheneedtoholdcashtomeetsomeexigencieswhichcannot beforeseen.Suchunexpectedneedsmayariseduetosuddenslowdownincollectionofaccounts receivable, cancellation of an order by a customer, sharp increase in prices of raw materials and skilled labour etc. The moneys held to meet such unforeseenfluctuations in cashflowsare called precautionary balances. Theamountof precautionarybalance alsodepends on thefirms abilityto raiseadditionalmoneyatashortnotice.Thegreaterthecreditworthinessofthefirminthemarket, thelesseristheneedforsuchbalances.Generally,suchcashbalancesareinvestedinhighlyliquid andlowriskmarketablesecurities. Speculative motive: This relates to holding cash to take advantage of unexpected changes in businessscenariowhicharenotnormalintheusualcourseoffirmsdealings.Itmayalsoresultin investinginprofitbackedopportunitiesasthefirmcomesacross.Thefirmmayholdcashtobenefit fromafallingpricescenarioorgettingaquantitydiscountwhenpaidincashordelaypurchasesof rawmaterialsinanticipationofdeclineinprices.Byandlarge,businessfirmsdonotholdcashfor speculativepurposesandevenifitisdone,itisdoneonlywithsmallamountsofcash.Speculation maysometimesalsoboomeranginwhichcasethefirmslosealot.

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Compensatingmotive:Thisisyetanothermotivetoholdcashtocompensatebanksforproviding certain services and loans. Banks provide a variety of services like cheque collection, transfer of fundsthroughDD,MT,etc.Toavailallthesepurposes,thecustomersneedtomaintainaminimum balance in their account at all times. The balance so maintained cannot be utilized for any other purpose.Suchbalancesarecalledcompensatingbalances.Compensatingbalancescantakeany ofthefollowingtwoforms(a)maintaininganabsoluteminimum,sayforexample,aminimumofRs. 25000 in current account or (b) maintaining an average minimum balance of Rs. 25000 over the month.Afirmismoreaffectedbythefirstrestrictionthanthesecondrestriction.

12.4 ObjectivesofCashManagement: Therearetwomajorobjectivesforcashmanagementinafirm(a)meetingpaymentsscheduleand (b)minimizingfundsheldintheformofcashbalances. Meeting payments schedule: In the normal course offunctioning, afirm will have to make many payments by cash to its employees, suppliers, infrastructure bills, etc. It will also receive cash throughsalesofitsproductsandcollectionofreceivables.Boththesedonothappensimultaneously. A basic objective of cash management is therefore to meet the payment schedule in time. Timely payments will help the firm to maintain its creditworthiness in the market and to foster good and cordial relationships with creditors and suppliers. Creditors give a cash discount if payments are madeintimeandthefirmcanavailthisdiscountaswell.Tradecreditreferstothecreditextended bythesupplierofgoodsandservicesinthenormalcourseofbusinesstransactions.Generally,cash isnotpaidimmediatelyforpurchasesbutafteranagreedperiodoftime.Thereisdeferralofpayment and is a source of finance. Trade credit does not involve explicit interest charges, but there is an implicitcostinvolved.Ifthecredittermsare,say,2/10,net30,itmeansthecompanywillgetacash discountof2%forpromptpaymentmadewithin10daysorelsetheentirepaymentistobemade within30days.Sincethenetamountisduewithin30days,notavailingdiscountmeanspayingan extra2%for20dayperiod. Theotheradvantageofmeetingthepaymentsintimeisthatitpreventsbankruptcythatarisesoutof thefirms inability to honour its commitments. At the same time, care shouldbetakennot to keep largecashreservesasitinvolveshighcost.

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Minimize funds committed to cash balances: Trying to achieve the second objective is very difficult.Ahighlevelofcashbalanceswillhelpthefirmtomeetitsfirstobjectivediscussedabove,but keepingexcess reserves is also not desirableas funds in its original form is idle cash anda non earningasset.Itisnotprofitableforfirmstokeephugebalances.Alowlevelofcashbalancesmay meanfailuretomeetthepaymentschedule.Theaimofcashmanagementisthereforetohavean optimallevelofcashbybringingaboutapropersynchronizationofinflowsandoutflowsandcheck the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of mismatchesbetweeninflowsandoutflows. The efficiency of cash management can be augmented by controlling a few important factors describedbelow: Promptbillingandmailing:Thereisatimelagbetweenthedispatchofgoodsandpreparationof invoice.Reductionofthisgapwillbringinearlyremittances. Collectionofchequesandremittancesofcash:Itisgenerallyfoundthatthereisadelayinthe receipt of cheques and their deposits into banks. The delay can be reduced by speeding up the processofcollectionanddepositingcashorotherinstrumentsfromcustomers.Theconceptoffloat helpsfirmstoacertainextentincashmanagement.Floatarisesbecauseofthepracticeofbanksnot creditingfirmsaccountinitsbookswhenachequeisdepositedbyitandnotdebitfirmsaccountin its books when a cheque is issued by it until the cheque is cleared and cash is realized or paid respectively. A firm issues and receives cheques on a regular basis. It can take advantage of the concept of float. Whenever cheques are deposited with the bank, credit balance increases in the firmsbooksbutnotinbanksbooksuntilthechequeisclearedandmoneyrealized.Thisrefersto collection float, that is, the amount of cheques deposited into a bank and clearance awaited. Likewise the firm may take benefit of payment float. The difference between payment float and collectionfloatiscalledasnetfloat.Whennetfloatispositive,thebalanceinthefirmsbooksis lessthanthebanksbookswhennetfloatisnegativethefirmsbookbalanceishigherthaninthe banksbooks.

12.5 DeterminingtheCashNeedsModelsforDeterminingOptimalCash One of the prime responsibilities of a Finance Manager is to maintain an appropriate balance between cash and marketable securities. The amount of cash balance will depend on riskreturn

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tradeoff.Afirmwithlesscashbalanceshasaweakliquiditypositionbutmaybeearningprofitsby investingitssurpluscashandontheotherhanditlosesontheprofitsbyholdingtoomuchcash.A balancehastobemaintainedbetweentheseaspectsatalltimes.Sohowmuchisoptimumcash? Thissectionexplainsthemodelsfordeterminingtheappropriatebalance.Twoimportantmodelsare studiedhereBaumolmodelandMillerOrrmodel. 12.5.1 BaumolModel TheBaumolmodelhelpsindeterminingtheminimumcostamountofcashthatamanagercanobtain byconvertingsecuritiesintocash.Itisanapproachtoestablishafirmsoptimumcashbalanceunder certainty.Assuch,firmsattempttominimizethesumofthecostofholdingcashandthecostof convertingmarketablesecuritiestocash.TheBaumolmodelisbasedonthefollowingassumptions: Thefirmisabletoforecastitscashrequirementsinanaccurateway. Thefirmspayoutsareuniformoveraperiodoftime. Theopportunitycostofholdingcashisknownanddoesnotchangewithtime. Thefirmwillincurthesametransactioncostforallconversionsofsecuritiesintocash.

A company will sell securities and realizes cash and this cash is used to make payments. As the cashbalancecomesdownandreachesapoint,theFinanceManagerreplenishesitscashbalance by selling marketable securities available with it and this pattern continues. Cash balances are refilledandbroughtbacktonormallevelsbytheactsofsaleofsecurities.Theaveragecashbalance isC/2.Thefirmbuyssecuritiesasandwhentheyhaveabovenormalcashbalances.Thispatternis explainedbelow:Error! C

Cashbalance

C/2

Average

T1

T2 Time

T3

BaumolsModel

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The total cost associated with cash management has two elements(a) cost of conversion of marketablesecuritiesintocashand(b)theopportunitycost. Thefirm incursa holding costfor keeping cashbalance which is theopportunity cost. Opportunity costisthebenefitforegoneonthenextbestalternativeforthecurrentaction.Holdingcostisk(C/2). Thefirmalsoincursatransactioncostwheneveritconvertsitsmarketablesecuritiesintocash.Total number of transactions during the year will be the total funds requirement, T, divided by the cash balance,C,i.e.T/C.Ifpertransactioncostisc,thenthetotaltransactioncostisc(T/C). Thetotalannualcostofthedemandforcashisk(C/2)+c(T/C).

Error!
Totalcost

Cost

Holdingcost

Transactioncost

Cashbalance

C* BaumolsCutoffModel

TheoptimumcashbalanceC*isobtainedwhenthetotalcostisminimumwhichisexpressedasC*= 2cT/k where C* is the optimum cash balance, c is the cost per transaction, T is the total cash needed during the year and k is the opportunity cost of holding cash balance. The optimum cash balancewillincreasewithincreaseinthepertransactioncostandtotalfundsrequiredanddecrease withtheopportunitycost. Example: AfirmsannualcostrequirementisRs.20000000.Theopportunitycostofcapitalis15%perannum. Rs.150isthepertransactioncostforthefirmwhenitconvertsisshorttermsecuritiestocash.Find

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out the optimum cash balance. What is the annual cost of the demand for the optimum cash balance? Solution C*=2cT/k=[2(150)(20000000)]/0.15=Rs.200000 Theannualcostis150(20000000/200000)+0.15(200000/2)=Rs.30000. Example: MysoreLampsLtd.requiresRs.30lakhstomeetitsquarterlycashrequirements.Theannualreturn on its marketable securities which are of the tune of Rs. 30 lakhs is 20%. The conversion of the securities into cash necessitates a fixed cost of Rs. 3000 per transaction. Compute the optimum conversionamount. Solution
@ C*=2cT/k=[2*3000*3000000]/0.05 =Rs.600000

@ is 20% / 4 as 20% is annual return and fund requirement is done on a quarterly basis.

12.5.2

MillerOrrmodel

MillerOrr came out with another model due to the limitation of the Baumol model. Baumol model assumesthatcashflowdoesnotfluctuate.Intherealworld,rarelydowecomeacrossfirmswhich have their cash needs as constant. Keeping other factors such as expansion, modernization, diversification constant, firms face situations wherein they need additional cash to maintain their presentpositionbecauseoftheeffectofinflationarypressures.Thefirmsthereforecannotforecast theirfundrequirementsaccurately.TheMillerOrrmodelovercomesthisshortcomingandconsiders dailycashfluctuations.TheMOmodelassumesthatcashbalancesrandomlyfluctuatebetweenan upperbound(uppercontrollimit)andalowerbound(lowercontrollimit).Whencashbalanceshitthe upperlimit,thefirmhastoomuchcashanditistimetobuyenoughmarketablesecuritiestobring backtotheoptimalbound.Whencashbalancestouchzerolevel,thelevelisbroughtupbyselling securitiesintocash.Returnpointliesbetweentheupperandlowerlimits.Symbolically,thiscanbe
2 2 expressedasZ=33/4*(c /i)whereZistheoptimalcashbalance,cisthetransactioncost, is

thestandarddeviationofthenetcashflowsandiistheinterestrate.MOmodelalsosuggeststhe optimumupperboundarybasthreetimestheoptimalcashbalanceandlowerlimit,i.e.upperlimit b=lowerlimit+3Zandreturnpoint=lowerlimit+Z.Thisisshowngraphicallyasfollows:

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Error!
Upperlimit Cashbalance

Returnpoint

MillerOrrModel Example:
Time

Lowerlimit

Mehta industries have a policy of maintaining Rs. 500000 minimum cash balance. The standarddeviationofthe companysdaily cashflows is Rs. 200000. The interest rate is14%. The companyhastospendRs.150pertransaction.Calculatetheupperandlowerlimitsandthereturn pointasperMOmodel. Solution
2 Z=33/4*(c /i) 2 33/4*(150*200000 )/0.14/365=Rs.227226

TheUppercontrollimit=lowerlimit+3Z=500000+3*227226= Rs.1181678 Returnpoint=lowerlimit+Z=500000+227226=Rs.727226 Average cash balance = lower limit + 4/3Z = 500000 + 4/3*227226 = Rs. 802968 12.5.3CashPlanning Cashplanningisatechniquetoplanandcontroltheuseofcash.Ithelpsindevelopingaprojected cashstatementfromtheexpectedinflowsandoutflowsofcash.Forecastsarebasedonthepast performanceandfutureanticipationofevents.Cashplanningcanbedoneadaily,weeklyorona monthlybasis.Generally,monthlyforecastsarecommonlypreparedbyfirms.

