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CH A PTER ON E

FIN AN CI AL M AN AG EM EN T : AN OVERV IEW

Ques t io n : What do yo u me a n b y fina nci al ma nag e me nt ?

Ans we r :
M e aning o f Fin anc ial M anag e me nt :
The pri mar y task of a C harte re d Ac c o un tant i s to de al w i th
fu nds, ' Man age me nt of Funds ' i s an i mpo rtan t aspe c t of fi na nc i al
ma na ge me nt i n a busi ne ss u nde rtak i n g or an y othe r i nsti tu ti on l i ke
hos pi tal , art soc i e ty, and so on. The te rm 'Fi na nc i al Mana ge me nt ' has
be e n de fi ne d di ffe re ntl y by di ffe re nt au thors.
Ac c o rdi n g to Sol o mon "Fi nanc i al Ma nage me nt i s c onc e rne d
w i th the e ffi ci e nt use of an i mport ant e c ono mi c re sourc e , name l y
c a pi tal fun ds. " Phi l l i pp atus has gi ve n a more el ab orate de fi ni ti on of
the te rm, as , "Fi nanc i al Ma na ge me n t, is c onc e rne d wi th the mana ge ri al
de c i si ons th at re sul ts i n the ac q ui si ti on an d fi na nc i ng of short and
l on g te rm c re di ts for the fi rm. " Thu s, i t de al s w i th the si tuati o ns th at
re qui re se le c ti on of spe c i fi c pro bl e m of si ze a nd grow t h of an
e nte rpri se . The an al ysi s of the se de c i si ons i s base d o n the expe c te d
i nfl ow s an d out fl ow s of fun ds an d the i r effe c t on ma na ge ri al obj e c ti ve s.
The most ac ce p tabl e de fi ni ti on of fi n anc i al ma nage me nt is th at gi ve n
by S. C .Kuc h hal as, "Fi na nc i al mana ge me nt de al s w i th proc ure me nt of
fu nds and thei r e ffe c ti ve uti l i sati on i n the b usi ne ss. " Thus, the re are 2
b asi c aspe c ts of fi na nc i al mana ge me nt :

1 ) p ro cure me nt o f f unds :
As fu nds c an be obtai ne d from di ffe re nt sourc e s th us, the i r
proc ure me nt i s alw ays c onsi de re d as a c ompl ex pro bl e m by b usi ne ss
c onc e rns. The se fu nds proc ure d from di f fere nt so urce s ha ve di ffe re nt
c ha rac te ri sti c s i n te rms of ri sk , c ost and c ontrol tha t a ma nage r mu st
c onsi de r w hi l e proc uri n g fun ds. The fun ds sho ul d be proc ure d at
mi ni mum c ost, at a bal a nc e d ri sk a nd c on trol fac tors.
Funds rai se d by issue of e qui ty share s are the be st from ri sk
poi nt of vi ew for the c om pan y, as i t h as no re pay me nt li a bi li ty exce p t
on wi n di ng u p of the c om pan y, but fro m c ost poi n t of vie w , i t i s most
expe nsi ve , as di vi de nd expe c ta ti ons of sh are hol de rs are hi g he r tha n
pre vai l i ng i nte re st rate s an d di vi de nds are ap prop ri ati on of profi ts an d
no t al l owe d as expe nse un de r the i nc ome tax ac t. The i ssue of ne w
e qui ty share s may di l ute the c ontrol of the exi sti n g share hol de rs.
De be nture s are c om para ti vel y c he ape r si nc e the i nte re st i s
p ai d out of profi ts be fore tax. B ut, the y e ntai l a hi gh de gre e of ri sk
si nc e the y have to be re p ai d as pe r the te rms of a gre e me nt; al so, the
i nte re st pay me nt has to be m ade w he t he r or n ot the c om pany make s
pro fi ts.
Funds c an al so be proc ure d from b ank s a nd fi na nc i al
i nsti t uti ons, t he y provi de fun ds su bje c t to c e rtai n re stri c ti ve c ove na nts.
The se c ove n ants re stri c t free do m of the bo rrowe r to rai se l oans from
ot he r so urc e s. The re form proc e ss i s al so movi n g i n di re c ti o n of a
c l ose r moni tori ng of 'e n d use ' of re sourc e s mobi l i se d thro ugh c api tal
ma rke ts. Suc h re stri c ti on s are e sse n ti al for the safe ty of fun ds provi de d
by i nsti tuti o ns an d i nve stors. The re are othe r fi nanc i al i nstr ume nts
use d for rai si ng fi na nc e e. g. c omme rc i al pape r, de e p di sc ou nt bo nds,
e tc . The fi na nc e mana ge r has to b al anc e the avai l abi l i ty of fu nds a nd
the re stri c ti ve provi si o ns tie d wi th suc h fu nds re sul ti n g i n l ac k of
fl exi bi l i ty.
I n the gl obal i se d c om pe ti ti ve sc e nari o, i t is no t e noug h to
de pe n d on avai l a ble w ays of fi na nc e but re sourc e mobi l i sati on i s to be
u nde rta ke n throu gh i nnovati ve w ays or fi na nc i al prod uc ts th at may
me e t the nee ds of i nve stors. M ul ti pl e o pti on c on ve rti ble bo nds c an be
si g hte d as an exa mpl e , fu nds c an be rai se d i ndi ge no usl y as al so from
a broad. Fore i gn Di re c t I nve stme nt (F DI ) a nd Fore i gn I nsti tu ti onal
I nve stors (FI I ) are tw o maj or sourc e s of fi na nc e from abro ad al on g w i th
A me ri c a n De p osi tory Re ce i pts (ADR 's) an d Gl obal De posi tor y Re c e i pts
(GD R's). The me c ha ni sm of proc uri ng fun ds i s to be modi fi e d i n the
l i ght of re q ui re me nts of forei g n i nve stors. Proc ure me n t of fun ds i nte r
al i a i nc l ude s :

- I de nti fi c ati on of sourc e s of fi nanc e


- De te rmi nati o n of fi nanc e mi x
- Rai si n g of fu nds
- Di vi si on of profi ts be twe e n di vi de nds and re te nti on of profi ts i .e .
i nte rn al fun d ge ne rati on.

2 ) e ff e ct ive us e o f s uch f unds :


The fi na nc e ma na ge r i s al so re sponsi bl e for e ffe c ti ve uti l i sati on of
fu nds. He must poi nt out si tua ti ons w he re fu nds are ke pt i dl e or are
use d i mprope rl y. All fu nds are proc ure d at a ce rtai n c ost an d afte r
e ntai l i ng a ce rtai n amou nt of ri sk . If the fu nds are not u ti li se d i n the
ma nne r so th at the y ge ne rate an i nc o me hi g he r tha n c ost of
proc ure me nt, the re i s no me ani n g i n run ni ng the busi ne ss. I t i s an
i mp orta nt c onsi de rati on i n di vi de n d de c i si ons al so, thus, i t i s c ruc i al to
e mpl oy fun ds prope rl y an d profi t abl y. The fun ds are to be e mpl oye d i n
the ma nne r so tha t the c omp any c an pro duc e at i ts opti m um l e ve l
w i tho ut e nda nge ri ng i ts fi n anc i al sol ve nc y. Th us, fi nanc i al i m pl i c ati ons
of e ac h de c i si on to i nve st i n fi xe d asse ts are to be pro pe rl y anal yse d.
For thi s, the fi nanc e ma nage r m ust pos se ss so un d k now le d ge of
te c hni que s of c api tal b ud ge ti ng and m ust ke e p i n vie w the nee d of
a de quate w ork i ng c api tal an d e nsure that w hi l e fi rms e nj oy an opti mum
l e ve l of w orki n g c api t al the y do not kee p too muc h fun ds bl oc ke d i n
i nve nto rie s, book de b ts, c ash, e tc.
Fixe d asse ts are to fi n anc e d from me di um or l on g te rm fu nds, an d
no t short te rm fun ds, as fi xe d asse ts c ann ot be sol d i n short te rm i. e .
w i thi n a ye ar, al so a l arge amo unt of fun ds w oul d be bl oc ke d i n stoc k i n
ha nd as the c ompa ny c an not i mme di ate l y se l l i ts fi ni she d goods.

Ques t io n : Exp l ain t he s co p e of fin anci al ma nag e me nt ?


Ans we r : Scop e of f inanc ial manag e me nt :
A sou nd fi n anc i al ma nage me nt is e sse nti al i n al l type of
fi na nc i al org ani sati o ns - w he t he r profi t orie n te d or not, w he re fu nds are
i nvol ve d a nd al so i n a c e ntral l y pl a nne d e c onom y as al so i n a c api tal i st
se t-u p. Fi rms, as pe r the c omme rc i al hi story, have no t li q ui date d
be c au se the i r te c hnol o gy w as obsol e te or the i r pro duc ts ha d no or l ow
de ma nd or due to any othe r fac tor, b ut due to l ac k of fi na nc i al
ma na ge me nt. Eve n i n boom pe ri o d, w he n a c o mpa ny ma ke s hi gh
pro fi ts, the re i s dan ge r of li q ui dati o n, due to ba d fi nanc i al
ma na ge me nt. The m ai n c ause of l i qui d ati on of suc h c om pani e s i s ove r-
tra di n g or over-exp andi ng w i tho ut an ade qua te fi n anc i al base .
Fina nc i al mana ge me nt op ti mi se s the o utp ut from the gi ve n i nput
of fu nds and atte mp ts to us e the fun ds i n a most prod uc ti ve man ner. I n
a c ou ntry li ke I ndi a, w he re re sourc e s are sc arc e and de man d on fu nds
are many, t he ne e d for pro pe r fi nanc i al ma nage me n t i s e normous. I f
pro pe r te c h ni que s are use d most of the e nte rpri se s c an re duc e the i r
c a pi tal e mpl oye d an d i mprove re turn on i nve stme nt. Th us, as me n an d
mac hi ne are pro pe rl y mana ge d, fi nanc e s are al so to be we ll ma nage d.
I n new l y starte d c omp ani e s, i t i s i mport ant to have soun d
fi na nc i al man age me nt, as i t e nsure s the i r su rvi val , ofte n suc h
c om pa nie s i gnore s fi na nc i al man age me nt at the i r ow n pe ri l . Eve n a
si m ple ac t, l i ke de posi ti ng the c he q ue s on the day of t hei r re ce i pt i s
no t pe rforme d. Suc h orga ni sati on s pay he avy i nte re st c ha rge s on
bo rrow e d fun ds, bu t are ta rdy i n re al i si n g the i r ow n de btor s. Thi s is d ue
to t he fac t the y l ac k re al i sati on of t he c onc e p t of ti me val ue of mone y,
i t i s not ap pre c i ate d tha t e ac h val ue of rupe e h as to be made use of
an d th at i t has a di re c t c ost of u ti li sati o n. It m ust be re al i se d tha t
ke e pi ng rupe e i dl e eve n for a day, re sul ts i nto losse s. A non- profi t
organi s ati on m ay not be ke e n to make profi t, tr adi ti on al l y, b ut i t doe s
ne e d to c ut dow n i ts c ost an d use the fun ds at i ts di s posal to the i r
op ti mu m c apac i ty. A soun d se nse of fi na nc i al man age me nt h as to be
c ul ti va te d amo ng ou r bure auc r ats, ad mi ni strat ors, e ngi nee rs,
e duc a ti oni sts a nd p ubl i c at l arge. Unl e ss thi s i s done , c ol ossal w astage
of t he c a pi tal re sourc e s c an not be arre ste d.

Ques t io n : What are t he ob je ct ive s of fin anci al m anag e me nt ?

Ans we r :
Ob je ct ive s of fin anci al ma nag e me nt :
Effi c i e nt fi nanc i al m ana ge me nt re qui re s exi ste nc e of some
obj e c ti ve s or goal s be c ause j ud gme nt as to w he the r or not a fi na nc i al
de c i si on i s effi c i e nt i s to be made i n li g ht of so me obj e c ti ve . The tw o
mai n obj e c ti ve s of fi na nc i al man age me nt are :

1 ) Pro f it M ax imis at io n :
I t i s tra di ti on al l y be i n g arg ue d, tha t the obj e c ti ve of a c om pan y i s to
e arn profi t, he nc e t he obj e c ti ve of fi nanc i al ma na ge me n t i s profi t
ma xi mi sati on. Th us, e ac h al te rnati ve , i s to be see n by the fi nanc e
ma na ge r fro m the vie w poi nt of profi t maxi mi sati on. B ut, i t c ann ot be
the onl y o bje c ti ve of a c omp any, i t i s at be st a li mi te d obj e c ti ve el se a
n um be r of probl e ms w oul d ari se . Some of the m are :
a) The te rm profi t i s vague an d doe s not cl ari fy w hat exac tl y i t me ans.
I t c onve ys di ffe re nt me ani n g to di ffe re nt pe opl e .

b) Profi t maxi mi sati on has to be atte m pte d w i th a re al i sati o n of ri sk s


i nvol ve d. The re i s di re c t re l ati on be tw ee n ri sk an d profi t; hi g he r the
ri sk , hi ghe r i s the profi t. For maxi mi si n g profi t, ri sk i s al to ge the r
i gn ore d, i mpl yi ng that fi n anc e man age r ac c e pts hi g hl y ri sky pro posal s
al so. Pr ac ti c al l y, ri sk i s a ve ry i m porta nt fac t or to be bal a nc e d wi th
pro fi t obj e c ti ve .

c ) Profi t maxi mi sati o n i s an obj e c ti ve no t tak i n g i nto ac c ou nt t he ti me


p atte rn of re tu rns.
E. g. Pro posal X gi ve s re turns hi g he r than that by pro posal Y bu t, the
ti me pe ri od i s say, 10 ye ars and 7 ye ars re spe c ti ve ly. Thus, t he ove ral l
pro fi t i s onl y c onsi de re d not the ti me pe ri od, nor the fl ow of profi t.

d) Profi t maxi mi sati on as an obj e c ti ve i s too na rrow , i t fai l s to ta ke


i nto ac c oun t the soc i al c onsi de rati ons and obl i gati o ns to vari ou s
i nte re sts of w orke rs, c on sume rs, soc i e ty, as we ll as e thi c al trade
pr ac ti c e s. I gnori ng the se fac tors, a c om pa ny c an not survi ve for l on g.
Pro fi t maxi mi sa ti on at the c ost of soc i al and m oral obl i ga ti ons i s a
sho rt si gh te d pol i c y.

2 ) We alt h m ax imis at io n :
The c omp ani e s havi n g profi t m axi mi sati o n as i ts obj e c ti ve ,
ma y ado pt pol i c i e s yi e l di ng exor bi tan t profi ts i n t he sho rt run w hi c h are
u nhe al thy for the grow th, survi v al and ove ral l i nte re sts of the b usi ne ss.
A c o mpa ny may not u nde rta ke pl a nne d a nd pre sc ri be d sh ut- dow ns of
the pl a nt for mai nte nanc e , an d so on for m axi mi si ng profi ts i n the shor t
ru n. Thus, the obj e c ti ve of a fi rm sho ul d be to maxi mi se i ts val ue or
w e al th.
Ac c o rdi n g to Van Ho rne , " Val ue of a fi rm i s re pre se nte d by the
ma rke t pri c e of the c o mpa ny's c ommo n stoc k . . .. . . . the marke t pri c e of a
fi rm 's stoc k re pre se n ts the foc al j ud gme nt of al l mar ke t parti c i pa nts as
to w ha t the val ue of the parti c ul ar fi rm i s. I t take s i nto ac c o unt pre se nt
as al so pro spe c ti ve f uture e arni n gs pe r share , t he ti mi n g an d ri sk of
the se e arni ng, t he di vi de nd pol i c y of t he fi rm and many othe r fac tors
ha vi ng a be ari ng on the marke t pri c e of stoc k . The m arke t pri c e se rve s
as a pe rfo rma nc e i n dex or re por t c ard of the fi rm' s progre ss. I t
i ndi c a te s how we ll ma nage me n t i s d oi ng o n be hal f of stoc k hol de rs. "
S hare pri ce s i n the share mar ke t, at a gi ve n poi nt of ti me, are t he
re sul t of a mi xt ure of ma ny fac t ors, as ge ne ral ec ono mi c outl ook ,
p arti c ul ar ou tl ook of the c om pani e s un de r c o nsi de rati on, te c hni c al
fac t ors an d e ve n ma ss psyc hol ogy, b ut, take n o n a l ong te rm basi s,
the y re fle c t the val ue , w hi c h vari ous p arti e s, p ut on the c ompa ny.
N ormal l y thi s val ue i s a fu nc ti on, of :

- the l i ke l y rate of e arni n gs pe r share of the c omp any; an d


- the c api t al i sati on rate .
The li ke l y rate of earni ngs pe r share (EP S) de pe n ds up on the
asse ssme nt as to the profi ta bl y a c om pany i s goi ng to ope rate i n t he
fu ture or w hat i t i s l i ke l y to earn agai nst e ac h of i ts ordi nary sh are s.
The c api tal i sati o n rate re fl e c ts the li k i ng of the i nve stors of a
c om pa ny. I f a c omp any earns a hi gh rate of earni ngs pe r sh are t hrou gh
i ts ri sky ope ra ti ons or ri sky fi na nc i n g pat te rn, the i nve stors wi l l not
l ook up on i ts share w i th favo ur. To that exte nt, the mar ke t val ue of the
sh are s of suc h a c om pany wi l l be l ow. A n e asy w ay to de te rmi ne the
c a pi tal i sati on ra te i s to start wi th fi xe d de p osi t i nte re st rate of ba nk s,
i nve stor w oul d w ant a hi g he r re tu rn i f he i nve sts i n sh are s, as the ri sk
i nc re ase s. How muc h hi g he r re turn i s expe c te d, de pe n ds on t he ri sk s
i nvol ve d i n t he p arti c ul ar sh are w hi c h i n tu rn de pe n ds on c ompa ny
pol i c i e s, p ast re c ords, ty pe of b usi ne ss an d c onfi de nc e c om man de d by
the ma na ge me n t. Thus, c api t al i sati on rate i s the c umul a ti ve re sul t of
the asse ssme nt of the vari ous sh are h ol de rs re ga rdi n g the ri sk and
ot he r q ual i tati ve fac tor s of a c omp any. I f a c o mpa ny i nve sts i ts fun ds i n
ri sky ve nt ure s, the i nve stors w i ll p ut i n the i r mone y i f the y ge t hi ghe r
re turn as c om pare d to th at from a l ow ri sk sh are.
The marke t val ue of a sh are i s thus, a f unc ti o n of e arni n gs pe r
sh are an d c api t al i sati on rate . Si nc e the profi t m axi mi sati o n c ri te ri a
c an not be a ppl i e d i n re al w orl d si tuati o ns be c ause of i ts te c hni c al
l i mi tati o n the fi nanc e ma nage r of a c om pan y has to ensure th at hi s
de c i si ons are suc h t hat the mar ke t val ue of the share s of the c ompa ny
i s maxi m um i n t he l on g run. Thi s i m pl ie s tha t the fi nanc i al pol i c y ha s to
be suc h that i t o pti mi se s the EPS, kee pi ng i n vi ew the ri sk and othe r
fac t ors. Thus, w e al th maxi mi s ati on i s a be tte r obj e c ti ve for a
c om me rci al u nde rtak i n g as c om pare d to re turn and ri sk.
The re i s a grow i ng emp hasi s on soc i al a nd ot he r o bl i gati on s of
an e nte rp ri se . I t c a nnot be de ni e d th at i n the c ase of un de rtak i ngs,
e spe c i all y th ose i n t he p ubl i c se c tor, the q ue sti on of w e al th
ma xi mi sati on i s to be see n i n c on text of soc i al an d othe r obl i ga ti ons of
the e nte rpri se .
I t must be u nde rstoo d tha t fi nanc i al de c i si on m ak i ng i s re l ate d
to t he o bje c ti ve s of the busi ne ss. The fi nanc e ma nage r ha s to e nsure
th at the re is a posi ti ve i mpac t of e ac h fi nanc i al de c i si on on the
fur the ranc e of the b usi ne ss obj e c ti ve s. O ne of t he mai n obj e c ti ve of an
u nde rtak i n g may be to " progre ssi vel y b ui l d up the c apa bi li ty to
u nde rta ke the de si gn and de ve l op me nt of ai rc raft e ngi ne s, he l i c opte rs,
e tc . " A fi nanc e ma nage r i n suc h c ase s w i ll al l oc ate fun ds i n a w ay tha t
thi s obje c ti ve i s ac hie ve d al th ou gh suc h an al l oc ati o n may no t
ne c e ssari l y maxi mi se we al th.

Ques t io n : What are t he funct io ns o f a Fi nan ce M anag e r ?

Ans we r :
Fun ct io ns o f a Fin ance M anag e r :
The tw i n aspe c ts, proc ure me nt and effe c ti ve uti l i sati o n of
fu nds are c ruc i al task s fac e d by a fi nanc e ma na ger. The fi nanc i al
ma na ge r i s re qui re d to l ook i nto the fi nanc i al i m pl i c ati ons of a ny
de c i si on i n the fi rm. Th us al l de c i si ons i nvol ve ma nage me n t of fun ds
u nde r the pur vie w of the fi nanc e ma nage r. A l arge nu mbe r of de c i si ons
i nvol ve sub stan ti al or mate ri al c han ge s i n val ue of f und s proc ure d or
e mpl oye d. The fi na nc e ma na ge r, has to man age fun ds i n suc h a w ay so
as to make the i r opti m um uti l i sati o n and to e nsure t hei r proc ure me nt i n
a w ay th at the ri sk , c ost and c ontrol are pro pe rl y bal anc e d unde r a
gi ve n si tu ati on. He may no t, be c onc e rne d wi t h the de ci si ons, t hat d o
no t affe c t the basi c fi na nc i al man age me nt a nd str uc ture .
The nat ure of j ob of an ac c ou nta nt an d fi na nc e m ana ge r is
di ffe re nt, an ac c o unt ant 's j ob i s pri mari l y to re c ord the busi ne ss
tra nsac ti o ns, pre pare fi nanc i al state me n ts show i ng re sul ts of the
organi s ati on for a gi ve n pe ri o d an d i ts fi nanc i al c on di ti on at a gi ve n
poi nt of ti me . He i s to re c ord vari ous hap pe ni ngs i n mone tary te rms to
e nsure tha t asse ts, li abi l i ti e s, i nc ome s an d expe nse s are pro pe rl y
gro upe d, c l assi fi e d an d di sc l ose d i n the fi nanc i al sta te me n ts.
Ac c oun tan t i s n ot c onc e rne d wi th mana ge me nt of fu nds that is a
spe c i al i se d task an d i n mode rn ti me s a c ompl ex one . The fi n anc e
ma na ge r or c o ntrol le r has a task e nti re l y di ffe re n t from th at of an
ac c o unt ant, he i s to mana ge fun ds. Some of the i mpo rtan t de c i si ons as
re gards fi na nc e are as fol l ow s :

1 ) Es t imat i ng t he re q uire me nt s of f und s : A b usi ne ss re qui re s


fu nds for l ong te rm pur pose s i. e. i nve stme nt i n fi xe d asse ts a nd so on.
A c are ful e sti mate of suc h fun ds i s re qui re d to be ma de . An
asse ssme nt has to be ma de re ga rdi n g re q ui re me n ts of w ork i ng c a pi tal
i nvol vi n g, esti m ati on of amou nt of fu nds bl oc ke d i n c urre nt asse ts and
th at l i kel y to be ge ne rate d for short pe ri ods throu gh c u rre nt l i abi l i tie s.
Fore c asti n g the re q ui re me nts of fun ds i s done by use of te c hni que s of
b ud ge tary c on trol and lon g ran ge pl anni ng. Esti m ate s of re q ui re me nts
of fu nds c an be ma de onl y if al l the physi c al ac ti vi ti e s of the
organi s ati on are fore c aste d. The y c an be transl a te d i nto mo ne tary
te rms.

2 ) De cis io n re g ard ing cap it a l s t ruct ure : O nce the re qui re me nts of
fu nds is e sti mate d, a de c i si on re gardi ng vari ous sourc e s from w he re
the fu nds woul d be rai se d is to be take n. A prope r mi x of the vari ous
sourc e s i s to be w orke d out, e ac h sourc e of fun ds i nvol ve s di ffe re nt
i ssue s for c onsi de rati on. The fi nanc e ma nage r has to c are f ul l y l ook i nto
the exi sti ng c api tal struc ture and se e how the vari ous pro posal s of
rai si n g fun ds w il l affe c t i t. He i s to mai nt ai n a pro pe r b al anc e be twe e n
l on g an d short te rm fun ds an d to e nsure that suffi c i e nt l ong- te rm fu nds
are rai se d i n orde r to fi na nc e fi xe d asse ts an d othe r l ong -te rm
i nve stme n ts an d to provi de for pe rmane nt nee ds of work i n g c api tal . I n
the ove ral l vol ume of l ong- te rm fu nds, he i s to mai ntai n a prope r
b al anc e be twe e n ow n an d l oan fu nds and to se e t hat t he ove ral l
c a pi tal i sati on of the c o mpa ny i s suc h, th at the c om pany is abl e to
proc ure f und s at mi ni m um c ost and is abl e to tol e rate shoc k s of l e an
pe ri ods. Al l the se de ci si ons are k now n as ' fi nanc i ng de c i si ons '.

3 ) Inve s t me nt de cis io n : Fun ds proc ure d from di ffe re nt sourc e s have


to be i nve ste d i n vari ous ki n ds of asse ts. Lon g te rm fu nds are use d i n a
proj e c t for fi xe d an d al so c urre nt asse ts. The i nve stme nt of fun ds i n a
proj e c t i s to be made afte r c are ful asse ssme nt of vari ous proj e c ts
throug h c api t al bu dge ti ng. A part of lon g te rm fu nds i s al so to be ke pt
for fi n anc i n g w ork i ng c api t al re q ui re me nts. Asse t m ana ge me nt pol i c i e s
are to be l ai d dow n re gardi ng vari ous i te ms of c urre nt asse ts, i nve nt ory
pol i c y i s to be de te rmi ne d by the prod uc ti on a nd fi na nc e mana ge r,
w hi le ke e pi ng i n mi n d the re qui re me nt of pro duc ti o n an d fut ure pri c e
e sti mate s of raw mate ri al s an d avai l abi l i ty of f und s.

4 ) Divid e nd de cis io n : The fi n anc e man age r i s c onc e rne d w i th the


de c i si on to p ay or de c l are di vi de n d. He i s to assi st the to p man age me nt
i n de c i di n g as to w hat amou nt of di vi de n d sho ul d be pai d to the
sh are h ol de rs and w hat amo unt be re tai ne d by the c ompa ny, i t i nvol ve s
a l arge n um be r of c onsi de rati ons. Ec o nomi c al l y spe ak i n g, the amou nt
to be re tai ne d or be pai d to the share hol de rs sho ul d de pe n d on w he the r
the c om pan y or share hol de rs c an make a more profi ta ble use of
re sourc e s, al so c on si de rati ons li ke tre n d of e arni n gs, the tre n d of share
ma rke t pri c e s, re qui re me nt of fu nds for future grow t h, c ash fl ow
si tu ati on, tax posi ti on of sh are hol de rs, a nd so on to be ke p t i n mi nd.
The pri nc i p al func ti o n of a fi nanc e ma na ge r re l ate s to
de c i si ons re gardi ng proc ure me nt, i nve stme nt and di vi de nds.

5 ) Sup p ly of f und s to all p art s o f t he o rg anis at io n o r cas h


ma nag e me nt : The fi n anc e man age r has to e nsure th at al l se c ti ons
i .e . bra nc he s, fac tori e s, u ni ts or de par tme nts of the orga ni sati on are
su ppl i e d w i th ade q uate fun ds. Se c ti ons h avi ng exce ss fu nds c ontri b ute
to t he c e ntral p ool for use i n othe r se c ti ons that nee ds fu nds. A n
a de quate su ppl y of c as h at al l poi nts of ti me i s absol ute l y esse nti al for
the smo oth fl ow of b usi ne ss ope rati ons. Eve n i f one of the man y
br anc he s i s short of fun ds, the w hole busi ne ss m ay be i n dan ge r, t hus,
c as h man age me nt a nd c as h di sb urse me nt pol i c i e s are i mport ant wi th a
vi ew to su ppl yi n g ade q uate fu nds at all ti me s an d poi nt s i n an
organi s ati on. I t shoul d e nsure th at the re is no exc e ssi ve c as h.

6 ) Ev alu at ing f inanci al pe rfo rm ance : Ma nage me n t c ontrol syste ms


are usual l y base d on fi na nc i al anal ysi s, e. g. RO I (re turn on i nve st me nt)
syste m of di vi si onal c ontrol . A fi na nc e mana ge r has to c on stan tl y
re vie w the fi n anc i al pe rformanc e of vari o us uni ts of the orga ni sati on.
A nal ysi s of the fi nanc i al pe rfo rma nc e he l ps the m ana ge me nt for
asse ssi n g how the fun ds are uti li se d i n vari o us di vi si ons an d w hat c an
be do ne to i mprove i t.

