Finacial Management Full Notes

Unit-I: Financial management: meaning, nature and scope of finance; financial goals:
profit maximization, wealth maximization; finance functions,- investment, financing

and dividend decisions.
Financial Management is a related aspect of finance function. In the present business

administration financial management is an important branch. Nobody will think over about-
business activity without finance implication.
Financial management includes adoption of general management principles for financial

implementation. The following may be said as the related aspects of financial management
raising of funds, using of these funds profitably, planning of future activities, controlling of
present implementations and future developments with the help of financial accounting, cost
accounting, budgeting and statistics.
It acts as guidance where more opportunities for investment is available. Financial

management is useful as a tool for allotment of resources to various projects depending on
their importance and repayment capacity.
Definition:
James Van Morne defines Financial Management as follows:
“Planning is an inextricable dimension of financial management. The term financial
management connotes that funds flows are directed according to some plan”. Financial
managements can be said a good guide for allotment of future resources of an organisation.
Preparing and implementation of some plans can be said as financial management. In other
words, collection of funds and their effective utilisation for efficient running of and
organization is called financial management. Financial management has influence on all
activities of an organisation. Hence it can be said as an important one.
Its main responsibility is to complete the finance function successfully. It also has relations
with other business functions. All business decisions also have financial implications.
According to Raymond Chambers, Management of finance function is the financial
management’.
BBA FINANCIAL MANAGEMENT GVP

However, financial management shall not be considered as the profit extracting device. If
finance is properly utilised through plans, they lead to profits. Besides, without profits there
won’t be finance generation. All these are facts. But this is not complete.
The implication of financial management is not only attaining efficiency and getting profits
but also maximising the value of the firm. It facilitates to protect the interests of various
classes of people related to the firm.
Hence, managing a firm for profit maximisation is not the meaning for financial
management. Financial management is applicable to all kinds of organisations. According to
Raymond Chambers, ‘the word financial management is applicable to all kinds of firms
irrespective of their objectives’.
Aims of Financial Management:

The aims of financial management should be useful to the firm’s proprietors, managers,
employees and consumers. For this purpose the only way is maximisation of firm’s value
The following aspects have place in maximising firm’s value:

1. Rise in profits:
If the firm wants to maximise its value, it should’ increase its profits and revenues. For this
purpose increase of sales volume or other activities can be taken up. It is the general feature
of any firm to increase profits by proper utilisation of all opportunities and plans.
Theoretically, firm gets maximum profits if it is under equilibrium. At that stage the average
cost is minimal and the marginal cost and the marginal revenues are equal. Here, we can’t say
the sales because there must be suitable market for the increased sales. Further, the above
costs must also be controlled.
2. Reduction in cost:
Capital and equity funds are utilised for production. So all types of steps should be taken to
reduce firm’s cost of capital.
3. Sources of funds:
It should be decided by keeping in view the value of the firm to collect funds through issue of
shares or debentures.

4. Reduce risks:
There won’t be profits without risk. But for this reason if more risk is taken, it may become
danger to the existence of the firm. Hence risk should be reduced to minimum level.
5. Long run value:

It should be the feature of financial management to increase the long-run value of the firm.
To earn more profits in short time, some firms may do the activities like releasing of low
quality goods, neglecting the interests of consumers and employees.
These trials may give good results in the short run. But for increasing the value of the firm in
the long run, avoiding; such activities are more essential.
SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT:

The scope of financial management includes three groups. First – relating to finance and
cash, second – rising of fund and their administration, third – along with the activities of
rising funds, these are part and parcel of total management, Isra Salomon felt that in view of
funds utilisation third group has wider scope.
It can be said that all activities done by a finance officer are under the purview of financial
management. But the activities of these officers change from firm to firm, it become difficult
to say the scope of finance. Financial management plays two main roles, one – participating
in funds utilisation and controlling productivity, two – Identifying the requirements of funds
and selecting the sources for those funds. Liquidity, profitability and management are the
functions of financial management. Let us know very briefly about them.
1. Liquidity:
Liquidity can be ascertained through the three important considerations.
i) Forecasting of cash flow:

Cash inflows and outflows should be equalized for the purpose of liquidity.
ii) Rising of funds:

Finance manager should try to identify the requirements and increase of funds.
iii) Managing the flow of internal funds:

Liquidity at higher degree can be maintained by keeping accounts in many banks. Then there
will be no need to depend on external loans.

2. Profitability:
While ascertaining the profitability the following aspects should be taken into consideration:
1) Cost of control:
For the purpose of controlling costs, various activities of the firm should be analyzed through
proper cost accounting system,
ii) Pricing:
Pricing policy has great importance in deciding sales level in company’s marketing. Pricing
policy should be evolved in such a way that the image of the firm should not be affected.
iii) Forecasting of future profits:

Often estimated profits should be ascertained and assessed to strengthen the firm and to
ascertain the profit levels.
iv) Measuring the cost of capital:

Each fund source has different cost of capital. As the profit of the firm is directly related to
cost of capital, each cost of capital should be measured.
3. Management:
It is the duty of the financial manager to keep the sources of the assets in maintaining the
business. Asset management plays an important role in financial management. Besides, the
financial manager should see that the required sources are available for smooth running of the
firm without any interruptions.
A business may fail without financial failures. Financial failures also lead to business failure.
Because of this peculiar condition the responsibility of financial management increased. It
can be divided into the management of long run funds and short run funds.
Long run management of funds relates to the development and extensive plans. Short run
management of funds relates to the total business cycle activities. It is also the responsibility
of financial management to coordinate different activities in the business. Thus, for the
success of any firm or organization financial management is said to be a must.

Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-
1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.
Functions of Financial Management
1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period
of financing.
4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current
liabilities, maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Difference Between Profit Maximization and Wealth Maximization
Profit Maximization:
The objective of financial management is profit maximisation. It cannot be the sole objective
of a company as there is a directs/relationship between risk and profit. If profit maximisation
is the only goal, then risk factories ignored.
Sometimes, higher the risk, higher is the possibility of profits. Hence, risk has to be balanced
with the objective of profit maximisation. In addition, a firm has to take into account the
social considerations, and normal obligations to the interests of workers, consumers, society,
government, as well as ethical trade practices. However, as profit maximisation ignores risk
and uncertainty and timing of returns, a firm can’t solely depend on the objective.
Wealth Maximisation:
Hence, the objective of a firm is to maximise its wealth and the value of its shares. According
to van Home value is represented by the market price of the company’s common stock. The
market price of a firm’s stock takes into account present and prospective future earnings per
share (EPS), the timing and risk of these earnings, the dividend policy of the firm and many
other factors that bear upon the market price of the stock.

Key Differences Between Profit Maximization and Wealth Maximization
The fundamental differences between profit maximization and wealth maximization is

explained in points below:
1. The process through which the company is capable of increasing earning capacity known as
Profit Maximization. On the other hand, the ability of the company in increasing the value of
its stock in the market is known as wealth maximization.
2. Profit maximization is a short term objective of the firm while the long-term objective is
Wealth Maximization.
3. Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which
considers both.
4. Profit Maximization avoids time value of money, but Wealth Maximization recognises it.
5. Profit Maximization is necessary for the survival and growth of the enterprise. Conversely,
Wealth Maximization accelerates the growth rate of the enterprise and aims at attaining the
maximum market share of the economy.
FINANCE FUNCTIONS
The following explanation will help in understanding each finance function in detail
Investment Decision
One of the most important finance functions is to intelligently allocate capital to long term
assets. This activity is also known as capital budgeting. It is important to allocate capital in
those long term assets so as to get maximum yield in future. Following are the two aspects of
investment decision
1. Evaluation of new investment in terms of profitability

2. Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected return.
Along with uncertainty comes the risk factor which has to be taken into consideration. This
risk factor plays a very significant role in calculating the expected return of the prospective
investment. Therefore while considering investment proposal it is important to take into
consideration both expected return and the risk involved.
Investment decision not only involves allocating capital to long term assets but also involves
decisions of using funds which are obtained by selling those assets which become less
profitable and less productive. It wise decisions to decompose depreciated assets which are
not adding value and utilize those funds in securing other beneficial assets. An opportunity
cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is
calculated by using this opportunity cost of the required rate of return (RRR)

Financial Decision
Financial decision is yet another important function which a financial manger must perform.
It is important to make wise decisions about when, where and how should a business acquire
funds. Funds can be acquired through many ways and channels. Broadly speaking a correct
ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known
as a firm’s capital structure.
A firm tends to benefit most when the market value of a company’s share maximizes this not
only is a sign of growth for the firm but also maximizes shareholders wealth. On the other
hand the use of debt affects the risk and return of a shareholder. It is more risky though it may
increase the return on equity funds.
A sound financial structure is said to be one which aims at maximizing shareholders return
with minimum risk. In such a scenario the market value of the firm will maximize and hence
an optimum capital structure would be achieved. Other than equity and debt there are several
other tools which are used in deciding a firm capital structure.
Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But the key function
a financial manger performs in case of profitability is to decide whether to distribute all the
profits to the shareholder or retain all the profits or distribute part of the profits to the
shareholder and retain the other half in the business.
It’s the financial manager’s responsibility to decide a optimum dividend policy which
maximizes the market value of the firm. Hence an optimum dividend payout ratio is
calculated. It is a common practice to pay regular dividends in case of profitability Another
way is to issue bonus shares to existing shareholders.
Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s

profitability, liquidity and risk all are associated with the investment in current assets. In
order to maintain a tradeoff between profitability and liquidity it is important to invest
sufficient funds in current assets. But since current assets do not earn anything for business
therefore a proper calculation must be done before investing in current assets.
Current assets should properly be valued and disposed of from time to time once they become
non profitable. Currents assets must be used in times of liquidity problems and times of
insolvency.

Unit-II: Capital budgeting: nature of investment decisions; investment evaluation
criteria- net present value, internal rate of return, profitability index, payback period,
accounting rate of return , NPV and IRR comparison; capital rationing; risk analysis in
capital budgeting
Nature of Capital Budgeting:

Capital budgeting is the process of making investment decisions in capital expenditures. A
capital expenditure may be defined as an expenditure the benefits of which are expected to be
received over period of time exceeding one year.
The main characteristic of a capital expenditure is that the expenditure is incurred at one
point of time whereas benefits of the expenditure are realized at different points of time in
future. In simple language we may say that a capital expenditure is an expenditure incurred
for acquiring or improving the fixed assets, the benefits of which are expected to be received
over a number of years in future.
The following are some of the examples of capital expenditure:

(1) Cost of acquisition of permanent assets as land and building, plant and machinery,
goodwill, etc.
(2) Cost of addition, expansion, improvement or alteration in the fixed assets.
(3) Cost of replacement of permanent assets.
(4) Research and development project cost, etc.
Capital expenditure involves non-flexible long-term commitment of funds. Thus, capital

expenditure decisions are also called as long term investment decisions. Capital budgeting
involves the planning and control of capital expenditure. It is the process of deciding whether
or not to commit resources to a particular long term project whose benefits are to be realized
over a period of time, longer than one year. Capital budgeting is also known as Investment
Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure and Analysis
of Capital Expenditure.

Charles T. Horngreen has defined capital budgeting as, “Capital budgeting is long term
planning for making and financing proposed capital outlays.”
According to G.C. Philippatos, “Capital budgeting is concerned with the allocation of the
firm’s scarce financial resources among the available market opportunities. The consideration
of investment opportunities involves the comparison of the expected future streams of
earnings from a project with the immediate and subsequent streams of earning from a project,
with the immediate and subsequent streams of expenditures for it”.
Richard and Greenlaw have referred to capital budgeting as acquiring inputs with long-run
return.
In the words of Lynch, “Capital budgeting consists in planning development of available

capital for the purpose of maximizing the long term profitability of the concern.”
From the above description, it may be concluded that the important features which
distinguish capital budgeting decision from the ordinary day to day business decisions
are:
(1) Capital budgeting decisions involve the exchange of current funds for the benefits to be
achieved in future;
(2) The future benefits are expected to be realized over a series of years;
(3) The funds are invested in non-flexible and long term activities;
(4) They have a long term and significant effect on the profitability of the concern;
(5) They involve, generally, huge funds;
(6) They are irreversible decisions.
(7) They are ‘strategic’ investment decisions, involving large sums of money, major
departure from the past practices of the firm, significant change of the firm’s expected
earnings associated with high degree of risk, as compared to ‘tactical’ investment decisions
which involve a relatively small amount of funds that do not result in a major departure from
the past practices of the firm.

Need and Importance of Capital Budgeting:
Capital budgeting means planning for capital assets.
Capital budgeting decisions are vital to any organisation as they include the decisions as
to:
(a) Whether or not funds should be invested in long term projects such as setting of an
industry, purchase of plant and machinery etc.
(b) Analyze the proposal for expansion or creating additional capacities.
(c) To decide the replacement of permanent assets such as building and equipment’s.
(d) To make financial analysis of various proposals regarding capital investments so as to

choose the best out of many alternative proposals.
The importance of capital budgeting can be well understood from the fact that an unsound
investment decision may prove to be fatal to the very existence of the concern.
The need, significance or importance of capital budgeting arises mainly due to the
following:
(1) Large Investments:
Capital budgeting decisions, generally, involve large investment of funds. But the funds
available with the firm are always limited and the demand for funds far exceeds the
resources. Hence, it is very important for a firm to plan and control its capital expenditure.
(2) Long-term Commitment of Funds:

Capital expenditure involves not only large amount of funds but also funds for long-term or
more or less on permanent basis. The long-term commitment of funds increases the financial
risk involved in the investment decision. Greater the risk involved, greater is the need for
careful planning of capital expenditure, i.e. Capital budgeting.

(3) Irreversible Nature:
The capital expenditure decisions are of irreversible nature. Once the decision for acquiring a
permanent asset is taken, it becomes very difficult to dispose of these assets without incurring
heavy losses.
(4) Long-Term Effect on Profitability:

Capital budgeting decisions have a long-term and significant effect on the profitability of a
concern. Not only the present earnings of the firm are affected by the investments in capital
assets but also the future growth and profitability of the firm depends upon the investment
decision taken today. An unwise decision may prove disastrous and fatal to the very existence
of the concern. Capital budgeting is of utmost importance to avoid over investment or under
investment in fixed assets.
(5) Difficulties of Investment Decisions:
The long term investment decisions are difficult to be taken because:

(i) Decision extends to a series of years beyond the current accounting period,
(ii) Uncertainties of future and
(iii) Higher degree of risk.
(6) National Importance:

Investment decision though taken by individual concern is of national importance because it
determines employment, economic activities and economic growth. Thus, we may say that
without using capital budgeting techniques a firm may involve itself in a losing project.
Proper timing of purchase, replacement, expansion and alternation of assets is essential.

LIMITATIONS OF CAPITAL BUDGETING:
Capital budgeting techniques suffer from the following limitations:

(1) All the techniques of capital budgeting presume that various investment proposals under
consideration are mutually exclusive which may not practically be true in some particular
circumstances.
(2) The techniques of capital budgeting require estimation of future cash inflows and
outflows. The future is always uncertain and the data collected for future may not be exact.
Obliviously the results based upon wrong data may not be good.
(3) There are certain factors like morale of the employees, goodwill of the firm, etc., which
cannot be correctly quantified but which otherwise substantially influence the capital
decision.
(4) Urgency is another limitation in the evaluation of capital investment decisions.
(5) Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting.

