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Corporate Finance

S. No

Reference No

Particulars

Slide
From-To

Chapter 1

An Introduction to Finance

4-17

Chapter 2

Time Value of Money

18-41

Chapter 3

Capital Budgeting

42-75

Chapter 4

Sources of Finance

76-95

Chapter 5

Capital Structure Management

96-129

Chapter 6

Leverages

130-153

Chapter 7

Dividend Policy

154-177

Chapter 8

Working Capital Management

178-212

Chapter 9

Receivables and Inventory


Management

213-231

10

Chapter 10

Budget and Budgeting

232-245

Course Introduction

Corporate finance is the area of finance that deals with the arrangement of
funds for the capital structure of corporations and managerial actions for
increasing the value for the shareholders.

This course offers a market-oriented framework for analysing the major


types of financial decisions taken by corporations.

Corporate finance explains topics such as capital budgeting, capital


structure, working capital management, dividend policy, asset valuation,
the operation and efficiency of financial markets, etc. and explains the
responsibilities of a financial officer, chief financial officer, treasurer,
controller, etc.

Corporate finance provides a framework of the concepts and tools used to


analyse financial decisions based on fundamental principles of modern
financial theory.

Chapter 1: An
Introduction to
Finance

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

Learning Objectives

Topic 1

Concept of Finance

Topic 2

Scope of Finance

Topic 3

Functions of Finance

Topic 4

Concept of Financial

10

Management
6

Topic 5

Objectives of Financial

11-12

Management
7

Topic 6

Analysing Financial Business

13-14

Decisions
8

Lets Sum Up

15

Explain the concept, scope and functions of finance

Describe the concept of financial management

Explain

the

objectives

of

financial

management,

such

as

profit

maximisation, wealth maximisation, and value maximisation

Analyse financial business decisions through cost-volume-profit analysis


and break-even analysis

Concept of Finance

Finance can be defined from the corporate and business point of view.

Corporate finance involves the financial decisions that an organisation


makes in its daily business operations.

It aims to utilise the capital, which the organisation has, to make more
money while simultaneously reducing risks of certain decisions.

Thus,

business

decisions

that

involve

the

decision

pertaining

to

identification of sources of capital for funding corporations are corporate


financial decisions.

Business finance, on the other hand, encompasses various activities and


disciplines concerning the management of money and other valuable
assets.

Scope of Finance

An organisation needs finance to acquire assets, manufacture goods, offer


high quality services, procure raw materials, pay its employees and invest
in development and expansion projects.

It is required in various areas of an organisation, which are:

Production
Marketing
Human Resource
Research and Development

Functions of Finance
The functions of finance are majorly influenced by four types of decisions,
which are as follows:
Investment Decision

Financing Decision

Dividend Decision

Liquidity Decision

Concept of Financial Management

According to J.C. Van Horne, Financial Management is concerned with


the acquisition, financing, and management of assets with some overall
goal in mind.

Financial Management can be defined as the function involved in the


management of financial resources.

There are three major elements of financial management, which are as


follows:

Financial planning
Financial control
Financial decision-making

1. Objectives of Financial Management

The main objective of financial management is to increase the profit of the


organisation.

The objectives of financial management are:


Profit Maximisation

Wealth Maximisation

Value Maximisation

2. Objectives of Financial Management

Profit maximisation: This is required for organisations survival, meeting


the other organisational objectives, measuring growth, and measuring
efficiency.

Wealth maximisation: The aim of wealth maximisation approach is to


maximise the wealth of shareholders by increasing Earning Per Share
(EPS).

Value maximisation: It can be defined as the managerial function


involved in the appreciation of the long-term market value of an
organisation. The total value of an organisation comprises of all the
financial assets, such as Equity shares , Preference Shares, and warrants
and it increases when the value of its shares increases in the market.

1. Analysing Financial Business Decisions

When decisions are taken regarding the allocation of an organisations


financial resources in the most efficient manner, it is called financial
business decision.

Before investing in a project, the organisation needs to determine the


feasibility of every available option.

Before investing in the project, it needs to estimate the cost of


manufacturing garment.

Further, it needs to decide the probable profit from the project. If the cost
incurred in manufacturing the garment is less than the expected profit,
then it would be feasible for the organisation to go ahead with the project.

This process of determining the feasibility of a project is known as financial


analysis.

2. Analysing Financial Business Decisions

A feasibility study includes the detailed analysis of a project or investment


avenue in order to predict the results of a specific future course of action.

An organisation can perform financial analysis by using various tools, which


are:
Cost-Volume-Profit Analysis
Break-Even Analysis
Marginal Costing
Margin of Safety

Lets Sum Up

Corporate finance involves the financial decisions that an organisation


makes in its daily business operations.

Financial

management

determines

the

future

strategies

related to

expansion, diversification, joint venture, and mergers and acquisitions.

The Cost-Volume-Profit (CVP) analysis determines the change in profit with


respect to changes in sales volume and cost.

BEP refers to a point where total cost is equal to total revenue of an


organisation.

Margin of Safety (MOS) means the difference between actual sales volume
and the sales volume at BEP.

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Chapter 2:
Time Value of Money

Chapter Index

S. No

Reference No

Particulars

Slide
From-To

Learning Objectives

20

Topic 1

Time Value of Money

21-23

Topic 2

Future Value of Cash Flow

24-35

Topic 3

Present Value of Cash Flow

36-38

Lets Sum Up

39

Explain the concept of time value of money

Discuss the future value of cash flow

Explain the present value of cash flow

1. Time Value of Money

Time value of money analyses the value of a unit of money at various


times.

This is because the money received in future involves risk and money
available at present offers investment opportunities.

For example, a person has an option to receive Rs.1000 now or after one
year. The person would prefer Rs.1000 now because he/she can invest the
money and earn interest on it. However, after one year it may be possible
that the individual would not receive Rs.1000 because of uncertain future.
Moreover, it may be possible that the value of money depreciates over
time. Hence, in such a case, Rs.1000 received at present is more valuable
than Rs.1000 received after one year.

2. Time Value of Money


A person values the money available at present due to the following reasons:

Investment options: It indicates the various ways in which money can be


invested. Interest and growth can be possible on the invested money and
hence, the amount of money available today is more valuable than in the
future.

Priority for consumption: It points to the fact that individuals give


priority to consumption over investment. This is because they think that
the future investments are uncertain. They are of the opinion that in future,
the value of money may depreciate due to inflation; therefore, they prefer
to have money available at present rather than at a future date.

3. Time Value of Money

Risk factor: It indicates that risk and uncertainty is always linked with
money to be received in future as the market conditions are volatile in
nature. Various factors, such as inflation, recession, and government
policies may influence the value of money to be received in future date.
Hence, the organisation or individual prefers to avail money in the present.
The time value of money is estimated in two ways: future value of cash
flow and present value of cash flow, which are discussed in detail in the
next few sections.

1. Future Value of Cash Flow

The future value of cash flow is defined as a technique that calculates the
value of cash at a fixed time in future at a specific compound interest rate.

If an individual purchases some investment policies then he/she considers


the future value of initial investment and returns earned on it.

Since, the future investments involve risk; the individual compares the risk
factor with total future value of the investment, i.e. the initial investment
along with the returns.

If the future value is greater than the risk associated with the investment,
the investment is considered to be favourable.

2. Future Value of Cash Flow


Future Value of Single Cash Flow

The future value of single cash flow is defined as the valuation of an


amount of money at a particular period of time in future.

It depends on the rate of compound interest earned on the amount of


money invested, i.e. if the rate of compound interest is high then the future
value of single cash flow is also higher.

Generally, people calculate future value of single cash flow while investing
in saving schemes, bonds, mutual funds, and derivative markets.

3. Future Value of Cash Flow


Future Value of Single Cash Flow

The mathematical formula used to calculate future value of single cash


flow is as follows:
FVn = P (1+i)n

Where,

FVn = Amount at the end of n years

P = Principal at the beginning of the year

i = Rate of interest

n = Number of years

4. Future Value of Cash Flow


Future Value of Single Cash Flow

Illustration: Assume Mr. Amjad invests Rs.10000 at the interest rate of 5


per cent compounded annually for three years in a business.

At the end of first year, he gets Rs.10500, which is considered as the


principal for the next year.

At the end of the second year, he receives Rs.11025, which is considered


as the principal for the third year.

Finally, he gets Rs.11576.25, which is the total amount received by him at


the end of third year and is the future value of single cash flow.

5. Future Value of Cash Flow


Future Value of Single Cash Flow

Calculation of Future Value of Single Cash Flow:


Year

Principal (original) amount

10000

10500

11025

Rate of interest

0.05

0.05

0.05

Interest amount

500

525

551.25

New principal

10000

10500

11025

Future value

10500

11025

11576.25

6. Future Value of Cash Flow


Future Value of Single Cash Flow

Illustration: Assume Mr. Yashwant has invested Rs.100 at the interest rate
of 8% compounded semi-annually for two years in a business.

He receives 4% interest compounded semi-annually four times in two


years.

7. Future Value of Cash Flow


Future Value of Single Cash Flow

Calculation: The calculation of future value of Rs.100 at the end of two


years are a shown in Table:
Year

6 months

1 year

18 months

2 years

Initial amount

100

104

108.16

112.48

Rate of interest

0.04

0.04

0.04

0.04

Interest amount

4.16

4.32

4.50

New principal

100

104

108.16

112.48

Future value

104

108.16

112.48

117

8. Future Value of Cash Flow


Future Value of Annuity

A fixed amount of cash paid or received at a regular interval of time is


called annuity.

For example, the fixed amount of premium paid at regular intervals by an


individual on insurance policy is called annuity.

If an individual buys property, such as house or land, on instalments then


annuity helps in calculating the monthly instalments paid by the individual.

The calculation of future value of annuity helps the investors to estimate


the amount of return on investment and compare the risk and returns
linked with the investment.

9. Future Value of Cash Flow


Future Value of Annuity

Illustration: Mr. K. K. Prasad deposits Rs. 100 for five years at the interest
rate of 5 % compounded annually in a bank.

It suggests that deposited amount would increase at the rate of 5 per cent
compounded annually for the next four years.

The amount at the end of first year would become principal for the next
year and this process continues for the next three years.

In the fifth year, no interest would be generated as Mr. Prasad would


withdraw the money.