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12.5.4

CashForecastingandBudgeting

Cashbudgetisadevicetoplanforandcontrolcashreceiptsandpayments.Itgivesasummaryof cashflowsoveraperiodoftime.TheFinanceManagercanplanthefuturecashrequirementsofa firmbasedonthecashbudgets.Thefirstelementofacashbudgetistheselectionofthetimeperiod whichisreferredtoastheplanninghorizon.Selectingtheappropriatetimeperiodisbasedonthe factors exclusive to the firms. Some firms may prefer to prepare weekly budget while others may workoutmonthlyestimateswhilesomeothersmaybepreparingquarterlyoryearlybudgets.Firms should keep in mind that the period selected should be neither too long nor too short. Too long a period, estimates will not be accurate and too short a period requires periodic changes. Yearly budgetscanbepreparedbysuchcompanieswhosebusinessisverystableandtheydonotexpect majorchangesaffectingthecompanysflowofcash. The second element that hasabearingon cash budgetpreparation is the selection offactors that have a bearing on cashflows. Only items of cash nature are to be selected while noncash items suchasdepreciationandamortizationareexcluded. Cashbudgetsarepreparedunderthreemethods: 1. ReceiptsandPaymentsmethod 2. IncomeandExpendituremethod 3. BalanceSheetmethod Weshallbediscussingonlythereceiptsandpaymentsmethodofpreparingcashbudgets. Example: GivenbelowisthepreparedacashbudgetofM/s.PandurangaSheetMetalsLtd.forthe6months
th st ending30 June2007.Ithasanopeningcashbalanceof Rs.60000on1 Jan2007.

Month Jan Feb March April May June

Sales Purchases Wages Production overheads 60000 70000 82000 85000 96000 110000 24000 27000 32000 35000 38800 41600 10000 11000 10000 10500 11000 12500 6000 6300 6400 6600 6400 6500

Selling overheads 5000 5500 6200 6500 7200 7500

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The company has a policy of selling its goods 50% on cash basis and the rest on credit terms. Debtorsaregivenamonthstimeperiodtopaytheirdues.Purchasesaretobepaidofftwomonths fromthedateofpurchase.Thecompanyhasatimelaginthepaymentofwagesofamonthand theoverheadsarepaidafteramonth.Thecompanyisalsoplanningtoinvestinamachinewhichwill beusefulforpackingpurposes,thecostbeingRs.45000,payablein3equalinstallments startingbimonthlyfromApril.ItalsoexpectstomakealoanapplicationtoabankforRs.50000and theloanwillbegrantedinthemonthofJuly.ThecompanyhastopayadvanceincometaxofRs. 20000inthemonthofApril.Salesmenareeligibleforacommissionof4%ontotalsaleseffectedby themandthisispayableonemonthafterthedateofsale. Solution Jan Openingcash balance Cashreceipts: Cashsales Creditsales Totalcash available Cash payments Materials Wages Production overheads Selling overheads Sales commission Purchase asset Payment advanceIT of of 5000 23900 5000 10500 6000 5000 2400 24000 10500 6300 5500 2800 27000 10250 6400 6200 3280 15000 20000 49100 117650 59250 79190 32000 10750 6600 6500 3400 35000 11750 6400 7200 3840 15000 30000 35000 30000 41000 35000 42500 41000 48000 42500 55000 48000 60000 Feb March April May June

85000 126100 153000 118850 150100

90000 150000 202100 236500 209350 253100

Total cash payments

Closing cash 85000 126100 153000 118850 150100 173930 balances

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Workingnote: Wagescalculation Jan 10000 5000 5000 Feb 11000 5500feb 5000mar 10500 Mar 10000 5000mar 5500feb 10500 Apr 10500 5250apr 5000mar 10250 May 11000 5500may 5250apr 10750 Jun 12500 6250jun 5500may 11750

SelfAssessmentQuestions1 1. Managementofcashbalancescanbedoneby____________and_________. 2. The four motives for holding cash are ___________, _______________, ____________ and ____________. 3. The greater the creditworthiness of the firm in the market lesser is the need for ___________ balances. 4. __________refers to the credit extended by the supplier of goods and services in the normal courseofbusinesstransactions. 5. When cheques are deposited ina bank, creditbalance increases in thefirms books butnot in banks books until the cheque is cleared and money realized. This is called as ________________. 6. AccordingtoBaumolmodel,thetotalcostassociatedwithcashmanagementhastwoelements ______________and____________. 7. TheMOmodelassumesthatcashbalancesrandomlyfluctuatebetweena____________anda __________________. 12.6

Summary

Allcompaniesarerequiredtomaintainaminimumlevelofcurrentassetsatallpointsoftime. Cash management is concerned with determination of relevant levels of cash balances and near cash assetsandtheirefficientuse. The need for holding cash arises due to a variety of motives transaction motive, speculation motive, precautionary motive and compensating motive. The objective of cash management is to makeshorttermforecastsofcashinflowsandoutflows,investingsurpluscashandfindingmeansto arrangeforcashdeficits.CashbudgetshelpFinanceManagertoforecastthecashrequirements.

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TerminalQuestions 1. MirajEngineeringCo.hasforecastitssalesforthe3monthsendingDec.asfollows: Oct.Rs.500000NovRs.600000Dec.Rs.650000 Thegoodsaresoldoncashandcreditbasis50%each.Creditsalesarerealizedinthemonth followingthesale.Purchasesamountto50%ofthemonthssalesandarepaidinthefollowing month. Wages and administrative expenses per month amount to Rs. 150000 and Rs. 80000
st respectively and are paid in the following month. On 1 Dec. the company has purchased a th st testingequipmentworthRs.20000payableon15 Nov.On31 Dec.acashdepositwithabank st will mature for Rs. 150000. The opening cash balance on 1 Nov. is Rs. 100000.What is the

closingbalanceinNov.andDec.? 2. Michael Industries Ltd. requests you to help them in preparing a cash budget for the period endingDec.2007. Rs.inlakhs Particulars May Sales Materials Rent Salaries Misc charges Taxes Purchase ofasset 15 7 June 20 20 July 22 22 0.50 1.5 0.15 Aug 3 29 0.5 2 0.2. Sep 34 15 0.5 2.5 0.2 Oct 25 15 0.50 1.5 0.4. 4 Nov 25 8 0.5 1 0.3. 10 Dec Jan 15 8 0.5 1 0.2 15 Nil

Creditterms:Customersareallowed1monthtime. Suppliersofmaterialsarepaidafter2months. Thecompanypayssalariesafteragapof15days. Rentispaidafteragapof1month.


st ThecompanyhasanopeningbalanceofRs.200000on1 June. st Prepareacashbudgetandfindoutwhatistheclosingcashbalanceon31 Dec.

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AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Deficitfinancingorinvestingsurpluscash 2. Transaction,speculative,precautionaryandcompensating 3. Precautionary 4. Tradecredit 5. Collectionfloat 6. Costofconversionofmarketablesecuritiesintocashandopportunitycost. 7. Upperbound(uppercontrollimit)andlowerbound(lowercontrollimit). AnswertoTerminalQuestions 1.PrepareaCashBudgetforNovemberandDecember.RefertotheExample12.5.4 2.PrepareacashbudgetasshowninExample12.5.4.

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Unit13
Structure
13.1 13.2 13.3 Introduction Costsassociatedwithinventoriesare InventorymanagementTechniques 13.3.1 DeterminationofStockLevels 13.3.2 Pricingofinventories 13.4 Summary TerminalQuestions AnswertoSAQsandTQs 13.1 Introduction

InventoryManagement

InventoriesarethemostsignificantpartofcurrentaspectsofmostofthefirmsinIndia.Since theyconstituteanimportantelementoftotalcurrentassetsheldbyafirmtheneedtomanage inventoriesefficiently andeffectivelyforensuringoptimalinvestmentininventorycannotbe ignored.Anylapseonthepartofmanagementofafirminmanaginginventoriesmaycausethe failureofthefirm.Themajorobjectivesofinventorymanagementare: a. Maximumsatisfactiontocustomer. b. Minimuminvestmentininventory. c. Achievinglowcostplantoperation. Theseobjectivesconflicteachother.Therefore,ascientificapproachisrequiredtoarriveatan optimalsolutionforearningmaximumprofitoninvestmentininventories. Decisionsoninventoriesinvolvemanydepartments: a. Rawmaterialpoliciesaredecidedbypurchasingandproductiondepartments b. Productiondepartmentplaysanimportantroleinworkinprocessinventory,policyand c. Finishedgoodsinventorypolicyisshapedbyproductionandmarketingdepartments. Butthedecisionsofthesedepartmentshavefinancialimplications.Therefore,asanexecutive entrustedwiththeresponsibilityofmanagingfinanceofthecompany,thefinancialmanagerofthe firmhastoensurethatmonitoringandcontrollinginventoriesofthefirmareexecutedina scientificmannerforattainingthegoalofwealthmaximizationofthefirm.

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LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Explainthemeaningofinventorymanagement. 2. Statetheobjectivesofinventorymanagement. 3. Bringouttheimportanceofinventorymanagement. 4. Statethepurposeofinventory. 5. Discussthetechniquesofinventorycontrol.

RoleofinventoryinworkingCapital: Inventoriesconstituteanimportantcomponentofafirmsworkingcapital.Thefollowingfeatures ofinventoryhighlightthesignificanceofinventoryinworkingcapitalmanagement. 1. Characteristicsofinventoryascurrentassets. Currentassetsarethoseassetswhichareexpectedtoberealizedincashorsoldorconsumed duringthenormaloperatingcycleofthebusiness.Variousformsofinventoryinany manufacturingunitare: a. Rawmaterialstobeconvertedintofinishedgoodsthroughtheprocessofproduction. b. Workinprocessinventoriesaresemifinishedproductsintheprocessofbeingconverted intofinishedgood. c. Finishedgoodsinventoriesarecompletelymanufacturedproductsthatcanbesold immediately. Thefirsttwoareinventoriesconcernedwithproductionandthethirdismeantforsmooth performanceofmarketingfunctionofthefirm. Natureofbusinessinfluencesthelevelsofinventorythatafirmhastomaintaininthesethree kinds.Amanufacturingunitwillhavetomaintainhighlevelsofinventoryinallthethreeforms.A retailfirmwillbemaintainingveryhighleveloffinishedgoodsinventoryonly. Thethreekindsofinventorieslistedabovearedirectinventories.Thereisananotherformof indirectinventories.Theseindirectinventoriesarethoseitemwhicharenecessaryfor manufacturingbutdonotbecomepartofthefinishedgoods.Theyarelubricants,grease,oil, petrol,officematerialmaintenancematerialetc. TheInventoriesareheldforthefollowingreasons. 1. Smoothproduction:toensuresmoothproductionaspertherequirementsofmarketing department,inventoriesareprocuredandsold.