7 ) Fi nanc ial neg o t iat io ns : Fi nanc e ma nage r 's maj or ti me i s uti li se d


i n c arr yi ng o ut ne goti a ti ons w i th fi na nc i al i nsti tuti o ns, bank s and pu bl i c
de po si tors. He ha s to furni sh a l ot of i nfo rma ti on to the se i nsti tuti o ns
an d pe rson s i n orde r to e nsure that rai si ng of fu nds i s w i thi n t he
sta tute s. Ne go ti ati ons for outsi de fi na nc i ng ofte n re qui re s spe c i al i se d
sk i l l s.

8 ) Ke e p ing in t o uch wit h st o ck e x chang e q uo t at io ns and


b e havio r of sha re p rice s : I t i nvol ve s anal ysi s of maj or tre n ds i n the
stoc k m arke t an d j ud gi ng thei r i mp ac t on share p ri ce s of the c om pan y's
sh are s.

Ques t io n : What are t he vario us me t hod s and to o ls us e d f o r


f inanci al m anag e me nt ?

Ans we r : Fi nanc e ma nage r use s vari ou s tool s to di sc h arge hi s


fu nc ti ons as re ga rds fi nanc i al ma nage me n t. In the are a of fi nanc i ng
the re are vari ous me thod s to proc ure fu nds fro m l ong as al so short
te rm sourc e s. The fi nanc e ma na ge r h as to de c i de an opti mum c api tal
str uc ture tha t c an c on tri bu te to the m axi mi sati o n of share hol de r 's
w e al th. Fi nanc i al l e ve ra ge or tra di n g on e qui ty i s an i m porta nt me th od
by w hi c h a fi nanc e ma nage r ma y i nc re ase the re tu rn to c ommo n
sh are h ol de rs.
For e val uati on of c api tal pro posal s, the fi na nc e ma na ge r
use s c api t al bu dge ti ng te c h ni que s as p ayb ac k , i nte rnal rate of re tu rn,
ne t pre se nt val ue , profi ta bi li ty i ndex, ave rage rate of re tu rn. I n the
are a of c urre nt asse ts mana ge me nt, he use s me t hods to c he c k e ffi c ie nt
uti l i sati o n of c urre nt re sourc e s at the e nte rpri se 's di sp osal . An
e nte rpri se c an i nc re ase i ts profi t abi l i ty w i thou t affe c ti ng i ts l i qui di ty by
an effi c i e nt ma nage me nt of w orki n g c api t al . For i nsta nc e , i n the are a of
w ork i ng c api tal ma nage me n t, c ash ma nage me nt may be c e ntral i se d or
de -c e ntral i se d; ce n tral i se d me thod i s c onsi de re d a be tte r tool of
ma na gi ng the e nte rpri se 's l i qui d re sourc e s. I n the are a of di vi de n d
de c i si ons, a fi rm i s fac e d w i th the pro ble m of de cl ara ti on or po stpo ni n g
de c l arati o n of di vi de n d, a probl e m of i nte rn al fi nanc i n g.
For e val uati on of an e nte rpri se 's pe rformanc e , the re are
vari o us me tho ds, as rati o an al ysi s. Thi s te c h ni que i s use d by al l
c onc e rne d pe rsons. Di ffe re nt rati os se rvi ng di ffe re nt obj e c ti ve s. A n
i nve stor use s vari o us rati os to e val ua te the profi t abi l i ty of i nve stme nt
i n a pa rti c ul ar c om pa ny. The y e na ble the i nve stor, to j ud ge t he
pro fi tabi l i ty, sol ve nc y, li q ui di ty an d grow t h aspe c ts of t he fi rm. A short-
te rm cre di tor i s more i nte re ste d i n the l i qui di ty aspe c t of the fi rm, an d
i t i s possi bl e by a stu dy of l i qui di ty rati os - c urre nt rati o, qui c k rati os,
e tc . The mai n c onc e rn of a fi n anc e man age r i s to provi de ade q uate
fu nds from be st possi ble sourc e , at the ri ght ti me a nd at mi ni mu m c os t
an d to e nsure tha t the fun ds so ac q ui re d are p ut to be st possi ble use .
Funds fl ow an d c ash fl ow state me nt s and proj e c te d fi n anc i al state me nt s
he l p a l ot i n thi s re gard.

Ques t io n : Dis cuss t he ro le o f a f inance ma nag e r ?

Ans we r : In the mo de rn e nte rpri se , a fi na nc e mana ge r oc c upi e s a ke y


po si ti on, he bei n g one of the dyn ami c me mbe r of c or porate ma nage ri al
te am. Hi s role , i s be c omi ng more an d more pe rvasi ve and si g ni fi c ant i n
sol vi n g c ompl ex m ana ge ri al pro bl e ms. Tradi ti o nal l y, the rol e of a
fi na nc e mana ge r w as c onfi ne d to rai si n g fun ds from a num be r of
sourc e s, bu t due to re ce nt de ve l op me nts i n the soc i o -ec o nomi c an d
pol i ti c al sc e nari o thro ug hou t the w orl d, he i s pl ac e d i n a ce n tral
po si ti on i n the org ani sati o n. He i s re spo nsi bl e for sha pi ng the for tune s
of t he e nte rpri se and is i nvol ve d i n the mos t vi tal de c i si on of al l oc ati on
of c a pi tal li ke me rge rs, ac q ui si ti ons, e tc. A fi na nc e m ana ge r, as ot he r
me m be rs of the c orpora te te am c a nnot be ave rse to the fast
de ve l opme nt s, aroun d hi m an d has to take note of the c ha nge s i n orde r
to ta ke re le va nt ste ps i n vi ew of the dy nami c c ha nge s i n
c i rc ums tanc e s. E. g. i ntrod uc ti on of Euro - as a si ngl e c urre nc y of
Euro pe i s an i nte rnati o nal le ve l c h ange , havi n g i mp ac t on t he c or porate
fi na nc i al pl ans and p ol i ci e s w orl d -w i de.
Dome sti c de vel o pme nts as eme rge nc e of fi na nc i al se rvi c e s
se c tors an d SEB I as a w atc h do g for i nve stor pro te c ti on an d re g ul ati n g
bo dy of c a pi tal mar ke ts is c on tri bu ti ng to the i mporta nc e of the fi nanc e
ma na ge r's j ob. B ank s an d fi nanc i al i nsti t uti ons we re the maj or so urc e s
of fi na nc e , mo no pol y w as the state of affai rs of I ndi a n busi ne ss,
sh are h ol de rs sati sfac ti o n w as not the pro mote r's c onc e rn as mos t of
the c om pani e s, we re c l osel y he l d. Due to the ope ni n g of ec on omy,
c om pe ti ti on i nc re ase d, se l le r's marke t i s be i ng c onve rte d i nto buye r 's
ma rke t. De ve l opme nt of i nte rne t has bro ug ht ne w c hal le n ge s be fore the
ma na ge rs. I ndi a n c onc e rns no l onge r have to c om pe te onl y nati on al l y,
i t i s fac i ng i nte rnati on al c ompe ti ti on. Th us a ne w era i s ushe re d duri n g
the re ce nt ye ars, i n fi na nc i al mana ge me nt, spe c i al l y, w i th the
de ve l opme nt of fi nanc i al tool s, te c hni que s, i nstrume n ts an d prod uc ts.
Al so d ue to i nc re asi n g e mph asi s on p ubl i c se c tor un de rtak i ngs to be
se lf-su pp orti n g and the i r de pe n de nc e on c api tal m arke t for fu nd
re qui re me nts an d the i nc re asi ng si g ni fi c anc e of li be ral i sati o n,
gl o bal i sati on and dere gul a ti on.

Ques t io n : Dra w a t yp ica l o rg anis at io n ch art hig hlig ht ing t he


f inance f unct io n o f a co mp any ?

Ans we r : The fi na nc e func ti o n i s t he sa me i n al l e nte r pri se s, de tai l s


ma y di ffe r, but m aj or fe ature s are uni ve rsal i n na ture . The fi na nc e
fu nc ti on oc c upi e s a si gni fi c an t posi ti on i n an organi sa ti on an d i s not
the re sponsi bi li ty of a sole exe c uti ve . The i mporta nt as pe c ts of fi nanc e
ma na ge r are to c arri e d on by top mana ge me nt i .e . man agi n g di re c tor,
c hai rma n, board of di re c tors. The board of di re c tors ta ke s de c i si ons
i nvol vi n g fi na nc i al c onsi de rati on s, the fi n anc i al c ontrol l e r i s b asi c al l y
me an t for assi sti n g the top mana ge me nt an d has an i mpor tan t role of
c on tri bu ti ng to goo d de c i si on mak i ng on i ssue s i nvol vi ng all fu nc ti onal
are as of b usi ne ss. He i s to bri ng out fi na nc i al i mpl i c ati ons of all
de c i si ons an d ma ke t he m un de rstood. He may be c al le d as the fi nanc i al
c on trol le r, vi ce -pre si de nt (fi n anc e ), c hi e f ac c ou nta nt, tre asure r, or b y
an y othe r de si gn ati on, b ut has the p ri mary re spo nsi bi l i ty of pe rformi ng
fi na nc e func ti o ns. He i s to di sc ha rge the re sp onsi bi l i ty ke e pi ng i n vi e w
the ove ral l outl ook of the organi sa ti on.

BOARD OF DIRECTORS

P RESI DEN T

V. P. ( Prod uc ti on) V. P. (Fi nanc e ) V. P. (Sal e s)

Tre asure r C ontrol l e r


C re di t C ash B ank i n g Portfol i C orpora te Taxe I nte rna B udge ti n
M gmt. M gmt. rel ati o n o Mg mt. Ge ne ral & s l A udi t g
s C ost
Ac c o unti n g

Org an is at io n cha rt of f inance f unct io n

The C hi e f fi n anc e exe c uti ve w ork s di re c tl y u nde r the Pre si de nt or


Ma nagi ng Di re c tor of the c omp any. Be si de s routi ne w ork , he kee ps the
B oard i nforme d abo ut al l phase s of b usi ne ss ac ti vi ty, i nc l usi ve of
e c onomi c , soc i al an d pol i ti c al de ve l op me nts affe c ti n g the busi ne ss
be ha vi our an d from ti me to ti me fu rni she s i nformati o n abo ut the
fi na nc i al stat us of the c omp any. Hi s func ti ons are : (i ) Tre as ury
fu nc ti ons and (i i ) C ontrol fu nc ti ons.

Re lat io ns hip Be t we e n f inanc ial man ag e me nt a nd o t he r are as of


ma nag e me nt : The re i s c l ose rel ati o nshi p be twe e n the are as of
fi na nc i al and othe r man age me nt li ke prod uc ti on, sal e s, m arke ti ng,
pe rso nne l, e tc . Al l ac ti vi ti e s di re c tl y or i ndi re c tl y i nvol ve ac qui si ti on
an d use of fu nds. De te rmi nati o n of pro duc ti o n, proc ure me nt an d
ma rke ti ng strate gi e s are the i mpor tant pre rogati ve s of the re spe c ti ve
de p artme nt he ads, bu t for i mpl e me nti n g, the i r de ci si ons fun ds are
re qui re d. Li ke , re pl ac e me nt of fi xe d asse ts for i m provi ng prod uc ti on
c a pac i ty re qui re s fun ds. Si mi l arl y, the p urc ha se an d sal e s promo ti on
pol i c i e s are l ai d dow n by the purc hase and marke ti n g di vi si ons
re spe c ti ve l y, bu t agai n proc ure me nt of raw m ate ri al s, ad ve rti si ng an d
ot he r sal e s prom oti on re qui re fun ds. Same i s for, re c rui tme nt and
pro moti o n of staff by the pe rson nel de par tme nt w oul d re q ui re fu nds for
p ayme nt of sal arie s, w age s and othe r be ne fi ts. I t may, ma ny ti me s, be
di ffi c ul t to de marc a te w he re one func ti on e nds and ot he r starts.
Al t hou gh, fi na nc e fu nc ti on has a si gni fi c a nt i mp ac t on the ot he r
fu nc ti ons, i t ne e d not l i mi t or obs truc t the ge ne ral fu nc ti ons of the
b usi ne ss. A fi rm fac i n g fi na nc i al di ffi c ul ti e s, may gi ve w ei g hta ge to
fi na nc i al c onsi de rati o ns an d de vi se i ts ow n pro duc ti o n an d marke ti n g
stra te gie s to sui t the si t uati on. W hi l e a fi rm havi n g sur pl us fi na nc e ,
w oul d have c omp arati ve l y l ow e r ri gi di ty as re gards the fi na nc i al
c onsi de rati ons vi s- a-vi s othe r fu nc ti ons of the mana ge me nt.

Pe rv as ive N at ure o f Fin ance Funct io n : Fi nanc e is the l i fe bl oo d of


of a n org ani sati o n, i t i s the c omm on thre a d bi ndi ng al l org ani sati o nal
fu nc ti ons. Thi s i nte rfac e c an be expl ai ne d as be l ow :

* Pro d uct io n - Fina nce : Prod uc ti on func ti o n re qui re s a l arge


i nve stme n t. Prod uc ti ve use of re sourc e s e nsure s a c ost adva nta ge for
the fi rm. O pti mum i nve st me nt i n i nve ntori e s i mprove s profi t margi ns.
Ma ny par ame te rs of prod uc ti on have an i mp ac t on c ost and c an
po ssi bl y be c ontrol l e d thro ug h i nte rnal ma na ge me n t, thus enh anc i n g
pro fi ts. I mporta nt pro duc ti o n de c i si ons l i ke ma ke or b uy c an be ta ke n
onl y afte r the fi nanc i al i mpl i c ati o ns are c o nsi de re d.
* M arke t ing - Fi nance : Vari ous as pe c ts of mar ke ti ng ma na ge me n t
ha ve fi na nc i al i mpl i c ati ons, de c i si ons to hol d i nve ntori e s on l arge sc al e
to provi de off the she l f se rvi c e to c ustome rs i nc re ase s i nve n tory
hol di ng c ost and at the same ti me may i nc re ase sal e s, si mi l ar w i th
exte nsi on of c re di t fac i l i ty to c us tome rs. Marke ti n g strate gi e s to
i nc re ase sal e i n most c ase s, have ad di ti onal c osts that are to be
w ei g hte d c are ful l y agai nst i nc re me ntal re ve nue be fore tak i ng de ci si on.

* Pe rs o nne l - Finan ce : I n t he gl o bal i se d c ompe ti ti ve sce n ari o,


b usi ne ss org ani sati o ns are m ovi ng to a fl atte r org ani sati o nal struc t ure .
I nve stme nts i n hum an re sourc e de ve l opme n ts are al so i nc re asi ng.
Re struc t uri n g of re m une rati on struc t ure, vol u ntary re ti re me nt sc he me s,
sw e at e qui ty, e tc. ha ve be c ome maj or fi n anc i al de c i si ons i n the hu man
re sourc e mana ge me nt.

Ques t io n : Dis cuss so me of t he ins t an ce s ind ic at ing t he chang ing


s ce n ario o f f inanc ial man ag e me nt in Ind ia ?

Ans we r : Mode rn fi n anc i al ma nage me nt has c ome a l ong w ay fro m


tra di ti onal c or porate fi na nc e, the fi na nc e m ana ge r is w ork i ng i n a
c hal l e ngi ng e nvi ron me nt tha t i s c h an gi ng c o nti nu ousl y. Due to the
ope ni ng of t he e c onomi e s, gl obal re sourc e s are be i ng tap pe d, the
op port uni ti e s avai l abl e to fi nanc e ma na ge rs vi rt ual l y have no l i mi ts, he
m ust al so u nde rsta nd t he ri sk s e ntai l i ng al l hi s de c i si on s. Fi nanc i al
ma na ge me nt i s passi n g thro ugh an e ra of expe ri me n tati on and
exc i te me nt is a par t of fi na nc e ac ti vi ti e s now a days. A fe w i nstanc e s
are as be l ow :

i ) I nte re st rate s have bee n fre e d from re gul ati o n, tre as ury ope rati o ns
th us, have to be more sophi sti c a te d due to fl uc t uati n g i nte re st rate s.
Mi ni m um c ost of c api tal ne c e ssi tate s anti c i pa ti ng i nte re st rate
mo ve me n ts.

i i ) The ru pee ha d be c ome ful l y c onve rti bl e on c urre nt ac c oun t.

i i i ) O pti m um de bt e qui ty mi x i s possi ble . Fi rms h ave to take adva nta ge


of t he fi na nc i al le ve rage to i nc re ase the share hol de r's we al th, how e ve r,
usi n g fi na nc i al le ve rage ne ce ssari l y ma ke s b usi ne ss vul ne ra ble to
fi na nc i al ri sk. Fi ndi ng a c orre c t tra de off be tw ee n ri sk and i mprove d
re turn to share hol de rs i s a c hal l e ngi n g task for a fi n anc e man age r.

i v) Wi t h fre e pri c i ng of issue s, the opti m um pri ce de te rmi n ati on of ne w


i ssue s i s a dau nti n g task as ove rpri c i n g re sul ts i n u nde r su bsc ri pti o n
an d l oss of i nve stor c on fi de nc e, w hi le un de r pri c i ng le ads to
u nw arra nte d i nc re ase i n n um be r of sh are s t he re by re duc i n g the EP S.

v) Mai n tai ni n g share pri c e s is c ruc i al . I n the l i be ral i se d sce nari o the
c a pi tal marke ts i s the i mpor tan t ave nue of fun ds for b usi ne ss. Di vi de n d
an d bo nus pol i ci e s frame d b y fi nanc e ma nage rs h ave a di re c t be ari n g
on the share p ri ce s.

vi ) Ens uri ng mana ge me nt c on trol is vi tal e spe ci al l y i n l i ght of fore i gn


p arti c i pati o n i n e qui ty, bac ke d by h uge re sourc e s mak i n g the fi rm a n
e asy take ove r targe t. Exi sti ng m ana ge me nts mi g ht l ose c ontrol i n the
e ve n tual i ty of bei n g un abl e to take up sh are e nti tl e me nts, fi nanc i al
stra te gie s, are vi tal to pre ve nt thi s.
I n a re sourc e s c onst rai nt si tu ati on, the i mp orta nc e of
fi na nc i al man age me nt i s hi g hl i ghte d as fi nanc i al stra te gie s are re qui re d
to ge t t he c om pa ny thro ug h the c onstr ai nts po si ti on. The re ason s for i t,
ma y be l ac k of de m and, sc arc i ty of raw mate ri al s, l ab our c ons trai nt s,
e tc . If the probl e m i s not prope rl y de al t wi t h at i ni ti al stage s, i t c oul d
l e ad ul ti ma tel y to b ank r uptc y and si c k ne ss. The fi nanc i al ma na ge r's
rol e i n suc h si tuati o ns, w oul d be fi rst to asc e rtai n, w he the r un de r the
c i rc ums tanc e s, the org ani sati o n i s vi a ble or not. I f the vi abi l i ty of the
organi s ati on, i tsel f i s i n dou bt, the n the al te rn ati ve of cl osi n g dow n
ope ra ti ons m ust be expl ore d. B ut, i n maj or c ase s t he pro bl e m c an be
sol ve d w i th pro pe r strate gi e s.

Ques t io n : What is t he re le van ce of t ime value o f mo ne y in


f inanci al d e cis io n mak ing ?

Ans we r : A fi nanc e ma nage r i s re q ui re d to make de c i si o ns on


i nve stme n t, fi n anc i n g an d di vi de nd i n vie w of the c ompa ny' s
obj e c ti ve s. The de c i si ons as p urc hase of asse ts or proc ure me nt of fu nds
i .e . the i nve stme nt/ fi na nc i ng de ci si ons affe c t the c ash fl ow i n di ffe re nt
ti me pe ri ods. C ash ou tfl ow s w oul d be at one poi n t of ti me and i nfl ow at
some ot he r p oi nt of ti me , he nc e, the y are not c om para bl e d ue to the
c ha nge i n ru pee val ue of mone y. The y c an be made c om para bl e by
i ntro duc i n g the i nte re st fac tor. I n t he the ory of fi nanc e , the i ntere st
fac t or i s one of t he c ruc i al a nd exc l usi ve c onc e pt, k now n as the ti me
val ue of mo ne y.
Ti me val ue of mo ne y me ans th at w orth of a rupe e re ce i ve d
to day i s di ffe re n t from the same re ce i ve d i n future . The pre fe re nc e for
mo ne y now as c omp are d to fut ure i s k now n as ti me pre fe re nc e of
mo ne y. The c onc e pt is ap pl i c abl e to bot h i ndi vi d ual s an d busi ne ss
ho use s.

Re as o ns o f t ime p ref e re nce of mo ne y :

1 ) Ris k :
The re i s unc e rtai nty a bout the re ce i pt of mone y i n fut ure .

2 ) Pre f e re nce f o r p re s e nt co ns ump t io n :


Mos t of the pe rsons a nd c om pa nie s have a pre fe re nc e for pre se nt
c ons um pti on may be due to u rge nc y of ne e d.

3 ) Inve s t me nt op po rt un it ies :
Mos t of the pe rsons a nd c om pa nie s have pre fe re nc e for pre se nt mone y
be c au se of av ai l abi l i tie s of op port uni ti e s of i nve st me nt for e arni n g
a ddi ti on al c ash fl ow s.

Imp o rt ance of t ime value o f mo ne y :


The c onc e pt of ti me val ue of mo ne y hel ps i n arri vi ng at the c omp arabl e
val ue of the di ffe re nt ru pee amo unt ari si n g at di ffe re nt poi nts of ti me
i nto e qui vale n t val ue s of a parti c ul ar poi n t of ti me , pre se nt or fu ture .
The c ash fl ow s ari si n g at di ffe re nt poi n ts of ti me c an be made
c om para bl e b y usi n g any one of the fol l ow i ng :
- by c ompo un di ng the pre se nt mo ne y to a fut ure d ate i. e. by fi n di n g out
the val ue of pre se nt mo ney.
- by di sc oun ti ng the f uture mone y to pre se nt d ate i. e. by fi n di n g out
the pre se nt val ue (PV) of fut ure mo ne y.

1 ) Te chniq ue s of co mpo und ing :


i) Fut u re value ( FV) o f a s ing le cas h f lo w :
The fut ure val ue of a si n gle c ash fl ow i s de fi ne d as :

FV = PV (1 + r)n

W he re, F V = fu ture val ue


P V = Pre se nt val ue
r = rate of i nte re st pe r ann um
n = nu mbe r of ye ars for w hi c h c om pou ndi n g i s done .
I f, a ny vari a ble i .e . PV, r, n varie s, the n F V al so vari e s. I t i s ve ry
te di ous to c al c ul ate the val ue of
(1 + r)n so di ffe re nt c ombi n ati ons are pu bl i she d i n the form of tabl e s.
The se may be re fe rre d for c om put ati on, ot he rw i se one sh oul d use the
k now l e dge of l ogari t hms.

ii) Fut u re value of an ann uit y :


A n ann ui ty i s a se ri e s of pe ri odi c c ash fl ow s, payme n ts or re c e i pts, of
e qual a mou nt. The pre mi um p ayme nts of a li fe i nsura nc e pol i c y, for
i nst anc e are an ann ui ty. I n ge ne ral te rms the fut ure val ue of a n ann ui ty
i s gi ve n as :

FVAn = A * ([(1 + r)n - 1]/r)


Where,

FVAn = Fu t u r e v a l u e o f a n a n n u i t y w h i c h h a s d u r a t i o n o f n y e a r s .

A = Constant periodic flow

r = Interest rate per period

n = Duration of the annuity

Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, rate of interest

a n d t h e t i m e p e r i o d , i f a n y o f t h e s e v a r i a b l e c h a n g e s i t w i l l c h a n g e t h e f u t u r e v a l u e o f t h e a n n u i t y. A
published table is available for various combination of the rate of interest 'r' and the time period 'n'.

2 ) Te chniq ue s of d is co unt ing :


i) Pre s e nt val ue of a s ing le c as h flo w :
The pre se nt val ue of a si ngl e c ash fl ow i s gi ve n as :

PV = FVn ( 1 )n
1 + r

Where,
FVn = F u t u r e value n years hence

r = rate of interest per annum

n = number of years for which discounting is done.

Fr o m a b o v e , i t i s c l e a r t h a t p r e s e n t v a l u e o f a f u t u r e m o n e y d e p e n d s u p o n 3 v a r i a b l e s i . e . F V , t h e r a t e o f

interest and time period. The published tables for various combinations of ( 1 )n

1 + r

are available.

ii) Pre s e nt val ue of an an nuit y :


So me ti me s i nste ad of a si ngl e c ash fl ow , c as h fl ow s of same amou nt i s
re ce i ve d for a nu mbe r of ye ars. The pre se nt val ue of a n ann ui ty ma y be
expre sse d as be l ow :

PVAn = A/(1 + r)1 + A/(1 + r)2 + ................ + A/(1 + r)n-1 + A/(1 + r)n

= A [1/(1 + r)1 + 1/(1 + r)2 + ................ + 1/(1 + r)n-1 + 1/(1 +


r) ]
n

= A [ (1 + r)n - 1]
r(1 + r)n

Where,
PVAn = Present value of annuity which has duration of n years
A = Constant periodic flow
r = Discount rate.

CH A PTER TH RE E

TOOL S OF FIN AN C IAL AN ALYSIS AN D PL AN N IN G


Ques t io n : Wr it e a no te o n Fin anci al St at e me nt An alys is ?

Ans we r : The basi s of fi na nc i al anal ysi s, pl an ni ng and de c i si on m ak i ng


i s fi nanc i al i nfo rma ti on. A fi rm pre p are s fi n al ac c oun ts vi z. B al a nc e
S hee t an d Profi t and Loss Ac c ou nt pro vi di n g i nformati on for de c i si on
mak i ng. Fina nc i al i nform ati on i s nee de d to pre di c t, c omp are an d
e val uate the fi rm 's e arni n g abi l i ty. Profi t an d Loss ac c o unt sh ow s the
c onc e rn's o pe rati ng ac ti vi tie s an d the B al anc e S hee t de pi c ts the
b al anc e val ue of the ac qui re d asse ts an d of l i abi l i tie s at a pa rti c ul ar
poi nt of ti me . Howe ve r, t he se state me nts do not di sc l ose al l of the
ne c e ssary an d rel e vant i nform ati on. For the pur pose of obt ai ni n g the
ma te ri al an d rel e vant i nform ati on ne c e ssary for asce rtai ni ng of
fi na nc i al stre ngt hs an d we ak ne sse s of an e nte rpri se , i t i s esse nti al to
an al yse t he d ata de pi c te d i n the fi n anc i al state me nt. The fi na nc i al
ma na ge r h ave ce rtai n anal yti c al tool s th at he l p i n fi na nc i al anal ysi s
an d pl a nni n g. I n a ddi ti on to stu dyi ng the past fl ow , the fi nanc i al
ma na ge r c a n e val uate future fl ow s by me ans of fun ds state me nt base d
on fore c ast s.
Fina nc i al State me nt Anal ysi s i s the proc e ss of i de nti fyi n g the
fi na nc i al stre ngt h an d we ak ne ss of a fi rm from the avai l abl e ac c ou nti ng
d ata an d fi na nc i al state me nts. I t i s do ne by pro pe rl y e stabl i shi ng
rel ati o nshi p be twe e n the i te ms of bal anc e she e t and profi t an d l oss
ac c o unt as,

1 ) The task of fi nanc i al an al ysts i s to de te rmi ne the i nform ati on


rel e van t to the de c i si o n un de r c o nsi de rati on from total i nfo rma ti on
c on tai ne d i n the fi na nc i al state me nt.

2 ) To arran ge i nform ati on i n a w ay to hi ghl i g ht si gni fi c a nt rel ati o nshi ps.

3 ) I nte rpre ta ti on an d draw i n g of i nfe re nc e s an d c onc l usi o n. Thus,


fi na nc i al anal ysi s i s the proc e ss of se l e c ti on, re l ati on and e val ua ti on of
the ac c o unti n g da ta/ i nformati o n.

Pu rpo s es o f Fin anci al St at e me nt An alys is : Fi nanc i al S tate me nt


A nal ysi s i s the me a ni ngf ul i nte rpre tati on of 'Fi na nc i al State me n ts' for
'Par tie s De man di n g Fi nanc i al I nformati o n', suc h as :

1 ) The G ove rnme n t may be i nte re ste d i n k now i n g the c om parati ve


e ne rgy c o nsum pti o n of some pri vate an d pu bl i c se c tor c e me nt
c om pa nie s.

2 ) A nati o nal i se d bank m ay may be ke e n to k now the possi ble de bt


c ove rage ou t of profi t at the ti me of l e ndi n g.

3 ) Prospe c ti ve i nve stors may be de si rous to k now the ac tual an d


fore c aste d yi e l d dat a.