10. Future Value of Cash Flow


Future Value of Annuity

The calculation of future value of annuity is as follows:

FVAn = Rs. 100 (1.05)4 + Rs. 100 (1.05)3 + Rs. 100 (1.05)2 + Rs. 100 (1.05)1
+ Rs. 100

FVAn = Rs. 100 (1.216) + Rs. 100 (1.158) + Rs. 100 (1.103) + Rs. 100
(1.050) + Rs. 100

FVAn = Rs. 121.55 + Rs. 115.76 + Rs. 110.25 + Rs. 105.50 + Rs. 100

FVAn = Rs. 553.05

11. Future Value of Cash Flow


Future Value of Annuity

The compounding value of annuity of Rs. 100 at the rate of 5 per cent are
as follows:

12. Future Value of Cash Flow


Future Value of Annuity

The mathematical formula to calculate the future value of annuity is as follows:


FVA5 = A (1+i) 4 + A (1+i) 3 + A (1+i) 2 + A (1+i) + A
= A [(1+i) 4 + (1+i) 3 + (1+i) 2 + (1+i) + 1]
= A [(1+i) 4 1/i]

When the time period extended to n years, the equation can be re-written as:
FVAn = P [(1+i) n 1/i]

Where,

FVAn = Future Value of Annuity of cash flow

P =Principal at the beginning of the year

i = Rate of interest

n = Number of years

1. Present Value of Cash Flow


Present Value of Single Cash Flow

The present value of single cash flow enables to determine the present
value of future cash flow.

The present value of cash flow is generally lesser than the future value of
cash flow.

Thus, it can be established that in future value of cash flow, there is always
some appreciation in the value of money. However, in present value of
cash flow, there is always some depreciation in the value of money.

2. Present Value of Cash Flow


Present Value of Annuity

Illustration: Mr. P. K. Chandra lends Rs. 100 at interest rate of 5 per cent
for five years. What would be the present value of annuity?

The present value of Rs. 100 received at the end of first year is P =
100/1.05 = Rs. 95.23, at the end of second year is P = 100/(1.05)2 = Rs.
90.70, at the end of third year is P=100/ (1.05)3= Rs. 86.38, at the end of
the fourth year is P =100/ (1.05)4 = Rs. 82.27 and after five year it would
be 100/ (1.05)5 = Rs. 78.35.

Therefore, the sum of the present value at the end of each year comprises
the present value of annuity of Rs. 100 at the end of five years.

3. Present Value of Cash Flow


Future Value of Annuity

The discounting value of annuity of cash flow of Rs. 100 at the rate of 5 per
cent is as follows:

Lets Sum Up

Time value of money analyses the value of a unit of money at various


times.

The time value of money is estimated in two ways: future value of cash
flow and present value of cash flow.

The future value of cash flow is defined as a technique that calculates the
value of cash at a fixed time in future at a specific compound interest rate.

The future value of single cash flow is defined as the valuation of an


amount of money at a particular period of time in future.

The present value of annuity is the sum of total present value of single
cash flow over the year.

The present value of annuity is also called discounting value of annuity.

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Chapter 3: Capital
Budgeting

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

Learning Objectives

44

Topic 1

Concept of Capital Budgeting

45-49

Topic 2

Techniques of Capital

50-62

Budgeting
4

Topic 3

Project Selection and

63-65

Evaluation
5

Topic 4

Capital Budgeting Problems

66-67

Topic 5

Capital Rationing

68-69

Topic 6

Sensitivity Analysis in Capital

70-72

Budgeting
8

Lets Sum Up

73

Describe the concept of capital budgeting

Explain various techniques of capital budgeting

Discuss project selection and evaluation

Explain the capital budgeting problems

Describe capital rationing

Explain sensitivity analysis in capital budgeting

1. Concept of Capital Budgeting

Capital budgeting can be defined as a process of allocating the resources


of the organisation in the long-term investment projects to generate profit.

Capital budget is prepared, implemented, and reviewed continuously by


the organisation. Some of the important aspects of capital budgeting are
as follows:
It affects the competitive position of the organisation in the long run
It needs a large sum of capital because it comprises investment in
long-term assets
It refers to one time process that cannot be either reversed or
withdrawn
It consists of the risk element as it is futuristic in approach

2. Concept of Capital Budgeting

The significance of capital budgeting is as follows:


Long-term Applications: It implies that capital budgeting decisions
are useful for an organisation in the long run as these decisions have a
direct impact on the cost structure and future prospects of the
organisation. Moreover, these decisions affect the organisations
growth rate. Hence, an organisation has to take capital decisions
carefully..
Competitive Position of an Organisation: It means an organisation
can plan its investment in various fixed assets via capital budgeting.
Moreover, capital investment decisions help the organisation to
estimate its future profits. All these decisions have a major impact on
the competitive position of an organisation.

3. Concept of Capital Budgeting

Cash Forecasting: It indicates that an organisation needs sufficient


funds for its investment decisions. With the help of capital budgeting,
an organisation is aware of the required amount of cash, thus, ensuring
availability of cash at the right time. This further helps the organisation
to achieve its long-term goals.
Maximisation of Wealth: It means that the long-term investment
decisions of an organisation helps in protecting the interest of
shareholders in the organisation. If an organisation has invested in a
planned manner, shareholders would also be interested to invest in the
organisation and in this way, the wealth of the organisation can be
maximised.

4. Concept of Capital Budgeting

Process of Capital Budgeting

Decisions regarding the capital budgeting and investment are very


important for a firm as it is on the basis of these decisions that matters
related to the risk, growth and profitability of an organisation are taken.

This process is also known as investment decision making or planning


capital expenditure.

Capital budgeting helps organisations to utilise its capital in the best way,
expecting the best returns from it.

5. Concept of Capital Budgeting

Process of Capital Budgeting

Organisations perform capital budgeting in the following five steps:


Exploring the opportunities
Evaluating the opportunities
Determining cash flow
Selecting the projects
Implementing capital budgeting

1. Techniques of Capital Budgeting

Various techniques to evaluate capital budgeting:

2. Techniques of Capital Budgeting

Traditional Techniques (ARR; payback Period Method)

Traditional methods of capital budgeting only determine the profitability of


an investment project, ignoring the time factor completely.

The two traditional methods used in the evaluation of capital budgeting are:

Average Rate of Return (ARR): Also known as accounting rate of return,


this method is based on the basic concepts of bookkeeping and uses
accounting information to evaluate capital budgeting.

ARR =

3. Techniques of Capital Budgeting

Traditional Techniques (ARR; payback Period Method)

Illustration: Let us assume that an organisation invests Rs. 1, 20,000 on


an average in a year in a project.

The average annual revenue received by the organisation from the project
is Rs. 1,50,000. Calculate the ARR of the project.

Solution:
Average annual profit = Average annual revenue- average annual cost =
1,50,000 1,20,000 = 30,000.

ARR = = 25%.

4. Techniques of Capital Budgeting


Traditional Techniques (ARR; payback Period Method)

Payback Period Method: This method uses the qualitative approach to


evaluate capital budgeting. Payback period refers to the time in which the
initial cash outflow of a project is expected to be recovered from the cash
inflows generated by the project. It is one of the simplest investment
appraisal techniques.

The mathematical formula to calculate the payback period is as follows:

5. Techniques of Capital Budgeting


Traditional Techniques (ARR; payback Period Method)

Illustration: Let us assume that the total investment required throughout


the lifetime of a project is Rs. 150,000 and the project will give an annual
return of Rs. 30,000. Calculate the payback period.

Solution:

The payback period of the project would be = 1, 50,000/30,000 = 5 Years.

6. Techniques of Capital Budgeting

Discounted Cash Flow Techniques


Discounted cash flow techniques help in determining the time value of
money of a project. The following are the techniques to determine the
discounted cash flow:

Net Present Value Method (NPV): It is the difference between the


present value of cash inflows and cash outflows in a given project. This
method is also used to evaluate the profitability of a project. The formula to
calculate NPV is as follows:

NPV = C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 +..+ Cn/(1+r)n I0

7. Techniques of Capital Budgeting


Discounted Cash Flow Techniques
The steps involved in calculating the NPV of a project:

Forecasting Cash Flows

Estimating the Required Rate of Return

Calculating the Present Value of Cash Flows

Finding out NPV

8. Techniques of Capital Budgeting


Discounted Cash Flow Techniques
The following are the advantages of using the NPV method:

Accurate profitability measurement: It takes into account all the cash


flows that occur throughout the life-time of a project to provide exact
profitability measures. The accurate measurement of the profitability of a
project helps in maximising the shareholders wealth.

Value-additivity: This refers to the principle that the net present value of
a set of independent projects is equal to the sum of the net present values
of the individual project. It is determined by adding the present values of all
the cash flows.

9. Techniques of Capital Budgeting


Discounted Cash Flow Techniques

Internal Rate of Return Method: It is used to determine the discount


rate that makes the NPVs of all cash flows arising out of any project equal
to zero.

This method does not take into account any external factors, such as
inflation.

IRR also denotes the interest rate at which the NPVs of all expenses made
on a project (cash outflow) equals to the NPVs of all the benefits or income
arising out of the project (cash inflow).

IRR is one of the time-based methods to analyse the capital investment


decisions.

10. Techniques of Capital Budgeting


Discounted Cash Flow Techniques

There are alternative ways to calculate IRR, the simplest of these methods
is as follows:
1. Estimate the value of r (discount rate) and calculate the NPV of the
project at that value.
2. If NPV is close to zero then IRR is equal to r.
3. If NPV is greater than 0 then increase r and go to step 5.
4. If NPV is smaller than 0 then decrease r and go to step 5.
5. Recalculate NPV using the new value of r and go back to step 2.

11. Techniques of Capital Budgeting

Time-framed Methods (Profitability Index, Net Terminal Value Method)

The time-framed methods take into consideration the time factor while
evaluating capital budgeting. These methods are:
Profitability Index: It is the ratio of the present value of the cash
inflow to the present value of the cash outflow. The profitability index
method is based on the time value of money and is intended to
maximise the wealth of the shareholders. The mathematical formula to
calculate profitability index is as follows:
Profitability Index =

12. Techniques of Capital Budgeting


Time-framed Methods (Profitability Index, Net Terminal Value Method)

Illustration: If the present value of cash inflows in a project is ` 7,50,000


and the present value of the cash outflows is Rs.3,00,000, then calculate
the profitability index.

Solution: The profitability index would be = Rs.7, 50,000/Rs.3,00,000 =


2.5.

Profitability index is very similar to the NPV method as it also measures the
difference between cash inflow and cash outflow in an organisation.

The profitability index should be greater than one for the selection of a
project. This method is also used to measure the relative cash surplus of an
organisation by comparing the cash inflow and outflow.

13. Techniques of Capital Budgeting


Time-framed Methods (Profitability Index, Net Terminal Value Method)

Net Terminal Value Method: In this method, the returns generated from
a project are further reinvested in the same project. In other words, the
cash inflow is reused in the project till it is completed.

1. Project Selection and Evaluation

Project selection and evaluation are among the key financial decisionmaking processes in an organisation.

These decisions affect the profitability and competitiveness of the


organisation in the long run.

The organisation selects only those projects for which NPV and IRR values
are positive.

There are two types of projects in an organisation: independent projects


and mutually exclusive projects.

2. Project Selection and Evaluation

Types of projects are:

3. Project Selection and Evaluation

Independent Projects: These projects are independent of other projects


handled by the organisation. The selected independent project should meet
the minimum required standards and norms set by the organisation, such
as its NPV should be greater than zero and IRR should exceed the expected
rate of return.