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2. ToachieveCompetitiveedge:Mostofthe retailandindustrialorganizationscarryinventory toensurepromptdeliverytocustomers.Nofirmlikestolosecustomersonaccountofthe itembeingoutofstock. 3. Toreapthebenefitsofbuyinginlargevolume.Sometimesbuyinginlargevolumesmaygive thefirmquantitydiscounts.Thisquantitydiscountsmaybesubstantialthatthefirmwilltake benefitofit. 4. Hedgeagainstuncertainleadtimes:Leadtimeisthetimerequiredtoprocurefreshsupplies ofinventory.Uncertaintyduetosuppliertakingmorethanthenormalleadtimewillaffectthe productionscheduleandtheexecutionoftheordersofcustomersaspertheordersreceived fromcustomers.Toavoidalltheseproblemsarisingfromuncertaintyinprocurementoffresh suppliesofinventories,thefirmsmaintainhigherlevelsofinventoriesforcertainitemsof inventory. 2. Levelofliquidity:Inventoriesaremeantforconsumptionorsale.Bothexcessandshortage ofinventoryaffectofthefirms.Profitability. Thoughinventoriesarecalledcurrentassets,incalculatingabsoluteliquidityofafirminventories areexcludedbecauseitmayhaveslowmovingordormantitemsofinventorywhichcannotbe easilydisposedof.Thereforelevelandcompositionofinventorysignificantlyinfluencethe quantumofworkingcapitalandhenceprofitability ofthefirm. 3. LiquidityLags:Inventorieshavethreetypesoflags. a. Creationlag: Rawmaterialsarepurchasedoncreditandconsumedtoproduce finishedgoods.Thereisalwaysalaginpaymenttosuppliers fromwhomraw materialsareprocured. Thisiscalledspontaneousfinance.Theamountof spontaneousfinancethatafirmiscapableofenjoyinginfluencesthequantumof workingcapitalofafirm. b. Storagelag: Thegoodsmanufacturedorheldforsalecannotbeconvertedinto cashimmediately.Beforedispatchingthegoodstocustomersonsale,thereis alwaysatimelag.Duringthistimelaggoodsarestoredinwarehouse.Many expensesofstoragewillberecurringinnatureandcannotbeavoided.Thelevel ofexpenditurethatafirmincursonthisaccountisinfluencedbytheinventory levelsofthefirm.Thisinfluencestheworkingcapitalmanagementofafirm. c. SaleLag:Firmsselltheirproductsoncredit.Thereissometimelagbetweensale offinishedgoodsandcollectionofdues fromcustomers.Firmswhichare aggressiveincapturingmarketsfortheirproductsmaintainhighlevelsofinventory andallowitscustomersliberalcreditperiod.Thiswillincreaseitsinvestmentin

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receivables.Thisincreaseininvestmentinreceivableswillhaveitseffecton workingcapitalofthefirm.

Purposeofinventory: Thepurposeofholdinginventoryisachievingefficiencythroughcostreductionandincreased salesvolume.Thefollowingarethepurposeofholdinginventories. 1. Sales:Customers placeordersforgoodsonlywhentheyneedit.Butwhencustomers approachthefirmwithordersthefirmsmusthaveadequateinventoryoffinishedgoodsto executeit.Thisispossibleonlywhenfirmsmaintainreadystockoffinishedgoodsin anticipation ofordersfromcustomers.Ifafirmsuffersfromcomplaintsfromcustomersof constantlytheproductbeingoutofstock,customersmaymigratetootherproducers.It willaffectthefirmscustomersbase,customerloyaltyandmarketshare. 2. Toavailquantitydiscounts: Suppliersgivediscountsforbulkpurchases.Such discountsdecreasethecostperunitofinventorypurchased.Suchcostreduction increasefirmsprofits.Firmsmaygoinforordersoflargequantitytoavailthemselvesof thebenefitofquantitydiscounts. 3. ReducingorderingCostsandtime Everytimeafirmplacesanorderitincurscostofprocuringit.Italsoinvolvesaleadtime inprocurement.Insomecasestheuncertaintyinsupplyduetocertainadministrative problemsofthesupplieroftheproductwillaffecttheproductionschedulesofthe organization.Therefore,firmsmaintainhigherlevelsofinventorytoavoidtherisksof lengtheningtheleadtimeinprocurement.Therefore,tosaveontimeandcostsfirmsmay placeordersforlargequantities. 4. Reduceriskofproductionstoppages Manufacturingfirmsrequirealotofrawmaterialsandsparesandtoolsforproductionand maintenanceofmachines.Nonavailabilityofanyvitalitemcanstoptheproduction process.Productionstoppagehasseriousconsequences.Lossofcustomersonaccount ofthefailuretoexecutetheirorderswillaffectthefirmsprofitability.Toavoidsuch situations,firmsmaintaininventoriesashedgeagainstproductionstoppages. Therefore,itcanbeconcludedthatthemotivesforholdinginventoriesare 1. Transactionmotive:formakingavailableinventoriestofacilitatesmooth productionandsales. 2. Precautionarymotive:Forguardingagainsttheriskofunexpectedchangesin demandandsupply.

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3.

Speculativemotive:Totakebenefitoutofthechangesinpricesfirmsincrease ordecreasetheinventorylevels.

13.2 Costsassociatedwithinventoriesare: 1. Materialcosts:Thesearethecostsofpurchasingthegoodsandrelatedcostssuchas transportationandhandlingcostsassociatedwithit. 2. OrderingCost:Theexpensesincurredtoplaceorderswithsuppliersandreplenish theinventoryofrawmaterialarecalledorderingcosts.Theyincludecostsofthe following. a. Requisitioning b. Purchaseordering orsetup c. Transportation d. Receiving,inspectingandreceivingatthewarehouse.Thesecostsincrease inproportiontothenumberofordersplaced.Firmsmaintaininglargeinventory levels,placeafewordersandincurlessorderingcosts. 3. CarryingCosts:costsincurredformaintainingtheinventoryinwarehousearecalled carryingcosts.Theyincludeinterestoncapitallockedupininventory,storage, insurance,taxes,obsolescence,deteriorationspoilage,salariesofwarehousestaff andexpensesonmaintenanceofwarehousebuilding.Thegreatertheinventoryheld thehigherthecarryingcosts. 4. Shortagecostsorstockoutcosts:Thesearethecostsassociatedwitheitheradelay inmeetingthedemandorinabilitytomeetthedemandatallduetoshortageofstock. Thesecostsinclude. a. Lossofprofitonaccountsaleslostcausedbythestockout. b. Lossoffuturesalescustomersmigratetootherdealers. c. Lossofcustomergoodwilland d. Extracostsassociatedwithurgentreplenishmentpurchases. Measurementofshortagecostattributabletothefirmsfailuretomeetcustomersdemandis difficultbecauseitisintangibleinnatureanditaffectstheoperationofthefirmnowandinfuture. SelfAssessmentQuestions1 1.Leadtimeisthetimerequiredto_______________. 2.Bothexcessandshortageofinventoryaffectthefirms____________. 3.Precautionarymotiveofholdinginventoryisforguardingagainsttheriskof _____________________andsupply. 4.Costsincurredformaintainingtheinventory inwarehousearecalled______.

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13.3 InventorymanagementTechniques Therearemanytechniquesofmanagementofinventory.Someofthemare: EconomicOrderQuantity: EOQreferstotheoptimalordersizethatwillresultinthelowestorderingandcarryingcostsfor anitemofinventorybasedonitsexpectedusage. EOQmodelanswersthefollowingkeyquantumofinventorymanagement. a. Whatshouldbethequantityorderedforeachreplenishmentofstock? b. HowmanyordersaretobepacedinayeartoensureeffectiveinventoryManagement? EOQisdefinedastheorderquantitythatminimizesthetotalcostassociatedwithinventory management. Itisbasedonthefollowingassumptions: 1. Constantoruniformdemand.Thedemandorusageiseventhroughouttheperiod. 2. Knowndemandorusage:Demandorusageforagivenperiodisknowni.edeterministic. 3. ConstantUnitprice:Perunitpriceofmaterialdoesnotchangeandisconstantirrespectiveof theordersize. 4. ConstantCarryingCosts Thecostofcarryingisafixedpercentageoftheaveragevalueofinventory. 5. Constantorderingcost Costperorderisconstantwhateverbethesizeoftheorder. 6. Inventoriescanbereplenishedimmediatelyasthestocklevelreachesexactlyequaltozero. Consequentlythereisnoshortageofinventory. 7.

TotalCost x Cost

CarryingCosts

OrderingCosts Q

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EconomicorderQuantity
x Q =

2DK Kc

D=Annualusageordemand
x Q =EconomicorderQuantity

K=orderingcostperorder kc =pc =priceperunitxpercentcarryingcost=carryingcostofinventoryperunitperannum. Example: Annualconsumptionofrawmaterialsis40,000units.CostperunitRs16 Carryingcostis15%perannum. Costofplacinganorder=Rs480 Solution: 2x40000x480

EOQ=
Example:

16x0.15

=4000units

Acompanyhasgatheredthefollowinginformation: Annualdemand30,000units Orderingcostperorder=Rs20(Fixed) Carryingcost=Rs10perunitperannum Purchasecostperuniti.epriceperunit=Rs32perunit DetermineEOQ,totalnumberofordersinayearandthetimegapbetweentwoorders. Solution: 2DK


x Q =

2x30000x20

Kc

10

=346units K=Rs.20 Kc =Rs.10 D=30000 Thetotalnumberofordersinayear=30,000 346 =87orders

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Timegapbetweentwoorders=365=4days 87 1. ABCSystem:theinventoryofanindustrialfirmgenerallycomprisesofthousandsofitems withdiverseprices,largeleadtimeandprocurementproblems.Itisnotpossibletoexercise thesamedegreeofcontroloveralltheseitems.Itemsofhighvaluerequiremaximum attentionwhileitemsoflowvaluedonotrequiresamedegreeofcontrol.Thefirmhastobe selectiveinitsapproachtocontrolitsinvestmentinvariousitemsofinventory.Suchan approachisknownasselectiveinventorycontrol.ABCsystembelongstoselectiveinventory control. ABCanalysisclassifiesalltheinventoryitemsinanorganizationintothreecategories. A: B: Itemsareofhighvaluebutsmallinnumber.Aitemsrequirestrictcontrol. Itemsofmoderatevalueandsizewhichrequirereasonableattentionofthe management.. C: Itemsrepresentrelativelysmall valueitemsandrequiresimplecontrol. Sincethismethodconcentratesattentiononthebasisoftherelativeimportanceofvarious itemsofinventoryitisalsoknownascontrolbyimportanceandexception.Astheitems areclassifiedinorderoftheirrelativeimportanceintermsofvalue,itisalsoknownas proportionalvalueAnalysis. AdvantagesofABCanalysis: 2. Itensuresclosercontrolsoncostlyelementsinwhichfirmsgreaterpartofresourcesare invested. 3. Bymaintainingstocksatoptimumlevel itreducestheclericalcostsofinventorycontrol. 4. Facilitatesinventorycontrolandcontroloverusageofmaterials,leadingtoeffectivecost control. Limitations: 1. Aneverendingproblemininventorymanagementisadequatelyhandlingthousandsoflow valueofcitems.ABCanalysisfailstoanswerthisproblem. 2. IfABCanalysisisnotperiodicallyreviewedandupdated,itdefeatsthebasicpurposeofABC approach.