4 ) C ustome rs w ant to k now the busi ne ss vi abi l i ty pri or to e nte ri n g i nto


a l on g-te rm c o ntrac t.
The re are othe r pur pose s al so, i n ge ne ral , the pur pose of
fi na nc i al state me nt a nal ysi s ai ds de c i si on mak i n g by use rs of ac c oun ts.
St e ps fo r f inan cia l st at e me nt an alys is :
• I de nti fi c ati on of the use r's p urpose
• I de nti fi c ati on of dat a sourc e , w hi c h p art of t he an nu al re port or
ot he r i nfo rma ti on i s re q ui re d to be anal yse d to sui t the pur pose
• Se l e c ti ng the te c hni q ue s to be use d for suc h anal ysi s
As suc h anal ysi s i s pu rposi ve , i t m ay be re stri c te d to any
p arti c ul ar p orti on of the av ai l abl e fi na nc i al state me nt, tak i n g c are to
e nsure obj e c ti vi ty an d un bi ase dne ss. I t c ove rs stu dy of rel ati o nshi ps
w i th a se t of fi nanc i al sta te me nts at a p oi nt of ti me an d wi t h tre nds, i n
the m, ove r ti me . I t c ove rs a stud y of some c omp ara ble fi rms at a
p arti c ul ar ti me or of a par ti c ul ar fi rm ove r a pe ri o d of ti me or may
c ove r bot h.

Typ e s of Fina nci al s t at e me nt a nal ys is : The mai n obj e c ti ve of


fi na nc i al anal ysi s i s to de te rmi ne the fi nanc i al he al th of a busi ne ss
e nte rpri se , w hi c h may be of the fol l owi n g type s :

1 ) Ex t e rna l an alys is : It i s pe rforme d by outsi de p arti e s, suc h as


tra de c re di tors, i nve stors, s u ppl i e rs of l ong te rm de bt, e tc.

2 ) Int e rn al a nalys is : I t is pe rforme d by c or porate fi na nc e a nd


ac c o unti n g de pa rtme nt and is more de tai le d than exte rnal anal ysi s.

3 ) H o rizo nt al ana lys is : Thi s an al ysi s c ompare s fi na nc i al state me nts


vi z. profi t and l oss ac c o unt and bal anc e she e t of pre vi o us ye ar wi th
th at of c u rre n t ye ar.

4 ) Ve rt ic al an alys is : Ve rti c al anal ysi s c on ve rts eac h el e me nt of the


i nfo rma ti on i nto a pe rc e nta ge of the total amo unt of state me nt so as to
e stabl i sh re l ati ons hi p w i th othe r c om pone n ts of the same state me nt.

5 ) Tre nd an alys is : Tre nd an al ysi s c omp are s rati os of di ffe re nt


c om pone n ts of fi na nc i al state me nts rel ate d to di ffe re n t pe ri od w i th tha t
of t he b ase ye ar.

6 ) Rat io An alys is : I t e stabl i she s the nu me ri c al or q ua nti tati ve


rel ati o nshi p be twe e n 2 i te ms/ vari abl e s of fi na nc i al state me nt so th at
the stre ng ths a nd w e ak ne sse s of a fi rm as al so i ts hi stori c al
pe rfo rma nc e a nd c u rre n t fi nanc i al p osi ti on ma y be de te rmi ne d.

7 ) Fund s f lo w st at e me n t : Thi s state me nt provi de s a c ompre he nsi ve


i de a abo ut t he mo ve me n t of fi nanc e i n a b usi ne ss uni t d uri ng a
p arti c ul ar pe ri od of ti me.

8 ) Bre ak- e ve n an alys is : Thi s ty pe of anal ysi s re fe rs to the


i nte rpre tati o n of fi na nc i al data that re pre se n t ope rati n g ac ti vi ti e s.
Ques t io n : What are t he us u ally fo llo we d rat io cat e g o rie s f o r
b us ine ss d at a a nalys is ? Me nt io n f inanc ial rat io s us e d in e ach
cat e go ry ?

Ans we r : Rati o An al ysi s i s a w i de l y use d tool of fi nanc i al a nal ysi s.


' Rati o ' i s re l ati onshi p expre sse d i n mathe m ati c al te rms be tw ee n 2
i ndi vi dual or gro up of fi gure s c onne c te d w i th e ac h othe r i n some
l ogi c al ma nne r; se l e c te d from fi nanc i al st ate me nts of the c onc e rn.
Ra ti o anal ysi s i s base d o n the fac t th at a si ngl e ac c ou nti ng fi gure by
i tse l f mi ght not c om mu ni c ate me a ni ngf ul i nformati on, b ut w he n
expre sse d i n re l ati on to some fi gure , i t ma y de fi ni tel y pro vi de ce rtai n
si g ni fi c ant i nfo rma ti on, thi s rel ati o nshi p be twe e n ac c ou nti n g fi gure s i s
k now n as fi nanc i al rati o. Fi nanc i al rati o he l ps to expre ss the
rel ati o nshi p be twe e n 2 ac c o unti n g fi g ure s i n a ma nne r tha t use rs c an
dr aw c onc l usi ons abou t the pe rformanc e , stre n gt hs an d we ak ne sse s of
a fi rm.

Cl ass if ic at io n of Rat io s :

I) Acco rd ing t o s o urce : Fina nc i al rati os ac c ordi ng to sourc e from


w hi c h t he fi g ure s are obtai ne d may be c l assi fi e d as be l ow :
1 ) Re ve nue rat ios : W he n 2 vari abl e s are take n from re ve nue
sta te me nt the rati o so c om pute d is k now n as, Re ve nue rati o.
2 ) B alan ce s he e t rat io : W he n 2 vari a ble s are take n from the b al anc e
she e t, the ra ti o so c omp ute d i s k now n as, B al anc e shee t rati o.
3 ) M ixe d rat io : W he n one vari abl e is ta ke n from the Re ve n ue
sta te me nt an d othe r from t he B al anc e shee t, the rati o so c om pu te d i s
k now n as, Mi xe d rati o.

II) Ac co rd ing to us ag e : Ge orge Foste r of S tanf ord Uni ve rsi ty gave


se ve n c ate gori e s of fi nanc i al rati os t hat exha usti ve l y c ove r di f fere nt
as pe c ts of a busi ne ss orga ni sati on, the y are :
1 ) C ash posi ti o n
2 ) Li q ui di ty
3 ) Work i ng C api t al /C as h Fl ow
4 ) C api tal struc ture
5 ) Profi ta bi li ty
6 ) De bt Se rvi ce C ove rage
7 ) Turno ve r
W hi le w ork i ng o n rati o anal ysi s, i t i s i mport ant to avoi d
d upl i c ati o n of w ork , as sa me i nfo rma ti on ma y be provi de d by more t han
one rati o, the anal ys t has to be se le c ti ve i n re spe c t of the use of
fi na nc i al rati os. The ope rati ons and fi n anc i al posi ti o n of a fi rm c an be
de sc ri be d b y stu dyi ng i ts short an d l on g te rm l i qui di ty posi ti on,
pro fi tabi l i ty an d ope rati o nal ac ti vi ti e s. Th us, rati os may be c l assi fi e d as
fol l ow s :
1 ) Li q ui di ty rati os
2 ) C api tal struc ture /l e ve ra ge rati os
3 ) Ac ti vi ty rati os
4 ) Profi ta bi li ty rati os
Ques t io n : Dis cuss t he vario us rat io s in d et a il ?

Ans we r :
1 ) L iq uid it y rat io s :
'L i qui di ty' and 'shor t-te rm sol ve nc y ' are use d as synon yms,
me ani ng a bi li ty of the b usi ne ss to pa y i ts short- te rm l i abi l i tie s.
I nabi l i ty to pay- off short te rm li a bi li ti e s affe c ts the c onc e rn 's c re di bi li ty
an d c re di t rati n g; c onti nu ous de fa ul t i n pay me nts l e ads to c om me rci al
b ank ru ptc y that e ve ntual l y l e ads to si c k ne ss an d di ssol uti o n. Shor t-
te rm le nde rs an d c re di t ors of a b usi ne ss are i nte re ste d i n k now i n g the
c onc e rn's st ate of li q ui di ty for t hei r fi na nc i al stake . Tradi ti o nal l y
c u rre n t an d qui c k rati os are use d to hi g hl i gh t the busi ne ss 'l i q ui di ty ',
ot he rs may be c ash rati o, i nte rval me asure rati o a nd ne t w ork i ng
c a pi tal rati o.

i) Cu rre nt r at io :

C urre nt rati o = C urre nt As se ts/C u rre nt Li a bi li ti e s

W he re,
C urre nt asse ts = I nve ntori e s + S un dry de bt ors + C as h and B ank
b al anc e s + Re ce i vabl e s/ Ac c r ual s +
Loans and adva nc e s + Di sposa bl e I nve stme nts.
C urre nt li abi l i ti e s = C re di to rs for goo ds an d se rvi ce s + Short -te rm
Loa ns + B ank O ve rdra ft + C ash
c re di t + O utst an di ng expe nse s + Provi si on for
tax ati on + Pro pose d di vi de n d +
Unc l ai me d di vi de nd.

C urre nt ra ti o i ndi c ate s the avai l abi l i ty of c u rre n t asse ts to


me e t c urre nt l i abi l i tie s, hi ghe r the rati o, be tte r i s the c ove ra ge.
Tr adi ti on al l y, i t i s c all e d 2 : 1 rati o i .e . 2 i s the stan dard c urre nt asse ts
for e ac h u ni t of c urre nt li abi l i ty. The le ve l of c urre nt rati o vary from
i nd ustry to i ndu stry de pe n di ng on the spe c i fi c i n dustr y c harac te ri sti c s
an d al so a fi rm di ffe rs from the i nd ustry rati o due to i ts pol i c y.

ii) Quick r at io :

Q ui c k rati o or ac i d te st rati o = Q ui c k Asse ts/ C urre nt or Q ui ck


l i abi l i tie s

W he re,
Q ui c k asse ts = S un dry de bt ors + C ash an d B ank bal anc e s +
Re ce i vabl e s/ Ac c r ual s +
Loans and adva nc e s + Di sposa bl e I nve stme nts i. e.
= C urre nt asse ts - I nve n tori e s.
C urre nt li abi l i ti e s = C re di to rs for goo ds an d se rvi ce s + Short -te rm
Loa ns + B ank O ve rdra ft + C ash
c re di t + O utst an di ng expe nse s + Provi si on for
tax ati on + Pro pose d di vi de n d +
Unc l ai me d di vi de nd.
Q ui c k li a bi li ti e s = C re di t ors for go ods a nd se rvi ce s + Shor t-te rm Loa ns
+ O utsta ndi n g expe nse s

+ Provi si on for ta xati on + Pro pose d di vi de nd +


Unc l ai me d di vi de nd i. e.
= C urre nt li a bi li ti e s - Bank ove rdraft - C ash c re di t.

I n the above formul a, i nste ad of total c urre nt li abi l i ti e s onl y


th ose c u rre nt l i abi l i tie s are ta ke n that are pa yabl e wi thi n 1 ye ar tha t
are k now n as q ui c k li abi l i ti e s. Q ui c k asse ts are al so c al le d li q ui d
asse ts, the y c onsi sts of c ash an d onl y ' ne ar c ash asse ts '. I nve nt orie s
are de duc te d from c urre nt asse ts, as t he y are not c onsi de re d as 'ne ar
c as h asse ts', bu t i n a se l le r 's marke t t he y are not so c onsi de re d. J ust
l i ke l ag i n c ol l e c ti on of de bt ors, the re i s l ag i n c onve rsi on of
i nve nto rie s i nto fi ni s he d goo ds an d sun dry de b tors, al so sl ow -movi n g
i nve nto rie s are not ne ar c ash asse ts. W hi l e c al c ul a ti ng the q ui c k rati o,
the c onse rva ti sm c onve n ti on, qui c k l i abi l i tie s are t hat p orti on of
c u rre n t li a bi li ti e s that fal l d ue i m me di ate l y, he nc e bank ove rdra ft an d
c as h c re di t are exc l ude d.

ii i) Cas h r at io :

C ash rati o = (C as h + Mar ke tabl e se c uri ti e s)/ C urre nt l i abi l i tie s

The c ash rati o me asure s absol u te l i qui di ty of the busi ne ss avai l abl e
w i th the c onc e rn.

iv) Int e rv al me as ure :

I nte rval me asure = (C u rre nt asse ts - I nve n tory)/ Ave ra ge d ai l y


ope rati n g expe nse s

W he re,
Ave rage dai l y ope rati n g expe nse s = (C ost of g oods + Se l li n g,
a dmi ni str ati ve a nd ge ne ral expe nse s -
De pre c i ati o n and othe r non- c ash
expe n di ture )/ no. of day s i n a ye ar.

2 ) C ap it al s t ruct ure / L e ve rag e rat io s :


The c api tal str uc ture or le ve rage rati os are de fi ne d as, those
fi na nc i al rati os th at me asure l ong te rm stabi l i ty an d struc ture of the
fi rm and i ndi c ate mi x of fun ds pro vi de d by ow ne rs an d l e nde rs, i n orde r
to ass ure l e nde rs of l ong te rm fun ds as to :
• Pe ri o di c payme n t of i nte re st d uri ng the pe ri o d of the l oan, an d
• Re pay me nt of the pri nc i pal amo unt o n mat uri ty.
The y are cl assi fi e d as :

i) C ap it al s t ruct ure rat io s :


C api tal str uc ture rati os pro vi de an i nsi gh t i nto the fi na nc i ng
te c hni que s use d by a busi ne ss an d c onse q ue ntl y foc us on the l ong- te rm
sol ve nc y po si ti on. From t he b al anc e shee t one c an ge t a bsol ute fu nd
e mpl oye d and i ts sourc e s, bu t c api tal str uc ture rati os sh ow re l ati ve
w ei g ht of di ffe re nt sourc e s. Fun ds on l i abi l i tie s si de of bal a nc e she e t
are cl assi fi e d as ' ow ne r's e qui ti e s' an d 'exte rn al e qui tie s' al so c all e d
'e q ui ty' and 'de bt '. Ow ne r's e qui tie s or e qui ty me a ns share hol de r' s
fu nds c onsi sti ng of e qui ty an d pre fe re nc e share c api tal an d re se rve s
an d sur pl us. Exte rn al e qui tie s me ans all outsi de l i abi l i tie s i nc l usi ve
of c urre nt l i abi l i tie s an d provi si o ns, w hil e de bt i s cl assi fi e d as l on g
te rm borrow e d fu nds t hus, exc l udi ng sh ort-te rm l oans, c urre nt
l i abi l i tie s an d provi si on s. As pe r gui de l i ne s for i ssue of 'De be n ture s by
Publ i c L i mi te d C ompa ny' de bt me ans te rm l oans, de be nt ure s a nd bo nds
w i th an i ni ti al ma turi ty pe ri o d of ye ars or more i nc l usi ve of i nte re st
ac c r ue d the re on, al l de fe rre d payme n t li a bi li ti e s, propose d de be nture
i ssue bu t exc l udi n g shor t-te rm b ank bo rrow i ngs and a dva nc e s,
u nse c ure d l oans or de posi t s from the p ubl i c , share hol de rs an d
e mpl oye e s and unse c ure d l oans a nd de p osi ts from ot he rs. C api t al
str uc ture rati os use d are :

a) Owne r's Eq uit y t o t o t al Eq uit y :

O w ne r's Eq ui ty to tot al e qui ty rati o = Ow ne r's Equi ty/ To tal Equi t y

I t i ndi c ate s prop orti on of ow ne rs ' fun d to tot al fun d i nve ste d
i n b usi ne ss. Tradi ti o nal be li e f says, hi ghe r the pro porti o n of ow ne r's
fu nd low e r is the de gree of ri sk .

b ) De b t Eq uit y Rat io :

De bt- e qui ty rati o = De bt/ E qui ty

I t is the i ndi c at or of l eve rage , show i ng the propor ti on of de b t


fu nd i n re l ati on to e qui ty. I t i s re fe rre d i n c a pi tal struc t ure de c i si on as
al so i n the l e gi sl ati o ns de al i ng wi th t he c a pi tal struc t ure de ci si ons i. e.
i ssue of share s an d de be nture s. Le n de rs are ke e n to k now thi s rati o as
i t show s rel ati ve w ei g hts of de bt and e qui ty. As pe r tradi ti on al sc hool ,
c ost of c api tal fi rstl y de c re ase s d ue to the hi ghe r dose of le ve rage ,
re ac he s mi ni mu m an d the re afte r i nc re ase s, thus i nfi ni te i nc re ase i n
l e ve ra ge i .e . de bt- e qui ty rati o i s not p ossi bl e. How e ve r, ac c ordi ng to
Mo di gl i ani -Mi l le r the ory, c ost of c api tal an d l e ve rage are i nde pe nde nt
of e ac h ot he r a nd b ase d on c e rtai n re stri c ti ve ass um pti ons, na me l y,
- pe rfe c t c api tal m arke ts
- ho moge ne ous expe c tati ons b y the pre se nt and prospe c ti ve i nve stors
- pre se nc e of ho mo ge ne o us ri sk c l ass fi rms
- 1 00 % di vi de nd pa y- ou t
- no ta x si tuati o n an d so on.
Most of the above assu mpti o ns are u nre ali sti c . I t is be l ie ve d
th at l e ve rage an d c ost of c a pi tal are re l ate d. There i s no norm for
ma xi mu m de bt- e qui ty rati o, l e ndi ng i nsti tuti o ns usu al l y, se t the i r ow n
no rms c o nsi de ri ng t he c a pi tal i nte nsi ty an d othe r fac t ors.
ii) Co ve r ag e r at io s :
The c ove rage rati o me asure s the fi rm' s abi l i ty to se rvi ce fi xe d
l i abi l i tie s. The se rati os esta bl i sh the re l ati ons hi p be tw ee n fi xe d c l ai ms
an d w hat is us ual l y avai l abl e out of w hi c h t he se c l ai ms are to be p ai d.
The fi xe d c l ai ms c onsi st of :
• I nte re st o n l oans
• Pre fe re nc e di vi de n d
• A morti sati o n of pri nc i pal or re p ayme nt of the i nstal me nt of l oa ns
or re de mpti o n of pre fe re nc e c api tal on maturi ty. The y are
c l assi fi e d as fol l ow s :

a) De b t s e rvice co ve r ag e r at io :
Le nde rs are i nte re ste d i n j udgi n g the fi rm 's abi l i ty to p ay off
c u rre n t i nte re st an d i nstal me nts an d th us the de bt se rvi ce c ove rage
rati o.

De bt se rvi ce c ove rage rati o = Earni ngs av ai l abl e for de bt


se rvi c e / (I nte re st + I nstal me n ts)

W he re,
Ea rni n g avai l abl e for de bt se rvi c e = Ne t profi t + N on- c ash ope rati ng
expe nse s l i ke de pre c i ati on
an d othe r amo rti sati on s + N on-
ope ra ti ng a dj ust me nts as l oss on
sal e of fi xe d asse ts + I nte re st on
de b t fun d.

b ) Int e re s t co ve rag e rat io :


I t is al so k now n as " ti me s i nte re st e arne d rati o" an d
i ndi c a te s the fi rm's a bi li ty to mee t i nte re st obl i gati o ns an d othe r fi xe d
c ha rge s.

I nte re st c ove ra ge rati o = EBI T/ I nte re st

W he re,
EB I T = Earni ngs Be fore I nte re st an d Ta x
EBI T i s use d i n the nu me rator as the abi l i ty to p ay i nte re st is
no t affe c te d by ta x bu rde n as i nte re st on de bt fun ds i s a de d uc ti bl e
expe nse . Thi s rati o i ndi c ate s the exte nt to w hi c h earni ngs may fal l
w i tho ut c ausi n g an y di ffi c ul t to t he fi rm re ga rdi n g the pa yme nt of
i nte re st c harge s. A hi gh i nte re st c ove rage rati o me ans th at an
e nte rpri se c an e asil y me e t i ts i ntere st obl i ga ti ons e ve n i f EB I T su ffe r a
c onsi de rabl e de cl i ne , w hi l e a l ow e r rati o i ndi c ate s exc e ssi ve use of
de b t or i ne ffi c i e nt ope rati o ns.

c) Pre f e re nce d ivid e nd co ve rag e rat io :


I t me asure s the fi rm's abi l i ty to pay pre fe re nc e di vi de n d at t he sta te d
rate .

Pre fe re nc e di vi de nd c ove ra ge rati o = EAT/ Pre fe re nc e di vi de nd l i abi l i ty


W he re,
E AT = Ea rni n gs afte r ta x
EAT i s c onsi de re d as u nl i ke de b t on w hi c h i nte re st i s a c ha rge
on the fi rm's profi t, pre fe re nc e di vi de nd i s an a ppro pri ati on of profi t.
The rati o i ndi c a te s margi n of safe ty avai l a ble to pre fe re nc e
sh are h ol de rs. A hi ghe r rati o i s de si rabl e from pre fere nc e share hol de rs
poi nt of vi ew.

ii i) Cap it a l Ge ari ng rat io :

C api t al ge ari ng rati o = (Pre fe re nc e Sh are C api t al + De be nture s + Lon g


te rm l oan)/
(Eq ui ty share c api tal + Re se rve s & S urpl us - Losse s)

I t is use d i n a ddi ti on to de bt e qui ty rati o to show the


pro porti o n of fi xe d i nte re st/ di vi de n d be ari ng c api tal to fu nds bel o ngi n g
to e qui t y share hol de rs.

For the j ud gi ng of the l on g-te rm sol ve nc y posi ti on, i n ad di ti on


to de b t-e qui ty and c api tal ge ari n g rati os, the fol l owi n g are use d :

a) Fix e d Ass e ts / L o ng t e rm f und : Fixe d asse ts an d c ore w ork i ng


c a pi tal are expe c te d to be fi na nc e d by l on g te rm fu nd. I n vari ous
i nd ustri e s the prop orti on of fi xe d an d c urre n t asse ts are di ffe re nt, thu s
the re c an be no uni f orm stan dard of thi s rati o, b ut i t shoul d be le ss
th an 1 . I f i t is more tha n 1 , i t me ans sho rt-te rm fun d has be e n use d to
fi na nc e fi xe d asse ts, ofte n bi g c om pani e s re sort to suc h p rac ti c e duri n g
expa nsi on. Thi s m ay be a te m porar y arra nge me nt but n ot a l ong- te rm
re me dy.

b ) Pro p rie t a ry r at io :

Pro pri e tary rati o = Pro pri e tary fu nd/ Total asse ts

W he re,
Pro pri e tary fu nd = Eq ui ty share c api tal + Pre fe re nc e share c api tal +
Re se rve s & surpl u s - Fi ci ti ti ou s
asse ts
Tot al asse ts = Al l asse ts, b ut exc l u de s fi c ti ti o us asse ts an d l osse s.
I t is possi ble to re duc e e qui ty sta ke b y l owe ri ng li qui di ty rati o
i .e c urre nt rati o,
Ex amp le : W he n c u rre nt an d de bt- e qui ty rati os are bot h 2 : 1 e ac h,
an d the pro porti o n of fi xe d and c urre nt asse ts i s
5 : 1 E qui ty/ tot al asse ts = 3 1. 67 % but i f t he c u rre n t rati o i s re d uc e d to
1 .5 : 1 e qui ty/ total asse ts = 31 .1 1 %.

3 ) Act ivit y r at ios :


The ac ti vi ty rati os al so k now n as turnove r or pe rformanc e
rati os are e mpl oye d to e val ua te the e ffi c ie nc y w i th w hi c h t he fi rm
ma na ge s a nd u ti li se s i ts asse ts. The se rati os usu al l y i ndi c ate the
fre que nc y of sale s w i th re spe c t to i ts asse ts, w hi c h m ay be c api tal
asse ts or w ork i ng c api tal or ave rage i nve ntory. The se are c al c ul ate d
w i th re fe re nc e to sale s/ c ost of go ods sol d and are expre sse d i n te rms of
rate or ti me s. The y are as fol l ow s :
i) C ap it al t urno ve r rat io :

C api t al turnove r rati o = S ale s/ C api t al empl o ye d

I t i ndi c ate s the fi rm's abi l i ty of ge ne rati n g sale s pe r ru pee


of l on g te rm i nve stme nt, t he hi ghe r the rati o, more e ffi c ie nt i s the
uti l i sati o n of the ow ne r's an d l ong- te rm c re di tors' fun ds.

ii) Fix e d Ass e ts t urno ve r r at io :

Fixe d Asse ts tu rno ve r rati o = Sal e s/ C api tal asse ts

A hi g h fi xe d asse ts turnove r rati o i ndi c a te s e ffi c ie nt


uti l i sati o n of fi xe d asse ts i n ge ne rati on of sal e s. A fi rm w hose pl ant and
mac hi ne ry are ol d may show a hi ghe r fi xe d asse ts turn ove r rati o tha n
the fi rm w ho purc h ase d the m re ce ntl y.

ii i) Wo rk ing cap it a l t urno ve r r at io :

Work i ng c a pi tal turnove r = Sal e s/ Work i n g C api tal

I t i s fu rthe r di vi de d as bel ow :
a) Inve nt o ry t urno ve r rat io :

I nve n tory tu rnove r rati o = Sal e s/ Ave rage i nve ntor y

W he re,
Ave rage i nve n tory = (O pe ni ng S toc k + C l osi ng stoc k )/2
I t may al so be c al c ul ate d wi th re fere nc e to c ost of sal e s i nste ad of
sal e s, as :

I nve ntory turnove r rati o = C ost of sale s/ Ave ra ge i nve nt ory

For i nve ntor y of raw mate ri al ,

I nve ntory turnove r rati o = Raw mate ri al c onsu me d/ Ave rage raw
ma te ri al stoc k .

Thi s rati o i n di c ate s the spee d of i nve nt ory usa ge . A hi gh


rati o is goo d from li q ui di ty poi nt of vi ew an d vi ce ve rsa. A l ow rati o
i ndi c a te s that i nve nt ory i s not use d/ sol d or i s l ost an d stay s i n a shel f
or i n the w are house for a l ong ti me.

b ) De b to rs t urno ve r r at io :
W he n a fi rm se l l s g oods on c re di t, the re ali sati o n of sal e s
re ve n ue i s de l aye d an d re c e i vabl e are c re ate d. C ash is re ali se d from
the se re c ei va bl e s l ate r on, the spe e d wi t h w hi c h i t is re ali se d affe c ts
the fi rm 's l i qui di t y posi ti on. De btors turnove r rati o throw s l i gh t on the
c ol le c ti o n and c re di t p ol i ci e s of the fi rm.

De b tors tu rnove r rati o = Sal e s or C re di t sal e s/ Ave rage ac c ou nts


re ce i vabl e

As ac c o unt re ce i va ble pe rtai ns to c re di t sale s onl y, i t i s


ofte n re c om me nde d to c omp ute de btor 's turnove r wi t h re fe re nc e to
c re di t sal e s rat he r tha n total sal e s.

Ave rage c oll e c ti on pe ri od = Ave rage ac c o unts re ce i va ble s/ ave rage dai l y
c re di t sal e s

W he re,
ave ra ge d ai l y c re di t sal e s = C re di t sale s/3 6 5
The above rati os provi de a uni q ue g ui de for de te rmi ni n g the
fi rm 's c re di t pol i c y.

c) C red it o rs t urno ve r r at io :
I t is c al c ul ate d on same li ne as de bt ors turnove r rati o an d
show s the ve l oc i ty of de bt payme n t by the fi rm,

C re di tors turnove r rati o = C re di t purc hase s or An nual ne t c re di t


purc hase s / Ave rage ac c ou nts p ayabl e

A l ow rati o re fl e c ts li be ral c re di t te rms gra nte d b y sup pl ie rs,


w hi le a hi g h rati o re fle c ts ra pi d se ttle me nt of ac c ou nts.

Ave rage payme n t pe ri od = Ave rage ac c ou nts p ayabl e / ave rage dai l y
c re di t p urc ha se s
W he re,
ave ra ge d ai l y c re di t p urc hase s = cre di t p urc hase s/ 36 5
The fi rm c an c ompare w hat cre di t pe ri od i t re ce i ve s fro m the
su ppl i e rs and w hat i t offe rs to the c usto me rs. I t c an al so c om pare the
ave ra ge c re di t pe ri od offe re d to the c usto me rs i n the i ndust ry to w hi c h
i t be l ongs.

4 ) Pro f it ab il it y rat io :
The profi ta bi l i ty rati os me asure profi ta bi l i ty or the ope rati on al
e ffi c ie nc y of the fi rm re fl e c ti ng t he fi nal re sul ts of b usi ne ss ope rati ons.
The re sul ts of the fi rm ma y be eval ua te d i n te rms of i ts e arni n gs w i th
re fe re nc e to a gi ve n le vel of asse ts or sal e s or ow ne rs i nte re st, etc .
Th us, the profi ta bi li ty rati os are bro adl y c l assi fi e d i n fol l owi n g
c ate go rie s :
i) Pro f it ab il it y rat io s are re q uire d f o r a nalys is f ro m o wne rs p o int
o f vie w :
a) Re t urn o n e q uit y (ROE) : I t me asure s the profi ta bi li ty of e qui ty
fu nds i nve ste d i n t he fi rm and re ve al s how profi ta bl y the ow ne r's fu nds
are uti l i se d b y the busi ne ss.