Three steps are involved in the EVALUATION OF AN INVESTMENT:
• Estimation of cash flows
• Estimation of the required rate of return (the cast of capital)
• Application of a decision rule for decision rule for making the choice
Investment decision rule
The investment decision rules may be referred to as capital budgeting techniques, or

investment criteria. A sound appraisal technique should be used to measure the economic
worth of an investment project. The essential property of a sound technique is that is should
maximize the shareholders wealth. The following other characteristics should also be
possessed by a sound investment evaluation criterion:
• It should consider all cash flows to determine the true profitability of then project.
• It should provide for an objective and unambiguous way of separate good projects from bad
projects.
• It should help ranking of projects according to their true profitability.
• It should recognize the fact that bigger cash flows are preferable to smaller ones and early
cash flows are preferable to later ones.
• It should help to choose among mutually exclusive projects that project which maximizes
the shareholders wealth.
• It should be a criterion which is applicable to any conceivable investment project

independent of others.
These conditions will be clarified as we discuss the features of various investment criteria in
the following posts.
Investment Appraisal Criteria
A number of investment appraisal criteria or capital budgeting techniques are in use of

practice. They may be grouped in the following two categories:
1. Discounted cash flow criteria 2. Not discounted cash flow criteria
• Net present value • Payback period
• Internal rate of return • Accounting rate of return
• Profitability index (PI) • Discounted payback period

The methods are:
1. Average Rate of Return Method
2. Pay-Back Method
3. Discounted Pay-Back Method
4. Internal Rate of Return Method
5. Present Value Method
6. Profitability Index Method.
Average Rate of Return Method:

The average rate of return method, also known as accounting method of ranking capital
investment projects, relies on the rate of return each project will earn over its life. There are
several methods to determine rate of return on investment. One such method is to divide
average annual income or earning after depreciation and taxes by the total investment figure.
Income after taxes but including cash flow from depreciation may be related to original
investment to find out rate of return on project. Income after taxes and depreciation is also
related to original investment to determine the rate of return.
The methods are: 1. Average Rate of Return Method 2. Pay-Back Method 3. Discounted Pay-
Back Method 4. Internal Rate of Return Method 5. Present Value Method 6. Profitability
Index Method.
Evaluating Economic Variability: Method # 1.
Average Rate of Return Method:
The average rate of return method, also known as accounting method of ranking capital
investment projects, relies on the rate of return each project will earn over its life. There are
several methods to determine rate of return on investment. One such method is to divide
average annual income or earning after depreciation and taxes by the total investment figure.
Income after taxes but including cash flow from depreciation may be related to original
investment to find out rate of return on project. Income after taxes and depreciation is also
related to original investment to determine the rate of return.

Instead of using original investment figure which is rejected on the ground that the original
outlay because of depreciation charges is gradually recovered over the project life, average
investment is equal to original investment divided by two. If a Rs. 20,000 project were to
yield an average income net after taxes and depreciation of Rs. 2,000 per annum for five
years, average rate of return would be;
Rs. 2,000/Rs. 10,000 × 100 = 20%
In this method, income figure is not based upon cash flows but upon the reported accounting
profit. The average return method is easy to comprehend and simple to calculate. By
comparing average rate of return so calculated with cost of capital, this method serves as
potent tool of ranking the desirability of projects.
However, this method is fraught with the following dangers:
(1) This method has primary weakness in that the time value of money is ignored.
(2) The average method fails to shed light on yearly rate of return of the project.
Consequently, real worth of projects can hardly be judged by this method. It may be possible
for the project producing the higher earnings in the early years to show a lower average rate
of return and be rejected in favour of other projects. Real rate of return actually depends on
the time pattern of the fund flows.
Illustration 1:
Bharat Electricals Ltd is thinking to buy any one of the following machines:
Evaluating Economic Variability of Investment Proposal With Illustration 1
Calculate the average rate of return on investment and advise on the selection of the machine.

Solution:
Machine X:
Machine Y:
Since average rate on Machine Y is higher than that on Machine X, Machine, Y should be
chosen.

Pay-Back Method:
Pay-Back method is a widely used method for ranking investment projects in order of their
relative desirability. Pay-back period represents the length of time required for the stream of
cash proceeds produced by the investment to be equal to the original cash outlay, i.e., the
time required for the project to pay for itself.
Pay- Back period is worked out with the help of the following formula:
While calculating pay-back period net cash benefit is based on expected cash flow and net
investment is actual outlay required for the project. For example, a project requires an
investment of Rs. 12,000 and has an estimated life of 8 years promising cash savings of Rs.
4,000 a year (before depreciation).
The pay-back period will be (12,000/4,000) = three years. This tells the finance manager that
if the net cash gains after taxes continue for at least three years, the firm will recoup its net
investment.
When the cash gains generated by the project are unevenly distributed, one has to complete
cumulative cash gains resulting from the project until the year in which the running total is
equal to the amount of investment outlay.
The following illustration will make the point clear.
Illustration 2:

It is evident that investment outlay of Rs. 18,400 will be recovered by its cash benefits after 5
years period but before the expiry of 6 year-period. Pay-back period would, therefore, be 5.5
years. On the basis of the pay-back period, projects can be ranked. Project with shortest pay-
back period is assigned highest rank and in that order other projects are ranked.
Companies employing pay-back criterion for ranking projects will specify a minimum pay-
back period which serves as cut-off point for acceptance of projects. Thus, if minimum pay-
back period fixed for acceptance of projects is 5 years, the management would disregard all
those projects whose pay-back period is more than 5 years.
A company must establish a series of cut-off points to allow projects that have different
expected lives and that have substantially different degrees of risk. The following illustration
will explain as to how project’s viability is judged under pay-back method.
Illustration 3:
Ranjan Firm is considering two projects. Each requires an investment of Rs. 1,000. The
firm’s cost of capital is 10%.
The net cash flows from projects A and B are shown in the following table:
The firm has set three-year payback period as cut-off point. Find out which project should be
accepted.
Solution:
Pay-back period of project A will be 2 ⅓ years and that of B 4 years. Since the firm has set 3
years pay-back period as cut-off point, project B will not be considered at all. Project A with
pay-back period less than the cut-off point will receive management approval.

Evaluation of Pay-back Method:
The greatest advantage of this method is that projects can be ranked in terms of their
economic merits without much complication. It involves only a simple calculation. Further,
this method indirectly takes cognizance of factors, like risk, obsolescence and liquidity of
investments while taking investment decision.
Project with short pay-back period is relatively less exposed to risk. This method may prove
more useful where a firm is experiencing shortage of cash because it helps in choosing a
project. That will yield a quick return of cash funds regardless of its long-term profitability.
However, the pay-back method suffers from the following shortcomings:
(i) The pay-back method does not measure profitability of projects. It insists only on recovery
of the cost of the project. In actual practice, funds are invested not only to recoup cost but
also to earn profit thereon.
(ii) This method fails to consider any receipt after the payback period, no matter how great
they might be. It can, therefore, not be helpful in accomplishing profit maximization goal of
the firm. Of the two projects, one may have a shorter pay-back than the other and be accepted
while the second one is rejected even though it has a longer income producing life and
promises greater return on investment.
It can, therefore, lead to wrong decisions.
(iii) It ignores time value of money. It considers the present value of cash inflows of different
years to be of equivalent value. Thus, rupee one cash income received four years from now is
considered to be the same as rupee one received today.
Thus, investment decision taken on the basis of pay-back method may not be prudent one.
Despite these deficiencies pay-back method continues to be the most frequently used one for
making investment decisions particularly in American industries.
A survey conducted by the Machinery and Allied Products Institute disclosed that about two-
thirds of the American firms employ pay-back approach to appraise merits of projects.
Reasons for its popularity are not far to seek. In countries like America where technological
changes are rapid, firms are usually exposed to great obsolescence risks. In view of this, the
management is interested to invest in a project with short pay-back period.
Accordingly, pay-back period as appraisal technique has received wider recognition. Further,
where the uncertainty surrounding the outcome estimates is great, prime consideration is the
speed of capital investment recovery. Under such a situation, a finance manager is inclined to
favour the use of pay-back approach.

Discounted Pay-Back Method:
This method is an improvement over the pay-back method evolved to overcome the time
value drawback of the pay-back approach. Discounted pay-back period is defined as the
length of time that elapses before the present value of the cumulative cash inflows is at least
as large as the initial cash outlay.
The pay-back period is computed after discounting the net cash inflows of the project at the
company’s cut-off rate to their present values. Thus, this method recognizes the time value of
funds that flow before pay-back is accomplished.
The following illustration will explain the mechanics of computation of discounted pay-back
period:
Illustration 4:
The discounted pay-back period of the project in this case would be 6½ years as the
investment outlay of Rs. 14,000 will be recovered after the expiry of the sixth year but before
the seventh year ends. Since this period is greater than the cut-off period, it could not be
advisable for the management to buy the new machine.
This, thus, confirms our belief that investment decision bereft of time value consideration
will be erroneous.

Internal Rate of Return Method:
Both average rate of return and pay-back methods fail to evaluate economic viability of
projects correctly because they do not take account of the timing of expected cash flows. In
any investment decision the timing of expected future cash flows is extremely important.
To obviate this major shortcoming of the above stated appraisal techniques and to make
objective evaluation of projects, discounted cash flow methods have been evolved.
These methods take account of both the magnitude and the timing of expected cash flows in
each period of a project’s life. With the help of these methods differences in the timing of
cash flows for various projects by discounting these cash flows to their present values can be
isolated and the present values can then be analysed to determine the desirability of the
project.
There are two methods based on discounted cash flow, approach, viz., Internal Rate of Return
Method and Present Value Method.
Internal rate of return method, also known by such names as time adjusted return, discounted
rate of return, or yield rate investor’s method, seeks to find the earnings rate at which the
present value of streams of cash gain equals the amount of the investment outlay.
The internal rate of return is defined as that rate of return which would equate the present
value of capital expenditure to the present value of the net cash inflows. Thus, the IRR is the
rate of discount which would reduce the sum of the present value of net cash flow over the
project life (including construction period) to zero.
If this rate is greater than the cost of capital, this means that the funds committed will earn
more than their cost. When the IRR equals the cost of capital, the firm in theory would be
indifferent to the proposal in question as it would not be expected to change the firm’s value.
The following equation is used to calculate the internal rate of return:

Some value of ‘r’ will cause the sum of the discounted receipts equal to the initial cost of the
project and the value of ‘r’ is defined to be the internal rate of return. The internal rate of
return is usually found through the process of trial-and-error or picking estimated rate and the
present values are then summed to find V-C (V denotes the present value of benefits and C
the present value of investment outlay).
If V-C is positive, a higher rate should be tried and if it is negative, a lower rate. If V-C = O,
the choice proves to be correct and the rate has been found, other-wise this procedure
continues till rate is found for which V – C = O or very insignificantly positive or negative
figure.
Illustration 5:
A firm is considering to buy a machine today for Rs. 6,340 and the project will yield an
annual net cash return of Rs. 2,000 each year for a four-year period. After the fourth year, the
businessman receives nothing. What rate of interest is being earned on this commitment?
Solution:
In the above example, cost of investment is Rs. 6,340 and the investment will yield an annual
net cash return of Rs. 2,000 for four years. Thus, total cash earnings comes to Rs. 8,000. By
trial-and-error we have to choose a rate of interest that will discount future cash earnings to
the level of cost of investment. Since the difference between cash earnings and outlay is not
marginal, we may try with a higher rate, say 9%.
We find the following present values of Re. 1 for four years:
If the above values are multiplied by cash earnings of their respective years, we arrive at the
following positions:

Thus, at discount rate of 9% present value of total cash earning works out to Rs. 6,479 which
is higher than the investment outlay. Therefore, we must apply higher rate to discount future
cash flows.
At 11% discount rate we arrive at the following position:
The present value of the cash earning at 11 per cent rate comes to Rs. 6,205 which is less than
the cost of the project. Therefore, this rate is not appropriate. We are now left with no choice
but to pick up rate of 10 per cent and discount the streams of future earnings at that rate.
At this rate present value will be:
There is a short-cut method which may be used in choosing appropriate discount rate quickly
without any complication of trial and error.
Steps involved in this method are:
(1) Divide the investment of Rs. 6,340 by the average annual cash flow of Rs. 2,000 and
obtain a quotient
= 6340/2000 = 3.170
(2) Go across the four-year row of the readymade table giving the present value of Re. 1
received annually for 4 years.
(3) Proceed to the right along the correct row until the number is reached that is closest to the
quotient (3.170).

(4) Proceed to the top of the table and find out the interest rate that heads the column in
which the factor is located. In this way, we get 10 per cent as discount rate.
But this approach of averaging the cash inflow cannot be used in cases of uneven cash flows
particularly when the magnitude of uneven-ness is quite high. The following example shows
how projects are ranked under internal rate of return method.
Illustration 6:
A firm has two alternatives under consideration: the acquisition of electric typewriter for use
in the offices of the firm and the acquisition of machine to manufacture dolls.
Data on two proposed capital expenditures are as given below:
Which of the two projects should be given priority? presuming corporate tax rate of 50%.
Solution:
Before ranking projects, cost of both projects and net cash benefits of each project will have
to be worked out:

Thus, electric typewriters will result in a net cash inflow of Rs. 4,000 a year for a three-year
period and salvage value of Rs. 1,000 in the third year. Machine for making toy dolls will
result in cash inflow of Rs. 7,000 a year for a four-year period and there will be an additional
cash inflow of Rs. 4,000 at the end of the fourth year as a result of the recovery of working
capital.
Now we have to find out rate of interest that these projects will yield and then rank them in
that order. By a trial and error process we will have to experiment with different interest rates
until the one is found that comes closest to equating the stream of net annual cash flows to a
present value that is equal to the cash investment in the project.

A perusal of the three situations reveals that rate of return in case of electric typewriter will
be 14% and that of machine for making toy dolls 20%. Therefore, machine for making toy
dolls should be given priority over electric typewriter.
Evaluation of Internal Rate of Return Method:
Internal rate of return method facilitates ranking of projects in terms of their economic worth.
The management finds it convenient to compute without much complication the yield for
different projects and to compare the yield with the cost of capital of different projects to
select most profitable project.
However, this method of investment analysis has some drawbacks. In the first instance, this
method implicitly assumes that the funds received at the end of each year to the end of the
life of the project can be reinvested at the same rate of return.
In the foregoing example of electric typewriter it is assumed that Rs. 4,000 received at the
end of first year can be reinvested at 14% and that the benefit of the compounding effect is at
that rate. This may not be found true in actual practice. If the firm fails to earn a return equal
to the yield, this method may give distorted answers and may lead to wrong decisions.
The second pitfall of the internal rate of return method is that it does not provide weight-age
to size of funds committed in projects. If taken too literally, a firm might be tempted to
choose a project of Rs. 500 that gives a yield of 20 per cent against a project of Rs. 40,000
which offers a return of 18 per cent.
Another limitation of this method is that under certain conditions it becomes very difficult to
take any decision. For example, under conditions of irregular cash flows, internal rate of
return method may give two or more answers.

Present Value Method:
Another method based on discounted cash flow approach that may be used to evaluate
economic merits of investment projects is the present value method. This method involves
discounting of streams of future cash earnings to present value at required rate of return to the
firm (cost of capital).
For ranking projects according to this method, net present value is computed. Project with
highest positive net present value is given the highest priority.
The following formula is used to calculate the net present value of a project:
Where E is either an inflow (+) or an outflow (-), I is the period in which E occurs and K is
the cost of funds to the firm.
Thus, evaluation of investment project under present value approach involves the following
steps:
(1) Selection of minimum acceptable hurdle rate of return such as a desired return on
investment or cost of capital.
(2) Computation of expected stream of net cash inflows.
(3) Determination of net investment outlay of project.
(4) Discounting of streams of net cash inflows to their present value at hurdle rate of return.