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13.3.1DeterminationofStockLevels Mostoftheindustriesaresubjecttoseasonalfluctuationsandsalesduringdifferentmonthsofthe yearareusuallydifferent.If,however,productionduringeverymonthisgearedtosalesdemand ofthemonth,facilitieshavetoinstalledtocatertofortheproductionrequiredtomeetthe maximumdemand.Duringtheslackseason,alargeportionoftheinstalledfacilitieswillremain idlewithconsequentuneconomicproductioncost.Toremovethisdisadvantage,attempthasto bemadetoobtainastabilizedproductionprogrammethroughouttheyear.Duringtheslack season,therewillbeaccumulationoffinishedproductswhichwillbegraduallyclearedassales progressivelyincrease.Dependinguponvariousfactorsofproduction,storingandcost,anormal capacitywillbedetermined.Tomeetthepressureofsalesduringthepeakseason,however, highercapacitymayhavetobesuedfortemporaryperiods.Similarly,duringtheslackseason,to avoidlossduetoexcessiveaccumulation,capacityusagemayhavetobescaleddown. Accordingly,therewillbeamaximumcapacityandminimumcapacity,onlyconsumptionofraw materialwillaccordinglyvarydependinguponthecapacity usage. Again,thedeliveryperiodorleadtimeforprocuringthematerialsmayfluctuate.Accordingly, therewillbemaximumandminimumdeliveryperiodandtheaverageofthesetwoistakenasthe normaldeliveryperiod. MaximumLevel: Maximumlevelisthatlevelabovewhichstockofinventoryshouldneverrise.Maximumlevelis fixedaftertakingintoaccountthefollowingfactors: 1. Requirementandavailabilityofcapital 2. Availabilityofstoragespaceandcostofstoring. 3. Keepingthequalityofinventory intact 4. Pricefluctuations 5. Riskofobsolescence,and 6. Restrictions,ifany,imposedbythegovernment.

MaximumLevel Where,

Orderinglevel(MRCxMDP)+standardorderingquantity.

MRC=minimumrateofconsumption MDP=minimumleadtime.

MinimumLevel: Minimumlevelisthatlevelbelowwhichstockofinventoryshouldnotnormallyfall. Minimumlevel=OL(NRCxNLT)

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Where, OL=orderinglevel NRC=Normalrateofconsumption NLT=NormalLeadTime. OrderingLevel: Orderinglevelisthatlevelatwhichactionforreplenishmentofinventoryisinitiated. OL=MRCXMLT Where, MRC=Maximumrateofconsumption MLT=Maximumleadtime.

3. Averagestocklevel Averagestocklevelcanbecomputedintwoways 1. minimumlevel+maximumlevel 2 2. Minimumlevel+1/2ofreorderquantity.

Averagestocklevelindicatestheaverageinvestmentinthatitemofinventory.Itinofquite relevantfromthepointofviewofworkingcapitalmanagement.

ManagerialsignificanceoffixationofInventorylevel: 1. Itensurethesmoothproductionsofthefinishedgoodsbymakingavailabletherawmaterial ofrightqualityinrightquantityattherighttime. 2. Itoptimizestheinvestmentininventories.Inthisprocess,managementcanavoidboth overstockingandshortageofeachandeveryessentialandvitalitemofinventory. 3. Itcanhelpthemanagementinidentifyingthedormantandslowmovingitemsofinventory. Thisbringsaboutbettercoordinationbetweenmaterialsmanagementandproduction managementontheonehandandbetweenstoresmanagerandmarketingmanageronthe other.

ReorderPoint: Whentoorderisanotheraspectofinventorymanagement.Thisisansweredbyreorder point.Thereorderpointisthatinventorylevelatwhichanordershouldbeplacedtoreplenish theinventory.

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Toarriveatthereorderpointundercertaintythetwokeyrequireddetailsare: 1. Leadtime 2. Averageusage leadtimereferstotheaveragetimerequiredtoreplenishtheinventoryafterplacingorders forinventory Reorderpoint=leadtimexAverageusage Undercertainty,reorderpointreferstothatinventorylevelwhichwillmeettheconsumption needsduringtheleadtime. SafetyStock:Sinceitisdifficulttopredictinadvanceusageandleadtimeaccurately,provision ismadeforhandlingtheuncertaintyinconsumptionduetochangesinusagerateandleadtime. Thefirmmaintainsasafetystocktomanagethestockoutarisingoutofthisuncertainty. Whensafetystockismaintained,(WhenVariationisonlyinusagerate) Reorderpoint=leadtimexAverageusage+Safetystock Safetystock= [(maximumusagerate)(Averageusagerate)]xleadtime. Or Safetystockwhenthevariationinbothleadtimeandusageratearetobeincorporated. Safetystock=(Maximumpossibleusage)(Normalusage) Maximumpossibleusage=MaximumdailyusagexMaximumleadtime Normalusage=AveragedailyusagexAverageleadtime Example:Amanufacturingcompanyhasanexpectedusageof50,000unitsofcertainproduct duringthenextyear.RecostofprocessinganorderisRs20andthecarryingcostperunitper annumisRs0.50.Leadtimeforanorderisfivedaysandthecompanywillkeepareserveoftwo daysusage.Calculate1.EOQ2.Reorderpoint.Assume250daysinayear Solution: 2DK 2x50000x20

EOQ=
=2000units

Kc

0.50

Reorderpoint Dailyusage= 50000=200units 250 Safetystock=2x200400units.

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Reorderpoint(leadtimexAverageusage)+safetystock (5x200)+400=1,400units

13.3.2 Pricingofinventories Therearedifferentwaysofpricinginventoriesusedinproduction.Iftheitemsininventoryare homogenous(identicalexceptforinsignificantdifferences)itisnotnecessarytousespecific identificationmethod.Theconvenientpriceisusingacostflowassumptionreferredtoasaflow assumption. Whenflowassumptionisuseditmeansthatthefirmmakesanassumptionastothesequencein whichunitsarereleasedfromthestorestotheproductiondepartment. Theflowassumptionsselectedbyacompanyneednotcorrespondtotheactualphysical movementofrawmaterials.Whenunitsofrawmaterialareidentical,itdoesnotmatterwhich unitsareissuedfromthestorestotheproductiondepartment. Themethodselectedshouldmatchthecostswiththerevenuetoensurethattheprofitsare uncertaininamannerthatreflectstheconditionsactuallyprevalent. 1. Firstin,firstout(FIFO):Itassumesthattherawmaterials(goods)receivedfirstareusedfirst. Thesamesequenceisfollowedinpricingthematerialrequisitions. 2. LIFO(lastin,firstout):Theconsignmentlastreceivedisfirstusedandifthisisnotsufficient fortherequisitionsreceivedfromproductiondepartmentthentheuseismadefromthe immediatepreviousconsignmentandsoon.Therequisitionsarepricedaccordingly.This methodisconsideredtobesuitableunderinflationaryconditions.Underthismethodthecost ofproductionreflectsthecurrentmarkettrend.Theclosinginventoryofrawmaterialwillbe valuedonaconservativebasisundertheinflationaryconditions. 3. Weightedaverage:Materialissuesarepriced,attheweightedaveragecostofmaterialsin stock.Thismethodconsidersvariousconsignmentsinstockalongwiththeirunitspricesfor pricingthematerialissuesfromstores. 4. othermethodsare: a. Replacementpricemethod:Thismethodpricestheissuesatthevalueatwhichitcanbe procuredfromthemarket. b. Standardpricemethod:underthismethodthematerialsarepricedatstandardprice. Standardpriceisdecidedbasedonmarketconditionsandefficiencyparameters.The differencebetweenthepurchasepriceandthestandardpriceisanalyzedthroughvariance analysis.

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SelfAssessmentQuestions2 1. ABCsystembelongsto______. 2. ______________areofhighvaluebutsmallinnumber. 3. ABCsystemisknownas_____________becausetheitemsareclassifiedinorderoftheir relativeimportanceintermsofvalue. 4. _________isdefinedastheorderquantitythatminimizesthetotalcostofinventory management.

13.4Summary
Inventoriesformpartofcurrentassetsoffirm.Objectivesofinventorymanagementare. a. Maximumcustomersatisfaction b. Optimuminvestmentininventoryand c. Operationoftheplantattheleastcoststructure.Inventoriescouldbegroupedintodirect inventoriesarerawmaterials,workinprocessinventoriesandfinishedgoodsinventory. Indirectinventoriesarethoseitemswhicharenecessaryforproductionprocessbutdonot becomepartofthefinishedgoods.Therearemanyreasonsattributabletoholdingof inventorybythemanagements. TerminalQuestions 1. Examinethereasonsforholdinginventoriesbyafirm. 2. Discussthetechniquesofinventorycontrol. 3. Discusstherelevanceandfactorsthatinfluencethedeterminationofstocklevel. 4. Explainthevariouscostofinventorydecision.

AnswerforSelfAssessmentQuestions SelfAssessmentQuestions1 1. Obtainfreshsuppliesofinventory 2. Profitability 3. Unexpectedchangesindemand,supply 4. Carryingcosts

SelfAssessmentQuestions2 1. Selectiveinventorycontrol. 2. Aitems 3. Proportionalvalueanalysis

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4. EOQ. AnswerforTerminalQuestions

1. Refertounit13.1
2. Referto13.3 3. Referto13.3.3 4. Referto13.2

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Unit14
Structure 14.1 Introduction

ReceivablesManagement

14.2 Costsassociatedwithmaintainingreceivables 14.3 Creditpolicyvariables 14.4 Evaluationofcreditpolicy 14.5 Summary TerminalQuestions 14.6 AnswertoSAQsandTQs 14.1Introduction: Firmssellgoodsoncredittoincreasethevolumeofsales.Inthepresenteraofintense competition, business firms, to improve their sales, offer to their customers relaxed conditionsofpayment.Whengoodsaresoldoncredit,finishedgoodsgetconvertedinto receivables.Tradecreditisamarketingtoolthatfunctionsasabridgeforthemovement ofgoodsfromthefirmswearhousetoitscustomers.Whenafirmsellsgoodsoncredit receivablesarecreated.Thereceivablesarisingoutoftradecredithavethreefeatures. 1. Itinvolvesanelementofrisk.Therefore,beforesanctioningcredit,carefulanalysisof theriskinvolvedneedstobedone 2. It isbasedon economicvalue.Buyer gets economicvaluein goods immediately on sale,whilethesellerwillreceiveanequivalentvaluelateronand 3. Ithasanelementoffuturity.Thebuyermakespaymentinafutureperiod. Amountsduefromcustomers,whengoodsaresoldoncredit,arecalledtradedebitsor receivables. Receivables form part of current assets. They constitute a significant portionofthetotalcurrentassetsofthebuyersnexttoinventories. Receivablesareassetaccountsrepresentingamountsowingtothefirmasaresultof saleofgoods/servicesintheordinarycourseofbusiness. Objectives: The main objective of selling goods on credit is to promote sales for increasingtheprofitsofthefirm.Customerswillalwaysprefertobuyoncredittobuying 218