RO E = Profi t afte r taxe s/ Ne t w ort h

b ) E arni ngs pe r sha re ( EPS) : The profi t abi l i ty of a fi rm fro m vie w


poi nt of ordi nary share hol de rs c an be me asure d i n te rm s of nu mbe r of
e qui ty share s k now n as e arni n gs pe r share .

EPS = N e t pro fi t avai l abl e to e qui ty hol de rs/ n o. of ordi nary sh are s
ou tsta ndi n g

c) Divid e nd pe r sha re : EP S as ab ove re fle c ts t he pro fi tabi l i ty of a


fi rm pe r share, i t doe s not re fle c t how m uc h profi t i s pai d as di vi de nd
an d how m uc h i s re tai ne d by the bu si ne ss. Di vi de nd pe r share ra ti o
i ndi c a te s the a mou nt of profi t di stri b ute d to share hol de rs pe r sh are.

Di vi de nd pe r sh are = Total profi ts di stri b ute d to e qui ty share


hol de rs/ N um be r of e qui ty share s

d ) Pr ice Ea rning r at io (P. E. Rat io ) : The pri ce e arni n g rati o


i ndi c a te s the expe c ta ti on of e qui ty i nve sto rs abo ut the e arni n gs of the
fi rm and re l ate s to marke t pri c e an d i s ge ne ral l y take n as a sum mary
me asure of grow t h pote n ti al of an i nve stme nt, ri sk c harac te ri sti c s,
sh are h ol de rs orie nt ati on, c orp orate i mage an d de gree of l i qui di ty.

P. E. Ra ti o = Mar ke t pri ce pe r share / EPS

ii) Pro f it ab il it y rat io s b as e d on as s et s/ in ves t me nt s :

a) Re t urn o n cap it al e mp lo yed / Ret ur n o n Inves t me nt ( ROI) :

RO I = Re tu rn/ C api t al e mpl oye d * 1 00

W he re,
Re turn = N e t profi t + / - N on-tra di ng adj ust me nts exc l u di ng ac c r ual
a dj ustme n ts for amo rti sati on of
pre li mi nary expe nse s, goo dw il l , etc . + I nte re st on l ong te rm
de b ts + Provi si on for tax -
I nte re st/ Di vi de nd fro m non- tra de i nve stme n ts.
C api t al e mpl oye d = E qui ty sh are c a pi tal + Re se rve s & Sur pl us +
Pre fe re nc e share c api tal + De be n ture s
an d othe r l ong te rm l oan - Mi sc el l ane ou s
expe n di ture and l osse s - N on-tra de
i nve stme nts.

I t c an be furt he r bi furc ate d as :

RO I = (Re turn/ sale s) * (Sal e s /C a pi tal e mpl oye d) * 10 0


W he re,
Re turn/ sale s * 1 00 = Profi t abi l i ty rati o
S ale s / C api tal e mpl oye d = C api tal tu rnove r rati o
Th us,
RO I = Profi ta bi l i ty rati o * C api tal tu rnove r rati o

RO I c an be i mprove d by i mprovi ng o pe rati ng profi t or c api t al turn ove r


or bo th.

c) Re t urn o n as se t s (ROA) :
The profi t abi l i ty rati o i s me asure d i n te rms of re l ati onshi p be twe e n ne t
pro fi ts an d asse ts e mpl oye d to e arn t hat pro fi t. It me asure s the fi rm 's
pro fi tabi l i ty i n te rms of asse ts empl o ye d i n the fi rm.

ROA = N e t profi t afte r taxe s/ Ave rage total asse ts or


= Ne t profi t a fte r taxe s/ Ave rage tan gi bl e asse ts or
= Ne t profi t a fte r taxe s/ Ave rage fi xe d asse ts.

The c ause of any i nc re ase or de c re ase i n RO I c an be tr ac e d out onl y


afte r a c ompl e te a nal ysi s thro ugh expe nse s a nd t urno ve r ra ti os.

ROI = Return/Capital employed * 100

Profitability ratios Capital Turnover ratio (Sales/Capital


(Return/Sales * 100) employed)
i) Material i) Fixed Fixed assets Working capital turnover
consumed/sales expenses/Sales turnover ratio ratio (sales/working
* 100 * 100 (sales/fixed capital)
assets)
ii) Wages/Sales *
100
ii) Variable Turnover of
iii) expenses/Sales individual Debt Credit
Manufacturing * 100 assets Invento
or's or's
expenses/sales ry
turno turnov
*100 turnove
ver er
r ratio
ratio ratio
iv)
Administration
expenses/sales *
100

v) Selling &
Distribution
expenses/Sales
* 100

ii i) Pro f it ab ilit y r at ios b as ed o n s ales o f t he f irm :

a) Gro ss p rof it r at io :

Gros s profi t rati o = Gross profi t/ sal e s * 1 00

I t i s use d to c omp are de p artme nt al or prod uc t profi t abi l i ty. If c osts are
c l assi fi e d sui ta bl y i nto fi xe d an d vari abl e el e me n ts, the n i nste ad of
gros s profi t rati o one m ay fi nd P/ V rati o.

P/ V rati o = (Sal e s - Vari abl e c ost)/ Sal e s * 10 0

Fixe d c ost re mai ni n g same , hi ghe r the P/ V rati o low e r is the bre ak e ve n
poi nt (B. E. P. ) O pe rati ng pro fi t rati o i s c al c ul ate d to e val uate ope rati ng
pe rfo rma nc e of b usi ne ss.

b ) Op e rat ing p rof it r at io :

O pe rati n g profi t rati o = O pe rati n g profi t/ S ale s * 1 00

W he re,
O pe rati n g profi t = Sal e s - C ost of sale s

c) N e t p ro f it r at io : I t me asure s the ove ral l profi ta bi li ty of the


b usi ne ss.
N e t profi t rati o = Ne t profi t/ sal e s * 10 0

Ques t io n : Are f inan cia l rat io s re le vant in f inanci al de cis io n


mak ing ?

Ans we r : A po pul ar te c hni que of anal ysi ng the pe rforma nc e of a


b usi ne ss c onc e rn i s tha t of fi na nc i al rati o anal ysi s, i t, as a tool of
fi na nc i al man age me nt i s of c ruc i al si gni fi c a nc e. I ts i mport anc e li e s i n
the fac t that i t pre se nts fac t s on a c om para ti ve ba si s and ena ble s
dr aw i ng of i nfe re nc e s as re gards a fi rm 's pe rfo rma nc e. I t is rel e vant i n
asse ssi n g the fi rm's pe rform anc e i n the bel ow me nti one d aspe c ts :

I) Fin anci al r at ios f o r e valuat io n of pe rf o rman ce :

• L iq uid it y po s it io n : Ra ti o anal ysi s assi sts i n draw i ng


c onc l usi ons as re gards the fi rm 's l i qui di ty posi ti on. I t w oul d be
sati sf ac tory if the fi rm is abl e to mee t i ts c u rre n t obl i ga ti ons
w he n the y be c ome due . A fi rm c an be sai d to ha ve the abi l i ty to
me e t i ts short- te rm li a bi li ti e s i f i t has suffi c ie n t li q ui di ty to pay
i nte re st on i ts short- mat uri n g de bt, usu al l y wi thi n a ye ar as al so
the pri nc i pal . Thi s abi l i ty i s re fle c te d i n the l i qui di t y rati os of the
fi rm and li q ui di ty rati os are use ful i n c re di t anal ysi s by bank s a nd
ot he r su ppl i e rs of short -te rm l oans.

• L o ng - t e rm so lve ncy : Rati o anal ysi s is e qual l y he l pful for


asse ssi n g a fi rm' s l ong- te rm fi nanc i al vi a bi li ty. Thi s aspe c t of the
fi na nc i al posi ti on of a borrow e r i s of c onc e rn to the l on g-te rm
c re di tors, se c uri ty anal ys ts an d the pre se n t and pote nti al ow ne rs
of a b usi ne ss. The l on g-te rm sol ve nc y is me asure d by the
l e ve ra ge/ c api t al struc t ure a nd pro fi tabi l i ty rati os foc usi n g on
e arni n g pow e r an d ope rati n g e ffi ci e nc y an d rati o a nal ysi s re ve al s
the stre ng th an d w e ak ne sse s of a fi rm i n re spe c t the re to. The
l e ve ra ge rati os, for exa mpl e , i n di c ate s w he the r a fi rm has a
re asona bl e pro porti o n of vari ou s sourc e s of fi nanc e or w he the r
he avi l y l oade d w i th de b t i n w hi c h c ase i ts sol ve nc y i s expose d to
se ri ous strai n. I n the same ma nne r, vari ous pro fi tabi l i ty rati os
re ve al w he the r or not t he fi rm i s a ble to offe r ade q uate re t urn to
i ts ow ne rs c onsi ste nt wi th t he ri sk i nvol ve d.

• Op e rat ing e ff icie n cy : Rati o an al ysi s throw s l i ght on the de gree


of e ffi c ie nc y i n t he m ana ge me nt an d uti l i sati on of i ts asse ts.
Vari ous ac ti vi t y rati os me asure thi s k i nd of ope rati onal e ffi c ie nc y,
a fi rm 's sol ve nc y i s, i n the ul ti mate anal ysi s, de pe nde n t on the
sal e s re ve nue s ge ne rate d by the use of i ts asse ts - total as we ll
as i ts c om pone n ts.

• Ove r- al l- p ro f it ab ilit y : Unl i ke ou tsi de parti e s, that are


i nte re ste d i n one as pe c t of the fi nanc i al po si ti on of a fi rm, t he
ma na ge me nt i s c onsta ntl y c onc e rne d abou t the ove ral l
pro fi tabi l i ty of the e nte rpri se i. e. the y are c onc e rne d ab out the
fi rm 's a bi li ty to mee t i ts short- te rm an d l ong -te rm obl i g ati ons to
i ts c re di tors, to e nsure re ason abl e re tu rn to i ts ow ne rs an d
se c ure o pti mu m uti l i sati on of the fi rm's asse ts. I t i s possi bl e i f an
i nte gr ate d vie w i s take n an d al l t he rati os are c onsi dere d
to ge the r.

• Int e r- f irm co mp aris o n : Rati o anal ysi s not onl y throw s l i ght on
the fi rm 's fi na nc i al posi ti on but al so se rve s as a ste ppi n g stone
to re me di al me asure s. I t i s made possi ble by i nte r-fi rm
c om pari so n/ c omp ari son w i th i nd ustry ave rage . It sho ul d be
re asona bl y expe c te d tha t the fi rm' s pe rform anc e i s i n bro ad
c on formi t y wi t h that of the i ndus try to w hi c h i t be l ong s. An i nte r-
fi rm c omp ari son de mo nstra te s the re l ati ve po si ti on vi s-à-vi s i ts
c om pe ti tors. I f t he re sul ts are at vari anc e ei the r w i th the i nd ustry
ave ra ge or w i th th at of the c om pe ti tors, the fi rm c an se e k to
i de nti fy the prob abl e re asons and i n i ts l i gh t, take re me di al
me asure s. Rati os not onl y pe rfo rm po st-mo rte m of ope rati o ns,
b ut al so se rve s as b arome te r for fut ure, the y ha ve pre di c tor y
val ue an d are he l pf ul i n fore c asti ng a nd pl a nni n g fut ure b usi ne ss
ac ti vi ti e s and hel ps i n bu dge ti ng.

II) Fi nanc ial rat io s fo r b ud g e t ing : I n thi s fi el d rati os are a ble to


pro vi de a gre at de al of assi stanc e , bu dge t i s onl y an e sti mate of fu ture
ac ti vi ty base d on past expe ri e nc e, i n the mak i n g of w hi c h the
rel ati o nshi p be twe e n di ffe re n t sphe re s of ac ti vi tie s are i nval ua ble . I t i s
us ual l y possi bl e to e sti mate bu dge te d fi g ure s usi ng fi na nc i al rati os.
Ra ti os al so c an be ma de use of for me as uri ng ac tual pe rfo rma nc e w i th
b ud ge te d fi gure s and i ndi c ate di re c ti ons i n w hi c h adj us tme nts shoul d
be ma de e i the r i n the bud ge t or i n pe rformanc e to bri n g the m c l ose r to
e ac h ot her.

Ques t io n : What are t he limit at io ns o f f inan cia l rat io s ?

Ans we r : Li mi ta ti ons of fi n anc i al rati os are as fol l ow s :

i) Dive rs if ie d p ro d uct line s : Ma ny b usi ne sse s ope ra te a l arge


n um be r of di vi si o ns i n qui te di ffe re n t i ndu stri e s. I n suc h c ase s rati os
c al c ul ate d on the basi s of a ggre ga te d ata c a nnot be use d for i nter-fi rm
c om pari so ns.

ii) Fi nanc ial d at a are b ad ly d is to rt e d by inf lat io n : Hi stori c al c ost


val ue s ma y be subst anti al l y di ffe re nt from true val ue s, suc h di storti o ns
i n fi na nc i al data are al so c arri e d i n fi na nc i al rati os.

ii i) Se as o nal f act o rs may als o inf lue n ce f inanci al d at a

iv) To g ive g oo d shap e t o t he f inan cia l rat io s us e d po p ular ly :


The bu si ne ss may ma ke so me ye ar-e nd adj ustme n ts, suc h w i ndow -
dre ssi n g c an c ha nge the c harac te r of fi nanc i al rati os t hat w oul d be
di ffe re nt ha d the re be e n no c h an ge.

v) Di ffe re nc e s i n ac c ou nti n g pol i c ie s an d ac c ou nti n g pe ri od ma ke t he


ac c o unti n g da ta of 2 fi rms no n-c om para bl e as al so t he ac c o unti ng
rati os.

vi ) The re i s no sta nda rd se t of rati os a gai nst w hi c h a fi rm's rati os may


be c om pare d, some ti me s, i f a fi rm de ci de s to be abo ve ave ra ge t he n,
i nd ustry ave rage be c ome s a l ow sta nda rd. O n the othe r ha nd, for a
be l ow ave rage fi rm, i ndu stry ave ra ge s be c ome too hi gh as st and ards to
ac hi e ve .

vi i ) It i s di ffi c ul t to ge ne ral i se w he the r a pa rti c ul ar rati o is goo d or ba d,


for i nst anc e , a l ow c urre nt rati o may be ' bad ' from the vi e w p oi nt of l ow
l i qui di t y, w hil e a hi gh c u rre nt rati o ma y be 'ba d' as i t m ay re sul t from
i ne ffi c ie nt w orki n g c api t al mana ge me nt.

vi i i ) Fi nanc i al rati os are i nter-re l ate d an d not i n de pe nde nt, w he n


vi ew e d i n i sol ati on o ne rati o may hi g hl i ght effi c ie nc y but, as a se t of
rati os i t m ay spe ak di ffe re n tl y. S uc h i nte rde pe nde nc e amon g the rati os
c an be ta ke n c are of t hrou gh m ul ti vari ate anal ysi s. Fi nanc i al rati os
pro vi de cl ue s bu t not c onc l usi ons. The se are tool s i n the ha nds of
expe rts as t he re i s no stan dard re ady- made i nte rpre tati o n of fi nanc i al
rati os.

Ques t io n: wh at are t he var io us r at ios b as ed o n cap it al marke t


info rm at io n?

Ans we r : fre que ntl y share p ri ce s da ta are punc he d w i th ac c ou nti n g


d ata to ge ne rate ne w se t of i nfo rma ti on, the se are :

i) Pr ice e arn ing rat io :


Pri c e e arni ng rati o (PE rati o) = ave rage or cl osi n g share pri c e s/ EPS

I t i ndi c ate s the pay bac k pe ri od to i nve stors or pros pe c ti ve i nve stors.

ii) Yie ld :

Yi e l d = di vi de nd/ ave ra ge or c l osi ng share pri ce * 10 0

I t i ndi c ate s re tu rn on i nve stme nt, w hi c h may be on ave rage


or c l osi ng i nve stme nt. Di vi de nd % i ndi c ate s re turn on pai d-u p val ue of
sh are s, bu t, yie l d % i s t he i n di c ator of tr ue re turn i n w hi c h share
c a pi tal i s ta ke n at i ts mar ke t val ue.

ii i) M arke t v alue /b o ok va lue fo r s hare :


Mar ke t val ue for share / book val ue pe r share = ave rage share pri c e / (ne t
w orth/ nu mbe r of e qui ty share s)
or

= cl osi n g share pri c e/ (ne t


w orth/ num be r of e qui ty share s)

I t i ndi c ate s marke t re spon se of sh are hol de rs' i nve stme n t.


Hi g he r t he rati o be tte r i s the share hol de rs p osi ti on i n te rms of re turn
an d c api t al gai ns.

Ques t io n: wh at are t he rat io s co mp ute d fo r inve s t me nt ana lys ts ?

Ans we r : Inve stme n t anal ysi s are pu bl i she d we e kl y i n e c onomi c


ne w spa pe rs, so me rati os are use d b y anal ysi s to re port pe rform anc e of
se le c te d c om pani e s. Le t us di sc uss the i ssue s hi ghl i g hte d by Ec onomi c
Ti me s un de r t he c a pti on ' pe rformanc e i ndi c at ors' :

i ) B ook val ue pe r share = (e q ui ty c a pi tal + re se rve s an d surpl us


exc l u di ng re val ua ti on re se rve s)/ num be r

of e qui ty sh are s

i i ) EPS = (ne t profi t - pre fe re nc e di vi de nd)/ n um be r of e qui ty share s

i i i ) di vi de n d %

i v) yie l d % = e qui ty di vi de n d/ marke t pri c e * 10 0

v) pa yout rati o % = di vi de n d i nc l udi ng pre fe re nc e di vi de n d/ profi t afte r


tax * 1 00

vi ) gross m argi n/ sale s (%)


w he re ,
gros s margi n = profi t be fore de pre ci ati o n bu t afte r i nte re st and be fore
tax

vi i ) gross ma rgi n/ c a pi tal e mpl oye d (%)


w he re ,
gros s margi n = profi t be fore de pre ci ati o n bu t afte r i nte re st and be fore
tax
c a pi tal e mpl oye d = fi xe d asse ts + c api tal w ork -i n- progre ss +
i nve stme n ts + c u rre nt asse ts
i .e . ag gre g ate of fi xe d asse ts, c a pi tal w ork -i n-pro gre ss, i nve stme nt and
c u rre n t asse ts bu t exc l udi n g ac c u mul ate d de fi c i t.

vi i i ) PE rati o = p ri ce /e a rni n gs

i x) c urre nt rati o = c u rre n t asse ts/ c urre nt l i abi l i tie s


Ques t io n : ho w do e s t he cas h f lo w an alys is he lp a bus ine ss e nt it y
?

Ans we r : c ash fl ow an al ysi s i s a n i mport ant tool wi th the fi n anc e


ma na ge r for asce rt ai ni ng the c han ge s i n c as h i n han d an d ba nk
b al anc e s as from one da te to anot he r, d uri ng the ac c o unti ng ye ar an d
al so be tw ee n tw o ac c o unti ng pe ri ods. I t show s i nfl ow s an d outfl ow s of
c as h i. e . sourc e s an d ap pl i c ati ons of c ash d uri ng a parti c ul ar pe ri o d.
The proc e d ure for pre p arati on of c ash fl ow state me nt, i ts obj e c ti ve s
an d re qui re me nts are c ove re d i n AS- 3. I t is an i mporta nt tool for short-
te rm anal ysi s, li ke othe r fi na nc i al state me nts, i t i s a nal yse d to re ve al
si g ni fi c ant re l ati onshi ps. Tw o maj or are as, that anal ysts exami ne w hil e
st udyi n g a c ash fl ow sta te me n t are di sc usse d as be l ow:

1 ) c as h ge ne rat i ng e ff ic ie ncy :
i t i s t he a bi li ty of a c ompa ny to ge ne rate c ash from i ts
c u rre n t or c onti n ui ng ope rati ons. Fol l ow i ng rati os are use d for t he
p urpo se.

i) c as h flo w yie ld :
c as h fl ow yi e l d = ne t c ash fl ow from ope rati n g ac ti vi ti e s/ ne t i nc ome

ii) c as h flo w t o s ales :


c as h fl ow to sale s = ne t c as h fl ow fro m ope rati n g ac ti vi ti e s/ ne t sal e s

ii i) cas h f lo ws t o ass e ts :
c as h fl ow to asse ts = ne t c ash fl ow from o pe rati ng ac ti vi tie s/ ave rage
tot al asse ts

2 ) Fre e cas h f lo w :
stri c tl y c ash fl ow i s the amou nt of c as h tha t re mai ns afte r
de d uc ti n g fun ds th at the c om pany has to c om mi t to c on ti nue ope rati n g
at i ts pl a nne d l e ve l . Suc h c ommi t me nt has to c ove r c u rre nt or
c on ti nui n g ope rati o ns, i nte re st, i nc ome tax, di vi de n d, ne t c api tal
expe n di ture s and so on. If the c ash fl ow i s posi ti ve , i t me ans the
c om pa ny has me t al l i ts pl an ne d c ommi t me nt an d has c ash avai l abl e to
re duc e de bt or exp and. A ne gati ve fre e c ash fl ow me ans the c om pany
w i ll have to se ll i nve stme nts, b orrow mo ne y or i ssue stoc k i n shor t-
te rm to c onti n ue at i ts pl a nne d le ve l .

3 ) o t he rs :
be si de s me asuri n g c ash e ffi c ie nc y and fre e c as h fl ow, w i th
the he l p of c ash fl ow sta te me nt, the fi nanc i al an al ysts al so c al c ul ate s a
n um be r of ra ti os base d on c ash fi g ure s rat he r than on e arni n g fi gure s.
So me of w hi c h are as be l ow:

i ) pri c e pe r share / free c ash fl ow pe r share


i i ) ope rati ng c ash fl ow / ope rati n g profi t
i t show s th at ac c ru al adj ust me nts are not h avi ng se ve re e ffe c t on
re porte d profi ts.

i i i ) se lf-fi na nc i n g i nve stme nt rati o = i nte rnal f undi ng/ ne t i nve stme nt
ac ti vi ti e s
i t i ndi c ate s how m uc h of t he fu nds ge ne rate d by t he b usi ne ss are re -
i nve ste d i n asse ts.

Ques t io n : what do yo u me an b y fund s f lo w an alys is ?

Ans we r : Fun ds fl ow anal ysi s i s an i mp orta nt l ong- te rm an al ysi s tool i n


the ha nds of fi nanc e ma nage r for asc e rtai ni ng c ha nge s i n fi na nc i al
po si ti on of fi rm be twe e n tw o ac c oun ti ng pe ri o ds. It an al yse s re asons
for c h an ge s i n fi na nc i al posi ti on be twe e n tw o bal anc e she e ts and show s
the i nfl ow an d outfl ow of fu nds i. e. sourc e s an d ap pl i c ati on of f und s
d uri ng a parti c ul a r pe ri od.
I t provi de s i nformati o n tha t bal a nc e she e t and profi t an d l oss ac c ou nt
fai l to provi de i .e . c han ge s i n fi nanc i al posi ti o n of an ente rpri se , w hi c h
i s of gre at he l p to the use rs of fi na nc i al i nform ati on. I t is of gre at he l p
to m ana ge me nt, share hol de rs, c re di t ors, broke rs, e tc. as i t he l ps i n
an swe ri n g the fol l ow i n g que sti on s:

- w he re have the profi ts gone ?


- w hy the re is an i mbal anc e exi sti ng be twe e n li q ui di ty an d profi t abi l i ty
po si ti on of the e nte rpri se ?
- w hy i s the c onc e rn fi na nc i al l y soli d i nspi te of l osse s ?

• The proj e c te d fun ds fl ow state me nt c a n be pre pare d for


b ud ge tary c on trol and c api tal expe ndi t ure c o ntrol i n the
organi s ati on. A proj e c te d fu nds fl ow state me nt may be pre pare d
an d re sourc e s prope rl y al l oc ate d afte r an anal ysi s of pre se nt
sta te of af fai rs.
• The opti mum uti l i sati on of av ai l abl e fu nds is e sse n ti al for ove rall
grow t h of the e nte rpri se. The fun ds fl ow state me nt pre p are d i n
a dvanc e gi ve s a c le ar-c ut di re c ti on to the mana ge me nt i n thi s
re gard.
• I t i s al so use ful to mana ge me nt for j u dgi n g the fi nanc i al
ope ra ti ng pe rfo rma nc e of the c ompa ny an d i ndi c ate s w ork i ng
c a pi tal posi ti on that he l ps the m ana ge me nt i n tak i n g pol i c y
de c i si ons re gardi ng di vi de nd, e tc . It he l ps the ma nage me nt to
te st w he the r the w orki n g c api t al is e ffe c ti ve l y use d or not and
th at w ork i ng c api tal l eve l i s ade q uate or i nade q uate for the
re qui re me nts of b usi ne ss.
• I t hel p s i nve stors to de c i de w he t he r c om pa ny has fun ds man age d
pro pe rl y, i n di c ate s c re di tw ort hi ne ss of a c omp any that he l ps
l e nde rs to de c i de w he the r to l e nd mo ne y to the c omp any or n ot.
I t hel p s man age me nt to make de c i si o ns an d de c i de a bout the
fi na nc i ng pol i c ie s an d c api tal expe n di ture progr am me for f uture .
CHAPTER FOUR

CAPITAL BUDGETING

Question : Explain the meaning of capital budgeting ?

Answer : The term capital budgeting means planning for


capital assets. Capital budgeting decision means the decision
as to whether or not to invest in long-term projects such as
setting up of a factory or installing a machinery or creating
additional capacities to manufacture a part which at present
may be purchased from outside and so on. It includes the
financial analysis of the various proposals regarding capital
expenditure to evaluate their impact on the financial
condition of the company for the purpose to choose the best
out of the various alternatives. The finance manager has
various tools and techniques by means of which he assists
the management in taking a proper capital budgeting
decision. Capital budgeting decision is thus, evaluation of
expenditure decisions that involve current outlays but are
likely to produce benefits over a period of time longer than
one year. The benefit that arises from capital budgeting
decision may be either in the form of increased revenues or
reduced costs. Such decision requires evaluation of the
proposed project to forecast likely or expected return from
the project and determine whether return from the project is
adequate. Also as business is a part of society, it is its moral
responsibility to undertake only those projects that are
socially desirable. Capital budgeting decision is an
important, crucial and critical business decision due to :

1) substantial expenditure :
capital budgeting decision involves the investment of
substantial amount of funds and is thus it is necessary for a
firm to make such decision after a thoughtful consideration,
so as to result in profitable use of scarce resources. Hasty
and incorrect decisions would not only result in huge losses
but would also account for failure of the firm.

2) long time period :


capital budgeting decision has its effect over a long period of
time, they affect the future benefits and also the firm and
influence the rate and direction of growth of the firm.

3) irreversibility :
most of such decisions are irreversible, once taken, the firm
may not been in a position to reverse its impact. This may be
due to the reason, that it is difficult to find a buyer for
second-hand capital items.

4) complex decision :
capital investment decision involves an assessment of future
events, which in fact are difficult to predict, further, it is
difficult to estimate in quantitative terms all benefits or
costs relating to a particular investment decision.

Question: discuss the various types of capital


investment decisions?

Answer : there are various ways to classify capital


budgeting decisions, generally they are
classified as :

1) on the basis of the firm's existence :


capital budgeting decisions are taken by both newly
incorporated and existing firms. New firms may require to
take decision in respect of selection of plant to be installed,
while existing firms may require to take decision to meet the
requirements of new environment or to face challenges of
competition. These decisions may be classified into:

i) replacement and modernisation decisions :


replacement and modernisation decisions aims to improve
operating efficiency and reduce costs. Usually, plants require
replacement due to they been economically dead i.e. no
more economic life left or on they becoming technologically
outdated. The former decision is of replacement and latter
one of modernisation , however, both these decisions are
cost reduction decisions.

ii) Expansion decision : existing successful firms may


experience growth in demand of the product and may
experience shortage or delay in delivery due to inadequate
production facilities and thus, would consider proposals to
add capacity to existing product lines.

iii) Diversification decisions : these decisions require


evaluation proposals to diversify into new product lines, new
markets, etc. to reduce risk of failure by dealing in different
products or operating in several markets. expansion and
diversification decisions are revenue expansion decisions.

2) on the basis of decision situation :

i) mutually exclusive decisions : decisions are said to be


mutually exclusive when two or more alternative proposals
are such that acceptance of one would exclude the
acceptance of the other.

ii) Accept-Reject decisions : the accept-eject decisions


occurs when proposals are independent and do not compete
with each other. The firm may accept or reject a proposal on
the basis of a minimum return on the required investment.
All those proposals which have a higher return than certain
desired rate of return are accepted and rest rejected.

iii) Contigent decisions :


contigent decisions are dependable proposals, investment in
one requires investment in another.