(5) Comparison of present value of net cash inflows with present value of investment outlay.
(6) If the difference is positive it is indicative of profitability of the project and the same
should be accepted; if the result is negative, making the investment in the project will entail a
financial loss to the firm and hence, it should be rejected.
The following illustration will make the procedure of evaluation of projects under “present
value approach” easily understandable.
Illustration 7:
Divya Company is using a machine whose original cost was Rs. 15,000/-. The machine is 5
years old and has a current (salvage) value of Rs. 2,000. The asset is being depreciated over a
15 years original life towards a zero estimated salvage value. Depreciation is on a straight
line basis and the tax rate is 50 per cent.
Management is contemplating the purchase of a replacement which costs Rs. 10,000/- and
whose estimated salvage value is Rs. 2,000. The expected savings with the new machine are
Rs. 3,000 a year. Depreciation is on a straight line basis over its 10 years life. The cost of
capital is 10 per cent. Should the firm replace the asset?
Solution:
Decision to replace old machine calls for the following steps, viz., determination of net
investment outlay, determination of net cash gains and discounting these gains to their
present value and comparison of the present value of gains with net investment outlay:

There will be annual net cash savings of Rs. 2,000 and this saving will be available for the
next 10 years. In the tenth year there will be additional cash proceeds of Rs. 2,000 resulting
from sale of old machine.
Thus, the present value of these cash earnings will be
Since the difference between discounted value of net cash inflows and net investment outlay
is positive and there will be financial benefits of Rs. 9,062.00, the management should
replace the old machine. Present value method has the merit of simplicity. It tells the finance
manager in one stroke whether a project should be adopted or given up.
If a firm has several mutually exclusive projects in hand, it helps the management to choose
the most profitable one.
Another advantage of this device is that in evaluating and ranking projects it focuses attention
on one of the goals of the firm, i.e., increasing the value of the firm. However, the chief
drawback of this approach is that it is not easy to rank projects as it does not take into
consideration size of the investment outlay and net cash benefits together.
Decision based on absolute amount of net present value without considering the size of
investment will certainly be incorrect and irrational.
Profitability Index Method:
To remove the above drawback and to ensure rational investment decision relationship
between the present value of the net cash inflows and the net investment outlay must be
established. This is done with the help of the profitability index.
The profitability index can be calculated by using the following formula:

Where the Greek Sigma stands for the sum of discounted cash flows from period 1 through
period N. Substituting the above formula with the aforesaid information we find.
As long as profitability index is equal to or higher than unity, the investment project is
accepted. Project with profitability index of less than unity should be rejected as it will entail
the firm in financial predicament. If profitability index is equal to unity, it is expected to
breakeven.
Since present value of streams of future cash earnings is divided by the present value of the
investment outlay, this technique is also designated as discounted benefit-cost ratio. The
profitability index has the merit of placing the present value of each investment project on a
relative basis so that projects of different size of capital outlay can be compared.
The following illustration will explain the usefulness of profitability index in ranking
mutually exclusive projects:
Illustration 8:
Since P1 in all the three projects is higher than unity all these projects will be useful to the
company. However, project C with highest P1 of 1.6 will have to be accorded first priority.
Let us take an example to explain how investment decision is taken on the basis of the
profitability index.
Illustration 9:
Sunita Steel Company is contemplating to purchase new machine for Rs. 6.00,000. It has a
life of 4 years and an estimated salvage value of Rs. 1,00,000. The machine will generate an
extra revenue of Rs. 20,00,000 and will have variable cost of Rs. 16,00,000 per annum. The
cost of capital is 20 percent and the tax rate is 50 percent.
Should the machine be acquired?

Solution:
Decision to acquire the new machine involves the computation of investment outlay and its
comparison with present value streams of cash earnings
(3) Calculation of Present value of the above cash Benefits:
(4) Matching of cash inflows with investment outlay by computing Profitability index:
Ans. Since PI is 1.26, the company should acquire the machine.

Definition of NPV
When the present value of the all the future cash flows generated from a project is added
together (whether they are positive or negative) the result obtained will be the Net Present
Value or NPV. The concept is having great importance in the field of finance and investment
for taking important decisions relating to cash flows generating over multiple years. NPV
constitutes shareholder’s wealth maximization which is the main purpose of the Financial
Management.
NPV shows the actual benefit received over and above from the investment made in the
particular project for the time and risk. Here, one rule of thumb is followed, accept the project
with positive NPV and reject the project with negative NPV. However, if the NPV is zero,
then that will be a situation of indifference i.e. the total cost and profits of either option will
be equal. The calculation of NPV can be done in the following way:
NPV = Discounted Cash Inflows – Discounted Cash Outflows
Definition of IRR
IRR for a project is the discount rate at which the present value of expected net cash inflows
equates the cash outlays. To put simply, discounted cash inflows are equal to discounted cash
outflows. It can be explained with the following ratio, (Cash inflows / Cash outflows) = 1.
At IRR, NPV = 0 and PI (Profitability Index) = 1
In this method, the cash inflows and outflows are given. The calculation of the discount rate,
i.e. IRR, is to be made by trial and error method.
The decision rule related to the IRR criterion is: Accept the project in which the IRR is
greater than the required rate of return (cut off rate) because in that case, the project will reap
the surplus over and above the cut-off rate will be obtained. Reject the project in which the
cut-off rate is greater than IRR, as the project, will incur losses. Moreover, if the IRR and Cut
off rate are equal, then this will be a point of indifference for the company. So, it is at the
discretion of the company, to accept or reject the investment proposal.

Key Differences Between NPV and IRR
The basic differences between NPV and IRR are presented below:
 The aggregate of all present value of the cash flows of an asset, immaterial of positive
or negative is known as Net Present Value. Internal Rate of Return is the discount rate
at which NPV = 0.
 The calculation of NPV is made in absolute terms as compared to IRR which is
computed in percentage terms.
 The purpose of calculation of NPV is to determine the surplus from the project,
whereas IRR represents the state of no profit no loss.
 Decision making is easy in NPV but not in the IRR. An example can explain this, In
the case of positive NPV, the project is recommended. However, IRR = 15%, Cost of
Capital < 15%, the project can be accepted, but if the Cost of Capital is equal to 19%,
which is higher than 15%, the project will be subject to rejection.
 Intermediate cash flows are reinvested at cut off rate in NPV whereas in IRR such an
investment is made at the rate of IRR.
 When the timing of cash flows differs, the IRR will be negative, or it will show
multiple IRR which will cause confusion. This is not in the case of NPV.
 When the amount of initial investment is high, the NPV will always show large cash
inflows while IRR will represent the profitability of the project irrespective of the
initial invest. So, the IRR will show better results.

What is 'Capital Rationing'
Capital rationing is the act of placing restrictions on the amount of new investments or
projects undertaken by a company. This is accomplished by imposing a higher cost of capital
for investment consideration or by setting a ceiling on specific portions of a budget.
Companies may want to implement capital rationing in situations where past returns of an
investment were lower than expected.
capital rationing is a technique of selecting the projects that maximize the firm’s value when
the capital infusion is restricted. Two types of capital rationing are soft and hard capital
rationing. The calculation and method prescribe arranging projects in descending order of
their profitability based on IRR, NPV and PI and selecting the optimal combination.
Many times, a firm may come across a situation when it has various profitable investment
proposals. Can it take all of them for execution? Not always because most of the times there
are capital restrictions. This restriction may be because of the investment policy of the firm
and at the same time, it is not possible to acquire unlimited capital at one cost of capital. In
such a situation, finance manager would accept a combination of those projects, totaling less
than the capital ceiling, to achieve maximization of wealth. This process of evaluation and
selection of a project is called capital rationing.
Definition of Capital Rationing
It can be defined as a process of distributing available capital among the various investment
proposals in such a manner that the firm achieves maximum increase in its value.
Capital Rationing
Types of Capital Rationing
Based on the source of restriction imposed on the capital, the capital rationing is divided into
two types viz. hard capital rationing and soft capital rationing.
Soft Capital Rationing: It is when the restriction is imposed by the management.
Hard Capital Rationing: It is when the capital infusion is limited by external sources.
Capital Rationing Decisions
Capital rationing decisions by managers are made to attain the optimum utilization of the
available capital. It is not wrong to say that all the investments with positive NPV should be
accepted but at the same time the ground reality prevails that the availability of capital is
limited. The option of achieving the best is ruled out and therefore, rational approach is to
make most out of the on hand capital.

CAPITAL RATIONING METHOD
The method of capital rationing can be bifurcated in four steps. The steps are
1. Evaluation of all the investment proposals using the capital budgeting techniques of
Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI)
2. Rank them based on various criterion viz. NPV, IRR, and Profitability Index
3. Select the projects in descending order of their profitability till the capital budget
exhausts based on each capital budgeting technique.
4. Compare the result of each technique with respect to total NPV and select the best out
of that.
Capital Budgeting Calculation with Example
Assume that we have the following list of projects with below-mentioned cash outflow and
their evaluation results based on IRR, NPV and PI along with their respective rankings. The
capital ceiling for investment is say 650.

In the table, if we select based on individual method, we will arrive at following result:
The results are quite obvious and we will go with B,F,E and D to achieve maximum value of 760

ADVANTAGES OF CAPITAL RATIONING
Capital rationing is a very prevalent situation in companies. There are few advantages of
practicing capital rationing:
BUDGET
The first and an important advantage are that capital rationing introduces a sense of strict
budgeting of corporate resources of a company. Whenever there is an injunction of capital in
the form of more borrowings or stock issuance capital, the resources are properly handled and
invested in profitable projects.
NO WASTAGE
Capital rationing prevents wastage of resources by not investing in each and every new
project available for investment.
FEWER PROJECTS
Capital rationing ensures that less number of projects are selected by imposing capital
restrictions. This helps in keeping the number of active projects to a minimum and thus
manage them well.
HIGHER RETURNS
Through capital rationing, companies invest only in projects where the expected return is
high, thus eliminating projects with lower returns on capital.
MORE STABILITY
As the company is not investing in every project, the finances are not over-extended. This
helps in having adequate finances for tough times and ensures more stability and increase in
the stock price of the company.

DISADVANTAGES OF CAPITAL RATIONING
Capital rationing comes with its own set of disadvantages as well. Let us describe the
problems that rationing can lead to:
EFFICIENT CAPITAL MARKETS
Under efficient capital markets theory, all the projects that add to company’s value and
increase shareholders’ wealth should be invested in. However, by following capital rationing
and investing in only certain projects, this theory is violated.
THE COST OF CAPITAL
In addition to limits on budget, capital rationing also places selective criteria on the cost of
capital of shortlisted projects. However, in order to follow this restriction, a firm has to be
very accurate in calculating the cost of capital. Any miscalculation could result in selecting a
less profitable project.
UN-MAXIMISING VALUE
Capital rationing does not allow for maximising the maximum value creation as all profitable
projects are not accepted and thus, the NPV is not maximized.
SMALL PROJECTS
Capital rationing may lead to the selection of small projects rather than larger scale
investments.
INTERMEDIATE CASH FLOWS
Capital rationing does not add intermediate cash flows from a project while evaluating the
projects. It bases its decision only the final returns from the project. Intermediate cash flows
should be considered in keeping the time value of money in mind.
Though capital rationing has few disadvantages, it is still followed widely in selecting
investment projects. A company should decide on following capital rationing after studying
the implications in details.

RISK ANALYSIS IN CAPITAL BUDGETING
Capital budgeting is used to ascertain the requirements of the long-term investments of a

company. Examples of long-term investments are those required for replacement of
equipments and machinery, purchase of new equipments and machinery, new products, and
new business premises or factory buildings, as well as those required for R&D plans.The
different techniques used for capital budgeting include:
 Profitability index
 Net present value
 Modified Internal Rate of Return
 Equivalent annuity
 Internal Rate of Return
Besides these methods, other methods that are used include Return on Investment (ROI),
Accounting Rate of Return (ARR), Discounted Payback Period and Payback Period.
The different types of risks that are faced by entrepreneurs regarding capital budgeting are the
following:
 Corporate risk
 International risk
 Stand-alone risk
 Competitive risk
 Market risk
 Project specific risk
 Industry specific risk
Methods of Risk Analysis in Capital Budgeting :
The following methods are used for Risk Analysis in Capital Budgeting:
Sensitivity Analysis:
This is also known as a “what if analysis”. Because of the uncertainty of the future, if an
entrepreneur wants to know about the feasibility of a project in variable quantities, for
example investments or sales change from the anticipated value, sensitivity analysis can be a
useful method. This is calculated in terms of NPV, or net present value.
Scenario Analysis:
In the case of scenario analysis, the focus is on the deviation of a number of interconnected
variables. It is different from sensitivity analysis, which usually concentrates on the change in
one particular variable at a specific point of time.

Break Even Analysis:
The Break Even Analysis allows a company to determine the minimum production and sales
amounts for a project to avoid losing money. The lowest possible quantity at which no loss
occurs is called the break-even point. The break-even point can be delineated both in
financial or accounting terms.
Hillier Model:
In particular situations, the anticipated NPV and the standard deviation of NPV can be
incurred with the help of analytical derivation. This was first realized by F.S. Hillier. There
are situations where correlation between cash flows is either complete or nonexistent.
Simulation Analysis: Simulation analysis is utilized for formulating the probability analysis
for a criterion of merit with the help of random blending of variable values that carry a
relationship with the selected criterion.
Decision Tree Analysis: The principal steps of decision tree analysis are the definition of the
decision tree and the assessment of the alternatives.
Corporate Risk Analysis: Corporate risk analysis focuses on the analysis of risk that may
influence the project in terms of the entire cash flow of the firm. The corporate risk of a
project refers to its share of the total risk of a company.
Risk Management: Risk management focuses on factors such as pricing strategy, fixed and
variable costs, sequential investment, insurance, financial leverage, long term arrangements,
derivatives, strategic alliance and improvement of information.
Selection of project under risk: This involves procedures such as payback period
requirement, risk adjusted discount rate, judgmental evaluation and certainty equivalent
method.
Practical Risk Analysis: The techniques involved include the Acceptable Overall Certainty
Index, Margin of Safety in Cost Figures, Conservative Revenue Estimation, Flexible
Investment Yardsticks and Judgment on Three Point Estimates.

Unit-III: Working capital: meaning, significance and types of working capital;
financing of working capital; sources of working capital; management of inventory;
management of cash; management of account receivables; optimum credit policy; credit
collection; factoring service; various committee reports on bank finance; dimensions of
working capital management
Meaning and Concept of Working Capital:

In ordinary parlance, working capital denotes a ready amount of fund available for carrying
out the day-to-day activities of a business enterprise. It is considered to be the life-blood of
the business and its effective and efficient management is necessary for the very survival of
the business.
There are two concepts of working capital:

(i) Gross concept, and (ii) Net concept.
(i) Gross Concept of Working Capital:

The gross working capital refers to the total fund invested in current assets. Current assets are
those assets which are easily converted into cash within a time period of one year. It includes
cash in hand and at bank, short term securities, debtors, bills receivable, prepaid expenses,
accrued expenses and inventories like raw materials, work-in-progress, stores and spare parts,
finished goods.
The gross concept of working capital refers to the firm’s investment in above current assets.
It is useful for the following purposes:

(a) It is the total investment in current assets which earns profit.
(b) Management can give attention to manage very efficiently and carefully each item of the
current assets in order to minimise bad debt, slow-moving and non-moving items, idle cash
etc.
(c) It takes into consideration of the fact that, if other things remain constant, infusion of fund
in the business increases its working capital.
(d) It enables management to compute the rate of return on total investment in current assets.