Mutually Exclusive Projects: These projects are exclusive in the sense


that their selection rules out the possibility to opt other projects. Suppose
an organisation wants to buy a machine and has three contenders in line
with different investment plans. The projects of all the three contenders are
mutually exclusive; however, the organisation would select the contender
who offers the most lucrative deal.

1. Capital Budgeting Problems


Ranking Conflicts in NPV and IRR

A project is considered profitable if its acceptance excludes the acceptance


of one or more projects. IRR methods may result in contradictions when:
Projects have different life expectancies.
Projects have different sizes of investments.
Projects whose cash flow may differ over time.

2. Capital Budgeting Problems


Multiple IRRS

There can be multiple IRRs when the sign of the cash flow is changed more
than once.

It is said that when a project has multiple IRRs, it may be more convenient
to compute the IRR of the project with the benefits reinvested.

1. Capital Rationing

Capital rationing is a concept in which the management of an organisation


restricts the approval of further projects to minimise the investment of
capital.

Such rationing decisions are taken by organisations when their financial


condition is not very favourable or when they have already accepted many
independent investment proposals.

There are two types of capital rationing:

2. Capital Rationing

Internal Capital Rationing: Here, the organisation stops taking projects


due to internal factors. For example, managers are unable to select the
approved profitable project due to limited funds.

External Capital Rationing: Here, the organisation stops taking projects


due to external factors. For example, suppose an organisation wants to
raise capital from the market by issuing debentures but due to unstable
market conditions, it fails to do so.

1. Sensitivity Analysis in Capital Budgeting

Sensitivity analysis is done to analyse the degree of responsiveness of the


dependent variable for a given change in any of the independent variables.

In other words, sensitivity analysis is a method in which the results of a


decision are forecasted, if the actual performance deviates from the
expected or assumed performance.

To find out the NPV or IRR of the project, the project managers need to
make the accurate predictions of independent variables.

Any change in the independent variables can change the NPV or IRR of the
project.

2. Sensitivity Analysis in Capital Budgeting

The following steps are performed to do a sensitivity analysis:


1. Identifying all the variables that affect the NPV or IRR of the project
2. Establishing a mathematical relationship between the independent and
dependent variables
3. Studying and analysing the impact of the change in the variables

3. Sensitivity Analysis in Capital Budgeting

Sensitivity analysis helps in providing different cash flow estimations in the


following three circumstances:
Worst or pessimistic condition: It refers to the most unfavourable
economic situation for the project.
Normal

condition:

It

refers

to

the

most

probable

economic

environment for the project.


Optimistic condition: It indicates the most favourable economic
environment for the project.

Lets Sum Up

The capital budgeting can be defined as a process of allocating the resources of


the organisation in the long-term investment projects to generate profit.

Capital budgeting helps organisations to evaluate the expected rate of return on


investments.

Payback period method uses the qualitative approach to evaluate capital


budgeting.

Value-additivity is determined by adding the present values of all the cash flows.

The time-framed methods take into consideration the time factor while evaluating
capital budgeting.

Capital rationing is a concept in which the management of an organisation


restricts the approval of further projects to minimise the investment of capital.

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Chapter 4:
Sources of Finance

Chapter Index
S. No

Reference

Particulars

No
1

Slide
From-To

Learning Objectives

Topic 1

Financial Market

Topic 2

Long-Term Sources of Finance

Topic 3

Medium-Term Sources of

78
79-81
82
83-84

Finance
5

Topic 4

Short-Term Sources of Finance

85-86

Topic 5

Overseas Sources of Finance

87-92

Lets Sum Up

93

Explain the concepts of financial market, capital market and money market

Describe long-term sources of finance such as shares, debentures, term


loans and mezzanine debt

Discuss medium-term sources of finance such as lease finance, hire


purchase, venture capital, public deposits and retained earnings

Explain short-term sources of finance such as trade credit, customer


advances and instalment credit

Describe ADR, GDR and ECB

1. Financial Market

A financial market is a place where investors trade securities and


commodities. It acts as a forum through which demanders and suppliers of
funds can perform business transactions.

The structure of a financial market:

2. Financial Market
Capital Market

Capital market is a type of financial market where debt capital and equity
share capital are raised by different business enterprises.

It facilitates an organisation to raise funds for long-term projects.

Capital market can be classified into two types:

3. Financial Market
Money Market

Money market is a part of financial market in which short-term loans are


raised.

The maturity period of these loans is one year or less than one year.

In the money market, funds can be raised through treasury bills,


commercial papers, bank loans and asset-backed securities.
Call money market
Treasury bills
Commercial papers
Certificate deposits

Long-term Sources of Finance

Long-term financing is a mode of financing that is offered for more than


one year.

It is required by an organisation during establishment, expansion,


technological innovation and research and development.

In addition, long-term financing is required to finance long-term investment


projects. Various sources of long-term finance are:

1. Medium-term Sources of Finance

Medium-term finance is required by an organisation for a period of more


than 1 year but less than 10 years.

The organisation can avail medium-term finance through various sources,


including lease finance and hire purchase, venture capital finance, public
deposits and retained earnings.

An organisation needs medium-term sources of finance for expansion,


replacement of old plant and machinery, writing off short-term debts and
technological upgrade.

2. Medium-term Sources of Finance


The sources of medium-term finance:

Different
Different Sources
Sources of
of MediumMediumTerm
Term Finance
Finance

Lease Finance
Hire Purchase
Venture Capital
Public Deposits
Retained Earnings

1. Short-term Sources of Finance

Short-term financing is aimed to meet the demand of current assets and


current liabilities of an organisation.

It helps in minimising the gap between current assets and current


liabilities.

There are different means to raise capital from the market for a small
duration.

Various agencies, such as commercial banks, co-operative banks, financial


institutions and National Bank for Agriculture and Rural Development
(NABARD), provide financial assistance to organisations.

2. Short-term Sources of Finance

These agencies provide short-term financing in various forms:

Short-term
Financing

Trade Credit

Customer
Advances

Instalment credit

1. Overseas Sources of Finance

Funds are raised by MNCs by determining the ideal capital structure (a


mixture of debt and equity) of the organisation.

The capital of an organisation mainly consists of issued shares or stocks,


borrowed funds or debt, retained earnings and undistributed dividends.

It is up to the strategy of the management to determine the proportion of


the debt to be raised by borrowing and the proportion of equity to be
raised from the market.

MNCs can raise capital from the domestic market by offering equity shares
in the domestic currency. They can also think about sourcing equity
globally by offering shares in foreign countries in the currencies of the
respective countries.

2. Overseas Sources of Finance

The mechanism that is followed for the issue of shares in the international
market is as follows:

3. Overseas Sources of Finance


ADR

ADR stands for American Depositary Receipt.

It is a share traded in the U.S. financial market by a non-U.S. organisation.

It is an indirect form of trading in the American market through the


depository receipts.

ADRs help the American investors in purchasing shares of the foreign


organisations in the same manner as that of the local organisations without
any problem of cross-country and cross-currency transaction.

ADRs are offered by a depository bank situated in the U.S. holding the
shares of the foreign organisations.

4. Overseas Sources of Finance


ADR

ADRs issued by the depository bank can be categorised into three different
levels:
Level 1: It is the most basic type or the lowest level of ADRs that do
not fulfil the conditions for listing on the U.S. stock exchange.
Level 2: These are the depository receipts which are listed on the U.S.
stock exchange and traded through stock exchanges such as NASDAQ,
NYSE and AMEX.
Level 3: This is the most prestigious stage of ADRs in the U.S. financial
market. This is the highest level that can be attained by a foreign
organisation operating in the U.S. market.

5. Overseas Sources of Finance


GDR

GDR refers to Global Depositary Receipt.

These are same as ADRs but with the right to tap multiple markets by
issuing shares.

It is a DR offered by the depository bank of a country to a foreign


organisation to participate in the stock trading of that country.

GDR transactions are mostly denominated in US dollars.

These receipts provide an opportunity to emerging organisations to expand


their presence in the foreign countries by offering shares. The pricing
policies of the GDRs are similar to that of the ordinary shares but differ in
trading and settlement of the shares.

6. Overseas Sources of Finance


ECB

ECB or external commercial borrowing refers to an instrument used for


raising funds from foreign markets by companies and public sector
undertakings (PSUs).

It caters to the financial needs of large companies and PSUs and enables
them to access foreign money.

Buyers credit, suppliers credit, commercial bank loans and security


instruments are included in ECBs.

Lets Sum Up

Long-term finance is a form of finance, which is required to fund the


projects with long-gestation period, while short-term finance is meant for
projects that may need a few months to a year for completion.

A financial market is a place where investors trade securities and


commodities. It is composed of capital market and money market.

Medium-term finance is required by an organisation for a period of more


than 1 year but less than 10 years. The organisation can avail mediumterm finance through various sources, including lease finance and hire
purchase, venture capital finance, public deposits and retained earnings.

Short-term financing helps in minimising the gap between current assets


and current liabilities.

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Chapter 5:
Capital Structure
Management

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

1
2

Learning Objectives
Topic 1

Capital Structure

98
99-101

Management
3

Topic 2

Capitalisation

102-104

Topic 3

Theories of Capital Structure

105-109

Management
5
6

Topic 4

Cost of Capital
Lets Sum Up

110-126
127

Explain capital structure management

Discuss various factors, such as internal, external, and general affecting


capital structure management

Describe capitalisation, over capitalisation and under capitalisation

Explain various theories of capital structure management, such as net


income approach, Modigliani-Miller approach, and traditional approach

Describe the concept of cost of capital, and cost of preference and equity
capital

Explain cost of retained earnings, weighted average cost of capital, and


marginal cost of capital

1. Capital Structure Management

A proportion of debt, preference, and equity capital in the overall capital of


an organisation is called the capital structure.

An ideal capital structure must maximise the overall value and minimise
the cost of capital of an organisation.

There are numerous factors, such as internal, external, and general factors
that affect the capital structure of an organisation.

Internal factors refer to the factors which affect the organisation by policies
and decisions of management and board of directors.

On the other hand, external factors are not influenced with management
control. These factors are affected by the external decisions and
environment, such as taxation policy, EXIM policy, interest rates, and
government policies.

2. Capital Structure Management


Internal Factors Affecting Capital Structure Management

Cost of Capital: It refers to the amount paid in the form of dividend and
interest. Generally, debt capital and equity capital forms the capital
structure of an organisation.

Control: It involves the decision-making power of equity shareholders,


who are also referred as the owners of the organisation. Generally, in an
organisation, major portion of decision-making power remains in the hands
of owners.

Risk: It refers to various uncertainties associated with raising different


types of capital. Risk refers to the obligation of an organisation to pay
returns to various sources of capital.

3. Capital Structure Management


External Factors Affecting Capital Structure Management
The external factors, which affect the capital structure of an organisation, are
as follows:
Interest Rates
Economic Condition
Policy of Lending Institutions
Statutory Restrictions
Taxation Policy

1. Capitalisation

The

process

of

determining

long-term

capital

requirements

of

an

organisation is termed as capitalisation.