Question: what are the various projects evaluation


techniques explain them in detail ?'

Answer : At each point of time, business manager, has to


evaluate a number of proposals as regards various projects
where he can invest money. He compares and evaluates
projects and decides which one to take up and which to
reject. Apart from financial considerations, there are many
other factors considered while taking a capital budgeting
decision. At times a project may be undertaken only to
establish foothold in the market or for better welfare of the
society as a whole or of the business or for increasing the
safety and security of workers, or due to requirements of law
or because of emotional reasons for instance, many
industrial sector projects are taken up at home towns even if
better locations are available. The major consideration in
taking a capital budgeting decision is to evaluate its returns
as compared to its investments. Evaluation of capital
budgeting proposals have two dimensions i.e. profitability
and risk, which are directly related. Higher the profitability,
higher would be the risk and vice versa. Thus, the finance
manager has to strike a balance between profitability and
risk. Following are some of the techniques used to evaluate
financial aspects of a project :

1) payback period :
it is one of the simplest method to calculate period
within which entire cost of project would be completely
recovered. It is the period within which total cash inflows
from project would be equal to total cash outflow of project,
cash inflow means profit after tax but before depreciation.

merits :

a) this method of evaluating proposals for capital budgeting


is simple and easy to understand, it has an advantage of
making clear that it has no profit on any project until the
payback period is over i.e. until capital invested is
recovered. When funds are limited, they may be made to do
more by selecting projects having shorter payback periods.
This method is particularly suitable in the case of industries
where risk of technological services is very high. In such
industries, only those projects having a shorter payback
period should be financed since changing technology would
make the projects totally obsolete, before all costs are
recovered.

b) in case of routine projects also use of payback period


method favours projects that generates cash inflows in
earlier years, thereby eliminating projects bringing cash
inflows in later years that generally are conceived to be risky
as this tends to increase with futurity.

c) by stressing earlier cash inflows, liquidity dimension is


also considered in selection criteria. This is
important in situations of liquidity crunch and high cost of
capital.
d) payback period can be compared to break-even point, the
point at which costs are fully recovered but profits are yet to
commence.

e) the risk associated with a project arises due to uncertainty


associated with cash inflows. A shorter payback period
means that uncertainty with respect to project is resolved
faster.

Limitations : Technique of payback period is not a scientific


one due to the following reasons:

a) It stresses capital recovery rather than profitability. It


does not take into account returns from the project after its
payback period. For example : project A may have payback
period of 3 years and project B of 8 years, according to this
method project A would be selected, however, it is possible
that after 3 years project B earns returns @ 20 % for another
3 years while project A stops yielding returns after 2 years.
Thus, payback period is not a good measure to evaluate
where the comparison is between 2 projects, one involving
long gestation period and the other yielding quick results but
for a short period.

b) this method becomes an inadequate measure of


evaluating 2 projects where the cash inflows are uneven.

c) this method does not give any consideration to time value


of money, cash flows occurring at all points of time are
simply added. This treatment is in contravention of the basic
principle of financial analysis that stipulates compounding or
discounting of cash flows and when they arise at different
points of time.

Some accountants calculate payback period after


discounting cash flows by a pre-determined rate and the
payback period so calculated is called "discounted payback
period".

2) payback reciprocal :
it is reciprocal of the payback period. A major
drawback of the payback period method of capital budgeting
is that it does not indicate any cut off period for the purpose
of investment decision. It is, argued that reciprocal of
payback would be a close approximation of the internal rate
of return if the life of the project is at least twice the
payback period and project generates equal amount of final
cash inflows. In practice, payback reciprocal is a helpful tool
for quickly estimating rate of return of a project provided its
life is at least twice the payback period.

payback reciprocal = average annual cash inflows/initial


investment

3) accounting or average rate of return method (ARR) :


accounting or average rate of return means
average annual yield on the project. Under this method profit
after tax and depreciation as percentage of total investment
is considered.

rate of return = (total profit * 100)/(net investments in the


project * number of years of profits)
this rate is compared with the rate expected on the
projects, had the same funds been invested alternatively in
those projects. Sometimes, the management compares this
rate with minimum rate known as cut-off rate.

Merits :
It is a simple and popular method as it is easy to
understand and includes income from the project throughout
its life.

Limitations :
it is based upon crude average profits of the future
years. It ignores the effect of fluctuations in profits from year
to year. And thus ignores time value of money which is very
important in capital budgeting decisions.

4) net present value method :


the best method for evaluation of investment
proposal is net present value method or discounted cash flow
technique. This method takes into account the time value of
money. The net present value of investment proposal may be
defined as sum of the present values of all cash inflows as
reduced by the present values of all cash outflows
associated with the proposal. Each project involves certain
investments and commitment of cash at certain point of
time. This is known as cash outflows. Cash inflows can be
calculated by adding depreciation to profit after tax arising
out of that particular project.
NPV = CF 0 /(1+K) 0 + CF 1 /(1+K) 1 .............................+
CF n /(1+K) n

= Σ(t=0 to n) CF t /(1+K) t

Where,
NPV = Net present value of a project
CF 0 = Cash outflows at the time 0(zero).
CF t = Cash flows at the end of year t(t = 0 to n) i.e. the
difference between cash inflow and outflow).
K = Discount rate
n = Life of the project

• Discounting cash inflows : Once cash inflows and


outflows are determined, next step is to discount each
cash inflow and work out its present value. For the
purpose, discounting rates must be known. Normally,
the discounting rate equals the opportunity cost of
capital as a project must earn at least that much as is
paid out on the funds locked in the project. The concept
of present value is easy to understand .To calculate
present value of various cash inflows reference shall be
had to the present value table.

• Discounting cash outflows : The cash outflows also


requires discounting as the whole of investment is not
made at the initial stage itself and will be spread over a
period of time. This may be due to interest-free
deferred credit facilities from suppliers of plant or some
other reasons. Another change in cash flows to be
considered in the capital budgeting decision is the
change due to requirement of working capital. Apart
from investment in fixed assets, each project involves
commitment of funds in working capital. The
commitment on this account may arise as soon as the
plant starts production. The working capital
commitment ends after the fixed assets of the project
are sold out. Thus, while considering the total outflows,
working capital requirement must also be considered in
the year the plant starts production. At the end of the
project, the working capital will be recovered and can
be treated as cash inflow of last year.
• Acceptance rule : A project can be accepted if NPV is
positive i.e. NPV > 0 and rejected; if it is negative i.e.
NPV < 0. If NPV = 0, project may be accepted as it
implies a project generates cash flows at the rate just
equal to the opportunity cost of capital.

Merits :

1) NPV method takes into account the time value of money.

2) The whole stream of cash flows is considered.

3) NPV can be seen as addition to the wealth of shareholders.


The criterion of NPV is thus in conformity with basic financial
objectives.

4) NPV uses discounted cash flows i.e. expresses cash flows


in terms of current rupees. NPV's of different projects
therefore can be compared. It implies that each project can
be evaluated independent of others on its own merits.

Limitations :

1) It involves different calculations.

2) The application of this method necessitates forecasting


cash flows and the discount rate. Thus accuracy of NPV
depends on accurate estimation of these 2 factors that may
be quite difficult in reality.

3) The ranking of projects depends on the discount rate.

5) Desirability factor/Profitability Index :


In cases of, a number of capital expenditure
proposals, each involving different amounts of cash inflows,
the method of working out desirability factor or profitability
index is followed. In general terms, a project is acceptable if
its profitability index value is greater than 1.

Merits :

1) This method also uses the concept of time value of money.

2) It is a better project evaluation technique than NPV.

Limitations of Profitability index :

1) Profitability index fails as a guide in resolving 'capital


rationing' where projects are indivisible. Once a single large
project with high NPV is selected, possibility of accepting
several small projects that together may have higher NPV,
then a single project is excluded.

2) Situations may arise where a project selected with lower


profitability index may generate cash flows in such a manner
that another project can be taken up one or two years later,
the total NPV in such case being more than the one with a
project having highest Profitability Index.

The profitability index approach thus, cannot be


used indiscriminately but all other type of alternatives of
projects would have to be worked out.

6) Internal Rate of Return(IRR) :


IRR is that rate of return at which the sum total of
discounted cash inflows equals to discounted cash outflows.
The IRR of a project is the discount rate that makes the net
present value of the project equal to zero.

CO 0 = CF 0 /(1+r) 0 + CF 1 /(1+r) 1 .............................+ CF n /(1+r) n


+ (SV + WC)/(1+r) n
= Σ(t=0 to n) CF t /(1+r) t + (SV + WC)/(1+r) n
...........................................
Where,
CO 0 = Cash outflows at the time 0(zero).
CF t = Cash flows at the end of year t.
r = Discount rate
n = Life of the project
SV & WC = Salvage value and Working capital at the end of
'n' years.

The discount rate i.e. cost of capital is assumed to


be known in the determination of NPV, while in the IRR, the
NPV is set at 0(zero) and discount rate satisfying this
condition is determined. IRR can be interpreted in 2 ways :

1) IRR represents the rate of return on the unrecovered


investment balance in the project.

2) IRR is the rate of return earned on the intial investment


made in the project.

It may not be possible for all firms to reinvest


intermediate cash flows at a rate of return equal to the
project's IRR, hence the first interpretation seems to be more
realistic. Thus, IRR should be viewed as the rate of return on
unrecovered balance of project rather than compounded rate
of return on initial investment over the life of the project.
The exact rate of interpolation as follows :

IRR = r + [(PV C FAT - PV C 0 )/ PV * r

Where,
PV C FAT = Present value of cash inflows (DF r * annuity)
PV C 0 = Present value of cash outlay
r = Either of 2 interest rates used in theformula
r = Difference ininterest rates
PV = Difference in present values ofinflows

Acceptance Rule :
The use of IRR, as a criterion to accept capital
investmentdecision involves a comparison of IRR with
required rate of return called as Cutoff rate. The project
should the accepted if IRR is greater than cut off rate.If IRR
is equal to cut off rate the firm is indifferent. If IRR less than
cutoff rate, the project is rejected.

Merits :

1) This method makes use of the concept of time value


ofmoney.

2) All the cash flows in the project areconsidered.

3) IRR is easier to use as instantaneous understanding


ofdesirability is determined by comparing it with
the cost of capital.

4) IRR technique helps in achieving the objective


ofminimisation of shareholders wealth.

Demerits :

1) The calculation process is tedious if there are more


thanone cash outflow interspersed between the cash inflows
then there would bemultiple IRR's, the interpretation of
which is difficult.
2) The IRR approach creates a peculiar situation if
wecompare the 2 projects with different inflow/outflow
patterns.

3) It is assumed that under this method all future cashinflows


of a proposal are reinvested at a rate equal to IRR which is
aridiculous assumption.

4) In case of mutually exclusive projects, investmentoptions


have considerably different cash outlays. A project with large
fundcommitments but lower IRR contribute more in terms of
absolute NPV and increasesthe shareholders' wealth then
decisions based only on IRR may not becorrect.

Question : What is the significance of cut off rate?

Answer: Cut off rateis the minimum that the management


wishes to have from any project, usually itis based on cost of
capital. The technical calculation of cost of capitalinvolves a
complicated procedure, as a concern procures funds from any
sourcesi.e. equity shares, capital generated from its own
operations and retained ingeneral reserves i.e. retained
earnings, debentures, preference share capital,long/short
term loans, etc. Thus, the firm's cost of capital can be known
onlyby working out weighted average of the various costs of
raising various types ofcapital. A firm should not and would
not invest in projects yielding returns ata rate below the cut
off rate.

Question : Distinguish between desirability factor, NPV


andIRR method of ranking projects?

Answer :In case of anundertaking having 2 or more


competing projects and a limited amount of fundsat its
disposal, the question of ranking the projects arises. For
every project,desirability factor and NPV method would give
the same signal i.e. accept orreject. But, in case of mutually
exclusive projects, NPV method is preferred dueto the fact
that NPV indicates economic contribution of the project in
absoluteterms. The project giving higher economic
contribution ispreferred.
As regards NPV vs.IRR method, one has to consider
the basic presumption under each. In case ofIRR, the
presumption is that intermediate cash inflows will be
reinvested at therate i.e. IRR, while that under NPV is that
intermediate cash inflows arepresumed to be reinvested at
the cut off rate. It is obvious that reinvestmentof funds at
cut off rate is possible than at the internal rate of return,
whichat times may be very high. Hence the NPV obtained
after discounting at a fixedcut off rate are more reliable for
ranking 2 or more projects than theIRR.

Question : Write a note on capital rationing?

Answer :Usually, firmsdecide maximum amount that can be


invested in capital projects, during a givenperiod of time, say
a year. The firm, then attempts to select a combination
ofinvestment proposals, that will be within specific limits
providing maximumprofitability and rank them in descending
order as per their rate of return,this is a capital rationing
situation. A firm should accept all investmentprojects with
positive NPV, with an objective to maximise the wealth
ofshareholders. However, there may be resource constraints
due to which a firm mayhave to select from amongst various
projects. Thus, there may arise a situationof capital rationing
where, there may be internal or external constraints
onprocurement of funds needed to invest in all investment
proposals with positiveNPV's. Capital rationing can be
experienced due to external factors, mainlyimperfections in
capital markets attributable to non-availability of
marketinformation, investor attitude, and so on. Internal
capital rationing is due toself-imposed restrictions imposed
by management as, not to raise additional debtor lay down a
specified minimum rate of return on each project. There
arevarious ways of resorting to capital rationing. It may put
up a ceiling when ithas been financing investment proposals
only by way of retained earnings i.e.ploughing back of
profits. Capital rationing can also be introduced by
followingthe concept of 'Responsibility Accounting', whereby
management may introducecapital rationing by authorising a
particular department to invest upto aspecified limit, beyond
which decisions would be taken by the higher-ups.Selection
of a project under capital rationing involves :

1) Identification of the projects that can be accepted byusing


evaluation technique as discussed.

2) Selection of the combination ofprojects.

In capital rationing, it would be desirable to acceptseveral


small investment proposals than a few large ones, for a
fullerutilisation of the budgeted amount. This would result in
accepting relativelyless profitable investment proposals if
full utilisation of budget is a primaryconsideration. It may
also mean that the firm forgoes the next
profitableinvestment following after the budget ceiling, even
if it is estimated to yielda rate of return higher than the
required rate. Thus capital rationing does notalways lead to
optimum results.

Question : Discuss the estimation of future cash flows?

Answer :In order touse any technique of financial


evaluation, data as regards cash flows from theproject is
necessary, implying that costs of operations and returns from
theproject for a considerable period in future should be
estimated. Future, isalways uncertain and predictions can be
made about it only with reference tocertain probability
levels, but, still would not be exact, thus, cash flows areat
best only a probability. Following are the various stages or
steps used indeveloping relevant information for cash flow
analysis :

1)Estimation of costs :To estimate cash outflows,


information as regards followingare needed which may be
obtained from vendors or contractors or by internalestimates
:

i) Cost of new equipment;

ii) Cost of removal and disposal of old equipment less


scrapvalue;
iii) Cost of preparing the site and mounting of
newequipment; and

iv) Cost of ancillary services required for new equipmentsuch


as new conveyors or new power supplies and so on.

The vendor may haverelated data on costs of


similar equipment or the company may have to estimatecosts
from its own experience. But, cost of a new project specially
the oneinvolving long gestation period, must be estimated in
view of the changes inprice levels in the economy. For
instance high rates of inflation has causedvery high
increases in the cost of various capital projects. The impact
ofpossible inflation on the value of capital goods must thus,
be assessed andestimated in working out estimated cash
outflow. Many firms work out a specificindex showing
changes in price levels of capital goods such as
buildings,machinery, plant and machinery, etc. The index is
used to estimate the likelyincrease in costs for future years
and as per it, estimated cash outflows areadjusted. Another
adjustment required in cash outflows estimates is
thepossibility of delay in the execution of a project
depending on a number offactors, many of which are beyond
the management's control. It is imperativethat an estimate
may be made regarding the increase in project cost due to
delaybeyond expected time. The increase would be due to
many factors as inflation,increase in overhead expenditure,
etc.

2)Estimation of additional working


capitalrequirements :The next step is toascertain additional
working capital required for financing increased activityon
account of new capital expenditure project. Project planners
often do nottake into account the amount required to finance
the increase in additionalworking capital that may exceed
amount of capital expenditure required. Unlessand until this
factor is taken into account, the cash outflow will
remainincomplete. The increase in working capital
requirement arises due to the needfor maintaining higher
sundry debtors, stock-in-hand and prepaid expenses, etc.The
finance manager should make a careful estimate of the
requirements ofadditional working capital. As the new capital
project commences operation, cashoutflows requirement
should be shown in terms of cash outflows. At the expiry
ofthe useful life of the project, the working capital would be
released and can bethus, treated as cash inflow. The impact
of inflation is also to be brought intoaccount, while working
out cash outflows on account of working capital. In
aninflationary economy, working capital requirements may
riseprogressively eventhough there is increase in activity of
a new project. This is because the valueof stock, etc. may
rise due to inflation, hence, additional working
capitalrequirements on this account should be shown as cash
outflows.

3)Estimation of production and sales :Planning for a new


project requires anestimate of the production that it would
generate and the sale that it wouldentail. Cash inflows are
highly dependent on the estimation of production andsales
levels. This dependence is due to peculiar nature of fixed
cost. Cashinflows tend to increase considerably after the
sales are above the break-evenpoint. If in a year, sales are
below the break-even point, which is quitepossible in a large
capital intensive project in the initial year of itscommercial
production, the company may even have cash outflows in
terms oflosses. On the basis of additional production units
that can be sold and priceat which they may be sold, the
gross revenues from a project can be worked out.In doing so
however, possibility of a reduction in sale price, introduction
ofcheaper or more efficient product by competitors,
recession in the marketconditions and such other factors are
to be considered.

4)Estimation of cash expenses :In thisstep, the amount of


cash expenses to be incurred in running the project after
itgoes into commercial production are to be estimated. It is
obvious thatwhichever level of capacity utilisation is attained
by the project, fixed costsremains the same. However,
variable costs vary with changes in the level ofcapacity
utilisation.

5)Working out cash inflows :The difference between gross


revenues and cash expenses hasto be adjusted for taxation
before cash inflows can be worked out. In view ofdepreciation
and other taxable expenses, etc. the tax liability of the
companymay be worked out. The cash inflow would be
revenues less cash expenses andliability for taxation.
One problem is oftreatment of dividends and
interest. Some accountants suggest that interestbeing a cash
expense is to be deducted and dividends to be deducted from
cashinflows. However, this seems to be incorrect. Both
dividends and interestinvolve a cash outflow, the fact
remains that these constitute cost of capital, hence,
ifdiscounting rate, is itself based on the cost of capital,
interest on long termfunds and dividends to equity or
preference shareholders should not be deductedwhile
working out cash inflows. The rate of return yielded by a
project at acertain rate of return is compared with cost of
capital for determining whethera particular project can be
taken up or not. If the cost of capital becomespart of cash
outflows, the comparison becomes vitiated. Thus, capital
cost likeinterest on long term funds and dividends should not
be deducted from grossrevenues in order to work out cash
inflows. Cash inflows can also be worked outbackwards, on
adding interest on long term funds and depreciation to net
profitsand deducting liability for taxation for the year.

Question : Write a note on social benefit analysis?

Answer :It is beingincreasingly recognised that commercial


evaluation of industrial projects is notenough to justify
commitment of funds to a project specially, if it belongs
tothe public sector and irrespective of its financial viability,
it is to beimplemented in the long term interest of the
nation. In the context of thenational policy of making huge
public investments in various sectors of theeconomy, the
need for a practical method of making social cost benefit
analysishas acquired great urgency. Hundreds of crores of
rupees are committed everyyear to various public projects of
all types - industrial, commercial and thoseproviding basic
infrastructure facilities, etc. Analysis of such projects has
tobe done with reference to social costs and benefits as they
cannot be expectedto yield an adequate commercial return
on the funds employed, at least duringthe short run. Social
cost benefit analysis is important for privatecorporations
having a moral responsibility to undertake socially
desirableprojects. In analysing various alternatives of capital
expenditure, a privatecorporation should keep in view the
social contribution aspect. It can thus beseen that the
purpose of social cost benefit analysis technique is not
toreplace the existing techniques of financial analysis but to
supplement andstrengthen them. The concept of social cost
benefit analysis has progressedbeyond the stage of
intellectual speculation. The planning commission hasalready
decided that in future, the feasibility studies for public
sectorprojects will have to include an analysis of the social
rate of return. In caseof private sector also, a socially
beneficial project may be more easilyacceptable to the
government and thus, this analysis would be relevant
whilegranting various licenses and approvals, etc. Also, if the
private sectorincludes social cost benefit analysis in its
project evaluation techniques, itwill ensure that it is not
ignoring its own long-term interest, as in the longrun only
those projects will survive that are socially beneficial and
acceptableto society.

Need for Social Cost Benefit Analysis (SCBA) :

1) Market prices used to measurecosts and benefits inproject


analysis do not represent social values due to
marketimperfections.

2) Monetary cost benefit analysis fails to consider


theexternalities or external effects of a project. The external
effects can bepositive like development of infrastructure or
negative like pollution andimbalance in environment.

3) Taxes and subsidies are monetary costs and gains,


butthese are only transfer payments from social viewpoint
and thusirrelevant.

4) SCBA is essential for measuring the redistribution effectof


benefits of a project as benefits going to poorer section are
more importantthan one going to sections which are
economically better off.

5) Projects manufacturing liqueur and cigarettes are


notdistinguished from those generating electricity or
producing necessities oflife. Thus, merit wants are important
appraisal criterion forSCBA.

The importantpublication on the technique of social


cost benefit analysis are those by theUnited Nations
Industrial Development Organisation(UNIDO) and the Centre
forOrganisation of Economic Cooperation and
Development(OECD). Both publicationdeal with the problem
of measuring social costs and benefits. In this context,it is
essential to understand that actual cost or revenues do not
essentiallyreflect cost or benefit to the society. It is so,
because the market price ofgoods and services are often
grossly distorted due to various artificialrestrictions and
controls from authorities. Thus, a different yardstick is to
beadopted in evaluating a particular proposal and its cost
benefit analysis areusually valued at "opportunity cost" or
shadow prices to judge the real impactof their burden as
costs to society. The social cost valuation
sometimescompletely changes the estimates of working
results of aproject.

Question : Is there any relationship between risk


andreturn, if yes, of what sort?

Answer :
Risk :The term risk with reference to investment decision
isdefined as the variability in actual return emanating from a
project in futureover its working life in relation to the
estimated return as forecasted at thetime of initial capital
budgeting decisions. Risk is differentiated withuncertainty
and is defined as a situation where the facts and figures are
notavailable or probabilities cannot be assigned.

Return :It cannot be denied that return is themotivating


force and the principal reward to the investment process. The
returnmay be defined in terms of :

1) realised return i.e. the return which was earned or


couldhave been earned, measuring the realised return allows
a firm to assess how thefuture expected returns may be.

2) expected return i.e. the return that the firm anticipatesto


earn over some future period. The expected return is a
predicted return andmay or may not occur.
For, a firm thereturn from an investment is the
expected cash inflows. The return may bemeasured as the
total gain or loss to the firm over a given period of time
andmay be defined as percentage on the initial amount
invested.
Relationship between risk and return :The main
objectiveof financial management is to maximise wealth of
shareholders' as reflected inthe market price of shares, that
depends on risk-return characteristics of thefinancial
decisions taken by the firm. It also emphasizes that risk and
returnare 2 important determinants of value of a share. So, a
finance manager as alsoinvestor, in general has to consider
the risk and return of each and everyfinancial decision.
Acceptance of any proposal does not alter the business riskof
firm as perceived by the supplier of capital, but, different
investmentprojects would have different degree of risk. Thus,
the importance of riskdimension in capital budgeting can
hardly be over-stressed. In fact, risk andreturn are closely
related, investment project that is expected to yield
highreturn may be too risky that it causes a significant
increase in the perceivedrisk of the firm. This trade off
between risk and return would have a bearing onthe investor'
perception of the firm before and after acceptance of a
specificproposal. The return from an investment during a
given period is equal to thechange in value of investment
plus any income received from investment. It isthus,
important that any capital or revenue income from
investments to investormust be included, otherwise the
measure of return will be deficient. The returnfrom
investment cannot be forecasted with certainty as there is
risk that thecash inflows from project may not be as
expected. Greater the variabilitybetween the estimated and
actual return, more risky is theproject.

CHAPTER FIVE

LEVERAGE

Question : Discuss the concept of leverage and its types


?

Answer : the term leverage generally, refers to a


relationship between 2 interrelated variables. In financial
analysis, it represents the influence of one financial variable
over some other related financial variable. These financial
variables may be costs, output, sales revenue, EBIT (Earnings
Before Interest and Tax), EPS (Earnings Per Share), etc.

Types of leverages : Commonly used leverages are of the


following type :

1) Operating Leverage :
It is defined as the "firm's ability to use fixed operating costs
to magnify effects of changes in sales on its EBIT ". When
there is an increase or decrease in sales level the EBIT also
changes. The effect of changes in sales on the level EBIT is
measured by operating leverage.

Operating leverage = % Change in EBIT / % Change in sales


= [Increase in EBIT/EBIT] / [Increase in
sales/sales]

Significance of operating leverage : Analysis of operating


leverage of a firm is useful to the financial manager. It tells
the impact of changes in sales on operating income. A firm
having higher D.O.L. (Degree of Operating Leverage) can
experience a magnified effect on EBIT for even a small
change in sales level. Higher D.O.L. can dramatically
increase operating profits. But, in case of decline in sales
level, EBIT may be wiped out and a loss may be operated. As
operating leverage, depends on fixed costs, if they are high,
the firm's operating risk and leverage would be high. If
operating leverage is high, it automatically means that the
break-even point would also be reached at a high level of
sales. Also, in case of high operating leverage, the margin of
safety would be low. Thus, it is preferred to operate
sufficiently above the break-even point to avoid the danger
of fluctuations in sales and profits.

2) Financial Leverage :
It is defined as the ability of a firm to use fixed financial
charges to magnify the effects of changes in EBIT/Operating
profits, on the firm's earnings per share. The financial
leverage occurs when a firm's capital structure contains
obligation of fixed charges e.g. interest on debentures,
dividend on preference shares, etc. along with owner's equity
to enhance earnings of equity shareholders. The fixed
financial charges do not vary with the operating profits or
EBIT. They are fixed and are to be repaid irrespective of
level of operating profits or EBIT. The ordinary shareholders
of a firm are entitled to residual income i.e. earnings after
fixed financial charges. Thus, the effect of changes in
operating profit or EBIT on the level of EPS is measured by
financial leverage.

Financial leverage = % change in EPS/% change in EBIT


or
= (Increase in EPS/EPS)/{Increase in
EBIT/EBIT}
The financial leverage is favourable when the firm earns
more on the investment/assets financed by sources having
fixed charges. It is obvious that shareholders gain a situation
where the company earns a high rate of return and pays a
lower rate of return to the supplier of long term funds, in
such cases it is called 'trading on equity'. The financial
leverage at the levels of EBIT is called degree of financial
leverage and is calculated as ratio of EBIT to profit before
tax.

Degree of financial leverage = EBIT/Profit before tax


Shareholders gain in a situation where a company has a high
rate of return and pays a lower rate of interest to the
suppliers of long term funds. The difference accrues to the
shareholders. However, where rate of return on investment
falls below the rate of interest, the shareholders suffer, as
their earnings fall more sharply than the fall in the return on
investment.

Financial leverage helps the finance manager in designing


the appropriate capital structure. One of the objective of
planning an appropriate capital structure is to maximise
return on equity shareholders' funds or maximise EPS.
Financial leverage is double edged sword i.e. it increases EPS
on one hand, and financial risk on the other. A high financial
leverage means high fixed costs and high financial risk i.e.
as the debt component in capital structure increases, the
financial risk also increases i.e. risk of insolvency increases.
The finance manager thus, is required to trade off i.e. to
bring a balance between risk and return for determining the
appropriate amount of debt in the capital structure of a firm.
Thus, analysis of financial leverage is an important tool in
the hands of the finance manager who are engaged in
financing the capital structure of business firms, keeping in
view the objectives of their firm.

3) Combined leverage :
Operating leverage explains operating risk and financial
leverage explains the financial risk of a firm. However, a firm
has to look into overall risk or total risk of the firm i.e.
operating risk as also financial risk. Hence, the combined
leverage is the result of a combination of operating and
financial leverage. The combined leverage measures the
effect of a % change in sales on % change in EPS.