(ii) Net Concept of Working Capital:
The term net working capital refers to the excess of current assets over current liabilities. In
other words, the amount of current assets that would remain in a firm after all its current
liabilities are paid.
Current liabilities are those claims of outsiders to the business enterprise which are payable
within a period of one year, and include sundry creditors, bills payable, outstanding expenses,
short-term loans, advances and deposits, bank overdraft, proposed dividend, provision for
taxation etc.
The net concept of working is useful for the following reasons:
(a) It indicates the liquidity position of the firm i.e., ability of the firm to meet its short- term
obligations.
(b) It helps creditors and other potential investors to judge the financial health of the firm.
(c) Gross concept of working capital may lead to incorrect conclusion regarding financial
stability of firms having the same amount of current assets.
(d) It indicates the extent of long-term sources of fund used in financing current assets of a
business enterprise.
So both gross concept of working capital and net concept of working capital are useful for
working capital management. However, while preparing a vertical form of balance sheet, the
Institute of Chartered Accountants of India has defined and shown working capital as the
difference between current assets and current liabilities.
There is yet another view, according to which the net working capital may be referred to as
the qualitative—and the gross working capital as the quantitative—aspects of the idea. These
two concepts of working capital are generally known as the balance sheet concepts as they
depend upon the contents of balance sheet items.

Types of Net Working Capital:
If gross concept of working capital is used, there will always be positive working capital as it
represents only current assets. On the other hand, if net concept of working capital is used,
there may be positive, negative or zero (nil) working capital.
(i) Positive Working Capital:

Positive working capital refers to excess of current assets over current liabilities. It indicates
the extent of long-term sources of funds such as equity share, preference share, retained
earnings, long-term loans and debentures etc. used to finance the current assets of a business
concern.
(ii) Negative Working Capital:

If current liabilities of a firm exceed current assets it is called negative working capital. In
other words, working capital is said to be negative when the current assets fall short of the
current liabilities. The excess of current liabilities over current assets is supposed to have
been used in procuring fixed assets of the firm.
So, it indicates the extent of short-term sources of fund used to finance the fixed assets of the
firm. A negative working capital means a negative liquidity and is disastrous for the firm.
(iii) Zero Working Capital:

If the current assets are equal to current liabilities, it is called zero or nil working capital.
Working Capital = Current Assets – Current Liabilities
A Ltd : Rs. 8,000 – Rs. 6,000 = (+) Rs. 2,000
B Ltd : Rs. 8,000 – Rs. 10,000 = (-) Rs. 2,000

In the case of A Ltd., a part of long-term funds (i.e., Rs. 14,000 – 12,000) or Rs. 2,000 is
invested for financing current assets while Rs. 6,000 is available from short-term funds. As a
result, working capital is positive. In the case of B Ltd. long-term funds (i.e., Rs. 6,000 + Rs.
4,000 = Rs. 10,000) is not sufficient to finance fixed assets.
As a result, a part of short-term sources (i.e., Rs. 10,000 – Rs. 8,000) or Rs. 2,000 is used for
financing fixed assets. Hence, working capital is negative.
Importance of Working Capital:

The importance of sufficient working capital in any business concern can never be
overemphasized. A concern requires adequate working capital to carry on its day-to-day
operations smoothly and efficiently. Lack of adequate working capital not only impairs firm’s
profitability but also results in stoppage in production and efficiency in payment of its current
obligations.
Thus working capital is considered the life-blood of the business.
The advantages of having adequate working capital may be summarised:

1. Smooth Flow of Production:
To maintain a smooth flow of production, it is necessary that adequate working capital is
available for paying trade suppliers, hiring labour and incurring other operating expenses.
2. Increase in Liquidity and Solvency Position:

It enhances the liquidity and solvency position of the business concern.
3. Goodwill:
A firm with sound working capital position can make timely payment of its outstanding bills.
This enhances the reputation of the firm.
4. Advantages of Cash Discount:

It enables the firm to avail itself of the facilities like cash discount by making prompt
payments.
5. Easy Loan:
Adequate amount of working capital builds a sound credit-worthiness of the firm. As a result
it becomes easier for the firm to obtain additional loans in favourable terms and conditions in

order to meet seasonal increase in demand or to finance the increased working capital
resulting from expansion.
6. Regular Payment of Wages and Salaries:

The firm can make regular and timely payment of wages and salaries to its employees. This
increases the morale and efficiency of employees.
7. Security and Confidence:

It creates a sense of security and confidence in the mind of management or officials of the
firm.
8. Efficient Use of Fixed Assets:

Adequate amount of working capital enables the firm to use its fixed assets more efficiently
and extensively. If the fixed assets remain idle due to paucity of working capital, depreciation
of fixed assets and interest on borrowed capital invested in fixed assets will have to be
incurred unnecessarily.
9. Meeting of Contingencies:
It can meet unforeseen contingencies of the firm. Unforeseen contingencies like business
depression, financial crisis due to huge losses etc. can easily be overcome, if adequate
working capital is maintained by a firm.
10. Completing operating cycle:

A sound management of working capital helps in completing the operating cycle quickly.
This enables a firm to increase its profitability.
11. Timely Payment of Dividend:

Adequate working capital ensures regular payment of dividends to the shareholders.
Components or Composition of Working Capital:

There are two components of working capital viz., current assets and current liabilities.
Current Assets:
Current assets generally mean those assets which, in the normal and ordinary course of
business, will be or are likely to be converted into cash within a year.
Examples of current assets are:

1. Inventories like raw materials, work-in-progress, stores and spare parts, finished goods

2. Sundry Debtors (net of provision)
3. Short-term investment or marketable securities
4. Short-term loans and advances
5. Bills receivable or accounts receivable
6. Pre-paid expenses
7. Accrued Income
8. Cash in hand and bank balances.
Current Liabilities:
Current liabilities means those liabilities repayable within the same period, i.e., a year. In
other words, current liabilities are those which are to be repaid in the ordinary course of the
business within a year.
Examples of current liabilities are:

1. Sundry creditors
2. Bills payable
3. Outstanding expenses
4. Short-term loans, advances and deposits
5. Provision for tax
6. Proposed dividend
7. Bank overdraft.

Different Sources of Working Capital:
A firm can use two types of sources to finance its working capital, namely:
(i) Long-term source, and
(ii) Short-term source.
(i) Long-Term Sources:

Every business organisation is required to maintain a minimum balance of cash and other
current assets at all the times—irrespective of the ups and downs in the level of activity. The
portion of working capital which is continuously maintained by the business at all times to
carry on its minimum level of activities is called permanent working capital.
This type of working capital should be arranged from long-term sources of fund.
The following are the long-term sources of financing permanent working capital:
(a) Issue of Equity shares
(b) Issue of Preference shares
(c) Retained earnings (ploughed-back profits)
(d) Issue of Debentures and other long-term bonds
(e) Long-term loans taken from financial institutions etc.
(ii) Short-Term Sources:

The short-term financing of working capital is generally used to support the temporary
working capital which is usually needed to meet the seasonal increase or sudden spurt in
demand.
Various short-term sources of financing of temporary working capital are:

(a) Bank credit (e.g., cash credit, letter of credit, bills finance, working capital demand loan,
overdraft facility etc.)
(b) Public deposits
(c) Trade credit

(d) Outstanding expenses
(e) Provision for depreciation
(f) Provision for taxation
(g) Advances from customers
(h) Loans from directors
(i) Security money received from employees
(j) Receipts from factoring.
Determinants of Working Capital:

A firm should always maintain a requisite amount of working capital for smooth and efficient
functioning of its operations. The total working capital requirement is determined by a wide
variety of factors. These factors affect different enterprises differently. They also vary from
time to time.
In general, the following factors are to be considered in determining the working capital
requirement of a firm:
1. Nature of Business:
The working capital requirements of a firm are widely influenced by the nature of business.
Public utilities like bus service, railways, water supply etc. have the lowest requirements for
working capital—partly because of the cash nature of their business and partly because of
their rendering service rather than manufacturing product and there is no need of maintaining
any inventory or book debt except capital assets.
On the contrary, trading concerns are required to maintain more working capital because they
have to carry stock-in-trade, receivables and liquid cash. Manufacturing concerns also require
large amount of working capital because of the time lag involved in the conversion of raw
materials into finished products and, finally, into cash.
2. Size of the Business:

The amount of working capital requirement also depends upon the size of the business. The
size can be measured in terms of the scale of operations. A large firm with a high scale of

operation will require to maintain a large amount of working capital than a firm with a small
scale of operation.
3. Production Cycle:
Production cycle is the time involved in manufacturing or processing a product. It starts when
raw materials are put in the production process and ends with the completion of
manufacturing of the product. Longer the production cycle, higher is the need of working
capital.
This is because funds remain blocked in work-in-progress for long periods of time. For
example, the working capital needs of a ship-building industry will be much longer than
those of a bakery.
4. Business Cycle:
The working capital requirements are also determined by the nature of the business cycle.
During the boom period, the need for working capital will increase to meet the requirements
of increased production and sales. On the other hand, in a slack period, the reduced volume of
operation will require relatively lower amount of working capital.
5. Credit terms of Purchase and Sale:

The period of credit given by the suppliers and the period of credit granted to the customers
will affect the working capital needs of a firm. If a firm allows a very short credit period, cash
will be realised very soon from debtors. So the need for the working capital will be less.
On the other hand, a liberal credit policy will result in higher amount of book debts. Higher
book debts will mean more working capital requirement. If the firm has to purchase raw
materials in cash or gets credit for shorter period, it has to arrange for relatively higher
amount of working capital.
6. Seasonal Variations:
There are industries like cold drinks, ice-cream and woolen where the goods are either
produced or sold seasonally. So, in such industries, working capital requirements during
production or sale seasons will be large and these will start decreasing when the season starts
coming-to end.
However, much depends on the policy of management with regard to production or sale of
goods. For example, the management of a woolen industry wants to carry on production

evenly throughout the year rather than concentrating on its production only in the busy
season. In that case the working capital requirements will be low.
7. Operating Efficiency:
If the operating efficiency of a firm is very high, the resources will be properly utilised. As a
result, it improves the profitability of the firm which ultimately, helps in releasing the
pressure of working capital. On other hand, inefficiency compels the firm to maintain
relatively a high level of working capital.
8. Price level changes:

If prices of input rise, the firm requires additional working capital to maintain the same level
of production.
9. Growth and Expansion of the Business:

Every concern wants to grow over a period of time and with the increase in its size, so the
working capital requirements are bound to increase. A growing firm would require greater
working capital than a static one.
10. Profitability and Retention Money:

The net profit earned by the firm goes to increase the working capital to the extent it has been
earned in cash. The cash profit can be found by adjusting non-cash items such as
depreciation, outstanding expenses and losses or intangible assets written-off in the net profit.
But what portion of this profit will be reinvested as working capital will depend upon the
retention policy of a firm which is, again influenced by corporate tax structure and dividend
policy. So, if the amount of retained profit is not immediately invested outside the business, it
would increase the amount of working capital.
11. Relationship of Material Cost to Total Cost:

In manufacturing concerns, where raw material costs bear a large proportion to the total cost
of production, a greater amount of working capital will have to be maintained. For example,
in industries like textile and electronics, large sums are required to maintain the inventory of
such raw materials.
12. Turnover of Current Assets:

The speed with which the current assets revolve around also affects working capital
requirements of a firm. In few cases like vegetables or fruit shops, stocks get sold very

quickly and, for this reason, a little or no working capital is required in carrying over the
stock.
On the other hand, there are some businesses, like jewellery, having very slow turnover of the
stocks—leading to the need for a larger amount of working capital.

Management of Cash, Receivables, Inventory and Current Liabilities
In managing financial growth of company, Cash, receivables and inventory jointly form
working capital of a firm. It is imperative for experts to keep good balance of these factors.
Management of Cash
Cash is considered as vital asset and its proper management support company development
and financial strength. An effective cash management program designed by companies can
help to realise this growth and strength. Cash is vital element of any company needed to
acquire supply resources, equipment and other assets used in generating the products and
services. Marketable securities also come under near cash, serve as back pool of liquidity
which provides quick cash when needed.
Cash management is the stewardship or proper use of an entity's cash resources. It assists to
keep an organization functioning by making the best use of cash or liquid resources of the
organization. Cash management is associated with management of cash in such a way as to
realise the generally accepted objectives of the firm, maximum productivity with maximum
liquidity. It is the management's capability to identify cash problems before they ascend, to
solve them when they arise and having made solution available to delegate someone carry
them out.
The notion of cash management is not new and it has attained a greater significance in the
modern world of business due to change that took place in business operations and ever
increasing difficulties and the cost of borrowing" (Howard, 1953 ). It is the most liquid
current assets, cash is the common denominator to which all current assets can be reduced
because the other current assets i.e. receivables and inventory get eventually converted into

cash (Khan, 1983 ). This emphasises the importance of cash management. The term cash
management denotes to the management of cash resource in such a way that generally
accepted business objectives could be accomplished. In this perspective, the objectives of a
firm can be combined as bringing about consistency between maximum possible
effectiveness and liquidity of a firm. Cash management may be defined as the ability of a
management to identify the problems related with cash which may come across in future
course of action, finding appropriate solution to curb such problems if they arise, and lastly
delegating these solutions to the competent authority for carrying them out. Cash
management maintains sufficient quantity of cash in such a way that the quantity denotes the
lowest adequate cash figure to meet business obligations. Cash management involves
managing cash flows (into and out of the firm), within the firm and the cash balances held by
a concern at a point of time.
In financial literature, Cash management denotes to wide area of finance involving the
collection, handling, and usage of cash. It involves assessing market liquidity, cash flow, and
investments. The notion of cash management is not novel and it has gained more significance
in contemporary business world due to change that took place in the conduct of business and
ever increasing difficulties and the cost of borrowing.
Objective of Cash Management
1. To make Payment According to Payment Schedule: Firm needs cash to meet its
routine expenses including wages, salary, taxes etc.
2. To minimise Cash Balance: The second objective of cash management is to reduce
cash balance. Excessive amount of cash balance helps in quicker payments, but
excessive cash may remain unused & reduces profitability of business. Contrarily,
when cash available with firm is less, firm is unable to pay its liabilities in time.
Therefore optimum level of cash should be maintained (Excel Books India, 2008).
An effective management is considered to be important for the following reasons:
1. Cash management guarantees that the firm has sufficient cash during peak times for
purchase and for other purposes.
2. Cash management supports to meet obligatory cash out flows when they fall due.
3. Cash management helps in planning capital expenditure projects.
4. Cash management helps to organize for outside financing at favourable terms and
conditions, if necessary.
5. Cash management helps to allow the firm to take advantage of discount, special
purchases and business opportunities.
6. Cash management helps to invest surplus cash for short or long-term periods to keep
the idle funds fully employed.

General Principles of Cash Management
Harry Gross has recommended certain general principles of cash management.
1. Determinable Variations of Cash Needs: A reasonable amount of funds, in the form

of cash is required to be kept aside to overcome the period expected as the period of
cash shortage. This period may either be short and temporary or last for a longer
duration of time. Normal and regular payment of cash leads to small cutbacks in the
cash balance at periodic intervals. Making this payment to different workers on
different days of a week can balance these reductions. Another practice for balancing
the level of cash is to schedule cash disbursements to creditors during the period when
accounts receivables collected amounts to a large sum but without putting the
helpfulness at stake.
2. Contingency Cash Requirement: There may arise certain cases, which fall beyond
the forecast of the management. These establish unexpected calamities, which are too
difficult to be provided in the normal course of the business. Such contingencies
always demand for special cash requirements that was not assessed and provided for
in the cash budget. Denials of wholesale product, huge amount of bad debts, strikes,
and lockouts are some of these contingencies. Only a prior experience and
investigation of other similar companies prove supportive as a customary practice. A
useful procedure is to shield the business from such calamities like bad-debt losses,
fire by way of insurance coverage.