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oncashbasis.Theyalwaysgotoasupplierwhogivescredit.Allfirmsthereforegrant credittotheircustomerstoincreasesales,profitsandtomeetcompetition. LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1.Understandthemeaningofreceivablesmanagement. 2.Whatarethecostsassociatedwithmaintainingreceivable? 3.Understandthecreditpolicyvariables. 4.Understandtheprocessofevaluationofcreditpolicy. MeaningofReceivablesManagement: Receivables are a direct result of credit sales are resorted to, by a firm to push up its sales which ultimately result in pushing up the profits earned by the firm. At thesame time, selling goods on credit results in blocking of funds in accounts receivables. Additional funds are, therefore, required for the operating needs of the business which involveextracostsintermsofinterest.Moreover,increaseinreceivablesalsoincreases thechancesofbaddebts.Thus,creationofaccountsreceivablesisbeneficialaswellas dangeroustothefirm. The financial manager needs to follow a policy of usingcash fundseconomically to the extent possible in extending receivables without adversely affecting the chances of increasing sales and making more profits. Management of accounts receivables may, therefore, be defined as, the process of making decision relating to the investment of fundsinreceivableswhichwillresultinmaximisingtheoverallreturnontheinvestmentof thefirm. Thus,theobjectiveofreceivablesmanagementistopromotesalesandprojectsuntilthe levelwherethereturnoninvestmentinfurtherfindingofreceivablesislessthenthecost offundsraisedtofinancethatadditionalcredit. 14.2Costsassociatedwithmaintainingreceivables: Costsofmaintainingreceivablesare: 1) Capitalcosts: Afirm whensells goodscredit achieveshigher sales. Sellinggoods oncredithasconsequencesofblockingthefirmsresourcesinreceivablesasthereis 219

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atimelagbetweenacreditsaleandcashreceiptfromcustomers.Totheextentthe fundsareheldupinreceivables,thefirmhastoarrangeforadditionalfundstomeet itsownobligationofmonthlyaswellasdailyrecurringexpenditure.Additionalfunds mayhavetoberaisedeitheroutofprofitsorfromoutside.Inboththecases,thefirm incursacost.Intheformercasethereistheopportunitycostoftheincomethefirm couldhaveearnedhadthesamebeeninvestedinsameotherprofitableavenue.In thelattercaseofobtainingfundsfromoutside,thefirmhastopayinterestontheloan taken. Therefore, sanctioning credit to customers on sale of goods oncredit has a capitalcost. 2) AdministrationCost: Whenafirmsellsgoodsoncreditithastoincurtwotypesof administrationcostviz a. Creditinvestigationandsupervisioncostsand b. CollectionCosts. Beforesanctioningcredit to anycustomerthe firm has toinvestigate thecreditratingof thecustomertoensurethatcreditgivenwillrecoveredontime.Therefore,administration costshavetobeincurredinthisprocess. Costs incurred in collecting receivables are administrative in nature. These include additional expenses on staff for administering the process of collection of receivables fromcustomers. 3. Delinquency Costs: The firm incurs this cost when the customer fails to pay the amount to it on the expiry of credit period. These costs take the form of sending remaindersandlegalcharges. BadDebtsorDefaultcost: Whenthefirmisunabletorecovertheamountduefromitscustomers,itresultsinbad debts.Whenafirmrelaxesitscreditpolicy,sellingtocustomerswithrelativelylowcredit ratingoccurs.Inthisprocessafirmmaymakecreditsalestoitscustomerswhodonot payatall. Therefore, the assessing the effect of a change in credit policy of a firm involves examinationof a. OpportunityCostoflostcontribution b. CreditadministrationCost 220

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c. CollectionCosts d. DelinquencyCost e. Baddebtloses SelfAssessmentQuestions1 1. Costs of maintaining receivables are ________________, _________ cost and _______. 2.AperiodofNet30meansthatitallowstoitscustomers30daysofcreditwith____ for___________. 3. Selling goods on credit has consequences of blocking the firms resources in receivablesasthereisatimelagbetween___________________and____________. 4.Whena firmsells goods oncredit it has to incur two types of administrationcostviz _____and_________________. 14.3CreditpolicyVariables 1. Creditstandards. 2. Creditperiod. 3. Cashdiscountsand 4. Collectionprogramme. 1.Creditstandards: Thetermcreditstandardsrefertothecriteriaforextendingcreditto customers.Thebasesforsettingcreditstandardsare. a. Creditrating. b. References c. Averagepaymentperiod d. Ratioanalysis Thereisalwaysabenefittothecompanywiththeextensionofcredittoitscustomersbut with the associated risks of delayed payments or non payment, funds blocked in receivablesetc.Thefirmmayhavelightcreditstandards.Itmayselloncashbasisand extend credit only to financial strong customers. Such strict credit standards will bring down bad debt lossesand reduce thecost of credit administration. But the firm may not be able to increase its sales. The profit on lost sales may be more than the costs

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savedbythefirm.Thefirmshouldevaluatethetradeoffbetweencostandbenefitof anycreditstandards. 2.Creditperiod: creditperiodreferstothelengthoftimeallowedtoitscustomersbya firm to make payment for the purchases made bycustomersof thefirm. It is generally expressed in days like 15 days or 20 days. Generally, firms give cash discount if paymentsaremadewithinthespecifiedperiod. Ifafirmfollowsacreditperiodofnet20itmeansthatitallowstoitscustomers20days ofcreditwithnoinducementforearlypayments.Increasingthecreditperiodwillbringin additionalsalesfromexistingcustomersandnewsalesfromnewcustomers.Reducing the credit period will lower sales, decrease investments in receivables and reduce the bad debt loss. Increasing the credit period increases sales increases investment in receivablesandincreasestheincidenceofbaddebtloss. The effects of increasing the credit period on profits of the firm are similar to that of relaxingthecreditstandards. 3.CashdiscountFirmsoffercashdiscountstoinducetheircustomerstomakeprompt payments.Cashdiscountshaveimplicationsonsalesvolume,averagecollectionperiod, investmentinreceivables,incidenceofbaddebtsandprofits.Acashdiscountof2/10net 20meansthatacashdiscountof2%isofferedifthepaymentismadebythetenthday
th otherwisefullpaymentwillhavetomadeby20 day.

4Collectionprogramme Thesuccessofacollectionprogrammedependsonthecollectionpolicypursuedbythe firm. The objective of acollection policy isto achieve.Timely collection of receivables, therebyreleasingfundslockedinreceivablesandminimizestheincidenceofbaddebts. Thecollectionprogrammesconsistsofthefollowing. 1. Monitoringthereceivables 2. Remindingcustomersaboutduedateofpayment 3. On line interaction through electronic media to customers about the payments due aroundtheduedate. 4. Initiatinglegalactiontorecovertheamountfromoverduecustomersasthelastresort torecovertheduesfromdefaultedcustomers.

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Collectionpolicyformulatedshallnotleadtobadrelationshipwithcustomers

SelfAssessmentQuestion2 1.Creditperiodisa______________. 2._______refertothecriteriaforextendingcredittocustomers. 3. _________ refers to the length of time allowed to its customers by a firm to make paymentforpurchasemadebycustomersofthefirm. 4.Acashdiscountof2/10net20meansthata____________isofferedifthepayment ismade__________________ 14.4EvaluationofCreditPolicy: Optimumcreditpolicyisonewhichwouldmaximize thevalueofthefirm.Valueofafirmismaximizedwhentheincrementalrateofreturnon an investment is equal to the incremental cost of fundsusedtofinance theinvestment. Therefore,creditpolicyofafirmcanberegardedasatradeoffbetweenhigherprofits fromincreasedsalesandtheincrementalcostofhavinglargeinvestmentinreceivables. The credit policy to be adopted by a firm is influenced by the strategies pursued by its competitors.Ifcompetitorsaregranting15dayscreditandifthefirmdecidestoextend the credit period to 30 days, the firm will be flooded with customers demand for companysproducts. Creditpolicyvariablesofafirmare 1. CreditStandard Theeffectofrelaxingthecreditstandardsonprofitcanbeestimatedasunder: Changeinprofit=P Increaseinsales=S Contribution=c=1V WhereV=Variablecosttosales BadDebtsonnewsales=Sxbn K=posttaxcostofcapital Increaseinreceivablesinvestment=I Therefore

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Change in profit = (Additional contribution on increase in sales Bad Debts on new sales) (1 tax rate) cost of incremental investment. (1 tax rate) cost of capital x Incrementalinvestmentinreceivables. Increase in profit i.e change in profit = [Incremental contribution Bad debts on new sales] Example: Followingdetailsareavailableinrespectofxltd: Currentsales=Rs100million The company is considering relaxation of its credit policy. Such relaxation would increase the sales by Rs 15 million on which bad debt losses would be 10%. The contributionmarginratioforthefirmis20%.Averagecollectionperiodis40days.Post taxcostoffundsis10%.Taxrateapplicabletothefirmis30%.Assume360daysina year. Examine the effect of relaxing the credit policy on the profitability of the organization. (MBA)adopted. Solution: Incrementalcontribution=1,50,00,000x0.20=Rs30,00,000 Baddebtsonnewsales=1,50,00,000x0.10=Rs15,00,000 Costofcapitalis10% Incrementalinvestmentinreceivables= Investmentinsales = No.ofdaysintheyear XAverageCollectionPeriodXVariableCosttoSalesratio

15000000 X40X0.8=Rs.13,33,333 360

CostofIncrementalInvestment 10 = 100 x 13,33,333

Thereforechangeinprofitiscalculatedasunder

IncrementalContribution=

3000000

Less:Baddebtsonnewsales= 1500000 224

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Less:Incometaxat30%=

450000 1050000

Less:Opportunitycostof Incrementalinvestmentin Receivables Increaseinprofit 13,33,333 916667

Sincetheimpact ofchangeincredit standards onprofit is positive thechange incredit standardsmaybeconsidered. 2.Creditperiod Theeffectofchangingthecreditperiodonprofitsofthefirmcanbecomputedasunder: Changein profit = (Incrementalcontribution Bad debts on new sales) (1 taxrate) costofincrementalinvestmentinreceivables. Example: Acompanyiscurrentlyallowingitscustomers,30daysofcredit.ItspresentsalesareRs 100 million. The firms cost of capital is 10% and the ratio of variables cost to sales is 0.80. The company is considering extending its credit period to 60 days. Such an extensionwillincreasethesalesofthefirm byRs100 million. Baddebtsonadditional saleswouldbe8%.Taxrateis30%.Assume360daysinayear. (MBA)adopted. Solution: Incrementalcontribution=10,000,000x0.2=Rs2,000,000 Baddebtsonnewsales=10,000,000x0.8=Rs8,000,000 Existinginvestmentinreceivables= 30 100000000x 360 Rs.8333333

Expectedinvestmentinreceivablesafterincreasingthecreditperiodto60days: Expectedinvestmentinreceivablesoncurrentsales= = 100000000 360 X60=Rs.16666667

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Additionalinvestmentinreceivableonnewsales 100000000x 60 360 X0.80=Rs.1333333

Expectedtotalinvestmentinreceivablesonincreasingtheperiodofcredit=18000000 Incrementalinvestmentinreceivables=180000008333333=Rs.9666667 OpportunitycostofIncrementalinvestmentinreceivables= 0.10x9666667=Rs.966667

Statementshowingtheeffectofincreasingthecreditperiodfrom30daysto60daysas firmsproject IncrementalContribution Less:Baddebtsonnewsales 200000 800000 1200000 Less:Incometaxat30% 360000 840000 Less:Opportunitycostofincremental Investmentinreceivables Changeinprofit 966667 (126667)negative

Since the impact of increasing the credit period on profits of the firm is negative, the proposedchangeincreditperiodisnotdesirable. 2. CashDiscount

Forassessingtheeffectofcashdiscountthefollowingformulacanbeused. Change in profit = (Incremental contribution increase in discount cost) (1 t) + opportunitycostofsavingsinreceivablesinvestment. Example Presentcredittermsofacompanyare1/10net30.ItssalesareRs100million,average collectionperiodis20days,variablecosttosalesratiois0.8,andcostofcapitalis10%. Theproportionofsalesonwhichcustomerscurrentlytakediscountis0.5.