Combined Leverage = Operating leverage * Financial


leverage
= (% change in EBIT/% change in sales) *
(% change in EPS/% change in EBIT)
= % change in EPS/% change in sales

The ratio of contribution to earnings before tax, is given by a


combined effect of financial and operating leverage. A high
operating and high financial leverage is very risky, even a
small fall in sales would affect tremendous fall in EPS. A
company must thus, maintain a proper balance between
these 2 leverage. A high operating and low financial leverage
indicates that the management is careful as higher amount
of risk involved in high operating leverage is balanced by low
financial leverage. But, a more preferable situation is to have
a low operating and a high financial leverage. A low
operating leverage automatically implies that the company
reaches its break-even point at a low level of sales, thus, risk
is diminished. A highly cautious and conservative manager
would keep both its operating and financial leverage at very
low levels. The approach may, mean that the company is
losing profitable opportunities.

The study of leverages is essential to define the risk


undertaken by the shareholders. Earnings available to
shareholders fluctuate on account of 2 risks, viz. operating
risk i.e. variability of EBIT may arise due to variability of
sales or/and expenses. In a given environment, operating risk
cannot be avoided. The variability of EPS or return on equity
depends on the use of financial leverage and is termed as
financial risk. A firm financed totally by equity finance has no
financial risk, hence it cannot be avoided by eliminating use
of borrowed funds. Thus, a company has to consider its likely
profitability position set before deciding upon the capital mix
of the company, as it has far reaching implications on the
financial position of the company.

Question : What is the effect of leverage on capital


turnover and working capital ratio ?

Answer : An increase in sales improves the net profit ratio,


raising the Return on Investment (R.O.I) to a higher level.
This however, is not possible in all situations, a rise in
capital turnover is to be supported by adequate capital base.
Thus, as capital turnover ratio increases, working capital
ratio deteriorates, thus, management cannot increase its
capital turnover ratio beyond a certain limit. The main
reasons for a fall in ratios showing the working capital
position due to increase in turnover ratios is that as the
activity increases without a corresponding rise in working
capital, the working capital position becomes tight. As the
sales increases, both current assets and current liabilities
also increases but not in proportion to current ratio. If
current ratio and acid test ratio are high, it is apparent that
the capital turnover ratio can be increased without any
problem. However, it may be very risky to increase capital
turnover ratio when, the working capital position is not
satisfactory.

CHAPTER SIX

CAPITAL STRUCTURE AND COST OF CAPITAL

Question : Explain the concept of capital structure ?

Answer : A finance manager for procurement of funds, is


required to select such a finance mix or capital structure that
maximises shareholders wealth. For designing optimum
capital structure he is required to select such a mix of
sources of finance, so that the overall cost of capital is
minimum. Capital structure refers to the mix of sources from
where long term funds required by a business may be raised
i.e. what should be the proportion of equity share capital,
preference share capital, internal sources, debentures and
other sources of funds in total amount of capital which an
undertaking may raise for establishing its business. In
planning the capital structure, following must be referred to :

1) There is no definite model that can be suggested/used as


an ideal for all business undertakings. This is due to varying
circumstances of various business undertakings. Capital
structure depends primarily on a number of factors like,
nature of industry, gestation period, certainty with which the
profits will accrue after the undertaking commences
commercial production and the likely quantum of return on
investment. It is thus, important to understand that different
types of capital structure would be required for different
types of undertakings.

2) Government policy is a major factor in planning capital


structure. For instance, a change in the lending policy of
financial institutions may mean a complete change in the
financial pattern. Similarly, rules and regulations for capital
market formulated by SEBI affect the capital structure
decisions. The finance managers of business concerns are
required to plan capital structure within these constraints.

Optimum capital structure : The capital structure is said


to be optimum, when the company has selected such a
combination of equity and debt, so that the company's
wealth is maximum. At this, capital structure, the cost of
capital is minimum and market price per share is maximum.
But, it is difficult to measure a fall in the market value of an
equity share on account of increase in risk due to high debt
content in the capital structure. In reality, however, instead
of optimum, an appropriate capital structure is more
realistic. Features of an appropriate capital structure are as
below :

1) Profitability : The most profitable capital structure is


one that tends to minimise financing cost and maximise of
earnings per equity share.

2) Flexibility : The capitals structure should be such that


the company is able to raise funds whenever needed.
3) Conservation : Debt content in capital structure should
not exceed the limit which the company can bear.

4) Solvency : Capital structure should be such that the


business does not run the risk of insolvency.

5) Control : Capital structure should be devised in such a


manner that it involves minimum risk of loss of control over
the company.

Question : Explain the major considerations in the


planning of capital structure ?

Answer : The 3 major considerations evident in capital


structure planning are risk, cost and control, they assist the
management in determining the proportion of funds to be
raised from various sources. The finance manager attempts
to design the capital structure in a manner, that his risk and
cost are least and there is least dilution of control from the
existing management. There are also subsidiary factors as,
marketability of the issue, maneuverability and flexibility of
capital structure and timing of raising funds. Structuring
capital, is a shrewd financial management decision and is
something that makes or mars the fortunes of the company.
The factors involved in it are as follows :

1) Risk :
Risks are of 2 kinds viz. financial and business risk.
Financial risk is of 2 kinds as below :

i) Risk of cash insolvency : As a business raises more


debt, its risk of cash insolvency increases, as :

a) the higher proportion of debt in capital structure increases


the commitments of the company with regard to fixed
charges. i.e. a company stands committed to pay a higher
amount of interest irrespective of the fact whether or not it
has cash. and
b) the possibility that the supplier of funds may withdraw
funds at any point of time.
Thus, long term creditors may have to be paid back in
installments, even if sufficient cash to do so does not exist.
Such risk is absent in case of equity shares.

ii) Risk of variation in the expected earnings available


to equity share-holders : In case a firm has a higher debt
content in capital structure, the risk of variations in expected
earnings available to equity shareholders would be higher;
due to trading on equity. There is a lower probability that
equity shareholders get a stable dividend if, the debt content
is high in capital structure as the financial leverage works
both ways i.e. it enhances shareholders' returns by a high
magnitude or reduces it depending on whether the return on
investment is higher or lower than the interest rate. In other
words, there is relative dispersion of expected earnings
available to equity shareholders, that would be greater if
capital structure of a firm has a higher debt content.

The financial risk involved in various sources of


funds may be understood with the help of debentures. A
company has to pay interest charges on debentures even in
case of absence of profits. Even the principal sum has to be
repaid under the stipulated agreement. The debenture
holders have a charge against the company's assets and
thus, they can enforce a sale of assets in case of company's
failure to meet its contractual obligations. Debentures also
increase the risk of variation in expected earnings available
to equity shareholders through leverage effect i.e. if return
on investment remains higher than interest rate,
shareholders get a high return and vice versa. As compared
to debentures, preference shares entail a slightly lower risk
for the company, as the payment of dividends on such shares
is contingent upon the earning of profits by the company.
Even in case of cumulative preference shares, dividends are
to be paid only in the year in which company earns profits.
Even, their repayment is made only if they are redeemable
and after a stipulated period. However, preference shares
increase the variations in expected earnings available to
equity shareholders. From the company's view point, equity
shares are least risky, as a company does not repay equity
share capital except on its liquidation and may not declare
dividends for years. Thus, as seen here, financial risk
encompasses the volatility of earnings available to equity
shareholders as also, the probability of cash insolvency.

2) Cost of capital :
Cost is an important consideration in capital
structure decisions and it is obvious that a business should
be atleast capable of earning enough revenue to meet its
cost of capital and also finance its growth. Thus, along with
risk, the finance manager has to consider the cost of capital
factor for determination of the capital structure.

3) Control :
Along with cost and risk factors, the control aspect
is also an important factor for capital structure planning.
When a company issues equity shares, it automatically
dilutes the controlling interest of present owners. In the
same manner, preference shareholders can have voting
rights and thereby affect the composition of Board of
directors, if dividends are not paid on such shares for 2
consecutive years. Financial institutions normally stipulate
that they shall have one or more directors on the board.
Thus, when management agrees to raise loans from financial
institutions, by implication it agrees to forego a part of its
control over the company. It is thus, obvious that decisions
concerning capital structure are taken after keeping the
control factor in view.

4) Trading on equity :
A company may raise funds by issue of shares or
by borrowings, carrying a fixed rate of interest that is
payable irrespective of the fact whether or not there is a
profit. Preference shareholders are also entitled to a fixed
rate of dividend, but dividend payment is subject to the
company's profitability. In case of ROI the total capital
employed i.e. shareholders' funds plus long term borrowings,
is more than the rate of interest on borrowed funds or rate of
dividend on preference shares, the company is said to trade
on equity. It is the finance manager's main objective to see
that the return and overall wealth of the company both are
maximised, and it is to be kept in view while deciding on the
sources of finance. Thus, the effect of each proposed method
of new finance on EPS is to be carefully analysed. This, thus,
helps in deciding whether funds should be raised by internal
equity or by borrowings.

5) Corporate taxation :
Under the Income tax laws, dividend on shares is
not deductible while interest paid on borrowed capital is
allowed as deduction. Cost of raising finance through
borrowings is deductible in the year in which it is incurred. If
it is incurred during the pre-commencement period, it is to
be capitalised. Cost of share issue is allowed as deduction.
Owing to such provisions, corporate taxation, plays an
important role in determination of the choice between
different sources of financing.

6) Government Policies :
Government policies is a major factor in
determining capital structure. For instance, a change in the
lending policies of financial institutions would mean a
complete change in the financial pattern followed by
companies. Also, rules and regulations framed by SEBI
considerably affect the capital issue policy of various
companies. Monetary and fiscal policies of government also
affect the capital structure decisions.

7) Legal requirements :
The finance manager has to keep in view the legal
requirements at the time of deciding as regards the capital
structure of the company.

8) Marketability :
To obtain a balanced capital structure, it is
necessary to consider the company's ability to market
corporate securities.

9) Maneuverability :
Maneuverability is required to have as many
alternatives as possible at the time of expanding or
contracting the requirement of funds. It enables use of
proper type of funds available at a given time and also
enhances the bargaining power when dealing with the
prospective suppliers of funds.

10) Flexibility :
It refers to the capacity of the business and its
management to adjust to expected and unexpected changes
in circumstances. In other words, the management would like
to have a capital structure providing maximum freedom to
changes at all times.
11) Timing :
Closely related to flexibility is the timing for issue of
securities. Proper timing of a security issue often brings
substantial savings due to the dynamic nature of the capital
market. Intelligent management tries to anticipate the
climate in capital market with a view to minimise cost of
raising funds and the dilution resulting from an issue of new
ordinary shares.

12) Size of the company :


Small companies rely heavily on owner's funds
while large companies are usually considered, to be less
risky by investors and thus, they can issue different types of
securities.

13) Purpose of financing :


The purpose of financing also, to some extent
affects the capital structure of the company. In case funds
are required for productive purposes like manufacturing, etc.
the company may raise funds through long term sources. On
the other hand, if the funds are required for non-productive
purposes, like welfare facilities to employees such as
schools, hospitals, etc. the company may rely only on
internal resources.

14) Period of Finance :


The period for which finance is required also affects
the determination of capital structure. In case funds are
required for long term requirements say 8 to 10 years, it
would be appropriate to raise borrowed funds. However, if
the funds are required more or less permanently, it would be
appropriate to raise borrowed funds. However, if the funds
are required more or less permanently, it would be
appropriate to raise them by issue of equity shares.

15) Nature of enterprise :


The nature of enterprise to a great extent affects
the company's capital structure. Business enterprises having
stability in earnings or enjoying monopoly as regards their
products may go for borrowings or preference shares, as they
have adequate profits to pay interest/fixed charges. On the
contrary, companies not having assured income should
preferably rely on internal resources to a large extent.

16) Requirement of investors :


Different types of securities are issued to different
classes of investors according to their requirement.

17) Provision for future :


While planning capital structure the provision for
future requirement of capital is also required to be
considered.

Question : Give in detail the various capital structure


theories ?

Answer : A firm's objective should be directed towards the


maximisation of the firm's value; the capital structure or
leverage decision are to examined from the view point of
their impact on the value of the firm. If the value of the firm
can be affected by capital structure or financing decision, a
firm would like to have a capital structure that maximises the
market value of the firm. There are broadly 4 approaches in
the regard, which analyses relationship between leverage,
cost of capital and the value of the firm in different ways,
under the following assumptions :

1) There are only 2 sources of funds viz. debt and equity.

2) The total assets of the firm are given and the degree of
leverage can be altered by selling debt to repurchase shares
or selling shares to retire debt.

3) There are no retained earnings implying that entire profits


are distributed among shareholders.

4) The operating profit of firm is given and expected to grow.

5) The business risk is assumed to be constant and is not


affected by the financing mix decision.

6) There are no corporate or personal taxes.

7) The investors have the same subjective probability


distribution of expected earnings.

The approaches are as below :


1) Net Income Approach (NI Approach) :
The approach is suggested by Durand. According to
it, a firm can increase its value or lower the overall cost of
capital by increasing the proportion of debt in the capital
structure. In other words, if the degree of financial leverage
increases, the weighted average cost of capital would decline
with every increase in the debt content in total funds
employed, while the value of the firm will increase. Reverse
would happen in a converse situation. It is based on the
following assumptions :

i) There are no corporate taxes.

ii) The cost of debt is less than cost of equity or equity


capitalisation rate.

iii) The use of debt content does not change the risk
perception of investors as a result of both the K d (Debt
capitalisation rate) and K e (equity capitalisation rate)
remains constant.

The value of the firm on the basis of Net Income


Approach may be ascertained as follows :

V = S + D

Where,
V = Value of the firm
S = Market value of equity
D = Market value of debt

S = NI/K e

Where,
S = Market value of equity
NI = Earnings available for equity shareholders
K e = Equity Capitalisation rate
Under, NI approach, the value of a firm will be maximum at a
point where weighted average cost of capital is minimum.
Thus, the theory suggests total or maximum possible debt
financing for minimising cost of capital.
Overall cost of capital = EBIT/Value of the firm

2) Net Operating Income Approach (NOI) :


This approach is also suggested by Durand,
according to it, the market value of the firm is not affected
by the capital structure changes. The market value of the
firm is ascertained by capitalising the net operating income
at the overall cost of capital, which is constant. The market
value of the firm is determined as :
V = EBIT/Overall cost of capital
Where,
V = Market value of the firm
EBIT = Earnings before interest and tax
S = V - D

Where,
S = Value of equity
D = Market value of debt
V = Market value of firm
Cost of equity = EBIT/(V - D)
Where,
V = Market value of the firm
EBIT = Earnings before interest and tax
D = Market value of debt

It is based on the following assumptions :

i) The overall cost of capital remains constant for all degree


of debt equity mix.

ii) The market capitalises value of the firm as a whole. Thus,


the split between debt and equity is not important.

iii) The use of less costly debt funds increases the risk of
shareholders. This causes the equity capialisation rate to
increase. Thus, the advantage of debt is set off exactly by
increase in equity capitalisation rate.

iv) There are no corporate taxes.

v) The cost of debt is constant.


Under, NOI approach since overall cost of capital is
constant, thus, there is no optimal capital structure rather
every capital structure is as good as any other and so every
capital structure is optimal.

3) Traditional Approach :
The traditional approach, also called an
intermediate approach as it takes a midway between NI
approach, that the value of the firm can be increased by
increasing financial leverage and NOI approach, that the
value of the firm is constant irrespective of the degree of
financial leverage. According to this approach the firm should
strive to reach the optimal capital structure and its total
valuation through a judicious use of debt and equity in
capital structure. At the optimal capital structure, the overall
cost of capital will be minimum and the value of the firm is
maximum. It further states, that the value of the firm
increases with financial leverage upto a certain point.
Beyond this, the increase in financial leverage will increase
cost of equity, the overall cost of capital may still reduce.
However, if financial leverage increases beyond an
acceptable limit, the risk of debt investor may also increase,
consequently cost of debt also starts increasing. The
increasing cost of equity owing to increased financial risk
and increasing cost of debt makes the overall cost of capital
to increase. Thus, as per the traditional approach the cost of
capital is a function of financial leverage and the value of
firm can be affected by the judicious mix of debt and equity
in capital structure. The increase of financial leverage upto a
point favourably affect the value of the firm. At this point,
the capital structure is optimal & the overall cost of capital
will be the least.

4) Modigliani and Miller Approach(MM Approach) :


According to this approach, the total cost of capital
of particular firm is independent of its method and level of
financing. Modigliani and Miller argued that the weighted
average cost of capital of a firm is completely independent of
its capital structure. In other words, a change in the debt
equity mix does not affect the cost of capital. They argued,
in support of their approach, that as per the traditional
approach, cost of capital is the weighted average of cost of
debt and cost of equity, etc. The cost of equity, is
determined from the level of shareholder's expectations.
That is if, shareholders expect a particular rate of return,
say 15 % from a particular company, they do not take into
account the debt equity ratio and they expect 15 % as they
find that it covers the particular risk which this company
entails. Suppose, the debt content in the capital structure of
the company increases, this means, that in the eyes of
shareholders, the risk of the company increases, since debt
is a more risky mode of finance. Thus, the shareholders
would now, expect a higher rate of return from the shares of
the company. Thus, each change in the debt equity mix is
automatically set- off by a change in the expectations of the
shareholders from the equity share capital. This is because, a
change in the debt-equity ratio changes the risk element of
the company, which in turn changes the expectations of the
shareholders from the particular shares of the company.
Modigliani and Miller, thus, argue that financial leverage has
nothing to do with the overall cost of capital and the overall
cost of capital is equal to the capitalisation rate of pure
equity stream of its class of risk. Thus, financial leverage has
no impact on share market prices nor on the cost of capital.
They make the following propositions :

i) The total market value of a firm and its cost of capital are
independent of its capital structure. The total market value
of the firm is given by capitalising the expected stream of
operating earnings at a discount rate considered appropriate
for its risk class.

ii) The cost of equity (Ke) is equal to the capitalisation rate


of pure equity stream plus a premium for financial risk. The
financial risk increases with more debt content in the capital
structure. As a result, Ke increases in a manner to offset
exactly the use of less expensive sources of funds.

iii) The cut off rate for investment purposes is completely


independent of the way in which the investment is
financed.

Assumptions :

i) - The capital markets are assumed to be perfect. This


means that investors are free to buy and sell securities.
- They are well-informed about the risk-return on all type of
securities.
- There are no transaction costs.
- They behave rationally.
- They can borrow without restrictions on the same terms as
the firms do.

ii) The firms can be classified into 'homogenous risk class'.


They belong to this class, if their expected earnings have
identical risk characteristics.

iii) All investors have the same expectations from a firms'


EBIT that is necessary to evaluate the value of a firm.

iv) The dividend payment ratio is 100 %. i.e. there are no


retained earnings.

v) There are no corporate taxes, but, this assumption has


been removed.

Modigliani and Miller agree that while companies in


different industries face different risks resulting in their
earnings being capitalised at different rates, it is not
possible for these companies to affect their market values,
and thus, their overall capitalisation rate by use of leverage.
That is, for a company in a particular risk class, the total
market value must be same irrespective of proportion of debt
in company's capital structure. The support for this
hypothesis lies in the presence of arbitrage in the capital
market. They contend that arbitrage will substitute personal
leverage for corporate leverage.
For instance : There are 2 companies X and Y in the same
risk class. Company X is financed by only equity and no debt,
while Company Y is financed by a combination of debt and
equity. The market price of shares of Company Y would be
higher than that of Company X, market participants would
take advantage of difference by selling equity shares of
Company Y, borrowing money to equate their personal
leverage to the degree of corporate leverage in Company Y
and use them for investing in Company X. The sale of shares
of Company Y reduces its price until the market value of the
company Y, financed by debt and equity, equals that of
Company X, financed by only equity.

Criticism :
These propositions have been criticised by numerous
authorities. Mostly criticism is as regards, perfect market and
arbitrage assumption. MM hypothesis argue that through
personnel arbitrage investors would quickly eliminate any
inequalities between the value of leveraged firms and that of
unleveraged firms in the same risk class. The basic argument
here, is that individual arbitrageurs, through the use of
personal leverage can alter corporate leverage, which is not
a valid argument in the practical world, as it is extremely
doubtful that personal investors would substitute personal
leverage for corporate leverage, as they do not have the
same risk characteristics. The MM approach assumes
availability of free and upto date information, this also is not
normally valid.

To conclude, one may say that controversy between


the traditionalists and the supporters of MM approach cannot
be resolved due to lack of empirical research. Traditionalists
argue that the cost of capital of a firm can be lowered and
the market value of shares increased by use of financial
leverage. But, after a certain stage, as the company becomes
highly geared i.e. debt content increases, it becomes too
risky for investors and lenders. Thus, beyond a point, the
overall cost of capital begins to rise, this point indicates the
optimal capital structure. Modigliani and Miller argues, that
in the absence of corporate income taxes, overall cost of
capital begins to rise.

Question : What kind of relationship exists between


taxation and capital structure ?

Answer : The leverage irrelevance theory of MM is valid only


in perfect market conditions, but, in face of imperfections
characterising the real world capital markets, the capital
structure of a firm may affect its valuation. Presence of taxes
is a major imperfection in the real world. When taxes are
applicable to corporate income, debt financing is
advantageous. This is because dividends and retained
earnings are not deductible for tax purposes, interest on
debt is a deductible expense for tax purposes. As a result,
the total available income for both stock-holders and debt-
holders is greater when debt capital is used. If the debt
employed by a leveraged firm is permanent in nature, the
present value of the tax shield associated with interest
payment can be obtained by applying the formula for
perpetuity.

Present value of tax shield (TD) = (T * k d * D)/k d


Where,
T = Corporate tax rate
D = Market value of debt
k d = Interest rate on debt

The present value of interest tax shields is


independent of the cost of debt, it being a deductible
expense. It is simply the corporate tax rate times the amount
of permanent debt.

Value of an unleveraged firm :

V u = [EBIT ( 1 - t )]/K 0

Value of leveraged firm :

V l = V u + Debt (t)

Greater the leverage, greater would be the value of


the firm, other things being equal. This implies that the
optimal strategy of a firm should be to maximise the degree
of leverage in its capital structure.

Question : Enumerate the methods to calculate the cost


of capital from various sources ?

Answer : The cost of capital is a significant factor in


designing the capital structure of an undertaking, as basic
reason of running of a business undertaking is to earn return
at least equal to the cost of capital. Commercial undertaking
has no relevance if, it does not expect to earn its cost of
capital. Thus cost of capital constitutes an important factor
in various business decisions. For example, in analysing
financial implications of capital structure proposals, cost of
capital may be taken as the discounting rate. Obviously, if a
particular project gives an internal rate of return higher than
its cost of capital, it should be an attractive opportunity.
Following are the cost of capital acquired from various
sources :

1) Cost of debt :
The explicit cost of debt is the interest rate as per contract
adjusted for tax and the cost of raising debt.
- Cost of irredeemable debentures :
Cost of debentures not redeemable during the life
time of the company,

K d = (I/NP) * (I - T)

Where,
K d = Cost of debt after tax
I = Annual interest rate
NP = Net proceeds of debentures
T = Tax rate

However, debt has an implicit cost also, that arises


due to the fact that if the debt content rises above the
optimal level, investors would start considering the company
to be too risky and, thus, their expectations from equity
shares will rise. This rise, in the cost of equity shares is
actually the implicit cost of debt.

- Cost of redeemable debentures :


If the debentures are redeemable after the expiry of
a fixed period the cost of debentures would be :

K d = I(1 - t) + [(RV - NP)]/N


[(RV + NP)/2]

Where,
I = Annual interest payment
NP = Net proceeds of debentures
RV = Redemption value of debentures
t = tax rate
N = Life of debentures

2) Cost of preference shares :


In case of preference shares, the dividend rate can
be taken as its cost, as it is this amount that the company
intends to pay against the preference shares. As, in case of
debt, the issue expenses or discount/premium on
issue/redemption is also to be taken into account.

- Cost of irredeemable preference shares :


Cost of irredeemable preference shares = PD/PO

Where,
PD = Annual preference dividend
PO = Net proceeds of an issue of preference shares

- Cost of redeemable preference shares :


If the preference shares are redeemable after the
expiry of a fixed period, the cost of preference shares would
be.

K p = PD + [(RV - NP)]/N
[(RV + NP)/2]
Where,
PD = Annual preference dividend
NP = Net proceeds of debentures
RV = Redemption value of debentures
N = Life of debentures

However, since dividend of preference shares is


not allowed as deduction from income for income tax
purposes, there is no question of tax advantage in the case
of cost of preference shares. It would, thus, be seen that
both in case of debt and preference shares, cost of capital is
calculated by reference to the obligations incurred and
proceeds received. The net proceeds received must be taken
into account in working cost of capital.

3) Cost of ordinary or equity shares :


Calculation of the cost of ordinary shares involves a
complex procedure, because unlike debt and preference
shares there is no fixed rate of interest or dividend against
ordinary shares. Hence, to assign a certain cost to equity
share capital is not a question of mere calculation, it requires
an understanding of many factors basically concerning the
behaviour of investors and their expectations. As, there can
be different interpretations of investor's behaviour, there are
many approaches regarding calculation of cost of equity
shares. The 4 main approaches are :
i) D/P ratio (Dividend/Price) approach : This emphasises
that dividend expected by an investor from a particular
share determines its cost. An investor who invests in the
ordinary shares of a particular company, does so in the
expectation of a certain return. In other words, when an
investor buys ordinary shares of a certain risk, he expects a
certain return, The expected rate of return is the cost of
ordinary share capital. Under this approach, thus, the cost of
ordinary share capital is calculated on the basis of the
present value of the expected future stream of dividends.

For example, the market price of the equity shares


(face value Rs. 10) of a particular company is Rs. 15. If it has
been paying a dividend of 20 % and is expected to maintain
the same, its cost of equity shares at face value is 0.2 *
10/15 = 13.3%, since it is the maximum rate of dividend, at
which the investor will buy share at the present value.
However, it can also be argued that the cost of equity capital
is 20 % for the company, as it is on this expectation that the
market price of shares is maintained at Rs. 15. Cost of equity
shares of a company is that rate of dividend that maintains
the present market price of shares. As the objective of
financial management is to maximise the wealth of
shareholders, it is rational to assume that the company must
maintain the present market value of its share by paying 20
% dividend, which then is its cost of equity capital. Thus, the
relationship between dividends and market price shows the
expectation of the investors and thereby cost of equity
capital.
This approach co-relates the basic factors of return
and investment from view point of investor. However, it is
too simple as it pre-supposes that an investor looks forward
only to dividends as a return on his investment. The
expected stream of dividends is of importance to an investor
but, he looks forward to capital appreciation also in the value
of shares. It may lead us to ignore the growth in capital
value of the share. Under, this approach, a company which
declares a higher amount of dividend out of a given quantum
of earnings will be placed at a premium as compared to a
company which earns the same amount of profits but
utilises a major part of the same in financing its expansion
programmes. Thus, D/P approach may not be adequate to
deal with the problem of determining the cost of ordinary
share capital.
ii) E/P (Earnings/Price) ratio approach : The advocates of
this approach co -relates the earnings of the company with
the market price of its shares. As per it, the cost of ordinary
share capital would be based on the expected rate of
earnings of a company. The argument is that each investor
expects a certain amount of earnings, whether distributed or
not from the company in whose shares he invests, thus, an
investor expects that the company in which he is going to
subscribe for share should have at least 20 % of earning, the
cost of ordinary share capital can be construed on this basis.
Suppose, a company is expected to earn 30 % the investor
will be prepared to pay Rs 150 (30/20 * 100) for each of Rs.
100 share. This approach is similar to the dividend price
approach, only it seeks to nullify the effect of changes in
dividend policy. This approach also does not seem to be a
complete answer to the problem of determining the cost of
ordinary share as it ignores the factor of capital appreciation
or depreciation in the market value of shares.

iii) D/P + growth approach : The dividend/price + growth


approach emphasises what an investor actually expects to
receive from his investment in a particular company's
ordinary share in terms of dividend plus the rate of growth in
dividend/earnings. This growth rate in dividend (g) is taken
to be good to the compound growth rate in earnings per
share.

K e = [D 1 /P 0 ] + g
Where,
K e = Cost of capital
D 1 = Dividend for the period 1
P 0 = Price for the period 0
g = Growth rate
D/P + g approach seems to answer the problem of
expectations of investor satisfactorily, however, it poses one
problem that is how to quantify expectation of investor
relating to dividend and growth in dividend.

iv) Realised yield approach : It is suggested that many


authors that the yield actually realised for a period of time
by investors in a particular company may be used as an
indicator of cost of capital. In other words, this approach
takes into consideration the basic factor of the D/P + g
approach but, instead of using the expected values of the
dividends and capital appreciation, past yields are used to
denote the cost of capital. This approach is based upon the
assumption that the past behaviour would be repeated in
future and thus, they may be used to measure the cost of
ordinary capital.