It involves the procurement of capital from various sources including


shares, debentures, and reserve funds.

An organisation can come across two situations:

Situations of
Capitalisation

Overcapitalisation

Undercapitalisation

2. Capitalisation
Over-capitalisation

Over-capitalisation is a situation when an organisation raises more capital


than its requirements.

A major portion of capital remains unutilised in such cases. The major


causes of over-capitalisation are as follows:
Inadequate Provision for Depreciation
High Promotion Cost
Purchase of Assets at Higher Prices
Liberal Dividend Policy

3. Capitalisation
Under-capitalisation

Undercapitalisation refers to the situation when an organisation does not


have sufficient capital to carry out its normal business operations and
repay its creditors.

This situation generally occurs when an organisation does not generate


enough cash flows or is not able to access financing options such as debt
or equity.

When an organisation cannot generate sufficient capital over time, it


increases its chances of becoming bankrupt by losing its debt repayment
ability.

1. Theories of Capital Structure Management

Capital structure management is the need of a business at each and every


phase of its life cycle.

There

are

organisation:

various

theories

of

managing

capital

structure

of

an

2. Theories of Capital Structure Management


Net Income Approach

David Durand proposed in this theory that, there exists a direct


relationship between the capital structure and valuation of the firm and
cost of capital.

The net income approach can be explained as follows:

3. Theories of Capital Structure Management


Net Operating Income Approach

David Durand, states that the valuation of the firm and its cost of capital
are independent of its capital structure.

The concept of net operating income approach:

4. Theories of Capital Structure Management


Modigliani-Miller Approach

Modigliani-Miller approach also takes risk factor into consideration while


determining the capital structure.

According to this approach, the value of the organisation and cost of capital
are independent from its capital structure.

As per the Modigliani-Miller approach, if the organisation raises more debt


capital as compared to equity capital, it implies that the organisation is
running on high risk.

If the organisation pays higher dividends to the equity shareholders, overall


cost of capital increases. It is important to note at this point of time that
the organisation raised more debt capital to reduce the cost of capital.

5. Theories of Capital Structure Management


Traditional Approach

In this approach, when debt capital is introduced up to a certain limit, it is


assumed that debt capital would increase EPS by decreasing overall cost of
capital and increasing the value of an organisation.

The graphical representation of the traditional approach:

1. Cost of Capital

Cost of capital is a rate at which an organisation raises capital to invest in


various projects.

The basic motive of an organisation is to raise any kind of capital to invest


in its various projects for earning profit.

Further, out of that profit, the organisation pays interest and dividend as a
return on the sources of capital.

The amount paid as interest and dividend is considered as cost of capital.

From the investors point of view, cost of capital is the rate of return, which
investors expect from the capital invested by them in the organisation.

2. Cost of Capital
The significance of cost of capital is as follows:

Capital Budgeting Decision: It refers to the decision, which helps in


calculating profitability of various investment proposals.

Capital Requirement: It refers to the extent to which fund is required by


an organisation at different stages, such as incorporation stage, growth
stage, and maturity stage. When an organisation is in its incorporation
stage or growth stage, it raises more of equity capital as compared to debt
capital. The evaluation of cost of capital increases the profitability and
solvency of an organisation as it helps in analysing cost efficient financing
mix.

3. Cost of Capital

Optimum Capital Structure: It refers to an appropriate capital structure


in which total cost of capital would be least. Optimal capital structure
suggests the limit of debt capital raised to reduce the cost of capital and
enhance the value of an organisation.

Resource Mobilisation: It enables an organisation to mobilise its fund


from non-profitable to profitable areas. The resource mobilisation helps in
reducing risk factor as an organisation can shut down its unproductive
projects and move the resources to productive ones to earn profit.

Determination of Method of Financing: When an organisation requires


additional finance, the finance manager opts for a capital source, which
bears the minimum cost of capital.

4. Cost of Capital

Cost of capital can be measured by using various methods:

5. Cost of Capital
Cost of Debt Capital

Formulae to calculate cost of debt are as follows:

1. When the debt is issued at par (it includes both redeemable and
irredeemable cases)
KD = [(1 T) * R] * 100
Where, KD = Cost of debt, T = Tax rate, R = Rate of interest on debt
capital, KD = Cost of debt capital
2. Debt issued at premium or discount when debt is irredeemable
KD = [ ((1 T) X I) / (NP) 100]
KD = [I/NP * (1 T) * 100]
Where, I = Annual Interest Payments, NP = Net proceeds of debt, KD =
Cost of debt capital, T = Tax rate

6. Cost of Capital
Cost of Preference Capital

Cost of preference capital is the sum of amount of dividend paid and


expenses incurred for raising preference shares.

The dividend paid on preference shares is not deducted from tax, as


dividend is an appropriation of profit and not considered as an expense.

Cost of redeemable preference shares:


Kp = {D + (P-NP) / n} /{(P+NP) / 2}

Where, KP = Cost of preference share, D = Annual preference dividend, P =


Redeemable value of debt, NP = Net proceeds of debt, n = Numbers of
years of maturity

7. Cost of Capital
Cost of Equity Capital

The dividend on equity shares varies depending upon the profit earned by
an organisation. There are various approaches to calculate cost of equity
capital:

8. Cost of Capital
Cost of Equity Capital
Dividend Price Approach: The dividend price approach describes the
investors view before investing in equity shares. According to this approach,
investors have certain minimum expectations of receiving dividend even before
purchasing equity shares. An investor calculates present market price of the
equity shares and their rate of dividend. The dividend price approach can be
mathematically calculated by using the following formula:
KE = (D /P) * 100
Where,
D = Dividend per share
P = Market price per share and
KE = Cost of equity capital

9. Cost of Capital
Cost of Equity Capital
Earnings Price Ratio Approach: According to the earnings price ratio approach,
an investor expects that a certain amount of profit must be generated by an
organisation. Investors do not always expect that the organisation distribute
dividend on a regular basis. Sometimes, they prefer that the organisation invests
the amount of dividend in further projects to earn profit, which in turn increases the
value of its shares in the market.
The formula to calculate cost of capital through the earnings price ratio approach
is:
KE = E/MP; where,
E = Earnings per share
MP = Market price of share

10. Cost of Capital


Cost of Equity Capital
Dividend Price Plus Growth Approach: The dividend price plus growth approach
refers to an approach in which the rate of dividend grows with the passage of time. In
the dividend price plus growth approach, investors not only expect dividend but
regular growth in the rate of dividend. The growth rate of dividend is assumed to be
equal to the growth rate in EPS and market price per share. The cost of capital can be
calculated mathematically by using the following formula:
KE = [(D/MP) + G] * 100
where,
D = Expected dividend per share, at the end of period
G = Growth rate in expected dividends
MP=Market Price of Share

11. Cost of Capital


Cost of Equity Capital
Realised Yield Approach: In the realised yield approach, an investor
expects to earn the same amount of dividend, which the organisation has
paid in past few years. In this approach, the growth in dividend is not
considered as major factors for deciding the cost of capital.
According to the realised yield approach, cost of capital can be calculated
mathematically by using the following formula:
KE = [(P+D)/p] - 1
Where;
P = Price at the end of the period,
p = Price per share today

12. Cost of Capital


Cost of Equity Capital
Capital Asset Price Model (CAPM): CAPM helps in calculating the expected
rate of return from a share of equivalent risk in the capital market. The
computation of cost of capital using CAPM is based on the condition that the
required rate of return on any share should be equal to the sum of risk less
rate of interest and premium for the risk:
E = R1 + {E (R2) R1}, where;
E = Expected rate of return on asset
= Beta coefficient of assets
R1 = Risk free rate of return
E (R2) = Expected return from market portfolio

13. Cost of Capital


Cost of Equity Capital
Bond Yield Plus Risk Premium Approach: The bond yield plus risk
premium approach states that the cost on equity capital should be equal to
the sum of returns on long-term bonds of an organisation and risk premium
given on equity shares. The risk premium is paid on equity shares because
they carry high risk. Mathematically, the cost of capital is calculated as:
Cost of equity capital= Returns on long-term bonds + Risk premium or
Ke = Kd + RP

14. Cost of Capital


Cost of Equity Capital
Gordon Model: Myron Gordon developed the Gordon model to calculate the cost of
equity capital. As per this model, an investor always prefers less risky investment as
compared to more risky investment. According to the Gordon model, cost of capital
can be calculated mathematically by using the following formula:
P = E (1 b)/K br, where;
P = Price per share at the beginning of the year
E = Earnings per share at the end of the year
b = Fraction of retained earnings, K = Rate of return required by

shareholders

r = Rate of return earned on investments made by the organisation, g = br

15. Cost of Capital


Cost of Retained Earnings

Retained earnings refer to the part of the profit that is kept as a reserve.

Though it is a part of the profit, but it is not distributed as dividend. These


are kept to finance long-term as well as short-term projects of the
organisation.

It is argued that the retained earnings do not cost anything to the


organisation.

It is debated that there is no obligation either formal or implied, to earn any


profit by investing retained earnings.

However, it is not correct because the investors expect that if the


organisation is not distributing dividend and keeping a part of profit as
reserves then it should invest the retained earnings in profitable projects.

16. Cost of Capital


Weighted Average Cost of Capital
Weighted average cost of capital can be calculated mathematically by using the
following formula:
Weighted Average Cost of Capital = (KE * E) + (KP * P) + (KD * D) + (KR *
R)
Where;
E = Proportion of equity capital in capital structure
P = Proportion of preference capital in capital structure
D = Proportion of debt capital in capital structure
KR = Cost of proportion of retained earnings in capital structure
R = Proportion of retained earnings in capital structure

17. Cost of Capital


Marginal Cost of Capital
Marginal cost of capital refers to the cost of additional capital required by an
organisation to finance the investment proposals. It is calculated by first
estimating the cost of each source of capital based on the market value of the
capital. In simpler terms, the marginal cost of capital is calculated in the same
manner as the weighted average cost of capital is calculated, adding
additional capital to the total cost of capital:
Marginal Cost of Capital = KE {E/(E + D + P + R)} + KD {D/(E +D + P
+ R)} + KP {P/(E + D + P R)} + KR {R/(E + D + P + R)}

Lets Sum Up

A proportion of debt, preference, and equity capital in the overall capital of


an organisation is called the capital structure.

There are numerous factors, such as internal, external, and general factors
that affect the capital structure of an organisation.

External factors refer to the factors which cannot be controlled by internal


decisions and policies of an organisation.

The

process

of

determining

long-term

capital

requirements

of

an

organisation is termed as capitalisation.

Under-capitalisation refers to a situation in which an organisation earns


exceptionally high profits as compared to the other organisations operating
in the same industry.