3. Availability of External Cash: This factor also has immense significance in the cash
management which refer to the availability of funds from outside sources. There
resources help in providing credit facility to the firm, which materialized the firm's
objectives of holding minimum cash balance. As such if a firm succeeds in obtaining
sufficient funds from external sources such as banks or private financers,
shareholders, government agencies, the need to maintain cash reserves lessens.
4. Maximizing Cash Receipts: Nearly, all financial managers have objective to make
the best possible use of cash receipts. Cash receipts if tackled carefully results in
minimizing cash requirements of a concern. For this purpose, the comparative cost of
granting cash discount to customer and the policy of charging interest expense for
borrowing must be appraised continually to determine the ineffectiveness of either of
the alternative or both of them during that particular period for maximizing cash
receipts. Some techniques proved helpful in this context are mentioned below:
i. Concentration Banking: In this system, a company launches banking centres

for collection of cash in different areas. Thus, the company instructs its
customers of neighbouring areas to send their payments to those centres. The
collection amount is then deposited with the local bank by these centres as
early as possible. Whereby, the collected funds are transferred to the
company's central bank accounts operated by the head office.
ii. Local Box System: Under this system, a company rents out the local post
offices boxes of different cities and the customers are asked to forward their
remittances to it. These remittances are picked by the approved lock bank
from these boxes to be transferred to the company's central bank operated by
the head office.
iii. Reviewing Credit Procedures: This type of technique assists to determine the
impact of slow payers and bad debtors on cash. The accounts of slow paying
customers should be revised to determine the volume of cash tied up. Besides
this, evaluation of credit policy must also be conducted for introducing
essential modifications. As a matter of fact, too strict a credit policy involves
rejections of sales. Thus, restricting the cash inflow. On the other hand, too
lenient, a credit policy would increase the number of slow payments and bad
debts again reducing the cash inflows.
iv. Minimizing Credit Period: Shortening the terms allowed to the customers
would definitely quicken the cash inflow side-by-side reviewing the discount
offered would prevent the customers from using the credit for financing their
own operations gainfully.
v. Others: There is a need to introduce various procedures for managing large to
very large remittances or foreign remittances such as, persona pick up of large
sum of cash using airmail, special delivery and similar techniques to accelerate
such collections.
5. Minimizing Cash Disbursements: The intention to minimize cash payments is the
ultimate benefit derived from maximizing cash receipts. Cash disbursement can be

brought under control by stopping deceitful practices, serving time draft to creditors
of large sum, making staggered payments to creditors and for payrolls.
6.
7. Maximizing Cash Utilization: It is emphasized by financial experts that suitable and
optimum utilization leads to maximizing cash receipts and minimizing cash payments.
At times, a concern finds itself with funds in excess of its requirement, which lay idle
without bringing any return to it. At the same time, the concern finds it imprudent to
dispose it, as the concern shall soon need it. In such conditions, company must invest
these funds in some interest bearing securities. Gitman suggested some fundamental
procedures, which helps in managing cash if employed by the cash management.
These include:
8.
1. Pay accounts payables as late as possible without damaging the firm's credit
rating, but take advantage of the favourable cash discount, if any.
2. Turnover, the inventories as quickly as possible, avoiding stock outs that
might result in shutting down the productions line or loss of sales.
3. Collect accounts receivables as early as possible without losing future loss
sales because of high-pressure collections techniques. Cash discounts, if they
are economically justifiable, may be used to accomplish this objective
(Gitman, 1979.).
Function of Cash Management

It is well acknowledged in financial reports and various studies that cash management is
concerned with minimizing fruitless cash balances, investing temporarily excess cash
usefully and to make the best possible arrangements for meeting planned and unexpected
demands on the firm's cash (Hunt, 1966). Cash Management must have objective to reduce
the required level of cash but minimize the risk of being unable to discharge claims against
the company as they arise. There are five cash management functions:
1. Cash Planning: Experts emphases the wise planning of funds that can lead to huge
success. For any management decision, planning is the primary requirement.
According to theorists, "Planning is basically an intellectual process, a mental pre-
disposition to do things in an orderly way, to think before acting and to act in the light
of facts rather than of a guess." Cash planning is a practise, which comprises of
planning for and controlling of cash. It is a management process of predicting the
future need of cash, its available resources and various uses for a specified period.
Cash planning deals at length with formulation of necessary cash policies and
procedures in order to perform business process constantly. A good cash planning
aims at providing cash, not only for regular but also for irregular and abnormal
requirements.
2. Managing Cash Flows: Second function of cash management is to properly manage
cash flows. It means to manage efficiently the flow of cash coming inside the business
i.e. cash inflow and cash moving out of the business i.e. cash outflow. These two can

be effectively managed when a firm succeeds in increasing the rate of cash inflow
together with minimizing the cash outflow. As observed accelerating collections,
avoiding excessive inventories, improving control over payments contribute to better
management of cash. Whereby, a business can protect cash and thereof would require
lesser cash balance for its operations.
3. Controlling the Cash Flows: It has been observed that prediction is not an exact
knowledge because it is based on certain conventions. Therefore, cash planning will
unavoidably be at variance with the results actually obtained. Due to this, control
becomes an unavoidable function of cash management. Moreover, cash controlling
becomes indispensable as it increases the availability of usable cash from within the
enterprise. It is understandable that greater the speed of cash flow cycle, greater
would be the number of times a firm can convert its goods and services into cash and
so lesser will be the cash requirement to finance the desired volume of business
during that period. Additionally, every business is in possession of some concealed
cash, which if traced out significantly decreases the cash requirement of the
enterprise.
4. Optimizing the Cash Level: It is important that a financial manager must focus to
maintain sound liquidity position i.e. cash level. All his efforts relating to planning,
managing and controlling cash should be diverted towards maintaining an optimum
level of cash. The prime need of maintaining optimum level of cash is to meet all
requirements and to settle the obligations well in time. Optimization of cash level may
be related to establishing equilibrium between risk and the related profit expected to
be earned by the company.
5. Investing Idle Cash: Idle cash or surplus cash is described as the extra cash inflows
over cash outflows, which do not have any specific operations or any other purpose to
solve currently. Usually, a firm is required to hold cash for meeting working needs
facing contingencies and to maintain as well as develop friendliness of bankers.
In banking area, cash management is a marketing term for some services related to
cash flow offered mainly to huge business customers. It may be used to describe all
bank accounts (such as checking accounts) provided to businesses of a certain size,
but it is more often used to describe specific services such as cash concentration, zero
balance accounting, and automated clearing house facilities. Sometimes, private
banking customers are given cash management services.
Financial instruments involved in cash management include money market funds,
treasury bills, and certificates of deposit.
Benefits of Cash Management System

In the period of technology progression, the Cash Management System provides following
Benefits to its customers:
1. Funds availability as per need on day zero, day one, day two, day three etc. i.e.
Corporate can plan their cash flows.
2. Bank interest saved as instruments are collected faster.
3. Affordable and competitive rates.

4. Single point enquiry for all queries.
5. Pooling of funds at desired locations.
To summarize, Cash Management denotes to the concentration, collection and disbursement

of cash. The major role for managers is to maintain the flow of cash. Cash Management
include a series of activities aimed at competently handling the inflow and outflow of cash.
This mainly involves diverting cash from where it is to where it is needed. It is established
that cash management is the optimization of cash flows, balances and short-term investments.
MANAGEMENT OF RECEIVABLE
Accounts receivable typically comprise more than 25 percent of a firm's assets. The term
receivables is described as debt owed to the firm by the customers resulting from the sale of
goods or services in the ordinary course of business. There are the funds blocked due to credit
sales. Receivables management denotes to the decision a business makes regarding to the
overall credit, collection policies and the evaluation of individual credit applicants.
Receivables Management is also known as trade credit management. Robert N. Anthony,
explained it as "Accounts receivables are amounts owed to the business enterprise, usually by
its customers. Sometimes it is broken down into trade accounts receivables; the former refers
to amounts owed by customers, and the latter refers to amounts owed by employees and
others".
Receivables are forms of investment in any enterprise manufacturing and selling goods on
credit basis, large sums of funds are tied up in trade debtors. When company sells its
products, services on credit, and it does not receive cash for it immediately, but would be
collected in near future, it is termed as receivables. However, no receivables are created when
a firm conducts cash sales as payments are received immediately. A firm conducts credit
sales to shield its sales from the rivals and to entice the potential clienteles to buy its products
at favourable terms. Generally, the credit sales are made on open account which means that
no formal reactions of debt obligations are received from the buyers. This enables business
transactions and reduces the paperwork essential in connection with credit sales.
Accounts Receivables Management denotes to make decisions relating to the investment in
the current assets as vital part of operating process, the objective being maximization of
return on investment in receivables. It can be established that accounts receivables
management involves maintenance of receivables of optimal level, the degree of credit sales
to be made, and the debtors' collection.
Receivables are useful for clients as it increases their resources. It is preferred particularly by
those customers, who find it expensive and burdensome to borrow from other resources.
Thus, not only the present customers but also the Potential creditors are attracted to buy the
firm's product at terms and conditions favourable to them.
Receivables has vial function in quickening distributions. As a middleman would act fast
enough in mobilizing his quota of goods from the productions place for distribution without
any disturbance of immediate cash payment. As, he can pay the full amount after affecting
his sales. Likewise, the customers would panic for purchasing their needful even if they are
not in a position to pay cash immediately. It is for these receivables are regarded as a

connection for the movement of goods from production to distributions among the ultimate
consumer.
Maintenance of receivable
Objectives of receivables management: The objective of Receivables Management is to

promote sales and profits until that point is reached where the return on investment in further
funding receivables is less than the cost of funds raised to finance that additional credit i.e.
cost of capita.
Management of Accounts Receivables is quite expensive. The following are the main costs
related with accounts receivables management:
Cost of Management of Accounts Receivables

Advantages of accounts receivable management:
Accounts Receivables Management has numerous benefits. These include:
1. Increased Sales: Offering goods or services on credit enhances sales, by holding old
customers and attraction potential customers.
2. Increased Market Share: When the firm is able to maintain old customers and attract
new customers automatically market share will be bigger to the extent new sales.
3. Increase in profits: Increase sales, leads to increase in profits, because it need to
produce more products with a given fixed cost and sales of products with a given
sales network in both cost per unit comes down and the profit will be better.
MANAGEMENT OF INVENTORY
Inventory management is basically related to task of controlling the assets that are produced
to be sold in the normal course of the firm's procedures. In supply chain management, major
variable is to effectively manage inventory. The significance of inventory management to the
company depends on the extent of its inventory investment.
The objectives of inventory management are of twofold:
1. The operational objective is to uphold enough inventory, to meet demand for product
by efficiently organizing the firm's production and sales operations.
2. Financial interpretation is to minimize unproductive inventory and reduce inventory,
carrying costs.
Effective inventory management is to make good balance between stock availability and the
cost of holding inventory.

Components of inventory management: Inventories exist in different forms in a
manufacturing company. These include:
1. Raw materials: Raw materials are those inputs that are transformed into completed
goods throughout manufacturing process. Those form a major input for manufacturing
a product. In other words, they are very much needed for uninterrupted production.
2. Work-in-process: Work-in-process is a stage of stocks between raw materials and
finished goods. Work-in-process inventories are semi-finished products. They signify
products that need to undergo some other process to become finished goods.
3. Finished products: Finished products are those products which are totally
manufactured and company can immediately sell to customers. The stock of finished
goods provides a buffer between production and market.
4. Stores and spares: It comprises of office and plant cleaning materials like soap,
brooms, oil, fuel, light, bulbs and are purchased and stored for the purpose of
maintenance of machinery.
Component of inventory
Inventory control encompasses managing the inventory that is previously in the warehouse,
stockroom or store. This is to know the type of products are "out there", how many each item
and where it is kept. It means having accurate, complete and timely inventory transactions
record and avoiding differences between accounting and real inventory levels. Two tools
commonly used to ensure inventory accuracy and control are ABC analysis and cycle
counting.
The process of Inventory management consists of determining, how to order products and
how much to order as well as identifying the most effective source of supply for each item in
each stocking location. Inventory management contains all activities of planning, forecasting
and replenishment. The main purpose of inventory management is minimize differences
between customers demand and availability of items. These differences have caused by three

factors that include customers demand fluctuations, supplier's delivery time fluctuations and
inventory control accuracy.
Types of Inventory
The aim of carrying inventories is to separate the operations of the firm. It means to make
each function of the business independent of each other function so that delays or closures in
one area do not affect the production and sale of the final product. Because production
cessations result in increased costs, and because delays in delivery can lose customers, the
management and control of inventory are important duties of the financial manager. There are
many types of inventory. The common categories of inventory include raw materials
inventory, work-in-process inventory, and finished-goods inventory.
Raw-Materials Inventory: Raw materials inventory include basic materials purchased from
other firms to be used in the firm's production operations. These goods may include steel,
lumber, petroleum, or manufactured items such as wire, ball bearings, or tires that the firm
does not produce itself. Regardless of the specific form of the raw-materials inventory, all
manufacturing firms maintain a raw-materials inventory. The intention is to separate the
production function from the purchasing function that is, to make these two functions
independent of each other so delays in the delivery of raw materials do not cause production
delays. If there is a delay, the firm can satisfy its need for raw materials by liquidating its
inventory.
Work-in-Process Inventory: Work-in-process inventory comprises of partly finished goods
requiring additional work before they become finished goods. The more difficult and lengthy
the production process, the larger the investment in work-in-process inventory. The main aim
of work-in-process inventory is to disengage the various operations in the production process
so that machine failures and work stoppages in one operation will not affect other operations.
Finished-Goods Inventory: Finished-goods inventory includes goods on which production
has been completed but that are not yet sold. The purpose of a finished-goods inventory is to
separate the production and sales functions so that it is not required to produce the goods
before a sale can occur and sales can be made directly out of inventory.
Motives of inventory management:
Managing inventories involve lack of funds and inventory holding costs.

Maintenance of inventories is luxurious. Still there is motive to retain inventories. There are
three general motives:
1. The transaction motive: Firm may hold the inventories in order to facilitate the
smooth and continuous production and sales operations. It may not be possible for the
company to obtain raw material whenever necessary. There may be a time lag
between the demand for the material and its supply. Therefore, it is needed to hold the
raw material inventory. Similarly, it may not be possible to produce the goods

instantly after they are demanded by the customers. Hence, it is needed to hold the
finished goods inventory. The need to hold work-in-progress may arise due to
production cycle.
2. The precautionary motive: Firms also prefer to hold them to protect against the risk of
unpredictable changes in demand and supply forces. For example, the supply of raw
material may get delayed due to the factors like strike, transport disruption, short
supply, lengthy processes involved in import of the raw materials.
3. The speculative motive: Firms may like to buy and stock the inventory in the quantity
which is more than needed for production and sales purposes. It is done to get the
advantages in terms of quantity discounts connected with bulk purchasing or expected
price rise.
Merits of Inventory Management

There are several advantages of managing inventory in proper way.
1. Inventory management guarantees adequate supply of materials and stores to

minimize stock outs and shortages and avoid costly interruption in operations.
2. It keeps down investment in inventories, inventory carrying costs, and obsolescence
losses to the minimum.
3. It eases purchasing economies throughout the measurement of requirements on the
basis of recorded experience.
4. It removes duplication in ordering stock by centralizing the source from which
purchase requisition emanate.
5. It allows better utilization of available stock by enabling inter-department transfers
within a firm.
6. It offers a check against the loss of materials through carelessness or pilferage.
7. Perpetual inventory values provide a stable and reliable basis for preparing financial
statements a better utilization.
Demerits of Holding Inventory

Besides several benefits, there are some drawbacks of holding inventory.
1. Price decline: It is a major disadvantage of inventory holding. Price decline is the

result of more supply and less demand. It can be said that it may be due to
introduction of competitive product. Generally, prices are not controllable in the short
term by the individual firm. Controlling inventory is the only way that a firm can
counter act with these risks. On the demand side, a decrease in the general market
demand when supply remains the same may also cause price to increase. This is also
long-lasting management problem, because reduction in demand may be due to
change in customer buying habits, tastes and incomes.
2. Product deterioration: It is also serious demerits of inventory holding. Holding of
finished completed goods for a long period or shortage under inappropriate conditions
of light, heat, humidity and pressures lead to product worsening.