Which approach to use ? In case of companies with stable


income and stable dividend policies the D/P approach may be
a good way of measuring the cost of ordinary share capital.
In case of companies whose earnings accrue in cycles, it
would be better if the E/P approach is used, but
representative figures should be taken into account to
include complete cycle. In case of growth companies, where
expectations of growth are more important, cost of ordinary
share capital may be determined as the basis of the D/P + g
approach. In the case of companies enjoying a steady growth
rate and a steady rate of dividend, the realised value
approach may be useful. The basic factor behind
determination of cost of ordinary share capital is to measure
expectation of investors from ordinary shares of that
particular company. Thus, the whole question of determining
the cost of ordinary shares hinges upon the factors which go
into the expectations of a particular group of investors in the
company of a particular risk class.

4) cost of reserves : The profits retained by a company and


used in the expansion of business also entail cost. Many
people tend to feel that reserves have no cost. However, it is
not easy to realised that by depriving the shareholders of a
part of the earnings, a cost is automatically incurred on
reserves. This may be termed as the opportunity cost of
retained earnings. Suppose, these earnings are not retained
and are passed on to shareholders, suppose further that
shareholders invest the same in new ordinary shares. This
expectation of the investors from new ordinary shares should
be the opportunity cost of reserves. In other words, if
earnings were paid out as dividends and simultaneously an
offer for right shares was made shareholders would have
subscribed to the right share on the expectation of a certain
return. This return may be taken as the indicator of the cost
of reserves. People do not calculate the cost of capital of
retained earnings as above. They take cost of retained
earnings as the same as that of equity shares. However, if
the cost of equity shares is determined on the basis of
realised value approach or D/P + g approach, the question of
working out a separate cost of reserves is not relevant since
cost of reserves is automatically included in the cost of
equity share capital.

5) Cost of depreciation funds : Depreciation funds, cannot


be construed as not having any cost. Logically speaking, they
should be treated on the same footing as reserves when it
comes to their use, though while calculating the cost of
capital these funds may not be considered.

Question : Enumerate the procedure of calculating the


weighted average cost of capital ?

Answer : The composite or overall cost of capital of a firm is


the weighted average of the costs of various sources of
funds. Weights are taken to be proportion of each source of
funds in the capital structure. While, making financial
decisions this overall or weighted cost is used. Each
investment is financed from a pool of funds which represents
the various sources from which funds have been raised. Any
decision of investment thus, has to be made with reference
to the overall cost of capital and not with reference to cost of
a specific source of fund used in that investment decisions.
The weighted average cost of capital (WACC) is calculated by
:
1) Calculating cost of specific sources of funds, e.g. cost of
debt, etc.
2) Multiplying the cost of each source by its proportion in
capital structure.
3) Adding the weighted component costs to get the firm's
WACC. Thus, WACC is ,

K 0 = K 1 W 1 + K 2 W 2 +.............
Where,
K 1 , K 2 are component costs and W 1 , W 2 are weights.

The weights to be used can be either book value weights or


market value weights. Book value weights are easier to
calculate and can be applied consistently. Market value
weights are supposed to be superior to book value weights as
component costs are opportunity costs and market values
reflect economic values. However, these weights fluctuate
frequently and fluctuations are wide in nature.
Question : What do you mean by marginal cost of
capital ?

Answer : The marginal cost of capital may be defined as the


cost of raising an additional rupee of capital. Since the
capital is raised in substantial amount in practice marginal
cost is referred to as the cost incurred in raising new funds.
Marginal cost of capital is derived, when we calculate the
average cost of capital using the marginal weights. The
marginal weights represent the proportion of funds the firm
intends to employ. Thus, the problem of choosing between
the book value weights and the market value weights does
not arise in the case of marginal cost of capital computation.
To calculate the marginal cost of capital, the intended
financing proportion should be applied as weights to
marginal component costs. The marginal cost of capital
should, thus, be calculated in the composite sense. When a
firm raises funds in proportional manner and the
component's cost remain unchanged, there will be no
difference between average cost of capital of total funds and
the marginal cost of capital. The component's cost may
remain unchanged, upto a certain level of funds raised and
then start increasing with amount of funds raised, e.g. The
cost of debt remains 7 % after tax till Rs. 10 lakhs and
between Rs. 10 - 15 lakhs, the cost may be 8 % and so on.
Similarly, if the firm has to use the external equity when the
retained profits are not sufficient, the cost of equity will be
higher because of flotation costs. When the components cost
starts rising, the average cost of capital would rise and
marginal cost of capital would however, rise at a faster rate.

Question : What is the effect of a financing decision on


EPS ?

Answer : One of the prime objective of a finance manager is


to maximise both the return on ordinary shares and the total
wealth of the company. This objective has to be kept in view
while, taking a decision on a new source of finance. Thus, the
effect of each proposed method of new finance on the EPS is
to be carefully analysed. EPS denotes what has been earned
by the company during a particular accounting period, on
each of its ordinary shares. This can be worked out by
dividing net profit after interest, taxes and preference
dividends by the number of equity shares. If a company has a
number of alternatives for new financing, it can compute the
impact of the various alternatives on earnings per share. It is
obvious that, EPS would be the highest in case of financing
that has the least cost to the company.

1) Explicit cost of new capital : It is a method that can


compare the alternatives available for raising capital can be
through the calculation of the explicit cost of new capital.
Explicit cost of new capital is the rate of return at which the
new funds must be employed so that the existing EPS is not
affected. In other words, the rate of return of new funds must
earn to maintain EPS at the existing levels. It is obvious that,
if EPS were Rs. 2 earlier, the rate of return required to be
earned by the source of new capital to maintain it at the old
level is to be found. Long term debt would again be preferred
as even if a lower rate of return is earned on the funds so
raised, the old EPS will be maintained.

2) Range of earnings chart/Indifference point : Another


method of considering the impact of various financing
alternatives on EPS is to prepare the EBIT chart or the range
of earnings chart. It shows the likely EPS at various probable
EBIT levels. Thus, under one particular alternative, EPS may
be Rs. 1 at a given EBIT level. However, the EPS may reduce
if another alternative of financing is chosen even though the
EBIT under the alternative may be drawn. Wherever this line
intersects, it is known as break - even point. This point is a
useful guide in formulating the capital structure. This is
known as EPS equivalency point or indifference point as, it
shows that, between the 2 given alternatives of financing i.e.
regardless of leverage in financial plans, EPS would be the
same at the given EBIT level. The equivalency or indifference
point can also be calculated algebraically as below :

[X - B]/S 1 = X/S 2
Where,
X = Indifference point (EBIT)
S 1 = Number of equity shares outstanding
S 2 = Number of equity shares outstanding when only equity
capital is used.
B = Interest on debt capital in rupees.

3) EPS Volatility : EPS Volatility refers to the magnitude or


extent of fluctuations in EPS of a company in various years
as compared to the mean or average EPS. In other words,
EPS volatility shows whether a company enjoys a stable
income or not. It is obvious that higher the EPS Volatility,
greater would be the risk attached to the company. A major
cause of EPS Volatility would be the fluctuations in the sales
volume and the operating leverage. It is obvious that the net
profits of a company would greatly fluctuate with small
fluctuations in the sales figures specially if the fixed cost
content is very high. Thus, EPS will fluctuate in such a
situation. This effect may be heightened by the financial
leverage.

CHAPTER SEVEN

SOURCES OF FINANCE

Question : List down the financial needs and the


sources available with a business entity to satisfy such
needs ?

Answer : One of the most important consideration for an


entrepreneur-company in implementing a new project or
undertaking expansion, diversification, modernisation and
rehabilitation scheme is ascertaining the cost of project and
the means of finance. There are several sources of
finance/funds available to any company. An effective
appraisal mechanism of various sources of funds available to
a company must be instituted in the company to achieve its
main objectives. Such a mechanism is required to evaluate
risk, tenure and cost of each and every source of fund. This
selection of fund source is dependent on the financial
strategy pursued by the company, the leverage planned by
the company, the financial conditions prevalent in the
economy & the risk profile of both i.e. the company and the
industry in which the company operates. Each and every
source of fund has some advantages and disadvantages.

I) Financial needs of a business are grouped as follows


:
1) Long term financial needs : Such needs generally refer
to those requirements of funds which are for a period
exceeding 5 - 10 years. All investments in plant and
machinery, land, buildings, etc. are considered as long term
financial needs. Funds required to finance permanent or hard
core working capital should also be procured from long term
sources.

2) Medium term financial needs : Such requirements refer


to those funds which are required for a period exceeding
one year but not exceeding 5 years. Funds required for
deferred revenue expenditure (i.e benefit of expense expires
after a period of 3 to 5 years), are classified as medium term
financial needs. Sometimes long term requirements, for
which long term funds cannot be arranged immediately may
be met from medium term sources and thus the demand of
medium term financial needs are generated, as and when the
desired long-term funds are available medium term loan may
be paid off.

3) Short term financial needs : Such type of financial


needs arise for financing current assets as, stock, debtors,
cash, etc. Investment in these assets is known as meeting of
working capital requirements of the concern. Firms require
working capital to employ fixed assets gainfully. The
requirement of working capital depends on a number of
factors that may differ from industry to industry and from
company to company in the same industry. The main
characteristic of short term financial needs is that they arise
for a short period of time not exceeding the accounting
period i.e. one year.

The basic principle for categorising the financial


needs into short term, medium term and long term is that
they are met from the corresponding viz. short term, medium
term and long term sources respectively. Accordingly the
source of financing is decided with reference to the period
for which funds are required. Basically, there are 2 sources of
raising funds for any business enterprise viz. owners capital
and borrowed capital. The owners capital is used for meeting
long term financial needs and it primarily comes from share
capital and retained earnings. Borrowed capital for all other
types of requirement can be raised from different sources as
debentures, public deposits, financial institutions,
commercial banks, etc.
II) Sources of finance of a business are :

1) Long term :
i) Share capital or Equity share capital
ii) Preference shares
iii) Retained earnings
iv) Debentures/Bonds of different types
v) Loans from financial institutions
vi) Loans from State Financial Corporation
vii) Loans from commercial banks
viii) Venture capital funding
ix) Asset securitisation
x) International financing like Euro-issues, Foreign currency
loans.

2) Medium term :
i) Preference shares
ii) Debentures/Bonds
iii) Public deposits /fixed deposits for a duration of 3 years
iv) Commercial banks
v) Financial institutions
vi) State financial corporations
vii) Lease financing/Hire-purchase financing
viii) External commercial borrowings
ix) Euro -issues
x) Foreign currency bonds.

3) Short-term :
i) Trade credit
ii) Commercial banks
iii) Fixed deposits for a period of 1 year or less
iv) Advances received from customers
v) Various short-term provisions

III) Financial sources of a business can also be


classified as follows on using different basis :

1) According to period :
i) Long term sources
ii) Medium term sources
iii) Short term sources

2) According to ownership :
i) Owners capital or equity capital, retained earnings, etc.
ii) Borrowed capital such as, debentures, public deposits,
loans, etc.

3) According to source of generation :


i) Internal sources e.g. retained earnings and depreciation
funds, etc.
ii) External sources e.g. debentures, loans, etc.

However, for convenience, the different sources of


funds can also be classified into the following :
a) Security financing - financing through shares and
debentures
b) Internal financing - financing through retained earning,
depreciation
c) Loans financing - this includes both short term and long
term loans
d) International financing
e) Other sources.

Question : Write a note on long term sources of finance.

Answer : There are different sources of funds available to


meet long term financial needs of the business. These
sources may be broadly classified into share capital (both
equity and preference) and debt (including debentures, long
term borrowings or other debt instruments). In India, many
companies have raised long term finance by offering various
instruments to public like deep discount bonds, fully
convertible debentures, etc. These new instruments have
characteristics of both equity and debt and it is difficult to
categorise them into equity and debt. Different sources of
long term finance are :

1) Owners' capital or equity capital :


A public limited company may raise funds from
promoters or from the investing public by way of owners
capital or equity capital by issuing ordinary equity shares.
Ordinary shareholders are owners of the company and they
undertake risks of business. They elect the directors to run
the company and have the optimum control over the
management of the company. Since equity shares can be
paid off only in the event in liquidation, this source has the
least risk involved, and more due to the fact that the equity
shareholders can be paid dividends only when there are
distributable profits. However, the cost of ordinary shares is
usually the highest. This is due to the fact that such
shareholders expect a higher rate of return on their
investments compared to other suppliers of long term funds.
The dividend payable on shares is an appropriation of profits
and not a charge against profits, meaning that it has to be
paid only out of profits after tax. Ordinary share capital also
provides a security to other suppliers of funds. Thus, a
company having substantial ordinary share capital may find
it easier to raise funds, in view of the fact that the share
capital provides a security to other suppliers of funds. The
Companies Act, 1956 and SEBI Guidelines for disclosure and
investors' protections and the clarifications thereto lays
down a number of provisions regarding the issue and
management of equity share capital.

Advantages of raising funds by issue of equity shares


are :

i) It is a permanent source of finance.

ii) The issue of new equity shares increases the company's


flexibility.

iii) The company can make further issue of share capital by


making a right issue.

iv) There is no mandatory payments to shareholders of equity


shares.

2) Preference share capital :


These are special kind of shares, the holders of
which enjoy priority in both, repayment of capital at the time
of winding up of the company and payment of fixed dividend.
Long-term funds from preference shares can be raised
through a public issue of shares. Such shares are normally
cumulative, i.e. the dividend payable in a year of loss gets
carried over to the next till, there are adequate profits to pay
cumulative dividends. Rate of dividend on preference shares
is normally higher than the rate of interest on debentures,
loans, etc. Most of preference shares now a days carry a
stipulation of period and the funds have to be repaid at the
end of a stipulated period. Preference share capital is a
hybrid form of financing that partakes some characteristics
of equity capital and some attributes of debt capital. It is
similar to equity because preference dividend, like equity
dividend is not a tax deductible payment. It resembles debt
capital as the rate of preference dividend is fixed. When
preference dividend is skipped, it is payable in future due to
the cumulative feature associated with most of preference
shares. Cumulative Convertible Preference Shares (CCPs)
may also be offered, under which the shares would carry a
cumulative dividend of specified limit for a period of say 3
years, after which the shares are converted into equity
shares. These shares are attractive for projects with a long
gestation period. For normal preference shares, the
maximum permissible rate of dividend is 14 %. Preference
share capital may be redeemed at a predecided future date
or at an earlier stage inter alia out of the company's profits.
This enables the promoters to withdraw their capital from the
company which is now self-sufficient, and the withdrawn
capital may be reinvested in other profitable ventures.
Irredeemable preference shares cannot be issued by any
company. Preference shares gained importance after the
Finance Bill 1997 as dividends became tax exempted in the
hands of the individual investor and are taxable in the hands
of the company as tax is imposed on distributable profits at a
flat rate. The Budget, for 2000 - 01 has doubled the dividend
tax from 10 % to 20 % besides a surcharge of 10 %. The
budget for 2001 - 2002 has reduced the dividend tax from 20
to 10 %. Many companies followed this route during 1997
especially through private placement or preference shares as
the capital markets were not vibrant.

The advantages of taking the preference share capital


are as follows :

1) No dilution in EPS on enlarged capital base : If equity is


issued it reduces EPS, thus affecting the market perception
about the company.

2) There is leveraging advantage as it bears a fixed charge.

3) There is no risk of takeover.

4) There is no dilution of managerial control.


5) Preference capital can be redeemed after a specified
period.

3) Retained Earnings :
Long term funds may also be provided by
accumulation of company's profits and on ploughing them
back into business. Such funds belong to the ordinary
shareholders and increases the company's net worth. A
public limited company must plough back a reasonable
amount of profit every year, keeping in view the legal
requirements in this regard, and its own expansion plans.
Such funds entail almost no risk and the present owner's
control is maintained as there is no dilution of control.

4) Debentures or bonds :
Loans can be raised from public on issue of
debentures or bonds by public limited companies.
Debentures are normally issued in different denominations
ranging from Rs. 100 to 1000 and carry different rates of
interest. On issue of debentures, a company can raise long
term loans from public. Usually, debentures are issued on the
basis of a debenture trust deed which lists terms and
conditions on which debentures are floated. They are
normally secured against the company's assets. As compared
with preference shares, debentures provide a more
convenient mode of long term funds. Cost of capital raised
through debentures is low as the interest can be charged as
an expense before tax. From the investors' view point,
debentures offer a more attractive prospect than preference
shares as interest on debentures is payable whether or not
the company makes profits. Debentures are thus,
instruments for raising long term debt capital. Secured
debentures are protected by a charge on the company's
assets. While the secured debentures of a well-established
company may be attractive to investors, secured debentures
of a new company do not normally evoke same interest in the
investing public.

Advantages :

1) The cost of debentures is much lower than the cost of


preference or equity capital as the interest is tax-deductible.
Also, investors consider debenture investment safer than
equity or preferred investment and thus, may require a lower
return on debenture investment.

2) Debenture financing does not result in dilution of control.

3) In a period of rising prices, debenture issue is


advantageous. The fixed monetary outgo decreases in real
terms as the price level increases.

Disadvantages of debenture financing are as below :

1) Debenture interest and capital repayment are obligatory


payments.

2) The protective covenants associated with a debenture


issue may be restrictive.

3) Debentures financing enhances the financial risk


associated with the firm.

These days many companies are issuing convertible


debentures or bonds with a number of schemes/incentives
like warrants/options, etc. These bonds or debentures are
exchangeable at the ordinary share holder's option under
specified terms and conditions. Thus, for the first few years
these securities remain as debentures and later they can be
converted into equity shares at a pre-determined conversion
price. The issue of convertible debentures has distinct
advantages from the view point of the issuing company.
- such as issue enables the management to raise equity
capital indirectly without diluting the equity holding, until
the capital raised starts earning an added return to support
additional shares.

- such securities can be issued even when the equity market


is not very good.

- convertible bonds are normally unsecured and, thus, their


issuance may ordinarily not impair the borrowing capacity.

These debentures/bonds are issued subject to the


SEBI guidelines notified from time to time. Public issue of
debentures and private placement to mutual funds, require
that the issue be rated by a credit rating agency as CRISIL
(Credit Rating and Information Services of India Ltd.). The
credit rating is given after evaluating factors as track record
of the company, profitability, debt service capacity, credit
worthiness and the perceived risk of lending.

5) Loans from financial institutions :


In India specialised institutions provide long-term
financial assistance to industries. Some of them are,
Industrial Finance Corporations, Life Insurance Corporation of
India, National Small Industries Corporation Limited,
Industrial Credit and Investment Corporation, Industrial
Development Bank of India and Industrial Reconstruction
Corporation of India. Before sanctioning of a term loan, a
company has to satisfy the concerned financial institution
regarding the technical, commercial, economic, financial and
managerial viability of the project for which the loan is
required. Such loans are available at different rates of
interest under different schemes of financial institutions and
are to be repaid as per a stipulated repayment schedule. The
loans in many cases stipulate a number of conditions as
regards the management and certain other financial policies
of the company. Term loans represent secured borrowings
and are an important source of funds for new projects. They
generally, carry a rate of interest inclusive of interest tax,
depending on the credit rating of the borrower, the perceived
risk of lending and cost of funds and generally repayable
over a period of 6 to 10 years in annual, semi-annual or
quarterly installments. Term loans are also provided by
banks, State Financial/Development institutions and all India
term lending financial institutions. Banks and State Financial
Corporations provide term loans to projects in the small scale
sector while, for medium and large industries term loans are
provided by State developmental institutions alone or in
consortium with banks and State financial corporations. For
large scale projects All India financial institutions provide
bulk of term finance singly or in consortium with other such
institutions, State level institutions and/or banks. After
independence, the institutional set up in India for the
provision of medium and long term credit for industry has
been broadened. The assistance sanctioned and disbursed by
these specialised institutions has increased impressively
over the years. A number of specialised institutions are
established over the country.

6) Loans from commercial banks :


The primary role of the commercial banks is to cater
to the short term requirement of industry. However, of late,
banks have started taking an interest in term financing of
industries in several ways, though the formal term lending is,
still, small and confined to major banks. Terms lendings by
bank is a controversial issue these days. It is argued that
term loans do not satisfy the canon of liquidity that is a
major consideration in all bank operations. According to
traditional values, banks should provide loans only for short
periods and operations resulting in automatic liquidation of
such credits over short periods. On the other hand, it is
contended that the traditional concept needs modification.
The proceeds of term loan are used for what are broadly
known as fixed assets or expansion in plant capacity. Their
repayment is usually scheduled over a long period of time.
The liquidity of such loans is said to depend on the
anticipated income of borrowers.

Working capital loan is more permanent and long


term as compared to a term loan. The reason being that a
term loan is always repayable on a fixed date and ultimately,
the account will be totally adjusted. However, in case of
working capital finance, though payable on demand, in actual
practice it is noticed that the account is never adjusted as
such and if at all the payment is asked back, it is with a clear
purpose and intention of refinance being provided at the
beginning of next year or half year. This technique of
providing long term finance is known as, "rolled over for
periods exceeding more than one year". Instead of indulging
in term financing by the rolled over method, banks can and
should extend credit term after a proper appraisal of
applications for term loans. The degree of liquidity in the
provision for regular amortisation of term loans is more than
in some of these so called demand loans which are renewed
from year to year. Actually, term financing, disciplines both
the banker and borrower as long term planning is required to
ensure that cash inflows would be adequate to meet the
instruments of repayments and allow an active turnover of
bank loans. The adoption of the formal term loan lending by
commercial banks will not hamper the criteria of liquidity,
and will introduce flexibility in the operations of the banking
system.

The real limitation to the scope of bank activities is


that all banks are not well equipped to appraise such loan
proposals. Term loan proposals involve an element of risk
because of changes in conditions affecting the borrower. The
bank making such a loan, thus, has to assess the situation to
make a proper appraisal. The decision in such cases depends
on various factors affecting the concerned industry's
conditions and borrower's earning potential.

7) Bridge finance :
It refers to loans taken by a company from
commercial banks for a short period, pending disbursement
of loans sanctioned by financial institutions. Normally, it
takes time for financial institutions to disburse loans to
companies. However, loans once approved by the term
lending institutions pending the signing of regular term loan
agreement, that may be delayed due to non-compliance of
conditions stipulated by the institutions while sanctioning
the loan. The bridge loans are repaid/adjusted out of term
loans as and when disbursed by the concerned institutions.
They are secured by hypothecating movable assets, personal
guarantees and demand promissory notes. Generally, the
interest rate on them is higher than on term loans.

Question : What do you mean by Venture Capital


Financing ?

Answer : Venture capital financing refers to financing of new


high risky venture promoted by qualified entrepreneurs
lacking experience and funds to give shape to their ideas.
Under it venture capitalist make investment to purchase
equity or debt securities from inexperienced entrepreneurs
undertaking highly risky ventures with a potential of success.
The venture capital industry in India is just a decade old. The
venture capitalist finance ventures that are in national
priority areas such as energy conservation, quality
upgradation, etc. The Government of India in November 1988
issued the first set of guidelines for venture capital
companies, funds and made them eligible for capital gain
concessions. In 1995, certain new clauses and amendments
were made in the guidelines that require the venture
capitalists to meet the requirements of different statutory
bodies and this makes it difficult for them to operate as they
do not have much flexibility in structuring investments. In
1999, the existing guidelines were relaxed for increasing the
attractiveness of the venture schemes and to induce high net
worth investors to commit their funds to 'sunrise' sectors,
particularly the information technology sector. Initially the
contribution to the funds available for venture capital
investment in the country was from the All India
development financial institutions, State development
financial institutions, commercial banks and companies in
private sector. Lately many offshore funds have been started
in the country and maximum contribution is from foreign
institutional investors. A few venture capital companies
operate as both investment and fund management
companies, other set up funds and function as asset
management company. It is hoped that changes in the
guidelines for implementation of venture capital schemes in
the country would encourage more funds to be set up to give
the required momentum for venture capital investment in
India. Some common methods of venture capital financing
are :

1) Equity financing : The venture capital undertakings


usually require funds for a longer period but, may not be
able to provide returns to investors during the initial stages.
Thus, the venture capital finance is generally provided by
way of equity share capital. The equity contribution of
venture capital firm does not exceed 49 % of the total equity
capital of venture capital undertakings so that the effective
control and ownership remains with the entrepreneur.

2) Conditional loan : It is repayable in the form of a royalty


after the venture is able to generate sales. No interest is
paid on such loans. In India venture capital financers charge
royalty ranging between 2 and 15 %, actual rate depends on
other factors of the venture as gestation period, cash flow
patterns, riskiness and other factors of the enterprise. Some
venture capital financers give a choice to the enterprise of
paying a high rate of interest, which can be well below 20 %,
instead of royalty on sales once it becomes commercially
sounds.

3) Income note : It is a hybrid security combining features


of both conventional and conditional loan. The entrepreneur
has to pay interest and royalty on sales but, at substantially
low rates. IDBI's Venture Capital Fund (VCF) provides funding
equal to 80 - 87.5 % of the project cost for commercial
application of indigenous technology.
4) Participating debentures : Such security carries
charges in 3 phases - in the start up phase no interest is
charged, next stage - a low rate of interest is charged upto a
particular level of operation and after that, a high rate of
interest is required to be paid.

Question : Write a note on Debt Securitisation ?

Answer : Debt securitisation is a method of recycling of


funds. It is especially beneficial to financial intermediaries to
support the lending volumes. Assets generating steady cash
flows are packaged together and against this asset pool
market securities can be issued. The basic debt
securitisation process can be classified in the following 3
functions :

1) The origination function : A borrower seeks a loan from


a finance company, bank, housing company or a lease from a
leasing company. The creditworthiness of the borrower is
evaluated and a contract is entered into with repayment
schedule structured over the life of the loan.

2) The pooling function : Similar loans or receivables are


clubbed together to create an underlying pool of assets. This
pool is transferred in favour of a SPV (Special Purpose
Vehicle), which acts as a trustee for the investor. Once the
assets are transferred, they are held in the originators'
portfolio.

3) The securitisation function : It is the SPV's job now to


structure and issue the securities on the basis of the asset
pool. The securities carry a coupon and an expected maturity
which can be asset based or mortgage based. These are
generally sold to investors through merchant bankers. The
investors interested in this type of securities are generally
institutional investors like mutual funds, insurance
companies, etc. The originator usually keeps the spread
available i.e. difference between yield from secured assets
and interest paid to investors. The process of securitisation
is generally without recourse i.e. the investor bears the
credit risk or risk of default and the issuer is under an
obligation to pay to investors only if the cash flows are
received by him from the collateral. The risk run by the
investor can be further reduced through credit enhancement
facilities as insurance, letters of credit and guarantees. In a
simple pass through structure, the investor owns a
proportionate share of the asset pool and cash flows when
generated are passed on directly to the investor. This is done
by issuing pass through certificates. In mortgage or asset
backed bonds, the investor has a lien on the underlying asset
pool. The SPV accumulates payments from borrowers from
time to time and make payments to investors at regular
predetermined intervals. The SPV can invest the funds
received in short term instruments and improve yield when
there is a time lag between receipt and payment.

Benefits to the originator :

1) The assets are shifted off the balance sheet, thus, giving
the originator recourse to off balance sheet funding.

2) It converts illiquid assets to liquid portfolio.

3) It facilitates better balance sheet management as assets


are transferred off balance sheet facilitating satisfaction of
capital adequacy norms.

4) The originator's credit rating enhances.

For the investor, securitisation opens up new investment


avenues. Though the investor bears the credit risk. The
securities are tied up to definite assets. As compared to
factoring or bill discounting which largely solve the problems
of short term trade financing. Securitisation helps to convert
a stream of cash receivables into a source of long term
finance. For a developed securitisation market, high quality
assets with low default rate are essential with standardised
loan documentation and stable interest rate structure and
sufficient data on asset performance, developed secondary
debt markets are essential for this. In Indian context debt
securitisation has began to take off. The ideal candidates for
this are hire purchase and leasing companies, asset finance
and real estate finance companies. ICICI, HDFC, Citibank,
Bank of America, etc. have or are planning to raise funds by
securitisation.
Question : Explain briefly the term Lease Financing ?

Answer : Leasing is a general contract between the owner


and user of the asset over a specified period of time. The
asset is purchased initially by the lessor (leasing company)
and thereafter leased to the user (lessee company) that pays
a specified rent at periodical intervals. Thus, leasing is an
alternative to the purchase of an asset out of own or
borrowed funds. Moreover, lease financing can be arranged
much faster as compared to term loans from financial
institutions. In recent years, leasing has become a popular
source of financing in India. From the lessee's view point,
leasing has the attraction of eliminating immediate cash
outflow and the lease rentals can be deducted for computing
the total income under the Income tax act. As against this,
buying has the advantages of depreciation allowance
inclusive of additional depreciation and interest on borrowed
capital being tax deductible. Thus, an evaluation of the 2
alternatives is to be made in order to take a decision.

Question : Explain the various sources of short term


finance ?