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Chapter 6:
Leverages

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

1
2

Learning Objectives
Topic 1

Concept of Leverage in

132
133-140

Finance
3

Topic 2

Financial Leverage

141-143

Topic 3

Operating Leverage

144-147

Topic 4

Combined Leverage

148-150

Lets Sum Up

151

Explain the concept of leverage in finance

Describe financial leverage ratios

Discuss what operating leverage is

Explain the concept of combined leverage

1. Concept of Leverage in Finance

In finance, leverage can be defined as the use of an optimal combination of


debt capital to increase the return on equity capital; that is, Earning per
Share (EPS).

EPS is the portion of a firm's profit allocated to each outstanding share of


common stock. It is an indicator of a firm's profitability.

As the rate of interest on debt capital is fixed, the ratio of debt capital in
the total capital affects the return on equity capital.

An increase in debt capital may increase the profit of an organisation.

As EPS (dividend) is a part of organisations profit, it would also increase.


This relationship between the EPS and debt capital is explained through the
concept of leverage.

2. Concept of Leverage in Finance

There are three types of leverages:

Financial Leverage

Types of Leverages

Operational Leverage

Combined Leverage

3. Concept of Leverage in Finance


EBIT-EPS analysis

Earnings before Interest and Tax (EBIT), is an indicator of an organisation's


profitability.

It is calculated as revenue minus expenses, eliminating tax and interest


charges. EBIT is also referred to as "operating earnings"/"operating
profit"/"operating income".

The formula to calculate EBIT is as follows:


EBIT = Revenue COGS Operating Expenses

EBIT can be calculated by adding back interest and taxes to net income.

4. Concept of Leverage in Finance


EBIT-EPS analysis

EBIT is a firms operating profit while EPS is the earnings per share, which
can be calculated as follows:
EPS = Profit after Tax (PAT)/ Number of shares outstanding
PAT = EBIT interest taxes

The EPS would be as follows:


EPS = ((EBIT-I)(1-t))/n
Where EBIT = Earnings before Interest and Tax
I= Interest
t = tax rate
n = number of shares outstanding

5. Concept of Leverage in Finance


EBIT-EPS analysis

Illustration: Suppose, an organisation wants to raise a total capital of Rs.


10,00,000. The organisation wants to use 75% debt and 25% equity capital.
In order to raise the equity capital of Rs. 2,50,000 the organisation wants to
issue 25,000 equity shares. The EBIT of the company is Rs. 2,40,000. The
interest on debt is 15% per annum. Calculate the EPS. Assume that the tax
rate is 0.5%.

Solution: Total interest paid will be (10,00,000-2,50,000)*15/100 = Rs.


1,12,500.

EPS = ((EBIT-I)(1-t))/n

EBIT = Rs. 2,40,000, I = 1,12,500, T = 0.05, n = 25,000.

EPS = ((2,40,000-1,12,500)(1-0.05))/25,000 = Rs. 4.85.

6. Concept of Leverage in Finance


Break-even Analysis

Break-even point is the level of sales at which a firms total revenues are
exactly equal to total operating costs.

Break-even analysis is used by an organisation by a company to assess how


much it needs to sell in order to pay for an investment, or at what point
expenses and revenue are equal. The break-even point is calculated as
follows:
Q* = F/(P-V)
Where Q* = break-even quantity,
F = fixed costs
P = price
V = variable costs

7. Concept of Leverage in Finance


Break-even Analysis
Operating costs are divided into three categories:

Fixed Costs

Variable Costs

Semi-fixed/Semi-variable Costs

8. Concept of Leverage in Finance


Break-even Analysis

Illustration: ABC company is involved in manufacturing a single product.


The company has invested Rs. 9, 00,000 as fixed cost. The variable cost is
Rs. 450/unit. The company sells its products at Rs. 900/unit. Calculate the

break-even production level.


Solution: At break-even point: Sp * Q = Vp*Q + FC
900 Q = 450 Q + 9,00,000
900 Q = 450Q + 9,00,000
450Q = 9, 00,000
Q = 2000 units.

Therefore, the company will achieve breakeven at 2,000 units.

1. Financial Leverage

Financial leverage refers to a situation in which an organisation earns


higher profit compared to the rate of interest it pays on the debt capital.

The rate of interest on debt capital is also termed as the cost of debt
capital.

L.J. Gitman defines financial leverage as the firms ability to use fixed
financial charges to magnify the effects of changes in EBIT on the firms
EPS.

Financial leverage is represented through different financial ratios, such as


debt to equity ratio, and interest coverage ratio.

2. Financial Leverage
Benefits and Limitations of Financial Leverage

The benefits offered by financial leverage are as follows:


Helps in increasing EPS when interest on debts is low
Reduces tax liability, as interest paid on debt is treated as expense
Reduces cost of capital, if the debt capital is raised on low rate of

interest
Preserves the control of an organisation.

The limitations of financial leverage are as follows:


Decreases return on equity in conditions when interest rates are high
Increases the liability to pay interest when profits fluctuates
Involves high risk as debts are raised by mortgaging the assets

3. Financial Leverage

Illustration:

PQR Ltd.s equity share capital = Rs.2,00,000; 20%

preference share capital = Rs. 2,00,000; 10% debentures = Rs. 1,50,000.


The present EBIT is Rs.1, 00,000 and tax rate is 50%. Calculate PQRs
financial leverage.
Particulars
Solution: PQRs financial leverage is calculated as follows:Amounts
(Rs.)
EBIT

1,00,000

Less: Interest on debentures

15,000

Less: Dividend on preference shares (Earnings before tax 40,000


= 20000/(1 0.50) = 40000)
PBT

45,000

Financial leverage (EBIT/PBT = 1,00,000/45,000 = 2.22)

2.22

1. Operating Leverage

Operating leverage measures the effect of change in sales volume and


operating capacity on EBIT.

It indicates the variation in operating profit (or simply profit), which is


directly proportional to sales volume.

This implies that if the sales volume increase, profits would also increase.

As discussed, there are two main costs in an organisation, fixed cost and
variable cost. Fixed cost remains unchanged with the change in the volume
of sales; while variable cost changes with the increase in volume of sales.

2. Operating Leverage
Significance of Operating Leverage

When there is high operating leverage, even a small rise in sales results in
significant increase in the EBIT.

Operating leverage arises when an organisation invests in fixed assets to


increase the sales volume and generate sufficient revenue for meeting its
fixed and variable costs.

As discussed, operating leverage indicates variations in operating profit.


Therefore, operating profit is calculated using the following formula:
Operating Profit = [N (SP VC)]/ [N (SP VC) FC]

Where, N = Number of units sold, SP = Selling price, VC = Variable cost,


FC = Fixed Cost

3. Operating Leverage
Benefits and Limitations of Operating Leverage

The benefits of operating leverage are as follows:


Helps in increasing the profit of an organisation by increasing sales
volume
Reduces dependency on variable cost.
Reduces the overall cost of production, if the sales figure increases and
covers the entire fixed cost

The limitations of operating leverage are as follows:


Helps only large-sized organisations as the concept of operating
leverage is not applicable to new and small-sized organisations with
insufficient fixed assets.

4. Operating Leverage

Illustration: Calculate DOL from the following information:

i.

Sales = Rs.1,00,000

ii.

Fixed cost = Rs.70,000

iii. Variable cost = Rs.20,000


.

Solution: The calculation of DOL is shown as follows:


DOL = (SP VC)/ (SP VC FC)
= (100000 70000)/ (100000 70000 20000) = 3

Therefore, DOL is three times as compared to sales.

1. Combined Leverage

Combined leverage refers to the combination of both operating and


financial leverages.

Combined leverage can be calculated by using the following formula:

Combined leverage = {(Sales VC)/EBIT} {EBIT/ (EBIT Interest)}


= (Sales VC)/ (EBIT Interest)
= Operating leverage Financial leverage

Degree of Combined Leverage (DCL) measures the relationship between


percentage changes in sales to percentage change in EPS. This relationship
can be represented by using the following formula:
DCL = % change in EPS / % change in sales
Or DCL = Contribution / (EBIT-I)

2. Combined Leverage

The advantage of DCL is that it shows the effect of changes in sales on


EPS.

It proves useful when an organisation needs to choose a new project


between various alternatives.

The organisation can compare the DCL of different projects before arriving
at a decision.

If the DCL of a project is equal to one, that project is exposed to constant


risk. In such a case, the profitability of the organisation would not be
affected.

Thus, the project may prove to be favourable.

3. Combined Leverage

The advantage of DCL is that it shows the effect of changes in sales on


EPS.

It proves useful when an organisation needs to choose a new project


between various alternatives.

The organisation can compare the DCL of different projects before arriving
at a decision.

If the DCL of a project is equal to one, that project is exposed to constant


risk. In such a case, the profitability of the organisation would not be
affected.

Thus, the project may prove to be favourable.

Lets Sum Up

Leverage can be defined as the use of an optimal combination of debt


capital to increase the return on equity capital; that is, Earning per Share
(EPS).

EBIT-EPS analysis helps organisations to understand the effect on EPS


resulting due to changes in EBIT under different financial combinations.

Break-even point is the level of sales at which a firms total revenues are
exactly equal to total operating costs.

Operating leverage measures the effect of change in sales volume and


operating capacity on EBIT.

Combined leverage refers to the combination of both operating and


financial leverages.

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Chapter 7:
Dividend Policy

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

Learning Objectives

156

Topic 1

Dividend Policy

157-159

Topic 2

Factors Determining Dividend

160-165

Policy
4

Topic 3

Types of Dividend Policy

166-168

Topic 4

Approaches to Dividend Policy

169-172

Topic 5

Forms of Dividend Payment

173-174

Lets Sum Up

175

Summarise the concept of dividend and dividend policy

Explain the factors that affect that determine a dividend policy

Classify and explain the different types of dividend policy

Explain and exemplify the different forms of dividend payment

1. Dividend Policy

Dividend policy refers to a policy under which the decisions related to the
distribution of profit in the form of dividends to the shareholders is made.

All financial policies play a crucial role in determining the value of the
organisation on a long term basis and the dividend policy plays a key role
in it.

The dividend is usually in the form of cash but it may be in the form of
shares as well.

In this case the company gives the shareholders shares of the value of the
dividend instead of cash.

The dividends are paid out of the profits of the organisation and never from
the capital of the company.

2. Dividend Policy

The following factors are considered before devising a dividend policy. They
are:
Fund availability: It means that the organisation must have sufficient
funds to distribute the dividends.
Shareholders expectations: The board of directors while deciding
the dividend policy must take into consideration the expectations of
the shareholders also.
Status quo factor: It refers to various factors that the organisation
must consider while framing a dividend policy.

Usually, the rate of

dividend is proportional to the level of profits that is the rate of


dividend increases when the profits increase and decreases when the
profits drop.

3. Dividend Policy

According to Professor I.M. Pandey, organisations need to answer a few


questions before devising the dividend policy:
What are the preferences of shareholders: dividend income or capital
gain?
What are the levels of financial needs of the company?
What are the constraints on paying dividends?
Should the company follow a stable dividend policy?
What should be the form of dividend (i.e., cash or bonus shares)?