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Thecompanyisconsideringrelaxingitsdiscounttermsto2/10,net30 Such a relaxation is expected to increase sales by Rs 10 million, reduce Average collectionperiodto14days,increasediscountsalesto0.8.Taxrateis0.30. Examinetheeffectofrelaxingthediscountpolicyonprofitsoftheorganisation Assume360daysinayear(MBAadopted). Solution IncrementalContribution=10000000x0.2=Rs.2000000 Increaseindiscount Discountcostbeforeliberalisingdiscountterms= 0.5x100000000x0.01=Rs.500000 Discountcostafterliberalisationofdiscountterms= 0.8x110000000x0.002=Rs.1760000 Increaseindiscountcost=Rs.1260000 Computationofsavingsinreceivablesinvestment = 10000000010000000 20 14 0.8x X14 360 360 100000000 60

311111

=1666667311111=Rs.1355556 Opportunitycost(savingsofreductionininvestmentinreceivables =0.1x135556=Rs.135556 Statementshowingtheeffectofchangeindiscountpolicyasprofitofthecompany IncreaseinContribution Less:increaseindiscountcost 2000000 1260000 740000 Less:Taxat30% 222000 518000 Add:Benefitofsavingsdueto Reductionininvestmentin 227

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Receivablesprofit

135556 653556

Itisdesirabletochangethediscountpolicyasitwillimprovetheprofitabilityofthefirm. 4.Collectionpolicy

Forcomputationoftheeffectofnewcollectionprogrammecanbeevaluatedwiththehelp offollowingformula . Changeinprofit=(IncrementalcontributionIncreaseinbaddebts)(1taxrate)cost ofincreaseininvestmentinreceivables. Example Acompanyisconsideringrelaxingitscollectioneffort.ItspresentsalesareRs50million, ACP=20days,variablecosttosalesratio=0.8,costofcapital10%.Itsbaddebtratiois 0.05. The relaxation in collection programme is expected to increase sales by Rs 5 million, increaseACPto40daysandbaddebtsratioto0.56.Taxrateis30%. Examine the effect of change in collection programme on firms profits. Assume 360 daysinayear.(MBAadoptedandalsoACS) Solution IncreaseinContribution=5000000x0.2=Rs.1000000 Increaseinbaddebts Baddebtsonexistingsales=50000000x0.05=2500000 Baddebtsontotalsalesafterincreaseinsales= 55000000x0.56=3300000 Increaseinbaddebts=Rs.800000 Incrementalinvestmentinreceivables = 50000000(4020) 5000000x40x0.8 + 360360

=2777778+444444=Rs.3222222 Opportunitycostofincrementalinvestmentinreceivables= 0.1 x3222222=Rs.322222 228

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Statementshowingtheimpactofnewcollectionprogrammeonprofitsoftheorganisation IncrementalContribution Less:Increaseinbaddebts Less:Incometaxat30% 1000000 800000 200000 60000 1,40,000 Less:Opportunitycostofincrease Ininvestmentinreceivables Profit 3,22,222 (182222)loss

Sincethechangewillleadtodecreaseinprofit(i,ealossofRs.182222)itisnotdesirable torelaxthecollectionprogrammeofthefirm SelfAssessmentQuestions3 1. Credit policy of a firm can be regarded as a tradeoff between ___________ and _______. 2.Optimumcreditpolicymaximisesthe__________. 3. Value of a firm is maximised when the incremental rate of return on investment in receivable is ________________ to the incremental cost of funds used to finance that investment. 4. Credit policy to be adopted by a firm is influenced by strategies pursued by its competitions. 14.5Summary Receivables are a direct result of credit sales. Management of accounts receivables is the process of making decision relating to investment of funds in receivable which will resultinmaximisingtheoverallreturnontheinvestmentofthefirm.Costofmaintaining receivables are capital costs, administration costs and delinquency costs. Credit policy variables are credit standards, credit period, cash discounts and collection programme. OptimumcreditpolicyisthatwhichMaximisesthevalueofthefirm.

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TerminalQuestions 1. Examinethemeaningofreceivablemanagement. 2. Examinethecostsofmaintainingreceivables. 3. Examinethevariablesofcreditpolicy. 4. Whatarethefeaturesofoptimumcreditpolicy AnswerforselfAssessmentQuestions SelfAssessmentQuestions1 1. Capitalcosts,administration,Delinquencycosts. 2. Noinducementforearlypayments 3. Creditsale,Cashreceiptfromcustomers. 4. Creditinvestigationandsupervisioncost,collectioncosts SelfAssessmentQuestions2 1. Creditpolicyvariable. 2. Creditstandards 3. Creditperiod 4. Cashdiscountof2%,onthetenthday. SelfAssessmentQuestions3 1. Higher profits from increased sales, incremental cost of having large investment in receivable. 2. Valueofthefirm. 3. Equal AnswerforTerminalQuestions 1. Refertounit14.1 2. Refertounit14.2 3. Refertounit14.3 4. Refertounit14.4

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Unit15
Structure 15.1 Introduction 15.2 TraditionalApproach 15.3 DividendRelevanceModel 15.3.1 15.3.2 WalterModel GordonsDividendCapitalizationModel

DividendDecision

15.4 DividendIrrelevanceTheory: MillerandModiglianiModel 15.5 StabilityofDividends 15.6 FormsofDividends 15.7 StockSplit 15.8 Summary TerminalQuestions AnswerstoSAQsandTQs 15.1Introduction Dividendsarethatportionofafirmsnetearningspaidtotheshareholders.Preferenceshareholders are entitled toafixed rateof dividend irrespective of thefirms earnings. Equity holders dividends fluctuateyearafteryear.Itdependsonwhatportionofearningsistoberetainedbythefirmandwhat portionistobepaidoff.Asdividendsaredistributedoutofnetprofits,thefirmsdecisionsonretained earningshaveabearingontheamounttobedistributed.Retainedearningsconstituteanimportant source of financing investment requirements of a firm. However, such opportunities should have enough growth potential and sufficient profitability. There is an inverse relationship between these two larger retentions, lesser dividends and vice versa. Thus two constituents of net profits are alwayscompetitiveandconflicting. Dividendpolicyhasadirectinfluenceonthetwocomponentsofshareholdersreturndividendsand capitalgains.Alowpayoutandhighretentionmayhavetheeffectofacceleratingearningsgrowth. Investorsofgrowthcompaniesrealizetheirmoneyintheformofcapitalgains. Dividend yield will belowforsuchcompanies.Theinfluenceofdividendpolicyonfuturecapitalgainsistohappenin 231

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distant future and therefore by all means uncertain. Share prices are a reflection of many factors including dividends. Some investors prefer current dividends to future gains as prophesied by an English saying A bird inhand is worth two in the bush. Given all these constraints, it is a major decisionoffinancialmanagement. Dividend policy of a firm is a residual decision. In true sense, it means that a firm with sufficient investmentopportunitieswillretaintheentireearningstofunditsgrowthavenues.Conversely,ifno suchavenuesareforthcoming,thefirmwillpayoutitsentireearnings.Sothereexistsarelationship betweenreturnoninvestmentsrandthecostofcapitalk.Solongasrexceedsk,afirmshallhave goodinvestmentopportunities.Thatis,ifthefirmcanearnareturnrhigherthanitscostofcapitalk, itwillretainitsentireearningsandifthissourceisnotsufficient,itwillgoinforadditionalsourcesin theformofadditionalfinancinglikeequityissue,debentureissueortermloans.Thus,thedividend decisionisatradeoffbetweenretainedearningsandfinancingdecisions. Different theories have been given by various people on dividend policy. We have the traditional theory andnewsetsoftheoriesbased on the relationshipbetweendividend policy andfirm value. Themoderntheoriescanbegroupedas(a)theoriesthatconsiderdividenddecisionasanactive variableindeterminingthevalueofthefirmand(b)theoriesthatdonotconsiderdividenddecisionas anactivevariableindeterminingthevalueofthefirm.

LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Explaintheimportanceofdividendstoinvestors. 2. Discusstheeffectofdeclaringdividendsonshareprices. 3. Mentiontheadvantagesofastabledividendpolicy. 4. Listoutthevariousformsofdividend. 5. Givereasonsforstocksplit.


15.2TraditionalApproach This approach is given by B. Graham and D. L. Dodd. They clearly emphasize the relationship betweenthedividendsandthestockmarket.Accordingtothem,thestockvaluerespondspositively

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tohighdividendsandnegativelytolowdividends,thatis,thesharevaluesofthosecompaniesrises considerablywhichpayhighdividendsandthepricesfallintheeventoflowdividendspaid. Symbolically,P=[m(D+E/3)] WherePisthemarketprice, Misthemultiplier, Disdividendpershare, EisEarningspershare. Drawbacks of the Traditional Approach: As per this approach, there is a direct relationship betweenP/Eratiosanddividendpayoutratio.HighdividendpayoutratiowillincreasetheP/Eratio andlowdividendpayoutratiowilldecreasetheP/Eratio.Thismaynotalwaysbetrue.Acompanys sharepricesmayriseinspiteoflowdividendsduetootherfactors. 15.3DividendRelevanceModel Underthissectionweexaminetwotheories WalterModelandGordonModel. 15.3.1WalterModel Prof. James E.Walter considers dividend payouts are relevant and have a bearing on the share prices of the firm. He further states, investment policies of a firm cannot be separated from its dividend policy and both are interlinked. The choice of an appropriate dividend policy affects the valueofthefirm.Hismodelclearlyestablishesarelationshipbetweenthefirmsrateofreturnr,its costofcapitalk,togiveadividendpolicythatmaximizesshareholderswealth.Thefirmwouldhave the optimum dividend policy that will enhance the value of the firm. This can be studied with the relationship between rand k. If r>k, thefirms earnings can be retainedas thefirm has betterand profitableinvestmentopportunitiesandthefirmcanearnmorethanwhattheshareholderscouldby reinvesting,ifearningsaredistributed.Firmswhichhaver>karecalledgrowthfirmsandsuchfirms shouldhaveazeropayoutratio. Ifreturnoninvestmentrislessthancostofcapitalk,thefirmshouldhavea100%payoutratioas theinvestorshavebetterinvestmentopportunitiesthanthefirm.Suchapolicywillmaximizethefirm value.

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IfafirmhasaROIrequaltoitscostofcapitalk,thefirmsdividendpolicywillhavenoimpactonthe firmsvalue.Thedividendpayoutscanrangebetweenzeroand100%andthefirmvaluewillremain constantinallcases.Suchfirmsarecallednormalfirms. WaltersModelisbasedoncertainassumptions: Financing:Allfinancingisdonethroughretainedearnings.Retainedearningsistheonlysource of finance available and the firm does not use any external source of funds like debt or new equity. Constantrateofreturnandcostofcapital:Thefirmsrandkremainconstantanditfollows thatanyadditionalinvestmentmadebythefirmwillnotchangetheriskandreturnprofile. 100%payoutorretention:Allearningsareeithercompletelydistributedorreinvestedentirely immediately. Constant EPS and DPS: The earnings and dividends do not change and are assumed to be constantforever. Life:Thefirmhasaperpetuallife.