Answer : Following are the various sources of short term


finance :

1) Trade credit : It represents credit granted by suppliers of


goods, etc. as an incident of sale. The usual duration of such
credit is 15 to 90 days. It generates automatically, in the
course of business and is common to almost all business
operations. It can be in the form of an 'open account' or 'bills
payable'. Trade credit is preferred as a source of finance as it
is without any explicit cost and till a business is a going
concern, it keeps on rotating. It also, enhances automatically
with the increase in the volume of business.
2) Advances from customers : Manufacturers and
contractors engaged in producing or constructing costly
goods involving considerable length of manufacturing or
construction time usually, demand advance money from their
customers at the time of accepting their orders for executing
their contracts or supplying the goods. This is a cost free
source of finance and really useful.

3) Bank advances :
Banks receive deposits from public for different
periods at varying rates of interest there are funds invested
and lent in such a manner that when required, they may be
called back. Lending results in gross revenues out of which
costs, such as interest on deposits, administrative costs, etc.
are met and a reasonable profit is made. A bank's lending
policy is not merely profit motivated but has to keep in mind
the socio-economic development of the country. As a prudent
policy, banks normally spread out their funds as under :

i) About 9 - 10 % in cash.

ii) About 32 % in approved government and semi-government


securities.

iii) About 58 % in advances to their credits.

Banks advances are in the form of loan, overdraft,


cash credit and bills purchased/discounted, etc. Banks do
not sanction advances on long term basis beyond a small
proportion of their demand and time liabilities. Advances are
granted against tangible securities such as goods, shares,
government promissory notes, bills, etc. In rare cases, clean
advances may also be allowed.

a) Loans : In a loan account, the entire advance is disbursed


at one time in cash or by transfer to the current account of
the borrower. It is a single advance, except by way of
interest and other charges, no further adjustments are made
in this account. Loan accounts are not running accounts like
overdraft and cash credit accounts, repayment under the
loan account, may be full amounts or by way of schedule of
repayments agreed upon as in case of terms loans. The
securities may be shares, government securities, life
insurance policies and fixed deposit receipts and so on.
b) Overdrafts : Under this facility, customers are allowed to
withdraw in excess of credit balance standing in their current
deposit account. A fixed limit is thus, granted to the
borrower within which the borrower is allowed to overdraw
his account. Opening of an overdraft account requires that a
current account is formally opened. Although overdrafts are
repayable on demand, they usually continue for long periods
by annual renewals of limits. This is a convenient
arrangement for the borrower, as he is in a position to avail
the sanctioned limit as per his requirements. Interest is
charged on daily balances, cheque books are provided, these
accounts being operative as cash credit and current
accounts. Security, as in case of loan accounts, may be
shares, debentures and government securities, life insurance
policies and fixed deposit receipts are also accepted in
special cases.

c) Clean overdrafts : Request for such facility is


entertained only from financially sound parties that are
reputed for their integrity. Bank is to rely on personal
security of the borrowers, thus, it has to exercise a good deal
of restraint in entertaining such proposals, as they have no
backing of any tangible security. In case parties are already
enjoying secured advance facilities, this may be a point in
favour and may be taken into account while screening such
proposals. The turnover in the account, satisfactory dealings
for considerable period and reputation in the market are also
considered by the bank. As a safeguard, banks take
guarantees from other persons who are credit worthy before
granting this facility. A clean advance is generally granted
for a short period and must not be continued for long.

d) Cash credits : Cash credit is an arrangement under


which, a customer is allowed an advance upto certain limit
against credit granted by bank. Under it, a customer need
not borrow, the entire amount of advance at one time. He
can only draw to the extent of his requirements and deposit
his surplus funds in his account. Interest is not charged on
the full amount of advance but, on the amount actually
availed by him. Usually, credit limits are sanctioned against
the security of goods by way of pledge or hypothecation,
though they are repayable on demand, banks usually do not
recall them, unless they are compelled to do so by adverse
factors. Hypothecation is an equitable charge on movable
goods for an amount of debt where neither possession nor
ownership is passed on to the creditor. For pledge, the
borrower delivers the goods to the creditor as security for
repayment of debt. Since the banker, as creditor, is in
possession of the goods, he is fully secured and in case of
emergency he may fall back on the goods for realisation of
his advance under proper notice to the borrower.

e) Advances against goods : Advances against goods


occupy an important place in total bank credit, goods as
security have certain distinct advantages :

- they provide a reliable source of repayment


- advances against goods are safe and liquid

Generally, goods are charged to the bank by way of


pledge or hypothecation. The term 'goods' includes all forms
of movables that are offered to the bank as security. They
may be agricultural commodities, industrial raw materials,
partly finished goods and so on. RBI issues directives from
time to time imposing restrictions on advances against
certain commodities. It is obligatory on banks to follow these
directives in letter and spirit, they may sometimes, also
stipulate changes in margin.

f) Bills purchased/discounted : These advances are


allowed against the security of bills that may be clean or
documentary. Bills are sometimes, purchased from approved
customer, in whose favour limits are sanctioned. Before
granting a limit, the banker satisfies himself as to the
creditworthiness of the drawer. Although the term 'bills
purchased' gives the impression that the bank becomes the
owner or purchaser of such bills, in reality, the bank holds
the bills as security only, for the advance. In addition to the
rights against the parties liable on the bills, the banks can
also exercise a pledgee's rights over the goods covered by
the documents. Usuance bills maturing at a future date or
sight are discounted by the banks for approved parties. When
a bill is discounted, the borrower is paid the present worth.
The bankers, however, collect the full amounts on maturity,
the difference between the 2 i.e. the amount of the bill and
the discounted amount represents earnings of bankers for
the period; it is termed as 'discount'. Sometimes, overdraft
or cash credit limits are allowed against the security of bills.
A suitable margin is usually maintained. Here the bill is not a
primary security but, only a collateral one. In such case, the
banker does not become a party to the bill, but merely
collects it as an agent for its customer. When a banker
purchases or discounts a bill, he advances against the bill,
he thus, has to be very cautious and grant such facilities
only to creditworthy customers, having an established steady
relationship with the bank. Credit reports are also complied
on the drawees.

g) Advance against documents of title to goods : A


document becomes of document of title to goods when its
possession is recognised by law or business custom as
possession of the goods. These documents include a bill of
lading, dock warehouse keeper's certificate, railway receipt,
etc. A person in possession of a document to goods can by
endorsement or delivery or both of document, enables
another person to take delivery of the goods in his right. An
advance against pledge of such documents is equivalent to
an advance against the pledge of goods themselves.

h) Advance against supply of bills : Advances against


bills for supply of goods to government or semi-government
departments against firm orders after acceptance of tender
fall under this category. Other type of bills under this
category are bills from contractors for work executed wholly
or partially under firm contracts entered into with the herein
mentioned government agencies. These are clean bills,
without being accompanied by any document of title of
goods. But, they evidence supply of goods directly to
Governmental agencies. They may, sometimes, be
accompanied by inspection notes from representatives of
government agencies for inspecting the goods before
despatch. If bills are without inspection report, banks like to
examine them with the accepted tender or contract for
verifying that the goods supplied under the bills strictly
conform to the terms and conditions in the acceptance
tender. These supply bills represent debt in favour of
suppliers/contractors, for goods supplied to government
bodies or work executed under contract from the
Government bodies. This debt is assigned to the bank by
endorsement of supply bills and executing irrevocable power
of attorney in favour of banks for receiving the amount of
supply bills from the Government departments. The power of
attorney has got to be registered with the department
concerned. The banks also take separate letter from the
suppliers/contractors instructing the Government body to pay
the amount of bills direct to the bank. Supply bills do not
enjoy the legal status of negotiable instruments as they are
not bills of exchange. The security available to a banker is by
way of assignment of debts represented by the supply bills.

i) Term loans by banks : It is an instalment credit


repayable over a period of time in monthly/quarterly/half-
yearly or yearly instalments. Banks grant term loans for
small projects falling under the priority sector, small scale
sector and big units. Banks have now been permitted to
sanction term loan for projects as well without association of
financial institutions. The banks grant loans for periods
normally ranging from 3 to 7 years and at times even more.
These loans are granted on the security of fixed assets.

j) Financing of exports by banks : Advances by


commercial banks for export financing are in the form of :

a) Pre-shipment finance i.e. before shipment of goods :


This usually, takes the form of packing credit facility, which
is an advance extended by banks to an exporter for the
purpose of buying, manufacturing, processing, packing,
shipping goods to overseas buyers. Any exporter, having at
hand a firm export order placed with him by his foreign buyer
or an irrevocable letter of credit opened in his favour, can
approach a bank for availing packing credit. An advance so
taken requires to be liquidated within 180 days from the date
of its commencement by negotiation of export proceeds in an
approved manner. Thus, packing credit is essentially a short
term advance. Usually, banks insist on their customers to
lodge with them irrevocable letters of credit opened in favour
of the customers by overseas buyers. The letter of credit and
firm sale contracts not only serve as evidence of a definite
arrangement for realisation of the export proceeds but also
indicate the amount of finance required by the exporter.
Packing credit in case of customers of long standing, may
also be granted against firm contracts entered into by them
with overseas buyers. Following are the types of packing
credit available :

i) Clean packing credit : This is an advance available to an


exporter only on production of a firm export order or a letter
of credit without exercising any charge or control over raw
material or finished goods. Each proposal is weighted
according to particular requirements of trade and credit
worthiness of the exporter. A suitable margin has to be
maintained. Also, Export Credit Guarantee Corporation
(E.C.G.C.) cover should be obtained by the bank.

ii) Packing credit against hypothecation of goods :


Export finance is made available on certain terms and
conditions where the exporter has pledgeable interest and
the goods are hypothecated to the bank as security with
stipulated margin. At the time of utilising the advance, the
exporter is required to submit, along with the firm export
order or letter of credit, relative stock statements and
thereafter continue submitting them every fortnight and/or
whenever there is any movement in stocks.

iii) Packing credit against pledge of goods : Export


finance is made available on certain terms and conditions
where the exportable finished goods are pledged to the
banks with approved clearing agents who would ship the
same from time to time as required by the exporter.
Possession of goods so pledged lies with the bank and are
kept under its lock and key.

iv) E.C.G.C. guarantee : Any loan given to an exporter for


the manufacture, processing, purchasing or packing of goods
meant for export against a firm order qualifies for packing.
Credit guarantee is issued by the Export Credit Guarantee
Corporation (E.C.G.C.).

v) Forward exchange contract : Another requirement of


packing credit facility is that if the export bill is to be drawn
in a foreign currency, the exporter should enter into a
forward exchange contract with the bank, thereby avoiding
risk involved in a possible change in the exchange rate.

Documents required :
- In case of partnership firms, banks usually require the
following documents :
• Joint and several demand pronote signed on behalf of
the firm as also by partners individually;
• Letter of continuity, signed on behalf of the firm and
partners individually;
• Letter of pledge to secure demand cash credit against
stock, in case of pledge or agreement of
hypothecation to secure demand cash credit, in case of
hypothecation.
• Letter of authority to operate the account;
• Declaration of Partnership, in case of sole traders, sole
proprietorship declaration;
• Agreement to utilise the monies drawn in terms of
contract;
• Letter of hypothecation for bills.
- Following documents are required by banks, in case of
limited companies :
• Demand pro -note;
• Letter of continuity;
• Agreement of hypothecation of letter of pledge, signed
on behalf of the company;
• General guarantee of the directors' resolution;
• Agreement to utilise the monies drawn in terms of
contract should bear the company's seal;
• Letter of hypothecation for bills
b) Post shipment finance : It takes the below mentioned
forms :

i) Purchase/Discounting of documentary export bills :


Finance is provided to exporters by purchasing export bills
drawn payable at sight or by discounting usuance export bills
covering confirmed sales and backed by documents inclusive
of documents of title to goods such as bill of lading, post
parcel receipts or air consignment notes. Documents to be
obtained are :
• Letter of hypothecation covering the goods; and
• General guarantee of directors or partners of the firm,
as the case may be.
E.C.G.C. Guarantee : Post-shipment finance, given to an
exporter by bank through purchase, negotiation or discount
of an export bill against an order, qualifies for post-shipment
export credit guarantee. It is necessary, that exporters
obtain a shipment or contracts risk policy of E.C.G.C. Banks
insist on the exporters to take a contracts shipments
(comprehensive risks) policy covering both political and
commercial risks. The Corporation, on acceptance of the
policy, would fix credit limits for individual exporters and the
Corporation's liability will be limited to the extent of the limit
so fixed for the exporter concerned irrespective of the policy
amount.

ii) Advance against export bills sent for collection :


Finance is provided by banks to exporters by way of advance
against export bills forwarded through them for collection,
taking into account the party's creditworthiness, nature of
goods exported, usuance, standing of drawee, etc.
appropriate margin is kept. Documents to be obtained :
Demand promissory note;
Letter of continuity;
Letter of hypothecation covering bills;
General guarantee of directors or partners of the firm, as the
case may be.

iii) Advance against duty draw backs, cash subsidy,


etc. : To finance export losses sustained by exporters, bank
advance against duty draw-back, cash subsidy, etc.
receivable by them against export performance. Such
advances are of clean nature, hence, necessary precaution is
to be exercised.

Conditions : Bank providing finance in this manner should


see that the relative export bills are either negotiated or
forwarded for collection through it so that, it is in a position
to verify the exporter's claims for duty draw-backs, cash
subsidy, etc. An advance so availed by an exporter is
required to be liquidated within 180 days from the date of
shipment of relative goods.

Documents to be obtained are :


• Demand promissory note;
• Letter of continuity;
• General guarantee of directors or partners of the firm,
as the case may be.
• Undertaking from the borrowers that they will deposit
the cheques/payments received from the appropriate
authorities immediately with the bank and will not
utilise such amounts in any other way.

c) Other facilities extended to exporters :

i) On behalf of approved exporters, banks establish letters of


credit on their overseas or up-country suppliers.

ii) Guarantees for waiver of excise duty, etc. due


performance of contracts, bond in lieu of cash security
deposit, guarantees for advance payments, etc. are also
issued by banks to approved clients.

iii) To approved clients undertaking exports on deferred


payment terms, banks also provide finance.
iv) Banks also endeavour to secure for their exporter-
customers status reports of their buyers and trade
information on various commodities through their
correspondents.

v) Economic intelligence on various countries is also


provided by banks to their exporter clients.

5) Inter corporate deposits : The companies can borrow


funds for a short period say 6 months from other companies
having surplus liquidity. The rate of interest on it varies
depending on the amount involved and time period.

6) Certificate of deposit (CD) : It is a document of title


similar to a time deposit receipt issued by a bank except,
that there is no prescribed interest rate on such funds. Its
main advantage is that banker is not required to encash the
deposit before maturity period and the investor is assured of
liquidity as he can sell it in the secondary market.

7) Public deposits : They are important source of short and


medium term finances particularly due to credit squeeze by
the RBI. A company can accept such deposits subject to the
stipulations of the RBI from time to time maximum upto 35 %
of its paid up capital and reserves, from the public and the
shareholders. These may be accepted for a period of 6
months to 3 years. Public deposits are unsecured loans, and
not meant to be used for acquisition of fixed assets, since,
they are to be repaid within a period of 3 years. These are
mainly used to finance working capital requirements.

Question : Enumerate and explain the other sources of


financing ?

Answer : The other sources of financing are as discussed


below :

1) Seed capital assistance : The seed capital assistance


scheme is designed by IDBI for professionally or technically
qualified entrepreneurs and/or persons possessing relevant
experience, skills and entrepreneurial traits. All the projects
eligible for financial assistance from IDBI, directly or
indirectly through refinance are eligible under the scheme.
The project cost should not exceed Rs. 2 crores and the
maximum assistance under the project will be restricted to
50 % of the required promoter's contribution or Rs. 15 lakhs,
whichever is lower. Seed capital assistance is interest free,
but carries a service charge of 1 % per annum for the first 5
years and at increasing rate thereafter. However, IDBI will
have the option to charge interest at such rate as
determined by it on the loan if the financial position and
profitability of the company so permits during the currency
of the loan. The repayment schedule is fixed depending on
the repaying capacity of the unit with an initial moratorium
upto 5 years. For projects with cost exceeding Rs. 200 lakhs,
seed capital may be obtained from the Risk Capital and
Technology Corporation Ltd. (RCTC). For small projects
costing upto Rs. 5 lakhs, assistance under the National
Equity Fund of the SIDBI may be availed.

2) Internal cash accruals : Existing profit making


companies undertaking an expansion/diversification
programme may be permitted to invest a part of their
accumulated reserves or cash profits for creation of capital
assets. In such cases, the company's past performance
permits capital expenditure from within the company by way
of disinvestment of working/invested funds. In other words,
the surplus generated from operations, after meeting all the
contractual, statutory and working requirement of funds, is
available for further capital expenditure.

3) Unsecured loans : They are provided by promoters to


meet the promoters' contribution norm. These loans are
subordinate to institutional loans and interest can be paid
only after payment of institutional dues. These loans cannot
be repaid without the prior approval of financial institutions.
Unsecured loans are considered as part of the equity for the
purpose of calculating debt equity ratio.

4) Deferred payment guarantee : Many a time suppliers of


machinery provide a deferred credit facility under which
payment for the purchase of machinery may be made over a
period of time. The entire cost of machinery is financed and
the company is not required to contribute any amount
initially towards acquisition of machinery. Normally, the
supplier of machinery would insist that the bank guarantee
be furnished by the buyer. Such a facility does not have a
moratorium period for repayment. Hence, it is advisable only
for an existing profit making company.

5) Capital Incentives : Backward area development


incentives available often determine the location of a new
industrial unit. They usually consist of a lumpsum subsidy
and exemption from or deferment of sales tax and octroi
duty. The quantum of incentives is determined by the degree
of backwardness of the location. Special capital incentive in
the form of a lumpsum subsidy is a quantum sanctioned by
the implementing agency as a percentage of the fixed capital
investment subject, to an overall ceiling. This amount forms
a part of the long-term means of finance for the project.
However, the viability of the project must not be dependent
on the quantum and availability of incentives. Institutions,
while appraising the project, assess its viability per se,
without considering the impact of incentives on the cash
flows and the project's profitability. Special capital incentives
are sanctioned and released to the units only after they have
complied with the requirements of the relevant scheme. The
requirements may be classified into initial effective steps,
that include formation of the firm/company, acquisition of
land in the backward area and registration for manufacture
of the products. The final effective steps include obtaining
clearances under FEMA, capital goods clearance/import
license, conversion of Letter of Intent to Industrial License,
tie up of the means of finance, all clearances required for the
setting up of the unit, aggregate expenditure incurred for the
project should exceed 25 % of the project cost and atleast 10
%, if the fixed assets should have been created/acquired at
site. The release of special capital incentives by the
concerned State Government generally takes 1 to 2 years.
Promoters thus, find it convenient to avail the bridge finance
against the capital incentives. Provision for the same should
be made in the pre-operative expenses considered in the
project cost. As the bridge finance may be available to the
extent of 85 %, the balance i.e. 15 % may have to be brought
in by the promoters from their own resources.

6) Various short term provisions/accruals account :


Accruals accounts are a spontaneous source of financing as
they are self-generating. The most common accrual accounts
are wages and taxes. In both cases, the amount becomes due
but is not paid immediately.
Question : Write short notes on :
1) Deep Discount Bonds 2)
Secured Premium Notes
3) Zero interest fully convertible debentures 4)
Zero Coupon Bonds
5) Double Option Bonds 6)
Option Bonds
7) Inflation Bonds 8)
Floating Rate Bonds

Answer :
1) Deep Discount Bonds :
It is a form of a zero interest bond, sold at a
discounted value and on maturity face value is paid to the
investors. In such bonds, there is no interest paid during lock
in period. IDBI was the first to issue a deep discount bond in
India in January, 1992. It had a face value of Rs. 1lakh and
was sold for Rs. 2700 with a maturity period of 25 years. The
investor could hold the bond for 25 years or seek redemption
at the end of every 5 years with maturity value as below :

Holding period
5 10 15 20 25
(years)
Maturity value
5700 12000 25000 50000 100000
(Rs.)
Annual rate of
16.12 16.09 15.99 15.71 15.54
interest (%)

The investor can sell the bonds in stock market and


realise the difference between face value (Rs. 2700) and the
market price as capital gain.

2) Secured Premium Notes :


It is issued along with a detachable warrant and is
redeemable after a notified period of say 4 to 7 years. The
conversion of detachable warrant into equity shares will have
to be done within the time period notified by the company.

3) Zero interest fully convertible debentures :


These are fully convertible debentures which do not
carry any interest. They are compulsorily and automatically
converted after a specified period of time and holders
thereof are entitled to new equity shares of the company at
predetermined price. From the company's view point, this
kind of instrument is beneficial in the sense, that no interest
is to be paid on it, if the share price of the company in the
market is very high, then the investor tends to get equity
shares of the company at a lower rate.

4) Zero Coupon Bonds :


A zero coupon bond does not carry any interest, but
it is sold by the issuing company at a discount. The
difference between the discounted and maturing or face
value represents the interest to be earned by the investor on
them.

5) Double Option Bonds :


Double Option Bonds are recently issued by the
IDBI. The face value of each bond is Rs. 5000, it carries
interest at 15 % per annum compounded half yearly from the
date of allotment. The bond has a maturity period of 10
years. Each having 2 parts, in the form of 2 separate
certificates, one for the principal of Rs. 5000 and other for
interest, including redemption premium of Rs. 16500. Both
these certificates are listed on all major stock exchanges.
The investor has the facility of selling either one or both
parts anytime he likes.

6) Option bonds :
These are cumulative and non-cumulative bonds
where interest is payable on maturity or periodically.
Redemption premium is also offered to attract investors.
These were recently issued by IDBI, ICICI, etc.

7) Inflation bonds :
They are bonds in which interest rate is adjusted for
inflation. The investor, thus, gets an interest free from the
effects of inflation. For instance, if interest rate is 12 % and
inflation rate is 5 %, the investor will earn 17 %, meaning
that the investor is protected against inflation.

8) Floating Rate Bonds :


As the name suggests, Floating Rate Bonds are ones,
where the rate of interest is not fixed and is allowed to float
depending upon the market conditions. This is an ideal
instrument that can be resorted to by the issuer to hedge
themselves against the volatility in interest rates. This has
become more popular as a money market instrument and has
been successfully issued by financial institutions like IDBI,
ICICI, etc.

Question : Give a detailed account of International


Financing ?

Answer : The essence of financial management is to raise &


utilise the funds raised effectively. There are various avenues
for organisations to raise funds either through internal or
external sources. External sources include :
• Commercial banks : Like domestic loans, commercial
banks all over the world extend Foreign Currency (FC)
loans, for international operations. These banks also
provide to overdraw over and above the loan amount.
• Development banks : offer long and medium term
loans including FC loans. Many agencies at the national
level offer a number of concessions to foreign
companies to invest within their country and to finance
exports from their countries e.g. EXIM Bank of USA.
• Discounting of trade bills :This is used as a short
term financing method widely, in Europe and Asian
countries to finance both domestic and international
business.
• International agencies : A number of international
agencies have emerged over the years to finance
international trade and business. The more notable
among them includes : International Finance
Corporation (IFC), International Bank for Reconstruction
& Development (IBRD), Asian Development Bank (ADB),
International Monetary Fund (IMF), etc.

International capital markets :


Modern organisations including MNC's depend upon
sizeable borrowings in Rupees as also Foreign Currency. In
order to cater to the needs of such organisation ,
international capital markets have sprung all over the globe
such as in London. In International capital market, the
availability of FC is assured under the 4 main systems, as :
• Euro-currency market
• Export credit facilities
• Bonds issues
• Financial Institutions
The origin of the Euro -currency market was with the
dollar denominated bank deposits & loans in Europe
particularly, London. Euro -dollar deposits are dollar
denominated time deposits available at foreign branches of
US banks and at some foreign banks. Banks based in Europe
accept & make dollar denominated deposits to the clients.
This forms the backbone of the Euro-currency market all over
the globe. In this market, funds are made available as loans
through syndicated Euro -credit of instruments as FRN's, FR
certificates of deposits.

Below mentioned are some of the financial instruments


:
1) Euro Bonds : Euro Bonds are debt instruments
denominated in a currency issued outside the country of that
currency, for instance : a yen note floated in Germany.

2) Foreign Bonds : These are debt instruments


denominated in a currency which is foreign to the borrower
and is sold in the country of that currency.

3) Fully Hedged Bonds : In foreign bonds, the risk of


currency fluctuations exists. They eliminate the risk by
selling in forward markets the entire stream of principal and
interest payments.

4) Floating Rate Notes : They are issued upto 7 years


maturity. Interest rates are adjusted to reflect the prevailing
exchange rates. They provide cheaper money than foreign
loans.

5) Euro Commercial Papers (ECP) : ECP's are short term


money market instruments, with maturity of less than 1 year
and designated in US dollars.

6) Foreign Currency Option : A FC Option is the right to


buy or sell, spot or future or forward, a specified foreign
currency. It provides a hedge against financial and economic
risks.
7) Foreign Currency Futures : FC Futures are obligations
to buy or sell a specified currency in the present for
settlement at a future date.

8) Euro Issues : In the Indian context, Euro Issue denotes


that the issue is listed on a European Stock Exchange.
However, subscription can come from any part of the world
except India. Finance can be raised by Global Depository
Receipts (GDR), Foreign Currency Convertible Bonds (FCCB)
and pure debt bonds. However, GDR's and FCCB's are more
popular.

9) Global Depository Receipts : A depository receipt is


basically a negotiable certificate, denominated in US Dollars
representing a non US company's publicly traded local
currency (Indian Rupee) equity shares,. Theoretically, though
a depository receipt can also signify debt instrument,
practically it rarely does so. DR's are created when the local
currency shares of an Indian company are delivered to the
depository's local custodian bank, against which the
depository bank issues DR's in US Dollars. These DR's may be
freely traded in the overseas- markets like any other dollar
denominated security via either a foreign stock exchange or
through a over the counter market or among a restricted
group as Qualified Institutional Buyers (QIB). Rule 144 A of
the Securities and Exchange Commission (SEC) of USA
permits companies from outside USA to offer their GDR's to
certain institutional buyers, known as QIBs.

10) GDR with Warrant : These receipts are more attractive


than plain GDR's in view of additional value of attached
warrants.

11) American Depository Receipts (ADR's) : Depository


Receipts issued by a company in USA is known as ADR's.
Such receipts have to be issued in accordance with the
provisions stipulated by the SEC, USA that are stringent. In a
bid to bypass such stringent disclosure norms mandated by
the SEC for equity shares, the Indian companies have,
however, chosen the indirect route to tap the vast American
financial market through private debt placement of GDR's
listed in London and Luxembourg stock exchanges.

Indian companies have preferred the GDR's and


ADR's as the US market exposes them to a higher level or
responsibility than a European listing in the areas of
disclosure, costs, liabilities and timing. The SECs regulations
set up to protect the retail investor base are some what more
stringent and onerous, even for companies already listed and
held by retail investors in their home country. Most onerous
aspect of a US listing for companies is to provide full, half
yearly and quarterly accounts in accordance with or atleast
reconciled with US GA APs. However, Indian companies are
shedding their reluctance to tap the US markets as evidenced
by Infosys Technologies Ltd. recent listing in NASDAQ. Most
of India's top notch companies in the pharmaceutical, info -
tech and other sunrise industries are planning forays into the
US markets. Another prohibitive aspect of the ADR's vis-à-vis
GDR's is the cost involved of preparing and filling US GA AP
accounts. Additionally, the initial SEC registration fees based
on a percentage of issue size anmd 'Blue Sky' registration
costs, permitting the securities to be offered in all States of
US, will have to be met. The US market is widely recognised
as the most litigious market in the world. Accordingly, the
broader the target investor base in US, higher is the
potential legal liability. An important aspect of GDR is that
they are non voting and hence spells no dilution of equity.
GDRs are settled through CEDEL and Euro -clear International
Book Entry Systems.

Other types of International issues :


• Foreign Euro Bonds : In domestic capital markets of
various countries the Bond issues referred to above are
known by different names as Yankee Bonds in US, Swiss
Frances in Switzerland, Samurai Bonds in Tokyo and
Bulldogs in UK.
• Euro Convertible Bonds : A convertible bond is a debt
instrument giving the holders of the bond an option to
convert the bonds into a pre-determined number of
equity shares of the company. Usually, the price of
equity shares at the time of conversion will have a
premium element. They carry a fixed rate of interest
and if the issuer company so desires may also include a
Call Option, where the issuer company has the option of
calling/buying the bonds for redemption prior to the
maturity date, or a Put Option, which gives the holder
the option to put/sell his bonds to the issuer company
at a pre-determined date and price.
• Euro Bonds : Plain Euro Bonds are nothing but debt
instruments. These are not very attractive for an
investor who desires to have valuable additions to his
investments.
• Euro Convertible Zero Bonds : These are structured
as a convertible bond. No interest is payable on the
bonds. But conversion of bonds take place on maturity
at a pre-determined price. Usually, there is a 5 years
maturity period and they are treated as a deferred
equity issue.
• Euro Bonds with Equity Warrants : These carry a
coupon rate determined by market rates. The warrants
are detachable. Pure bonds are traded at a discount.
Fixed Income Funds Management may like to invest for
the purposes of regular income.