1. Factors Determining Dividend Policy

There are various factors that influence the dividend policy of the
organisation.

They are grouped under two categories which are internal factors and the
external factors.

Internal factors are the factors which are internal to an organisation and
can be controlled to a large extent.

On the contrary, there are external factors that are external to an


organisation and are not under the control of the organisation.

2. Factors Determining Dividend Policy

Internal factors influencing dividend policy:


Stability of earnings: Ideally the profits should show a stable and
increasing trend. For an organisation having stable earnings the
dividend policy will also be consistent and vice versa.
Life stage of the organisation: If the organisation is in the
introduction stage then it follows a conservative dividend policy, If the
organisation is in the mature phase then it can follow a liberal dividend
policy, and so on.
Liquidity of funds: It is important to look at the cash available with
the organisation and also the assets that the organisation holds and
their convertibility to cash.

3. Factors Determining Dividend Policy


Retained earnings: The organisation has to retain a part of profit that
needs to be reinvested in the organisation to enhance its base i.e. for
expansion and consolidation reasons and to enhance its financial
position. The organisations of small size have a hard time finding
sources of funds and therefore they follow a conservative dividend
policy and keep a good share of the profit for reinvesting in the
company.
Information on previous dividend rates: It is a general practice to
keep the share dividends at a rate that shows a consistent trend and
they must be near to the average dividend returns paid by the
organisation in the past. Therefore while deciding the rate of dividends
the board of directors must keep in mind the trend of the dividends
paid in the past.

4. Factors Determining Dividend Policy


Consistency of Dividend Payout: The dividend payments to the
shareholders must be consistent and preferably in an increasing trend
over the years. It serves to motivate the investors to invest further in
the organisation and thereby help in strengthening the goodwill of the
organisation in the market.
Shareholders tax situation: Stock holders prefer lower cash
dividend because of higher tax to be paid on the dividend income.

5. Factors Determining Dividend Policy

External factors affecting the dividend policy:


Business cycles: Every business organisation goes through stages
where they go through a boom period or period of low profits due to
various reasons. The organisation follows generous policy and gives
higher dividends in periods of boom. On the contrary an organisation
follows a restrictive dividend policy during periods of low profits.
Government policies: Government policies include the fiscal policy
that relates to the taxes and subsidies, industrial, and labor policies.
Any change in these policies has a direct impact on the organisation
and its earnings.

6. Factors Determining Dividend Policy


Statutory and legal requirements: For the organisations to function
there are a set of established statutory and legal requirements which
also play a significant role in deciding the dividend policy of the
organisation.
External obligations: When the organisation borrows funds from the
external sources then it needs to pay the interest and/or principal
amount. On the other hand, if the organisation does not borrow funds
and uses its retained earnings in the business the organisation does
not need to pay the interest and principal liabilities.

1. Types of Dividend Policy

The dividend policy of the organisation is decided based on various factors


and the dividend policy differs from organisation to organisation.

There are five basic types of dividend policies:

Types of
Dividend
Policy

Stable
Dividend
Policy

Long-term
Dividend
Policy

Regular
and Extra
Dividend
Policy

Irregular
Dividend
Policy

Regular
Stock
Policy

2. Types of Dividend Policy

Stable dividend policy: Also called the constant-payout-ratio, under this


policy the organisation gives dividend to the shareholders on a regular
basis.

Long-term dividend policy: Under this policy, the dividend is paid to the
shareholders on a long term basis. Irrespective of the fact whether the
organisation makes huge profits or losses the dividend is not paid regularly.

Regular and extra dividend policy: Under this dividend policy, the
organisation pays a fixed amount of dividend on a regular basis. In addition
to this, an extra amount of dividend is paid to the shareholders in case the
organisation earns abnormal profits.

3. Types of Dividend Policy

Irregular Dividend Policy: Under this dividend policy the dividend


payout ratio keeps on changing and is not constant. The dividend per share
depends on the profits earned by the organisation. This type of dividend
policy is pursued by the organisations which have instable profits. This is
the

least

preferred

dividend

policy

from

the

perspective

of

the

shareholders.

Regular

Stock

Dividend

Policy:

Under this dividend policy the

organisation gives dividend in the form of stocks instead of cash. It is a


very strong method of maintaining the liquidity position of the organisation
as the cash is not distributed as dividend. The organisation issues bonus
shares instead of dividend in cash form.

1. Approaches to Dividend Policy

There are two approaches that describe the relation between the dividend
policy of the organisation and the value of the organisation.

Firstly, there is irrelevance model supported by a section of economists


who believe that the dividend policy has no impact on the value of the
organisation.

Secondly, there is the relevance model supported by a section of


economists who believe that the decision regarding dividends has an
impact on the value of the organisation.

2. Approaches to Dividend Policy


Irrelevance Approach (Modigliani and Miller)

According to the irrelevance approach there is no relation between the dividend


policy and the value of an organisation.

This approach advocates that dividend is residual in nature which is paid after
paying the debt liabilities, corporate tax and other liabilities out of profit.

The economists who support the irrelevance approach argue that the decision to
pay the dividend depends upon the availability of investment opportunities.

In case there are some investment opportunities available to the organisation


then the profit is not distributed as dividends and reinvested in the business.

In the counter case, when there are no investment opportunities available the
dividend is distributed.

3. Approaches to Dividend Policy


Irrelevance Approach (Modigliani and Miller)

Irrelevance approach can be represented mathematically as follows:


Po = (D1 + P1) / (1+Ke)

Where,
Po - Current Market Price
Ke - Cost of Equity Capital
D1- Dividend received at the end of period 1
P1- Market price of a share at the end of period 1

4. Approaches to Dividend Policy


Relevance Approach (Walter and Gordon)
According to the relevance approach the dividend policy plays an important
role in determination of the value of an organisation.
This approach assumes that the shareholders have preference for current
consumption rather than future earnings which are quite uncertain and highly
risky. The formula used to make dividend decision is as follows:
P = D/ (Key g)
Or (D+(r/Ke)(E-D))/Ke
P- Price of Equity Shares, D- Initial Dividend, E = Earnings per share, R = Rate
of return on the companys investments, Ke- Cost of Capital, g= Expected
growth rate of the earnings

1. Forms of Dividend Payment

An organisation has the option to pay dividend to its shareholders in the


form of either cash or in form of bonus shares.

The decision to pay either in cash or stock depends on the dividend policy
and the existing economic con

The different forms of dividend payment are:

Dividend

Cash
Dividend

Stock
Dividend

2. Forms of Dividend Payment

Cash dividend: It is a type of dividend payment where the profits are


distributed among the shareholders in form of cash or through cheque. The
dividend rate is decided by the top management. An organisation is bound
to fulfill all legal formalities of Companies Act, while making any dividend
declaration. It should declare dividend as per Companies (Declaration of
Dividend out of Reserves) Rules, 1975.

Stock Dividend: It is a type of dividend that is paid in the form of bonus


shares. It is also known as bonus issue. When an organisation wants to use
the retain earnings for the purpose of reinvestment instead of paying cash
dividend then this type of dividend is issued.

Lets Sum Up

Dividend policy refers to a policy under which the decisions related to the
distribution of profit in the form of dividends to the shareholders are taken.

Two approaches that describe the relation between the dividend policy of
the organisation and the value of the organisation are the irrelevance
model and the relevance model.

The decision to invest the earnings or to distribute them is based on two


parameters namely the return on the investment (r) and the cost of the
capital (k).

When r > k, in this case the profit is reinvested back in the business.

When r < k, then the profit is not invested further in the organisation.

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Chapter 8:
Working Capital
Management

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

1
2

Learning Objectives
Topic 1

Concept of Working Capital

181
182-188

Management
3

Topic 2

Principles of Working Capital

189-193

Management
4

Topic 3

Factors Affecting Working Capital

194-198

Management
5

Topic 4

Methods for Assessing Working


Capital

199-202

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

Topic 5

Financing of Working Capital

203-205

Requirement
7

Topic 6

Asset Securitisation (Way for

206-207

Raising the Working Capital)


8

Topic 7

Working Capital Factoring

Lets Sum Up

208-209

210

Learn the concept of working capital management

Discuss the principles of working capital management

Explain the factors affecting working capital management

Elaborate on financing of working capital requirement

Explain asset securitisation

Discuss working capital factoring

1. Concept of Working Capital Management

Working capital management implies the process of controlling the flow of


working capital in the organisation.

There are two types of working capital namely gross working capital and
net working capital.

Gross working capital refers to the current assets of an organisation.

Current assets are those assets that can be converted into cash within one
year or less than one year.

These include bills receivables, stocks, sundry debtors, and cash in hand
and at bank.

A difference between current assets and current liabilities is net working


capital.

2. Concept of Working Capital Management

Types of working capital are:

Types of
Working
Capital

Temporary
Working
Capital

Permanent
Working
Capital

Seasonal
Working
Capital

Special
Working
Capital

3. Concept of Working Capital Management

Temporary working capital:

The working capital that is required to

produce extra units of products in case of excess demand is called


temporary working capital. This is also known as fluctuating working
capital. When the demand of the product increases, extra working capital is
raised from short-term sources.

Permanent working capital: The working capital that is needed for the
smooth running of the business is called permanent working capital. This
capital is required on a daily basis for production and payment of current
liabilities. If an organisation fails to maintain permanent capital, it will
cease to exist in the long run.

4. Concept of Working Capital Management

Seasonal Working Capital: This is the capital required by organisations


in seasonal industries that operate in a specific season and shut down or
slow down their activities by the end of the season. Examples of seasonal
industries are the umbrella and raincoat industries.

Special Working Capital:

This is the capital requirement of different

sectors, such as primary, secondary, and tertiary, of an economy. The


working capital requirement of primary sector is seasonal in nature. The
secondary sector requires huge working capital for maintaining stock and
paying salaries. The tertiary sector requires less working capital as
compared to secondary sector as it renders services to conduct its
business on a cash basis.

5. Concept of Working Capital Management


Need of Adequate Working Capital

Working capital is needed for long term success and run of a business

Investment in current assets represents a substantial portion of total


investment

Working capital helps an organisation to meet its current liabilities

Working capital helps in taking advantage of financial opportunities

Working capital ensures the smooth operating cycle of the business

Working capital speeds up the flow of funds for meeting the capital needs
of existing operations and thus, avoids the stagnation of funds Working
capital strikes a balance between twin objectives namely liquidity and
profitability

6. Concept of Working Capital Management


Working Capital and Cash Management

Working capital ensures that an organisation has an enough cash flow for
meeting the debt obligation and operating expenses.

The functions of cash management are as follows:


Establish a reliable forecasting and reporting system.
Streamline the system of cash collection.
Achieve the optimum savings.

Cash budget shows the estimated cash inflows and cash outflows over the
planning horizon.

It highlights the net cash position of an organisation.