Waltersformulatodeterminethemarketpriceisasfollows: P=
D [ ( - D /Ke r E ) ] + Ke Ke

WherePisthemarketpricepershare, Disthedividendpershare, Keisthecostofcapital, gisthegrowthrateofearnings, EisEarningspershare, risIRR. Example: ThefollowinginformationrelatestoAlphaLtd.Showtheeffectofthedividendpolicyonthemarket priceofitssharesusingtheWaltersModel EquitycapitalizationrateKe11% Earningspershare Rs.10 ROI(r)maybeassumedasfollows:15%,11%and8% Showtheeffectofthedividendpoliciesonthesharevalueofthefirmforthreedifferentlevelsofr, takingtheDPratiosaszero,25%,50%,75%and100%

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Solution Ke11%,EPS10,r15%,DPS=0 P=
D [ /Ke( - D r E )] + Ke Ke

CaseIr>k(r=15%,K=11%)

a. DP=0

0 + [ . /0 1110- 0 015 . ( )] =13.64/0.11=Rs.123.97 011 . 2. + [ . /01110- 2 5 5 0 15 . ( . )] = 12.73/0.11=Rs.115.73 0 11 . 5 + [ . /0 1110- 5 015 . ( )] =11.82/0.11=Rs.107.44 011 . 7. + [ . /0 1110- 7 5 5 0 15 . ( . )] =10.91/0.11=Rs.99.17 0 11 . 10 + [ . /0 1110- 10 015 . ( )] =10/0.11=Rs.90.91 0 11 .

b. DP=25% c. DP=50% d. DP=75%

e. DP=100%

CaseIIr=k(r=11%,K=11%) a. DP=0
0 + [ . /0 1110- 0 0 11 . ( )] =10/0.11=Rs.90.91 0 11 . 2. + [ . /0 1110- 2 5 5 0 11 . ( . )] =10/0.11=Rs.90.91 011 . 5 + [ . /0 1110- 5 0 11 . ( )] =10/0.11=Rs.90.91 0 11 . 7. + [ . /01110- 7 5 5 011 . ( . )] =10/0.11=Rs.90.91 0 11 . 10 + [ . /0 1110- 10 0 11 . ( )] =10/0.11=Rs.90.91 0 11 .

b. DP=25% c. DP=50% d. DP=75% e. DP=100%

CaseIIIr<k(r=11%,K=8%) f. DP=0
0 + [ . /0 08( - 0 011 . 10 )] =13.75/0.08=Rs.171.88 0 08 . 2. + [ . /008( - 2 5 5 0 11 . 10 . )] =12.81/0.08=Rs.160.13 0 08 .

g. DP=25%

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h. DP=50% i. DP=75%

5 + [ . /0 08( - 5 011 . 10 )] =11.88/0.08=Rs.107.95 0 08 . 7. + [ . /008( - 7 5 5 0 11 . 10 . )] =10.94/0.08=Rs.99.43 0 08 .

j. DP=100%

10 + [ . /0 08( - 10 011 . 10 )] =10/0.08=Rs.90.91 0 08 .

Interpretation:Theaboveworkingscanbesummarizedasfollows: 1. Whenr>k,thatis,ingrowthfirms,thevalueofsharesisinverselyrelatedtoDPratio,astheDP increases,marketvalueofsharesdecline.MarketvalueofshareishighestwhenDPiszeroand leastwhenDPis100%. 2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected whetherthefirmretainstheprofitsordistributesthem. 3. Inthethirdsituation,whenr<k,indecliningfirms,themarketpriceofashareincreasesastheDP increases.Thereisapositivecorrelationbetweenthetwo. Limitations Walterhasassumedthatinvestmentsareexclusivelyfinancedbyretainedearningsandnoexternal financing is used. This model is applicable only to allequity firms. Secondly r is assumed to be constant whichagain isnot a realistic assumption. Finally,Ke isalsoassumed tobe constant and thisignoresthebusinessriskofthefirmwhichhasadirectimpactonthefirmvalue. 15.3.2GordonsDividendCapitalizationModel Gordonalsocontendsthatdividendsarerelevanttothesharepricesofafirm.MyronGordonuses theDividendCapitalizationModeltostudytheeffectofthefirmsdividendpolicyonthestockprice. Assumptions Allequityfirm:Thefirmisanallequityfirmwithnodebt. No external financing is used and only retained earnings are used to finance any expansion schemes. Constantreturnr ConstantcostofcapitalKe Thelifeofthefirmisindefinite. Constantretentionratio:Theretentionratiog=brisconstantforever. 236

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Costofcapitalgreaterthanbr,thatisKe>br

Gordons model assumes investors are rational and riskaverse. They prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount uncertain returns. The shareholders therefore prefer current dividends to avoid risk. In other words, they discount future dividends. Retained earnings are evaluated by the shareholders as risky and thereforethemarketpriceoftheshareswouldbeadverselyaffected.Gordonexplainshistheorywith preference for current income. Investors prefer to pay higher price for stocks which fetch them currentdividendincome.Gordonsmodelcanbesymbolicallyexpressedas:
P= E1- b ( ) Ke- br

WherePisthepriceoftheshare, EisEarningsPerShare, bisRetentionraio, (1b)isdividendpayoutratio, Keiscostofequitycapital, brisgrowthrateintherateofreturnoninvestment. Example: GivenKeas11%,EisRs.10,calculatethestockvalueofMahindraTech.for(a)r=12%,(b)r=11% and(c)r=10%forvariouslevelsofDPratiosgivenunder: DPratio(1b) Retentionratio A B C D E 10% 20% 30% 40% 50% 90% 80% 70% 60% 50%

Solution CaseIr>k(r=12%,K=11%) P=E(1b) Kebr

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a. DP10%,b90% 10(10.9) 0.11(0.9*0.12) b. DP20%,b80% 10(10.8) 0.11(0.8*0.12) c. DP30%,b70% 10(10.7) 0.11(0.7*0.12) d. DP40%,b60% 10(10.6) 0.11(0.6*0.12) e. DP50%,b50% 10(10.5) 0.11(0.5*0.12) CaseIIr=k(r=11%,K=11%) P=E(1b) Kebr a. DP10%,b90% 10(10.9) 0.11(0.9*0.11) b. DP20%,b80% 10(10.8) 0.11(0.8*0.11) c. DP30%,b70% 10(10.7) 0.11(0.7*0.11) d. DP40%,b60% 10(10.6) 0.11(0.6*0.11) equals4/.044=Rs.90.91 equals3/.033=Rs.90.91 equals2/.022=Rs.90.91 equals1/.011=Rs.90.91 equals5/.05=Rs.100 equals4/.038=Rs.105.26 equals3/.026=Rs.115.38 equals2/.014=Rs.142.86 equals1/.002=Rs.500

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e. DP50%,b50% 10(10.5) 0.11(0.5*0.11) CaseIIIr<k(r=10%,K=11%) P=E(1b) Kebr a. DP10%,b90% 10(10.9) 0.11(0.9*0.1) b. DP20%,b80% 10(10.8) 0.11(0.8*0.1) c. DP30%,b70% 10(10.7) 0.11(0.7*0.1) d. DP40%,b60% 10(10.6) 0.11(0.6*0.1) e. DP50%,b50% 10(10.5) 0.11(0.5*0.1) Interpretation:Gordonisoftheopinionthatdividenddecisiondoeshaveabearingonthemarket priceoftheshare. 1. Whenr>k,thefirmsvaluedecreaseswithanincreaseinpayoutratio.Marketvalueofshareis highestwhenDPisleastandretentionhighest. 2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected whetherthefirmretainstheprofitsordistributesthem. 3. Whenr<k,marketvalueofshareincreaseswithanincreaseinDPratio. equals5/.06=Rs.83.33 equals4/.05=Rs.80 equals3/.04=Rs.75 equals2/.03=Rs.66.67 equals1/.02=Rs.50 equals5/.55=Rs.90.91

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15.4MillerandModiglianiModel TheMMhypothesisseekstoexplainthatafirmsdividendpolicyisirrelevantandhasnoeffecton thesharepricesofthefirm.Thismodeladvocatesthatitistheinvestmentpolicythroughwhichthe firmcanincreaseitssharevalueandhencethisshouldbegivenmoreimportance. Assumptions Existence of perfect capital markets: All investors are rational and have access to all information free of cost. There are no floatation or transaction costs, securities are infinitely divisibleandnosingleinvestorislargeenoughtoinfluencethesharevalue. No taxes: There are no taxes, implying there is no difference between capital gains and dividends. Constant investment policy: The investment policy of the company does not change. The implicationisthatthereisnochangeinthebusinessriskpositionandtherateofreturn. No Risk Certainty about future investments, dividends and profits of the firm. This assumptionwas,however,droppedatalaterstage. Basedontheaboveassumptions,MillerandModiglianihaveexplainedtheirrelevanceofdividendas the crux of the arbitrage argument. The arbitrage process refers to setting off or balancing two transactions whichare entered into simultaneously. The two transactions are paying out dividends andraisingexternalfundstofinanceadditionalinvestmentprograms.Ifthefirmpaysoutdividend,it will have to raise capital by selling new shares for financing activities. The arbitrage process will neutralizetheincreaseinsharevalue(duetodividends)withtheissueofnewshares.Thismakes theinvestorindifferenttodividendearningsandcapitalgainsasthesharevalueismoredependent onthefutureearningsofthefirmthanonitscurrentdividendpolicy. Symbolically,themodelisgivenas: StepI:ThemarketpriceofashareinthebeginningisequaltothePVofdividendspaidandmarket priceattheendoftheperiod. P0= 1 (1+Ke) WhereP0isthecurrentmarketprice, P1ismarketpriceattheendofperiod1, D1isdividendstobepaidattheendofperiod1, Keisthecostofequitycapital. 240 *(D1+P1)

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StepII:Assumingthereisnoexternalfinancing,thevalueofthefirmis: nP0== 1 (1+Ke) Wherenisnumberofsharesoutstanding. StepIII:Ifthefirmsinternalsourcesoffinancingitsinvestmentopportunitiesfallshortoffunds required,newsharesareissuedattheendofyear1atpriceP1.Thecapitalizedvalueofthe dividendstobereceivedduringtheperiodplusthevalueofthenumberofsharesoutstandingisless thanthevalueofnewshares. nP0== 1 (1+Ke) Firmswillhavetoraiseadditionalcapitaltofundtheirinvestmentrequirementsafterutilizingtheir retainedearnings,thatis, n1P1=I(EnD1)whichcanbewrittenasn1P1=IE+nD1 WhereIistotalinvestmentrequired, nD1istotaldividendspaid, Eisearningsduringtheperiod, (EnD1)isretainedearnings. StepIV:Thevalueofshareisthus: nP0== Example: Acompanyhasacapitalizationrateof10%.Itcurrentlyhasoutstandingsharesworth25000shares sellingcurrentlyatRs.100each.ThefirmexpectstohaveanetincomeofRs.400000forthecurrent financial year and it is contemplating to pay a dividend of Rs. 4 per share. The company also requires Rs.600000 tofund its investment requirement. Show that under MM model, the dividend paymentdoesnotaffectthevalueofthefirm. Solution CaseI:Whendividendsarepaid: StepI:P0= 1 (1+Ke) *(D1+P1) 1 *(nD1+(n+n1)P1I+EnD1) (1+Ke) *(nD1+(n+n1)P1n1p1) *(nD1+nP1)

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100=1/(1+0.1)*(4+P1) P1=Rs.106 StepII:n1P1=I(EnD1),nD1is25000*4 n1P1=600000(400000100000)=Rs.300000 StepIII:Numberofadditionalsharestobeissued 300000/106=2831shares StepIV:Thefirmvalue nP0== (n+n1)P1I+E (1+Ke) (25000+2831)*106600000+400000 equalsRs.2500000 (1+0.1) CaseII:Whendividendsarenotpaid: StepI:P0= 1 (1+Ke) 100=1/(1+0.1)*(0+P1) P1=Rs.110 StepII:n1P1=I(EnD1),nD1is25000*4 n1P1=600000(4000000)=Rs.200000 StepIII:Numberofadditionalsharestobeissued 200000/110=1819shares StepIV:Thefirmvalue nP0== (n+n1)P1I+E (1+Ke) (25000+1819)*110600000+400000 equalsRs.2500000 (1+0.1) Thus,thevalueofthefirmremainsthesameinboththecaseswhetherornotdividendsare declared. CriticalAnalysisofMMHypothesis: Floatation costs: Miller and Modigliani have assumed the absence of floatation costs. Floatation costsrefertothecostinvolvedinraisingcapitalfromthemarket,thatis,thecostsincurredtowards underwritingcommission,brokerageandothercosts.Thesecostsordinarilyaccounttoaround10% 242 *(D1+P1)