3. Product obsolescence: If items are hold for long time, it may become outdated.
Product may become outmoded due to improved products, changes in customer
choices, particularly in high style merchandise, changes in requirements. Then this is
a major risk and it may affect in terms of huge revenue loss. It is costly for the firms
whose resources are limited and tied up in slow moving inventories.
In final words, the notion of inventory management has been one of the many analytical
characteristics of management. It involves optimization of resources available for holding
stock of various materials. If there is shortage of inventory, it leads to stock-outs, causing
stoppage of production and a very high inventory will result in increased cost due to cost of
carrying inventory.
MANAGING CURRENT LIABILITIES

A current liability is an obligation that is payable within one year. The collection of liabilities
comprising current liabilities is closely watched, a business must have enough liquidity to
guarantee that they can be paid off when due. In accounting area, current liabilities are often
understood as all liabilities of the business that are to be settled in cash within the financial
year or the operating cycle of a given firm, whichever period is longer.
In exceptional cases where the operating cycle of a business is longer than one year, a current
liability is described as being payable within the term of the operating cycle. The operating
cycle is the time period required for a business to acquire inventory, sell it, and convert the
sale into cash. In most cases, the one-year rule will apply.
Since current liabilities are normally paid by liquidating current assets, the presence of a large
amount of current liabilities calls attention to the size and prospective liquidity of the
offsetting amount of current assets listed on a company's balance sheet. Current liabilities
may also be settled through their replacement with other liabilities, such as with short-term
debt.
The combined amount of current liabilities is major component of several measures of the
short-term liquidity of a business. That include:
o Current ratio. This is current assets divided by current liabilities.

o Quick ratio. This is current assets minus inventory, divided by current liabilities.
o Cash ratio. This is cash and cash equivalents, divided by current liabilities.
Common examples of Current Liabilities

Accounts payable: These are the trade payables due to suppliers, usually as evidenced by
supplier invoices.
Sales taxes payable: This is the obligation of a business to remit sales taxes to the
government that it charged to customers on behalf of the government.
Payroll taxes payable: This is taxes withheld from employee pay, or matching taxes, or
additional taxes related to employee compensation.
Income taxes payable: This is income taxes owed to the government but not yet paid.

Interest payable: This is interest owed to lenders but not yet paid.
Bank account overdrafts: These are short-term advances made by the bank to offset any
account overdrafts caused by issuing checks in excess of available funding.
Accrued expenses: These are expenses not yet payable to a third party, but already incurred,
such as wages payable.
Customer deposits: These are payments made by customers in advance of the completion of
their orders for goods or services.
Dividends declared: These are dividends declared by the board of directors, but not yet paid
to shareholders.
Short-term loans: This is loans that are due on demand or within the next 12 months.
Current maturities of long-term debt: This is that portion of long-term debt that is due
within the next 12 months.
To summarise, financial experts defined current liabilities as "obligations whose liquidation

is reasonably expected to require the use of existing resources properly categorized as current
assets or the certain of current liabilities."

THE OPTIMAL CREDIT POLICY minimizes the total cost of granting credit.
Firms should avoid offering credit at all cost. An increase in a firm's average collection
period generally indicates that an increased number of customers are taking advantage of the
cash discount. The costs of the credit application process and the costs expended in the
collection process are carrying costs of granting credit. Capacity refers to the ability of a firm
to meet its credit obligations out its operating cash flows. The optimal credit policy is the
policy that produces the largest amount of sales for a firm.
The firm’s operating profit is maximized when total cost is minimised for a given level of
revenue. Credit policy at point an in represents the maximum operating profit (since total cost
is minimum). But it is not necessarily the optimum credit policy. Optimum credit policy is
one which maximizes the firm’s value. The value of the firm is maximized when the
incremental or marginal rate of return of an investment is equal to the incremental or
marginal cost of funds used to finance the investment. The incremental rate of return can be
calculated as incremental operating profit divided by the incremental investment in
receivable. The incremental cost of funds is the rate of return required by the suppliers of
funds, given the risk of investment in accounts receivable. Note that the required rate of
return in not equal to the borrowing rate. Higher the risk of investment, higher the required
rate of return. As the firm loosens its credit policy, its investment in accounts receivable
becomes more risky because of increase in slow-paying and defaulting accounts. Thus the
required rate of return is an upward sloping curve.

DEBT COLLECTION
A process when a third-party agency takes on the debt of your business and attempts to
retrieve money owed through a series of letters, phone calls and other legal processes to
receive payment in full.
FACTORING SERVICE
Factoring is a popular mode of small and medium enterprise working capital financing across
the world but more so in the developed economies. Actually, Factoring is a complete
financial package that combines working capital financing, credit risk protection, accounts
receivable bookkeeping and collection services. In simple words, Factors (lenders /service
providers) purchase the accounts receivables (AR) of sellers due from buyers (debtors) at a
discount. In return the seller receives upfront advance payment from the factor thus
converting the AR into cash and thereby significantly helping cash flow management. The
‘receivable’ itself is the security, no other collateral /mortgage is needed in proper factoring.
Since the credit limit can grow with sales, it is extremely useful for fast growing companies
with genuine sales.

VARIOUS COMMITTEE REPORTS ON WORKING CAPITAL
The following committees were especially appointed for the purpose to administer the
working capital.
Dheja Committee Report 1969Tandon Committee Report 1975Chore Committee Report
1980Marathe Committee Report 1984
The various committee report implications are the following:

DHEJA COMMITTEE REPORT 1969
"The study carried out on the credit need of the industry and trade and how that needs inflated
and such trends were checked" by the under the chairmanship of Dheja Committee.
Findings
General tendency was found among the firms to avail the bank credit more than their
requirements.Another tendency was among them that the short term credit was generally
made use of by thee for the acquisition of the long term assetsThe lending through cash credit
should be done on the basis of security in order to assess the financial position of the firm
Recommendations
Appraisal should be done by the bankers on the present and future performance of the
firmsThe total dealings are segmented into two categories viz core and short-term needsThe
committee suggested the firms to maintain only one account with the one banker For huge
amount of borrowing, consortium was suggested among the bankers to lend the corporate
borrowers
TANDON COMMITTEE
The next committee was appointed Tandon Committee 1975, in an intention of granting loans
and advances to the industry on the need basis through the study of the development proceeds
only in order to improve the weaker section of the people.
Findings of the Committee
The bank should not reveal this much only to lent to the requirements of the firm in
accordance with lending policy, in spite of that the banks were expected to lend to the tune of
firm's requirement.It should be treated as supplementary source of finance but not as major
source of financeLoans were lent only in accordance on the basis of the securities produced
by the borrower but not on basis of level of operationsSecurity compliance wont provide any
safety to the banks but the periodical follow up only should facilitate the banker to get back
the amount of loans and advances lent
Recommendations: It reached the land mark in studying the need of the industries towards
the requirements of the working capital. The committee has submitted its report on 9th Aug,
1975 by studying the lending policies.
Necessary information about the future operations are to be suppliedThe supporting current
assets should be shown to the banker at the moment of borrowingThe bank should understand

that the bank credit is only for the purposes to meet out the needs of the borrower but not for
any other.
CHORE COMMITTEE REPORT 1979

This committee especially constituted only for the purpose to study the sanctionable limits of
the banker and the extent of the loan amount utilization of the borrower. The another purpose
of the committee to appoint that to provide the alternate ways and means to afford credit
facility to the industries to enhance the productive activities in the country.
Continuance of the existing three system of credits by the banker viz cash credit, loans and
billsNo need to bifurcate the cash credit accounts of the borrower for the implementation of
the differential rate of interestAccording to the specifications of the borrower, the banker
should come to one conclusion which in normal peak level and non peak level of operations
only to the tune of operationsNo frequent sanction of ad hoc limits of borrowing from the
bankerThe overdependence on the bank credit should be lessened among the practices of the
industrialists through emphasizing the need of term finance.
Marathe Committee Report 1984

The fourth committee is Marathe committee which was instituted by the Reserve bank of
India and it submitted the report on 1983. The recommendations were implemented by the
Government of India from April 1,1984.
Recommendations
Reasonability of the projection statements are to be studied by the banks more
carefullyCurrent assets and liabilities are to be classified in accordance with the norms issued
by the Reserve bank of IndiaMaintenance of the current assets ratio 1.33:1Timely supply the
information stipulated by the bankersApt supply of annual accounting information
Illustration
ABC Ltd. decides to liberalise credit to increase its sales. The liberalized credit policy will
bring additional sales of Rs. 3,00,000. The variable costs will be 60% of sales and there will
be 10% risk for non-payment and 5% collection cost .Will the company benefit from the new
credit policy ?
The new credit policy pave way for the firm to earn Rs.75,000 as an additional revenue
through the volume of incremental sales.

DIMENSIONS OF WORKING CAPITAL MANAGEMENT
Working capital management is concerned with all the aspects of managing current assets
and current liabilities. Let us pinpoint its significant dimensions which require the attention of
financial executives.
Managing Investment incurrent Assets
Determination of appropriate level of investment in current assets is the first and foremost
responsibility of a working capital management. Although the amount of investment in any
current assets ordinarily varies from day-to-day, the average amount or level over a period of
time can be used in determining the fluctuating and permanent investment in current assets.
This distinction is of great importance in devising appropriate financing strategies. We shall
elaborate this point a little later. Beside the level of investment, the type of current assets to
be held is equally important decision variables. Think of the inventory of a dealer in
construction equipment, the dealer must decide how many bulldozers to keep in stock as well
as whether to stock bulldozer or dump trucks. From the viewpoint of the financial managers,
all the decisions as to particular items add up to an average level of inventory for a given item
and these averages, for all items add up to the total average inventory investment of the firm.
Investment in receivables and marketable securities also pose a similar choice.
The result is that there is a very large number of alternative levels of investment in each type
of current assets. Therefore in principle, current assets investment is a problem of evaluating
a large number of mutually exclusive investment opportunities.
Financing of Working Capital
Another important dimension of working capital management is determining the mix of

finance for working capital which may be combination of spontaneous, short-term and long-
term credit and other instance as the firm makes purchase of raw materials and supplies, trade
credit is often made available spontaneously as per trade usage from the firm’s suppliers. In
addition to trade credit, wages and salaries payable, accrued interest and accrued taxes also
provide the firm with valuable source of spontaneous financing.

Bills payable, short-term bank loans, inter-corporate loans, commercial papers are the most
common examples of short-term sources of working capital finance. Term loans, debenture,
equity and retained earning constitute long-term sources of working capital finance.
Inter-relatedness
Characteristic of working capital decision, the financial manager cannot simply decide that
the investment in inventory for example, will be so much and stop there. The desired level of
inventory is itself, a changing quantity. For example, the desired level for a period when its
sales are very high would not be the same desired level for a period when its sales are very
low.
Furthermore, no decision regarding inventory and sales could be made without considering
the implication for accounts receivables. Moreover, any business decision that results in
increased sales and collections for the firm is likely to mean that lower average cash balances
will be needed or that a new cash management system will be desirable. Thus, all the current
assets decisions are interrelated. We may now consider some of the units between current
assets and current liabilities. If sales increase, purchases must increase to maintain a constant
level of inventory and growing sales will usually require greater inventory investment and
purchases unless the firm purchases on cash terms and increase in purchases will lead to an
increase in accounts payable. Thus, an increase in inventory will be financed spontaneously
with trade credit. The amount of trade-credit financing will depend on decision regarding
payments; inventory decisions are thus linked to trade-credit decisions The inventory and
account receivable commonly provide collateral for loans, thus, for firms unable to obtain
unsecured financing, the nature and quality of these current assets affects the availability and
terms of short-term financing. The working capital managers thus have to pay attention to the
interrelated nature of current assets and current liabilities and take into account major
interactions that influence the working capital investment and financing decisions.
VOLATILITY AND REVERSIBILITY
Another significant feature of the working capital management is that the amount of money
invested in current assets can change rapidly and so does the financing required. The level of
investment in current assets is influenced by a variety of factors which may be as erratic as
labour unrest or flooding of the plant. Seasonal and cyclical fluctuations in demands are a
common sense of rapid changes in investment in current assets and current liabilities which

mean that the cash flow related to these could be readily reversed. Suppose we have taken a
loan of N10,000 at 20% p.a. interest payable quarterly, we will continue to pay N500 per
quarter so long as we do not repay N10,000.
At any time we choose to repay N10,000, the quarterly cash flow of N500 stops. This type of
transaction is described as reversible. The current assets and current liabilities will be treated
as reversible in our decision.

Unit-IV: Capital structure theories: traditional and MM hypotheses; determining
capital structure in practice; Capital structure planning. Cost of capital: meaning and
significance of cost of capital; calculation of cost of debt, preference capital, equity
capital and retained earnings; Operating and financial leverages; measurement of
leverages; effects of operating and financial leverages on profit
Theories of Capital Structure
The capital structure decision can affect the value of the firm either by changing the expected
earnings or the cost of capital or both.
The objective of the firm should be directed towards the maximization of the value of the
firm the capital structure, or average, decision should be examined from the point of view of
its 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 which maximizes the market value of the firm. The capital
structure decision can affect the value of the firm either by changing the expected earnings or
the cost of capital or both.
If average affects the cost of capital and the value of the firm, an optimum capital structure
would be obtained at that combination of debt and equity that maximizes the total value of
the firm (value of shares plus value of debt) or minimizes the weighted average cost of
capital. For a better understanding of the relationship between financial average and the value
of the firm, assumptions, features and implications of the capital structure theories are given
below.
Assumptions and Definitions:

In order to grasp the capital structure and the cost of capital controversy property, the
following assumptions are made:
Firms employ only two types of capital: debt and equity.
The total assets of the firm are given. The degree of average can be changed by selling debt
to purchase shares or selling shares to retire debt.
The firm has a policy of paying 100 per cent dividends.
The operating earnings of the firm are not expected to grow.

The business risk is assumed to be constant and independent of capital structure and financial
risk. The corporate income taxes do not exist. This assumption is relaxed later on.
The following are the basic definitions:
The above assumptions and definitions described above are valid under any of the capital
structure theories. David Durand views, Traditional view and MM Hypothesis are tine
important theories on capital structure.
1. David Durand views:

The existence of an optimum capital structure is not accepted by all. There exist two extreme
views and a middle position. David Durand identified the two extreme views – the Net
income and net operating approaches.
a) Net income Approach (Nl):

Under the net income (Nl) approach, the cost of debt and cost of equity are assumed to be
independent of the capital structure. The weighted average cost of capital declines and the
total value of the firm rise with increased use of average.

b) Net Operating income Approach (NOI):
Under the net operating income (NOI) approach, the cost of equity is assumed to increase
linearly with average. As a result, the weighted average cost of capital remains constant and
the total of the firm also remains constant as average changed.
Thus, if the Nl approach is valid, average is a significant variable and financing decisions
have an important effect on the value of the firm, on the other hand, if the NOI approach is
correct, then the financing decision should not be of greater concern to the financial manager,
as it does not matter in the valuation of the firm.
2. TRADITIONAL VIEW:
The traditional view is a compromise between the net income approach and the net operating
approach. According to this view, the value of the firm can be increased or the cost, of capital
can be reduced by the judicious mix of debt and equity capital.
This approach very clearly implies that the cost of capital decreases within the reasonable
limit of debt and then increases with average. Thus an optimum capital structure exists and
occurs when the cost of capital is minimum or the value of the firm is maximum.
The cost of capital declines with leverage because debt capital is chipper than equity capital
within reasonable, or acceptable, limit of debt. The weighted average cost of capital will
decrease with the use of debt. According to the traditional position, the manner in which the
overall cost of capital reacts to changes in capital structure can be divided into three stages
and this can be seen in the following figure.