7. Concept of Working Capital Management


Working Capital and Cash Management

The working capital is managed with the help of cash budget in the following
ways:

Coordinate the timings of cash needs: With the cash budget, it is easy
to identify the period when there can be shortage of cash or excessive
cash requirement

Plan the discounts: With the knowledge of excess cash, organisation can
plan for dividend discounts (assessing the present value of a stock based
on the growth rate of dividends), payment of debts and finance capital
expansion

Prevents accumulation of funds: Cash budget provides advance


knowledge of the cash that has not been employed in operating activities.

1. Principles of Working Capital Management

There are four principles of working capital management that determine


the relationship between profitability and risk, cost of capital and risk, cash
inflow and cash outflow, and the contribution of current assets and net
worth of an organisation.

The principles of working capital management are:


Principle of Risk Variation
Principles of Working Capital
Management

Principle of Cost of Capital


Principle of Equity Position
Principle of Maturity
Payment

2. Principles of Working Capital Management

Principle of Risk Variation: This principle helps in determining the


relationship between risk and profitability associated with working capital
management. (Risk here refers to the ability of an organisation to write-off
its current liabilities.)

The risk for the organisation may increase and profitability may decrease if
the working capital increases by raising short-term loans.

The organisation can increase its profitability by paying short-term loans. In


such a case, its working capital and risk would decrease.

Therefore, it can be stated that there is an inverse relationship between


the risk and profitability of an organisation.

3. Principles of Working Capital Management

Principle of Cost of Capital: According to this principle, there is an


inverse relationship between the cost of capital and degree of risk.

For example, if the debt capital increases, the cost of capital goes down,
but the risk of paying return at the time of loss increases.

This happens because the organisation does not pay dividends on equity at
the time of loss.

4. Principles of Working Capital Management

Principle of Equity Position: According to this principle, the amount of


working capital employed in a current asset should positively influence the
returns on equity and value of the organisation. The investment in current
assets would increase the working capital of the organisation. The optimum
amount, which should be invested in current assets to raise the equity
position of the organisation, is calculated with the help of following two
ratios:
Level of Current Assets = Current assets/Percentage of total assets
Level of Current Assets = Current assets/Percentage of total sales

5. Principles of Working Capital Management

Principle

of

Maturity

Payment:

This

principle

states

that

an

organisation should frame its policies in such a way so that its cash inflow
would be sufficient to meet cash outflow.

This facilitates the timely payment of short-term debts, which in turn


enhances the goodwill and creditworthiness of an organisation.

1. Factors Affecting Working Capital


Management

The need of capital requirement depends on various factors that influence


different organisations in different ways.

The factors affecting working capital management are:


Characteristics of Business
Labour Requirement
Cost of Raw Material
Credit Policy
Seasonal Variation
Sales Turnover
Dividend Policy
Profitability of the Organisation

2. Factors Affecting Working Capital


Management

Characteristics of business: If the organisation is in a public utility


business then it requires more working capital as most of the transactions
are carried on a cash basis. However, a manufacturing organisation would
require less working capital as majority of transactions would require
credit.

Labour requirement: It is the amount of labour required in the mode of


production adopted by an organisation. There are two modes of production,
such as labour intensive and capital intensive. If an organisation adopts
labour intensive mode of production then it requires more working capital
for wage payment. However, if an organisation adopts capital intensive
mode of production then it requires less working capital.

3. Factors Affecting Working Capital


Management

Cost of Raw Material: If an organisation requires expensive raw


materials then more working capital is needed to carry out production. On
the other hand, if an organisation needs low-priced raw materials then it
requires less working capital. For example, iron and steel industries need
more working capital as they require expensive raw materials as compared
to the plastic industry that requires low-priced raw materials.

Credit Policy: The agreement between an organisation and its suppliers


for the purchase of raw materials. An organisation would require less
working capital if the suppliers agree to provide raw materials on a credit
basis. However, if the suppliers provide raw materials on a cash basis then
the organisation would require more working capital.

4. Factors Affecting Working Capital


Management

Seasonal Variation: Some products may have high demand in a


particular season and moderate demand in other seasons. The working
capital requirement of the organisation producing seasonal products is
more in the peak season and less in other seasons.

Sales Turnover: One of the most important factors affecting the


requirement of working capital is the organisations sales turnover. A firm
maintains current assets because they are needed to support the
operational activation, which result in sales. The volume of sale and the
size of the working capital are directly related to each other. As the volume
of sales increases, the working capital investment increases and vice
versa.

5. Factors Affecting Working Capital


Management

Dividend policy: A shortage of working capital often acts as powerful


reason for reducing a cash dividend.

Profitability of the organisation: Adequate profit contributes to the


generation of cash. High profitability allows organisations to plough back a
part of the earnings into the business and build up on financial resources to
internally fund the working capital needs.

1. Methods for Assessing Working Capital


Operating Cycle Method

The operating cycle is the time duration starting from the procurement of
raw materials and ending with the sales realisation.

The length and nature of operating cycle may differ as per the size and
nature of different organisations.

At different stages of operating cycle, the need of working capital varies.

Thus, operating activities create the necessity of working capital, which is


neither synchronised nor certain.

The longer the cycle, the greater is the need for operating cycle.

2. Methods for Assessing Working Capital


Operating Cycle Method

Calculation of operating cycle:

a. Procurement of Raw Material


b. Conversion/Process Time
c. Average Time for Holding Finished Goods
d. Average Collection Period
e. Operating Cycle (a + b + c + d)
.

Operating cycles per year = 365/e

Working Capital Requirement = (Operating Expenses per annum)/


(Number of operating cycles per annum)

3. Methods for Assessing Working Capital


Maximum Permissible Bank Finance (MPBF) Method

MPBF method was suggested by Tandon Committee and relates to the


banking sector.

This method indicates the maximum level for holding the inventory and
receivables in each industry.

As per the Tandon Committee, organisations are discouraged from


accumulation of stocks of current assets and required to move towards the
lean inventories and receivable levels.

4. Methods for Assessing Working Capital


Other Methods
Drawing power method: Drawing power implies the amount of funds that a
borrower is allowed to draw from the working capital limit allocated to him/her.
Thus, working capital is analysed with the help of percentage allocated by the
banks.
Turnover method: Under this method, the working capital requirements are
estimated at 25%. The banks can finance up to maximum extent of 20% of
projected turnover. Balance 5% is net working capital which is brought in by
borrower as his margin.
Cash budget method: Under this method, the borrower submits the cash
budget for future period and then the working capital is calculated.

1. Financing of Working Capital Requirement

The decision to finance the working capital of an organisation is taken by


the management after considering all the sources and applications of
funds.

The sources to finance working capital are as follows:


Bank credit: This refers to a short-term source of financing working
capital. The bank credit can take the forms of cash credit, bank
overdrafts, and discounting of bill. In addition, bank credit is used to
raise low amount of working capital for meeting daily needs. Generally,
small organisations use bank credit to finance their working capital as
their requirements are low. Bank credit is a type of secured loans
(organisation has to mortgage their assets against these loans) and
interest has to be paid on them till the time of maturity.

2. Financing of Working Capital Requirement


Loans from financial institutions: This refers to a long-term source
of financing working capital. Generally, large organisations need large
amount of loans for long term. Such loans are provided by major
financial institutions, such as ICICI and IDBI.
Public deposits: Apart from the issue of shares and debentures,
organisations may accept deposits from the public to finance its
medium and short-term capital needs. This source is very popular
among the public as organisations often offer interests at rates, which
are

higher

than

those

offered

by

banks.

Under

this

method,

organisations can obtain funds directly from the public eliminating the
financial intermediaries. The maturity period of a public deposit is more
than one year and less than three years.

3. Financing of Working Capital Requirement


Prepaid Income: This refers to the income that is received in the form
of advance payments from distributors. Prepaid income is the most
economical source to finance the working capital as the organisation
does not need to pay interest to distributors on prepaid income.
Retained Earnings: These are reserve funds that are maintained by
an organisation. Retained earnings are the most reliable source of
financing working capital as they can be raised at the time of need
without any delay. The organisation has no obligation to mortgage its
assets for using these funds.

1. Asset Securitisation (Way for Raising the


Working Capital)

Asset securitisation is the process of combining several individual assets


and pooling them together so that investors may buy interests in the pool
rather than in the individual assets.

Owing to the high degree of predictability inherent in large groups, asset


securitisation increases predictability of investments, lowers risks, and
increases asset value.

Securitisation of assets helps in funding and liquidity for wide range of


consumer and business credit needs.

This involves securitisation of residential and commercial mortgages,


automobile loans, students loans, credit card financing and business trade
receivables.

2. Asset Securitisation (Way for Raising the


Working Capital)

Asset securitisation enhances the liquidity in the market and acts as an


important tool for raising funds. The salient features are as follows:
Asset backed security is issued through a special purpose entity
Issuing an asset backed security is asset sale rather than debt financing
The credit of asset backed security is derived from credit of underlying

assets

The benefits of securitisation for the organisations are as follows:


Provides liquidity to organisation by covering illiquid assets into cash
Provides better asset liability management
Helps in recycling the assets easily
Improves transparency of the assets

1. Working Capital Factoring

Factoring can be defined as a way to convert the accounts receivables (illiquid


receivables) into money which can be further invested in the working capital.

This is done by using factors such as banks, financial institutions that are ready
to purchase these assets.

As this helps in getting direct cash, this is also called working capital factoring.

This helps in growing the business by ensuring the capital needed as steady
flow of cash is ensured.

The process of working capital factoring involves a factor (bank, leasing


company) and a client (with receivables).

Working capital factoring gives an unlimited access to capital as the amount to


be borrowed with this method increases with increase in sales.

2. Working Capital Factoring

Factoring involves the following parties:

The client: an organisation with receivables.

A factor: a financial service organisation/ bank.

Debtor: One who is creating the receivables.

The benefits of factoring are as follows:

Increases liquidity by raising cash.

Provides access to capital at lower rate of cost.

Enhances the working capital of the organisation.

Transfer the credit risk of receivables to the factor from the firm.

Reduces the firms burden in setting up collection centers.

Lets Sum Up

Working capital management implies the process of controlling the flow of


working capital in the organisation. There are two types of working capital
namely gross working capital or net working capital.

The operating cycle is time duration starting from the procurement of raw
materials and ending with the sales realisation.

MPBF method indicates the maximum level for holding the inventory and
receivables in each industry.

Asset securitisation is the process of creating securities by pooling together


various cash flow producing financial assets, which are sold further to investors

Factoring can be defined as way to convert the accounts receivables (illiquid


receivables) into money which can be further invested in the working capital.