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15%ofthetotalissueandtheycannotbeignoredgiventheenormityofthesecosts.Thepresenceof these costs affects the balancing nature of retained earnings and external financing. External financingisdefinitelycostlierthanretainedearnings.Forinstance,ifashareisissuedworthRs.100 andfloatationcostsare12%,thenetproceedsareonlyRs.88. Transactioncosts:ThisisanotherassumptionmadebyMMthattherearenotransactioncostslike brokerage involved in capital market. These are the costs associated with sale of securities by investors.Thistheoryimpliesthatifthecompanydoesnotpaydividends,theinvestorsdesirousof currentincomesellpartoftheirholdingswithoutanycostincurred.Thisisveryunrealisticasthesale of securities involves cost, investors wishing to get current income should sell higher number of sharestogettheincometheyaretoreceive. Underpricingofshares:Ifthecompanyhastoraisefundsfromthemarket,itshouldsellsharesat apricelesserthantheprevailingmarketpricetoattractnewshareholders.Thisfollowsthatatlower prices,thefirmshouldsellmoresharestoreplacethedividendamount. Marketconditions:Ifthemarketconditionsarebadandthefirmhassomelucrativeopportunities,it is not worthapproaching new investors at this juncture, given the presence of floatation costs. In such cases, the firms should depend on retained earnings and low payout ratio to fuel such opportunities. 15.5 StabilityofDividends Stabilityofdividendsistheconsistencyinthestreamofdividendpayments.Itisthepayment ofcertainamountofminimumdividendtotheshareholders.Thesteadinessisasignofgoodhealth of the firm and may take any of the following forms (a) constant dividend per share, (b)constantDPratioand(c)constantdividendpershareplusextradividend. Constant dividend per share: As per this form of dividend policy, a firm pays a fixed amount of dividendpershareyearafteryear.Forexample,afirmmayhaveapolicyofpaying25%dividendper share on its paidup capital of Rs. 10 per share. It implies that Rs. 2.50 is paid out every year irrespectiveofitsearnings.Generally,afirmfollowingsuchapolicywillcontinuepaymentsevenifit incurs losses. In such years when there is a loss, the amount accumulated in the dividend equalizationreserveisutilized.Asandwhenthefirmstartsearningahigheramountofrevenueitwill considerpaymentofhigherdividendsandinfutureitisexpectedtomaintainthehigherlevel.

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ConstantDPratio:WiththistypeofDPpolicy,thefirmpaysaconstantpercentageofnetearnings totheshareholders.Forexample,ifthefirmfixesitsDPratioas25%ofitsearnings,itimpliesthat shareholdersget25%ofearningsasdividendyearafteryear.Insuchyearswhereprofitsarehigh, theygethigheramount. Constant dividend per share plus extra dividend: Under this policy,a firm usually pays afixed dividendordinarilyandinyearsofgoodprofits,additionalorextradividendispaidoverandabove theregulardividend. Thestabilityofdividendsisdesirablebecauseofthefollowingadvantages: Build confidence amongst investors: A stable dividend policy helps to build confidence and remove uncertainty in the minds of investors. A constant dividend policy will not have any fluctuationssuggestingtotheinvestorsthatthefirmsfutureisbright.Incontrast,shareholdersof afirmhavinganunstableDPwillnotbecertainabouttheirfutureinsuchafirm. Investors desire for current income: A firm has different categories of investors old and retired persons, pensioners, youngsters, salaried class, housewives, etc. Of these, people like retiredpersonsprefercurrentincome.Theirlivingexpensesarefairlystablefromoneperiodto another. Sharp changes in current income, that is, dividends, may necessitate sale of shares. Stabledividendpolicyavoidssaleofsecuritiesandinconveniencetoinvestors. Informationaboutfirmsprofitability:Investorsusedividendpolicyasameasureofevaluating thefirmsprofitability.Dividenddecisionisasignoffirmsprosperityandhencefirmshouldhave astableDP. Institutional investors requirements: Institutional investors like LIC, GIC and MF prefer to invest in companies which have a record of stable DP. A company having erratic DP is not preferred by these institutions. Thus to attract these organizations having large quantities of investiblefunds,firmsfollowastableDP. Raise additional finance: Shares of a company with stable and regular dividend payments appearasqualityinvestmentratherthanaspeculation.Investorsofsuchcompaniesareknown for their loyalty and whenever the firm comes with new issues, they are more responsive and receptive.Thusraisingadditionalfundsbecomeseasy. Stability in market price of shares: The market price of shares varies with the stability in dividendrates.Suchshareswillnothavewidefluctuationsinthemarketpriceswhichisgoodfor investors. 244

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SelfAssessmentQuestionsI 1. ____________constituteanimportantsourceoffinancinginvestmentrequirementsofafirm. 2. Dividendpolicyhasadirectinfluenceonthetwocomponentsofshareholdersreturn__________ and____________. 3. ______________considers dividend payouts are relevant and have a bearing on the share pricesofthefirm. 4. IfafirmhasaROIrequaltoitscostofcapitalk,itiscalleda___________ 5. ________ model explains that consumers prefer certain returns to uncertain returns and thereforegiveapremiumtotheconstantreturnsanddiscountuncertainreturns. 6. The__________processreferstosettingofforbalancingtwotransactionswhichareenteredinto simultaneously. 7. __________costsrefertothecostinvolvedinraisingcapitalfromthemarket. 8. ______________arethecostsassociatedwithsaleofsecuritiesbyinvestors. 15.6 FormsofDividends Dividendsarethatpotionofearningsavailabletoshareholders.Generally,dividendsaredistributed incash,butsometimestheymayalsodeclaredividendsinotherformswhicharediscussedbelow: Cashdividends: Mostcompaniespaydividendsincash.Theinvestorsalso,especiallytheold andretiredinvestorsdependonthisformofpaymentforwantofcurrentincome. Scripdividend:Inthisformofdividends,equityshareholdersareissuedtransferablepromissory notes with shorter maturity periods which may or may not have interest bearing. This form is adopted if thefirmhasearned profitsand it willtake some timeto convert itsassets into cash (havingmoreofcurrentsalesthancashsales).Paymentofdividendinthisformisdoneonlyif thefirmissufferingfromweakliquidityposition. Bond dividend: Scrip and bond dividend are the same except that they differ in terms of maturity.Bonddividendscarrylongermaturityperiodandbearinterest,whereasscripdividends carryshortermaturityandmayormaynotcarryinterest. Stockdividend(Bonusshares):Stockdividend,asknownisUSAorbonussharesinIndia,is thedistributionofadditionalsharestotheshareholdersatnoadditionalcost.Thishastheeffect of increasing thenumberofoutstanding sharesof thefirm. The reservesand surplus (retained earnings) are capitalized to give effect to bonus issue. This decision has the effect of

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recapitalization,thatis,transferfromreservestosharecapitalnotchangingthetotalnetworth. Theinvestorsareallottedsharesinproportiontotheirpresentshareholding.Declarationofbonus shareshasafavourablepsychologicaleffectoninvestors.Theyassociateitwithprosperity. 15.7StockSplit Astocksplitisamethodtoincreasethenumberofoutstandingsharesbyproportionatelyreducing thefacevalueofashare.Astocksplitaffectsonlytheparvalueanddoesnothaveanyeffectonthe totalamountoutstandinginsharecapital.Thereasonsforsplittingsharesare: Tomakesharesattractive:Theprimereasonforeffectingastocksplitistoreducethemarket price of a share to make it more attractive to investors. Shares of some companies enter into highertradingzonemakingitoutofreachtosmallinvestors.Splittingtheshareswillplacethem inmorepopulartradingrangethusprovidingmarketabilityandmotivatingsmallinvestorstobuy them. Indication of higher future profits: Share split is generally considered a method of managementcommunicationtoinvestorsthatthecompanyisexpectinghighprofitsinfuture. Higher dividend to shareholders: When shares are split, the company does not resort to reducingthecashdividends.Ifthecompanyfollowsasystemofstabledividendpershare,the investorswouldsurelygethigherdividendswithstocksplit. 15.8Summary Dividendsaretheearningsofthecompanydistributedtoshareholders.Paymentofdividendisnot mandatory,butmostcompaniesseetoitthatdividendsarepaidonaregularbasistomaintainthe imageofthecompany.Aspaymentofdividendisnotcompulsory,thequestionwhicharisesinthe minds of policy makers is Should dividends be paid, if yes, what should be the quantum of payment?Varioustheorieshavecomeoutwithvarioussuggestionsonthepaymentofdividend.B. GrahamandD.L.Doddareoftheviewthatthereisacloserelationshipbetweenthedividendsand thestockmarket.Thestockvaluerespondspositivelytohighdividendsandviceversa. Prof. James E. Walter considers dividend payouts are necessary but if the firms ROI is high, earningscanberetainedasthefirmhasbetterandprofitableinvestmentopportunities.

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Gordon also contends that dividends are significant to determine the share prices of a firm. Shareholders prefer certain returns (current) to uncertain returns (future) and therefore give a premiumtotheconstantreturnsanddiscountuncertainreturns. MillerandModiglianiexplainthatafirmsdividendpolicyisirrelevantandhasnoeffectontheshare prices of the firm. They are of the view that it is the investment policy through which the firm can increaseitssharevalueandhencethisshouldbegivenmoreimportance. Dividendscanbepaidoutinvariousformssuchascashdividend,scripdividend,bonddividendand bonusshares. TerminalQuestions 1. Writeashortnoteonthedifferenttypesofdividend. 2. Whatisstocksplit?Whatareitsadvantages? 3. Thefollowinginformationisavailableinrespectofacompany. Equitycapitalization15% EPSRs.25 Dividendpayoutratio25% ROI12% WhatisthepriceoftheshareasperWalterModel? 4. Consideringthefollowinginformation,whatisthepriceoftheshareasperGordonsModel? Netsales Netprofitmargin Outstandingpreferenceshares No.ofequityshares Costofequityshares Retentionratio ROI Rs.120lakhs 12.5% Rs.50lakhs@12%dividend 250000 12% 40% 16%

5. IftheEPSisRs.5,dividendpayoutratiois50%,costofequityis20%,growthrateintheROIis 15%,whatisthevalueofthestockasperGordonsDividendEqualizationModel? 6. NileLtd.makesthefollowinginformationavailable.WhatisthevalueofthestockasperGordon Model? 247

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Ke14%,EPSRs.20,D/Pratio35%Retentionratio65%,ROI16% 7. WhatisthestockpriceasperGordonModelifDPratiois60%intheabovecase? AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Retainedearnings 2. Dividendsandcapitalgains 3. Prof.JamesE.Walter 4. Normalfirm 5. Gordon 6. Arbitrage 7. Floatationcosts 8. Transactioncosts AnswerstoTerminalQuestions: 1. Referto10.6 2. Referto10.7 3.Hint:ApplytheformulaWaltersformulatodeterminethemarketprice P= D + [r(ED)/Ke] KeKe 4,5,6,7:Hint:ApplytheGordonformulaofP=E(1b) Kebr

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