Criticism:
1. The traditional view is criticised because it implies that totality of risk incurred by all
security-holders of a firm can be altered by changing the way in which this totality of risk is
distributed among the various classes of securities.
2. Modigliani and Miller also do not agree with the traditional view. They criticise the
assumption that the cost of equity remains unaffected by leverage up to some reasonable
limit.
3. MM HYPOTHESIS:
The Modigliani – Miller Hypothesis is identical with the net operating income approach,
Modigliani and Miller (M.M) argue that, in the absence of taxes, a firm’s market value and
the cost of capital remain invariant to the capital structure changes.
Assumptions:
The M.M. hypothesis can be best explained in terms of two propositions.
It should however, be noticed that their propositions are based on the following
assumptions:
1. The securities are traded in the perfect market situation.
2. Firms can be grouped into homogeneous risk classes.

3. The expected NOI is a random variable
4. Firm distribute all net earnings to the shareholders.
5. No corporate income taxes exist.
Proposition I:
Given the above stated assumptions, M-M argue that, for firms in the same risk class, the
total market value is independent of the debt equity combination and is given by capitalizing
the expected net operating income by the rate appropriate to that risk class.
This is their proposition I and can be expressed as follows:
According to this proposition the average cost of capital is a constant and is not affected by
leverage.
Arbitrary-process:
M-M opinion is that if two identical firms, except for the degree of leverage, have different
market values or the costs of capital, arbitrary will take place to enable investors to engage in
‘personal leverage’ as against the ‘corporate leverage’ to restore equilibrium in the market.
Proposition II: It defines the cost of equity, follows from their proposition, and derived a
formula as follows:
Ke = Ko + (Ko-Kd) D/S
The above equation states that, for any firm in a given risk class, the cost of equity (Ke) is
equal to the constant average cost of capital (Ko) plus a premium for the financial, risk,
which, is equal to debt-equity ratio times the spread between the constant average of ‘capita’
and the cost of debt, (Ko-Kd) D/S.

The crucial part of the M-M hypothesis is that Ke will not rise even if very excessive raise of
leverage is made. This conclusion could be valid if the cost of borrowings, Kd remains
constant for any degree of leverage. But in practice Kd increases with leverage beyond a
certain acceptable, or reasonable, level of debt.
However, M-M maintain that even if the cost of debt, Kd, is increasing, the weighted average
cost of capital, Ko, will remain constant. They argue that when Kd increases, Ke will increase
at a decreasing rate and may even turn down eventually. This is illustrated in the following
figure.
Criticism:
The shortcoming of the M-M hypothesis lies in the assumption of perfect capital market in
which arbitrage is expected to work. Due to the existence of imperfections in the capital
market/arbitrage will fail to work and will give rise to discrepancy between the market values
of levered and unlevered firms.

Capital Structure - Meaning and Factors Determining Capital Structure
Meaning of Capital Structure
Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as
long-term finance. The capital structure involves two decisions-
a) Type of securities to be issued are equity shares, preference shares and long term
borrowings (Debentures).
b) Relative ratio of securities can be determined by process of capital gearing. On this
basis, the companies are divided into two-
I. Highly geared companies - Those companies whose proportion of equity
capitalization is small.
II. Low geared companies - Those companies whose equity capital dominates total
capitalization.
For instance - There are two companies A and B. Total capitalization amounts to be USD
200,000 in each case. The ratio of equity capital to total capitalization in company A is USD
50,000, while in company B, ratio of equity capital is USD 150,000 to total capitalization, i.e,
in Company A, proportion is 25% and in company B, proportion is 75%. In such cases,
company A is considered to be a highly geared company and company B is low geared
company.
Factors Determining Capital Structure
Trading on Equity- The word “equity” denotes the ownership of the company. Trading on
equity means taking advantage of equity share capital to borrowed funds on reasonable basis.
It refers to additional profits that equity shareholders earn because of issuance of debentures
and preference shares. It is based on the thought that if the rate of dividend on preference
capital and the rate of interest on borrowed capital is lower than the general rate of
company’s earnings, equity shareholders are at advantage which means a company should go
for a judicious blend of preference shares, equity shares as well as debentures. Trading on
equity becomes more important when expectations of shareholders are high.
Degree of control- In a company, it is the directors who are so called elected representatives
of equity shareholders. These members have got maximum voting rights in a concern as
compared to the preference shareholders and debenture holders. Preference shareholders have
reasonably less voting rights while debenture holders have no voting rights. If the company’s
management policies are such that they want to retain their voting rights in their hands, the
capital structure consists of debenture holders and loans rather than equity shares.
Flexibility of financial plan- In an enterprise, the capital structure should be such that there
is both contractions as well as relaxation in plans. Debentures and loans can be refunded back
as the time requires. While equity capital cannot be refunded at any point which provides

rigidity to plans. Therefore, in order to make the capital structure possible, the company
should go for issue of debentures and other loans.
Choice of investors- The company’s policy generally is to have different categories of

investors for securities. Therefore, a capital structure should give enough choice to all kind of
investors to invest. Bold and adventurous investors generally go for equity shares and loans
and debentures are generally raised keeping into mind conscious investors.
Capital market condition- In the lifetime of the company, the market price of the shares has
got an important influence. During the depression period, the company’s capital structure
generally consists of debentures and loans. While in period of boons and inflation, the
company’s capital should consist of share capital generally equity shares.
Period of financing- When company wants to raise finance for short period, it goes for loans
from banks and other institutions; while for long period it goes for issue of shares and
debentures.
Cost of financing- In a capital structure, the company has to look to the factor of cost when
securities are raised. It is seen that debentures at the time of profit earning of company prove
to be a cheaper source of finance as compared to equity shares where equity shareholders
demand an extra share in profits.
Stability of sales- An established business which has a growing market and high sales
turnover, the company is in position to meet fixed commitments. Interest on debentures has to
be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and
company is in better position to meet such fixed commitments like interest on debentures and
dividends on preference shares. If company is having unstable sales, then the company is not
in position to meet fixed obligations. So, equity capital proves to be safe in such cases.
Sizes of a company- Small size business firms capital structure generally consists of loans
from banks and retained profits. While on the other hand, big companies having goodwill,
stability and an established profit can easily go for issuance of shares and debentures as well
as loans and borrowings
Planning of Capital Structure

Capital structure planning is very important to survive the business in long run. After simple
watching the balance sheet of company, you see two sides of balance sheet. One side is
liability side and other side is asset side. Liability side is the mixture of finance of company
which company has collected from internal and external sources and it has been used or will
be used for development of company.
Liability side of balance sheet is made under perfect capital structure planning. Finance
manager and other promoters decides which source of fund or funds should be selected after
monitoring the factors affecting capital structures. So, capital structure planning makes
strong balance sheet. The right capital structure planning also increases the power of
company to face the losses and changes in financial markets. Following points shows the
importance of capital structure and its planning.
1. To reduce the overall risk of company

When we make capital structure before actual getting money from money supplier, we can do
many adjustments for reducing our overall risk. Suppose, we have made capital structure in
which we add three sources of fund, one is equity share, and other is debenture and last is
pref. shares. Because we know that we have to pay debt at its maturity at any cost and its
interest at fixed rate. So, we try to get minimum debt in new business because in new
business our rate of return will be less than rate of interest and for getting more loan means
taking high risk of return more amount of interest even there is no profit.
But, if our business will be succeeded, at that time, we can increase estimated amount of debt
by just changing the value of debt in capital structure (written just for planning) in excel
sheet. We can easily pay the interest because our ROI is very high. At that, time company can
enjoy the trading on equity. But finance manager should also careful watch whether
shareholders are more expected regarding dividend or not. Because high expectation will also
against the development of our company.
2. To do adjustment according to Business Environment

Company also adjusts different sources expected amount according to business environment.
Suppose in future, if government of India cuts off his relation with China, from where our
company is getting fund, it will definitely tough for us to get more money from China. But
proper planning of capital structure of future sources will be helpful for us to enlarge our area
for getting money. In finance, it is called maneuverability. It means to create mobility of
sources of fund by including maximum alternatives in planned capital structure. Suppose, if
RBI increases the interest rate, it means your cost for getting debt will be high, at that time,
you can choose any other cheap source of fund.
3. Idea generation of new source of fund

Good planning of capital structure will make versatile to finance manager for getting money
from new sources. If you have studied Wikipedia’s page of venture capital or private equity
sources, you would precisely understand that how finance managers of company are
generating new and new idea for getting money from public at low risk. Promoters or
managers do 10 minutes meeting with investors and motivate them by showing the special
event which they have made in PPT.
Cost of Capital: Concept, Definition

and Significance
Concept:
A firm raises funds from various sources, which are called the components of capital.
Different sources of fund or the components of capital have different costs. For example, the
cost of raising funds through issuing equity shares is different from that of raising funds
through issuing preference shares. The cost of each source is the specific cost of that source,
the average of which gives the overall cost for acquiring capital.
The firm invests the funds in various assets. So it should earn returns that are higher than the
cost of raising the funds. In this sense the minimum return a firm earns must be equal to the
cost of raising the fund. So the cost of capital may be viewed from two viewpoints—
acquisition of funds and application of funds. From the viewpoint of acquisition of funds, it is
the borrowing rate that a firm will try to minimize.
On the other hand from the viewpoint of application of funds, it is the required rate of return
that a firm tries to achieve. The cost of capital is the average rate of return required by the
investors who provide long-term funds. In other words, cost of capital refers to the minimum

rate of return a firm must earn on its investment so that the market value of company’s equity
shareholders does not fall.
It is the yardstick to evaluate the worthiness of an investment proposal. In this sense it may be
termed as the minimum rate necessary to attract an investor to purchase or hold a security.
From the viewpoint of economics, it is the investor’s opportunity cost of making an
investment, i.e. if an investment is made, the investor must forego the return available on the
next best investment.
This foregone return then is the opportunity cost of undertaking the investment and
consequently, is the investor’s required rate of return. This required rate of return is used as a
discounting rate to determine the present value of the estimated future cash flows.
Thus the cost of capital is also referred to as the discounting rate to determine the present
value of return. Cost of capital is also referred to as the breakeven rate, minimum rate, cut-off
rate, target rate, hurdle rate, standard rate, etc. Hence cost of capital may be defined
according to the operational as well as the economic sense.
In the operational sense, cost of capital is the discount rate used to determine the present
value of estimated future cash inflows of a project. Thus, it is the rate of return a firm must
earn on a project to maintain its present market value.
In the economic sense, it is the weighted average cost of capital, i.e. the cost of borrowing
funds. A firm raises funds from different sources. The cost of each source is called specific
cost of capital. The average of each specific source is referred to as weighted average cost of
capital.
Definition of Cost of Capital:

We have seen that cost of capital is the average rate of return required by the investors.
Various authors defined the term cost of capital in different ways some of which are
stated below:
Milton H. Spencer says ‘cost of capital is the minimum required rate of return which a firm
requires as a condition for undertaking an investment’.

According to Ezra Solomon, ‘the cost of capital is the minimum required rate of earnings or
the cut-off rate of capital expenditure’.
L. J. Gitman defines the cost of capital as ‘the rate of return a firm must earn on its
investment so the market value of the firm remains unchanged’.
Cost of Capital—Pricing the Sources of Fund:

The definition given by Keown et al. refers to the cost of capital as ‘the minimum rate of
return necessary to attract an investor to purchase or hold a security’. Analysing the above
definitions we find that cost of capital is the rate of return the investor must forego for the
next best investment. In a general sense, cost of capital is the weighted average cost of fund
used in a firm on a long-term basis.
Significance and Relevance of the Cost of Capital:

Cost of capital is an important area in financial management and is referred to as the
minimum rate, breakeven rate or target rate used for making different investment and financ-
ing decisions. The cost of capital, as an operational criterion, is related to the firm’s objective
of wealth maximization.
The significance and relevance of cost of capital has been discussed below:
Investment Evaluation:
The primary objective of determining the cost of capital is to evaluate a project. Various
methods used in investment decisions require the cost of capital as the cut-off rate. Under net
present value method, profitability index and benefit-cost ratio method the cost of capital is
used as the discounting rate to determine present value of cash flows. Similarly a project is
accepted if its internal rate of return is higher than its cost of capital. Hence cost of capital
provides a rational mechanism for making the optimum investment decision.
Designing Debt Policy:

The cost of capital influences the financing policy decision, i.e. the proportion of debt and
equity in the capital structure. Optimal capital structure of a firm can maximize the share-
holders’ wealth because an optimal capital structure logically follows the objective of
minimization of overall cost of capital of the firm. Thus while designing the appropriate
capital structure of a firm cost of capital is used as the yardstick to determine its optimality.
Project Appraisal:

The cost of capital is also used to evaluate the acceptability of a project. If the internal rate of
return of a project is more than its cost of capital, the project is considered profitable. The
composition of assets, i.e. fixed and current, is also determined by the cost of capital. The
composition of assets, which earns return higher than cost of capital, is accepted.
CALCULATION OF COST OF DEBT, PREFERENCE CAPITAL, EQUITY

CAPITAL AND RETAINED EARNINGS
a.) Cost of debt
It is used to measure the cost of capital. This is the first thing which should be calculated in
the beginning to find out the cost of capital. It includes both contractual cost and imputed
cost. It is defined as the required rate of return that an investment which is debt has to yield to
protect the shareholder's interest.
b.) Cost of preference shares
Costs of preference share are also used to calculate the cost of capital and are the fixed cost
bearing securities. In this the rate of dividend is fixed in advance when they are issued. It is
equal to the ratio of annual dividend income per shares to net proceed. It is not used for taxes
and it should not be adjusted for the same. Basically it is larger than the cost of debt.
c.) Cost of equity shares
Cost of equity shares is the hardest job to calculate and it also raises lots of problem while
working on its calculations. Its main motive is to enable the management which is to make
the decisions in the best interest of the equity holders. There is a certain amount of equity
capital which must be earned on projects before raising any equity funds or acceptance of
finance for other projects.
d.) Cost of retained earnings
Cost of retained earnings have the opportunity cost associated with it and it can be computed
as well without any difficulty. The opportunity cost in this is same as the rate of return of the
shareholders which determine the cut off point for the deals. It is also the rate of return which
shareholders can get by investing after tax dividends in alternative opportunity.
Measurement of Cost of Capital:

Cost of capital is measured for different sources of capital structure of a firm. It includes cost
of debenture, cost of loan capital, cost of equity share capital, cost of preference share capital,
cost of retained earnings etc.
A. Cost of Debentures:
The capital structure of a firm normally includes the debt capital. Debt may be in the form of
debentures bonds, term loans from financial institutions and banks etc. The amount of interest
payable for issuing debenture is considered to be the cost of debenture or debt capital (Kd).
Cost of debt capital is much cheaper than the cost of capital raised from other sources,
because interest paid on debt capital is tax deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: Kd = r (1 – t)
where Kd = Cost of debenture
r = Fixed interest rate
t = Tax rate
(ii) When the debentures are issued at a premium or discount but redeemable at par
Kd = I/NP (1 – t)
where, Kd = Cost of debenture
I = Annual interest payment
t = Tax rate
Np = Net proceeds from the issue of debenture.
(iii) When the debentures are redeemable at a premium or discount and are redeemable after
‘n’ period:
Kd
I(1-t)+1/N(Rv – NP) / ½ (RV – NP)
where Kd = Cost of debenture .
I = Annual interest payment
t = Tax rate

NP = Net proceeds from the issue of debentures
Ry = Redeemable value of debenture at the time of maturity
Example 1:
(a) A company issues Rs. 1,00,000, 15% Debentures of Rs. 100 each. The company is in 40%
tax bracket. You are required to compute the cost of debt after tax, if debentures are issued at
(i) Par, (ii) 10% discount, and (iii) 10% premium.
(b) If brokerage is paid at 5%, what will be the cost of debentures if issue is at par?
Example 2:
ZED Ltd. has issued 12% Debentures of face value of Rs. 100 for Rs. 60 lakh. The floating
charge of the issue is 5% on face value. The interest is payable annually and the debentures
are redeemable at a premium of 10% after 10 years.
What will be the cost of debentures if the tax is 50%?