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Chapter 9:
Receivables and
Inventory
Management

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

1
2

Learning Objectives
Topic 1

Concept of Receivables

216
217-218

Management
3

Topic 2

Credit Policies and Credit

219-221

Terms
4

Topic 3

Collection Policies

Topic 4

Concept of Inventory
Management

222
223-224

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

Topic 5

Tools and Techniques of

225

Inventory Management
7

Topic 6

Reorder Point

226-227

Topic 7

Safety Stock

228

Lets Sum Up

229

Explain the concept of receivables management

List credit policies and credit terms

Discuss collection policies

Describe the concept of inventory management

List various tools and techniques of inventory management

Explain the concept of reorder point

Discuss safety stock

1. Concept of Receivables Management

Receivables include the amount of money to be received by an


organisation from its debtors.

In other words, receivables encompass all debts (even if they are not
currently

due),

unsettled

transactions,

or

various

other

monetary

obligations owed to an organisation by its debtors or customers.

Receivables are recorded in the balance sheet of an organisation.

They provide a number of benefits to an organisation, such as enhanced


sales volume and increased profits.

An organisation invests in receivables through a trade credit policy with an


aim to expand the customer base and survive in the competitive business
environment.

2. Concept of Receivables Management


Objectives of Receivables Management

The primary objective of receivables management is to maximise the


returns on investments and minimise the risk of bad debts. Apart from this,
the following are some other objectives of receivables management:
To maintain a proper balance between profitability and risk associated
with receivables.
To sell goods on credit by issuing receivables when an organisation has
sufficient money to meet daily expenses without any constraints.
To survive in the competitive market by increasing credit sales.

1. Credit Policies and Credit Terms

The credit policy of an organisation encompasses a set of written


guidelines that state the terms and conditions related to offering goods on
credit; credit criteria for customers; procedure to be adopted for the
collection; actions to be taken in case of debtors inability.

The credit policy of any organisation has two important elements: credit
standards and credit analysis.

After establishing credit standards and creditworthiness of customers, the


organisation needs to define the credit terms for extending trade credit.

Credit terms have two important components:


Credit period
Cash discount

2. Credit Policies and Credit Terms


Credit Period

Credit period refers to a time span within which debtors or customers are allowed
to pay for their purchases. This period generally varies from 15-60 days.

The formula for calculating the effect of the credit period on the residual income:

RI = [S (1 - V) - Sbn] (1 - t) k I where,
I = (ACPn - ACPo) [So/360] + V (ACPn) S/360

Where, RI = Changes in residual income, S = Increase in sales, V = Ratio of


variable costs to sales, bn = Bad debts loss ratio on new sales, t = Corporate tax
rate, k = Post-tax cost of capital, I = Increase in receivables investment, ACP n =
New average collection period (after enhancing the credit period), ACP o = Old
average collection period.

3. Credit Policies and Credit Terms


Cash Discount

Organisations provide cash discounts to customers in order to induce them


to make prompt payments.

For example, credit terms of 2/10, net 30 means that a discount of 2%


would be offered if the payment is made by the 10th day; otherwise the full
payment is due on the 30th day. The effect of cash discount on residual
income may be estimated by the following formula:
RI = [S (1 - V) - DIS] (1 - t) + k I

Where, S = Increase in sales, V = Ratio of variable, k = Cost of capital, I


= Savings in receivables investment, DIS = Increase in discount cost

Collection Policies

An effective collection policy leads to short average collection period,


reduction in the percentage of bad debts, and increase in collection
expenses.

The collection policy of an organisation aims at the following:


Timely collection of receivables.
Monitoring the state of receivables
Giving reminders to customers whose due date is approaching
Reminding customers about the legal action that can be taken against
overdue payments
Taking a legal action against overdue accounts

1. Concept of Inventory Management

The word inventory refers to the stock possessed by an organisation.

It is broadly classified into three types, namely raw materials, work-inprogress, and finished goods.

Raw materials are the components used for manufacturing final products.

Work-in-progress represents goods that are required at the intermediate


stages of production.

Finished goods are final products that are ready for sale.

Inventory management is a process of monitoring and controlling the level


of stock available in an organisation.

It prevents situations like excessive inventory or shortage of inventory by


taking into consideration the factors that influence inventory levels.

2. Concept of Inventory Management


Objectives of Inventory Management

The main objective of inventory management is to ensure a smooth flow of


production process in the organisation.

Apart from this, the following are the other objectives of inventory
management:
To meet a sudden rise in demand
To optimise investments in inventory
To organise and schedule production activities
To manage replenishment orders

Tools and Techniques of Inventory


Management

An organised approach should be followed to inventory management for


balancing out the anticipated costs and benefits of holding inventories.

There are various techniques practiced by the finance manager to manage


inventories:
Stock Levels
VED Analysis
FSN Analysis
Just in Time (JIT) Inventory Management
ABC System
Economic Order Quantity (EOQ) Model

1. Reorder Point

Reorder point refers to the level of inventory that triggers an order for
replenishing the current inventory.

In simple words, a reorder point can be defined as the level of inventory


when a fresh order should be placed with suppliers for procuring additional
inventory.

The reorder point is based on the following assumptions:


The usage inventory is constant on a daily basis.
The lead-time to procure inventory is fixed.

The formula for determining the reorder point is as follows:


Reorder point = Lead time in days * Average daily usage of
inventory

2. Reorder Point

Illustration: A manufacturing plant has estimated that 1,20,000 units of


its products will be sold in the next year. The processing cost of an order is
Rs. 10 and the plant incurs Rs. 0.6 as carrying cost for one unit. The lead
time for an order is 3 days. Calculate the (a) Economic Order Quantity
(EOQ) and Reorder point.(Assume 300-day year).

Solution: EOQ = = (21,20,00010)/0.6=2,000 units

Reorder point = Daily usage* Lead time

Daily usage = 1,20,000/300 = 400 units

Reorder point = 400*3 = 1,200 units.

Safety Stock

Safety stock can be defined as the minimum additional inventory to serve


as a safety margin or buffer to meet an unanticipated increase in demand.

The formula to calculate the level of safety stock is as follows:


(Maximum usage rate Average usage rate) * Lead time

Where, the usage rate is the rate at which inventory is used in the
organisation.

The safety stock is maintained to avoid the situations of shortage of stock,


which is also known as stock out.

If the lead time and usage rate change frequently, the organisation may
face a situation of stock out.

In such a situation, complete protection against stock-out is required by


maintaining a large safety stock.

Lets Sum Up

Receivables management, also called credit management, is a technique


of reducing and mitigating bad debt risks by having insight into
creditworthiness of debtors and customers.

The primary objective of receivables management is to maximise the


returns on investments and minimise the risk of bad debts.

Inventory management is a process of monitoring and controlling the level


of stock available in an organisation. Reorder point refers to the level of
inventory that triggers an order for replenishing the current inventory.

Safety stock can be defined as the minimum additional inventory to serve


as a safety margin or buffer to meet an unanticipated increase in demand.

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Chapter 10:
Budget and Budgeting

Chapter Index
S. No

Reference No

Particulars

Slide
From-To

Learning Objectives

234
235

Topic 1

Concept of Budget

Topic 2

Types of Budget

Topic 3

Budgeting as Tool of Cost Control

238

Topic 4

Advantages and Limitations of

239

236-237

Budgeting
6

Topic 5

Zero-Based Budgeting (ZBB)

240

Topic 6

Rolling Budget

241

Topic7

Cash Budget

242

Lets Sum Up

243

Discuss the concept of budget

Describe different types of budget

State advantages and limitations of budgeting

Define zero-based budgeting

Explain rolling budget

Describe cash budget

Concept of Budget

Budget can be defined as a quantitative statement developed to ascertain


the funds required for various projects and the income that would be
generated from them. In simple words, budget helps in allocating the
income to various expenses.

The main objectives behind preparing budget in organisations are:


Ensuring

better

co-ordination

among

the

activities

of

various

departments
Spotting and correcting deviations by periodically comparing the actual
performance with budgeted performance
Maintaining a two-way communication in all the levels of management
to reduce the gap between actual and budgeted performance

1. Types of Budget

Budget is generally divided into four types:

Perform
ance
Budget

Incrementa
l Budget

Types of
Budgets

Flexible
Budget

Fixed
Budget

2. Types of Budget

Performance Budget: Performance budget is the collection of all the


activities carried out in the organisation along with their outcomes.

Fixed Budget: It is usually a short-term budget as it does not consider


variations that may occur in the long run.

Flexible Budget: Flexible budget is the one that can be altered


depending upon different activity levels of the organisation.

Incremental Budget: In incremental budget, extra amount is summed up


to the previous budget on yearly basis. Incremental budget is prepared by
keeping actual performance of preceding year as a base.

Budgeting as Tool of Cost Control

By providing quantitative statement, budgeting helps an organisation not


just in arranging resources and funds, but also helps in cost controlling too.
Generally a budget comprises of the following:
Profit Planning(Pro-forma Income
Statement)

Cash Budgeting

Balance Sheet Forecasting

Advantages and Limitations of Budgeting

Advantages of budgeting:
It helps in problem-solving in a disciplined manner.
It helps an organisation in planning and arranging resources.
It ensures the availability of fund at the time of need.
It enhances the goodwill of an organisation.

Limitations of budgeting:
Forecasts only quantitative data.
Budgeting is impacted by external factors beyond the control of an
organisation.
Requires high cost that makes the budgeting difficult for small
organisations.

Zero-Based Budgeting (ZBB)

Zero-Based Budgeting (ZBB) is a process of production planning that


requires each departmental head to justify their entire budget in a detailed
form.

In ZBB, every cost element of various activities is analysed and justified


every time when a new budget is prepared.

In ZBB, no base budget is considered or referred for preparing a new


budget.

Moreover, various activities are arranged according to their priority and the
cost of each activity is forecasted on the basis of certain facts.

The cost involved in all the activities is subjected to verification.

Rolling Budget

Rolling budget is prepared by making changes in a given budget at a fixed


interval of time.

The changes can be made on monthly, quarterly, half yearly or annual


basis.

Thus, it can be stated that rolling budget has a scope of amendments at


any period of time.

The rolling budget is prepared for a very short period of time.

It is very useful for industries that are facing swift changes and require
forecasting for a short interval of time.

For example, in most of the cases, an IT organisation faces swift changes


due to frequent enhancements in technology.

Cash Budget

Cash budgets are generally prepared by analysing cash inflow and outflow
of an organisation.

These budgets help in ensuring the sound liquid position of an organisation


for the payment of short-term liabilities and help the organisation in
avoiding situations in which there is idle cash or shortage of cash. The cash
budget is generally divided into four sections:
Receipts Section
Payment Section
Cash Flow Section
Financing Section

Lets Sum Up

Budget can be defined as a quantitative statement developed to ascertain


the funds required for various projects and the income that would be
generated from them.

The process of preparing the budget of an organisation is known as


budgeting. It is used to assess overall funds required to finance various
projects of the organisation.

Zero-Based Budgeting (ZBB) is a process of production planning that requires


each departmental head to justify their entire budget in a detailed form.

Rolling budget is prepared by making changes in a given budget at a fixed


interval of time.

Cash budgets are generally prepared by analysing cash inflow and outflow of
an organisation.

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