B. Cost of Preference Share Capital:
For preference shares, the dividend rate can be considered as its cost, since it is this amount
which the company wants to pay against the preference shares. Like debentures, the issue
expenses or the discount/premium on issue/redemption are also to be taken into account.
(i) The cost of preference shares (KP) = DP / NP

Where, DP = Preference dividend per share
NP = Net proceeds from the issue of preference shares.
(ii) If the preference shares are redeemable after a period of ‘n’, the cost of preference shares
(KP) will be:
where NP = Net proceeds from the issue of preference shares
RV = Net amount required for redemption of preference shares

DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its dividend is not allowed
deduction from income for income tax purposes. The students should note that both in the
case of debt and preference shares, the cost of capital is computed with reference to the
obligations incurred and proceeds received. The net proceeds received must be taken into
account while computing cost of capital.
Example 3:
A company issues 10% Preference shares of the face value of Rs. 100 each. Floatation costs
are estimated at 5% of the expected sale price.
What will be the cost of preference share capital (KP), if preference shares are issued (i) at
par, (ii) at 10% premium and (iii) at 5% discount? Ignore dividend tax.
Solution:
We know, cost of preference share capital (KP) = DP/P

Example 4:
Ruby Ltd. issues 12%. Preference Shares of Rs. 100 each at par redeemable after 10 years at
10% premium.
What will be the cost of preference share capital?
Example 5:
A company issues 12% redeemable preference shares of Rs. 100 each at 5% premium
redeemable after 15 years at 10% premium. If the floatation cost of each share is Rs. 2, what
is the value of KP (Cost of preference share) to the company?

C. Cost of Equity or Ordinary Shares:
The funds required for a project may be raised by the issue of equity shares which are of
permanent nature. These funds need not be repayable during the lifetime of the organisation.
Calculation of the cost of equity shares is complicated because, unlike debt and preference
shares, there is no fixed rate of interest or dividend payment.
Cost of equity share is calculated by considering the earnings of the company, market value
of the shares, dividend per share and the growth rate of dividend or earnings.
(i) Dividend/Price Ratio Method:

An investors buys equity shares of a particular company as he expects a certain return (i.e.
dividend). The expected rate of dividend per share on the current market price per share is the
cost of equity share capital. Thus the cost of equity share capital is computed on the basis of
the present value of the expected future stream of dividends.
Thus, the cost of equity share capital (Ke) is measured by:

Ke = where D = Dividend per share
P = Current market price per share.
If dividends are expected to grow at a constant rate of ‘g’ then cost of equity share capital
(Ke) will be Ke = D/P + g.

This method is suitable for those entities where growth rate in dividend is relatively stable.
But this method ignores the capital appreciation in the value of shares. A company which
declares a higher amount of dividend out of given quantum of earnings will be placed at a
premium as compared to a company which earns the same amount of profits but utilizes a
major part of it in financing its expansion programme.
Example 6:
XY Company’s share is currently quoted in market at Rs. 60. It pays a dividend of Rs. 3 per
share and investors expect a growth rate of 10% per year.
You are required to calculate:

(i) The company’s cost of equity capital.

(ii) The indicated market price per share, if anticipated growth rate is 12%.
(iii) The market price, if the company’s cost of equity capital is 12%, anticipated growth rate
is 10% p.a., and dividend of Rs. 3 per share is to be maintained.
Example 7:
The current market price of a share is Rs. 100. The firm needs Rs. 1,00,000 for expansion and
the new shares can be sold at only Rs. 95. The expected dividend at the end of the current
year is Rs. 4.75 per share with a growth rate of 6%.
Calculate the cost of capital of new equity.
Solution:
We know, cost of Equity Capital (Ke) = D/P + g
(i) When current market price of share (P) = Rs. 100
K = Rs 4.75 / Rs. 100 + 6% = 0.0475 + 0.06 = 0.1075 or 10.75%.
(ii) Cost of new Equity Capital = Rs. 4.75 / Rs. 95 + 6% = 0.11 or, 11%.
Example 8:
A company’s share is currently quoted in the market at Rs. 20. The company pays a dividend
of Rs. 2 per share and the investors expect a growth rate of 5% per year.

You are required to calculate (a) Cost of equity capital of the company, and (b) the market
price per share, if the anticipated growth rate of dividend is 7%.
Solution:
(a) Cost of equity share capital (Ke) = D/P +g = Rs. 2/Rs. 20 + 5% = 15%
(b) Ke = D/P + g
or, 0.15 = Rs. 2 / P + 0.07 or, P = 2/0.08 = Rs. 25.
Example 9:
Green Diesel Ltd. has its equity shares of Rs. 10 each quoted in a stock exchange at a market
price of Rs. 28. A constant expected annual growth rate of 6% and a dividend of Rs. 1.80 per
share has been paid for the current year.
Calculate the cost of equity share capital.
Solution:
D0 (1 + g)/ P0 + g = 1.80 (1 + .06)/ 28 + 0.06
= 0.0681 + 0.06 = 12.81%
(ii) Earnings/Price Ratio Method:

This method takes into consideration the earnings per share (EPS) and the market price of
share. Thus, the cost of equity share capital will be based upon 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.
If the earnings are not distributed as dividends, it is kept in the retained earnings and it causes
future growth in the earnings of the company as well as the increase in market price of the
share.
Thus, the cost of equity capital (Ke) is measured by:

Ke = E/P where E = Current earnings per share

P = Market price per share.
If the future earnings per share will grow at a constant rate ‘g’ then cost of equity share
capital (Ke) will be
Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the factor of capital
appreciation or depreciation in the market value of shares. Adjustment of Floatation Cost
There are costs of floating shares in market and include brokerage, underwriting commission
etc. paid to brokers, underwriters etc.
These costs are to be adjusted with the current market price of the share at the time of
computing cost of equity share capital since the full market value per share cannot be
realised. So the market price per share will be adjusted by (1 – f) where ‘f’ stands for the rate
of floatation cost.
Thus, using the Earnings growth model the cost of equity share capital will be:
Ke = E / P (1 – f) + g
Example 10:
The share capital of a company is represented by 10,000 Equity Shares of Rs. 10 each, fully
paid. The current market price of the share is Rs. 40. Earnings available to the equity
shareholders amount to Rs. 60,000 at the end of a period.
Calculate the cost of equity share capital using Earning/Price ratio.
Example 11:

A company plans to issue 10,000 new Equity Shares of Rs. 10 each to raise additional capital.
The cost of floatation is expected to be 5%. Its current market price per share is Rs. 40.
If the earnings per share is Rs. 7.25, find out the cost of new equity.
D. Cost of Retained Earnings:

The profits retained by a company for using in the expansion of the business also entail cost.
When earnings are retained in the business, shareholders are forced to forego dividends. The
dividends forgone by the equity shareholders are, in fact, an opportunity cost. Thus retained
earnings involve opportunity cost.
If earnings are not retained they are passed on to the equity shareholders who, in turn, invest
the same in new equity shares and earn a return on it. In such a case, the cost of retained
earnings (Kr) would be adjusted by the personal tax rate and applicable brokerage,
commission etc. if any.
Many accountants consider the cost of retained earnings as the same as that of the cost of
equity share capital. However, if the cost of equity share capital i9 computed on the basis of
dividend growth model (i.e., D/P + g), a separate cost of retained earnings need not be
computed since the cost of retained earnings is automatically included in the cost of equity
share capital.
Therefore, Kr = Ke = D/P + g.
Example 12:

It is given that the cost of equity of a company is 20%, marginal tax rate of the shareholders
is 30% and the Broker’s Commission is 2% of the investment in share. The company
proposes to utilise its retained earnings to the extent of Rs. 6,00,000.
Find out the cost of retained earnings.
E. Overall or Weighted Average Cost of Capital:

A firm may procure long-term funds from various sources like equity share capital,
preference share capital, debentures, term loans, retained earnings etc. at different costs
depending on the risk perceived by the investors.
When all these costs of different forms of long-term funds are weighted by their relative
proportions to get overall cost of capital it is termed as weighted average cost of capital. It is
also known as composite cost of capital. While taking financial decisions, the weighted or
composite cost of capital is considered.
The weighted average cost of capital is used by an enterprise because of the following
reasons:
(i) It is useful in taking capital budgeting/investment decisions.
(ii) It recognises the various sources of finance from which the investment proposal derives
its life-blood (i.e., finance).
(iii) It indicates an optimum combination of various sources of finance for the enhancement
of the market value of the firm.
(iv) It provides a basis for comparison among projects as a standard or cut-off rate.
I. Computation of Weighted Average Cost of Capital:

Computation of Weighted Average cost of capital is made in the following ways:

(i) The specific cost of each source of funds (i.e., cost of equity, preference shares, debts,
retained earnings etc.) is to be calculated.
(ii) Weights (i.e., proportion of each, source of fund in the capital structure) are to be
computed and assigned to each type of funds. This implies multiplication of each source of
capital by appropriate weights.
Generally, the-following weights are assigned:

(a) Book values of various sources of funds
(b) Market values of various sources of capital
(c) Marginal book values of various sources of capital.
Book values of weights are based on the values reflected by the balance sheet of a concern,
prepared under historical basis and ignoring price level changes. Most of the financial
analysts prefer to use market value as the weights to calculate the weighted average cost of
capital as it reflects the current cost of capital.
But the determination of market value involves some difficulties for which the measurement
of cost of capital becomes very difficult.
(iii) Add all the weighted component costs to obtain the firm’s weighted average cost of
capital.
Therefore, weighted average cost of capital (Ko) is to be calculated by using the following
formula:
Ko = K1w1 + K2w2 + …………
where K1, K2 ……….. are component costs and W1, W2 ………….. are weights.
Example 13:
Jamuna Ltd has the following capital structure and, after tax, costs for the different
sources of fund used:

Example 14:
Excel Ltd. has assets of Rs. 1,60,000 which have been financed with Rs. 52,000 of debt and
Rs. 90,000 of equity and a general reserve of Rs. 18,000. The firm’s total profits after interest
and taxes for the year ended 31st March 2006 were Rs. 13,500. It pays 8% interest on
borrowed funds and is in the 50% tax bracket. It has 900 equity shares of Rs. 100 each selling
at a market price of Rs. 120 per share.
What is the Weighted Average Cost of Capital?

Example 15:
RIL Ltd. opts for the following capital structure:
Example 16:
In considering the most desirable capital structure for a company, the following
estimates of the cost Debt and Equity Capital (after tax) have been made at various
levels of debt-equity mix:

You are required to determine the optimum debt-equity mix for the company by calculating
composite cost of capital.
Optimal debt-equity mix for the company is at the point where the composite cost of capital
is minimum. Hence, the composite cost of capital is minimum (10.75%) at the debt-equity
mix of 3: 7 (i.e., 30% debt and 70% equity). Therefore, 30% of debt and 70% equity mix
would be an optimal debt-equity mix for the company.

Unit-V: Dividend decisions—Types of dividend- dividend models - Determinants of dividend
policy - Practical aspects of dividend.
Meaning:
Dividend is the payment by a company to its shareholders out of its distributable profit. In
other words, dividend is paid to the shareholders out of the revenue profits earned by it in the
ordinary course of business.
Concept of Dividend:
Dividend represents that part of the profit of a firm which is distributed to the shareholders.
The company declares the amount of dividend at its shareholders’ meeting. Shareholders will
get dividends in proportion to their shareholding in the company. Dividend may be in the
form of cash or non-cash, i.e. bonus shares.
Nature of Dividend:
Dividend decision is the financing decision of a business. It is the distribution of revenue
profit to the shareholders in proportion to their holdings.
The nature of dividends is discussed below:

i. Cash or Non-cash:
Dividends may either be in cash or non-cash. Dividends are generally paid in cash to the
shareholders but sometimes instead of cash payments, shares are issued to the existing
shareholders, free of cash—which is known as issue of bonus shares.
ii. Final or Interim:

After finalization of accounts, the directors judge the financial position and then recommend
the amount of dividend at the annual general meeting. Such dividend is called final dividend
whereas any dividend paid between two annual general meetings is called interim dividend.
iii. Fixed or Variable:

In case of profit, preference shareholders are entitled to get dividend at a fixed rate as per
terms of their issue. Equity shareholders are entitled to get dividend out of the balance left
after payment of preference dividend and their rate of dividend may vary from year to year
depending on the volume of profit.

Types of Dividend Decisions of a Firm:
i. Long-Term Financing Decision:
As long-term financing decision the significance of the profits of the firm after tax is to be
considered in paying dividends. Investor should know that cash dividends have the nature of
reducing the funds of the firm and firm is restricted to grow or to find other financing
sources. If the firm desires to fund dividend as a long-term decision, then it should be guided
by the following points.
Projects available with the firm:

When a firm has many large projects to put its investments then instead of distributing a large
amount of profit it may retain earnings of the firm and advance these projects
Requirement of equity funds:

A company may be able to finance itself either through long-term loans or through raising of
capital such as equity and preference shares. To raise capital also, the firm has to incur a large
cost. The company may thus take a decision of retaining some part of the earnings of the firm
and may be guided by this view at the time of paying dividends to shareholders.
ii. Wealth Maximization Decisions:

While the firm regards the needs of investment and expansion programmes and is guided by
the decision of paying dividends as a long-term financing requirement, the other decisions
that the firm may be guided by, is the project of paying to the shareholders a high amount of
dividend to satisfy them and also to raise the price of its equity stock in the capital market.
This project takes into consideration the expectation of both the investors and the
shareholders. The management may adopt any one of these methods after taking into
consideration the factors which affect the dividend decisions.
Factors affecting Dividend Decisions of Firms:

There are many factors affecting the decisions relating to dividends to be declared to
shareholders.
These are discussed below:

i. Expectation of Investors:
People who invest in the firms have basically done so, with the view of long-term investment
in a particular firm to avoid the necessity of shifting from one firm to another. The

expectation of the investor has been two fold. They expect to receive income annually and
have a stable investment.
Capital Gains:
All investors who are less interested in speculation and more interested in long-term
investment do so with a view to making some capital appreciation on their investment.
Capital gain is the profit, which results from the sale of any capital investment. If the investor
invests in equity stock, the capital gain would be out of the sale of equity stock after holding
it for a reasonable period of time.
Current Income:
The investor would like to have some current earnings which are also continuous in nature
and it is the price of abstinence from current consumption to more profitable avenues.
The expectation of the shareholder should be considered before taking any appropriate
decision regarding dividends. In this sense, the company has to think of both maximization of
wealth of the investor as well as its own internal requirements for long-term financing.
ii. Reducing of Uncertainty:

Dividends should be declared in a manner that the investor is confident about the future of his
earnings. If he receives dividends annually and the amount is such that it satisfies him then
the company is able to gain his confidence because it reduces his uncertainty about future
capital gains or appreciation of the company’s equity stock.
A current dividend is the present value cash in-flow to the investors. This also helps him to
assess the kind of future that his investments will carry for him. The decisions for paying
dividend should also considered this point.
iii. Financial Strength:

The payment of dividend which is regular, stable and continuous with a promise of capital
appreciation, helps the company in judging its own financial strength and also it receives
financial commitments from creditors and financial institutions because they are in a position
to gauge the kind of working of the firm through the information they receive regarding the
amount of dividend and the market value of their shares.

While all investors would like to maximize their wealth, the company must also see its
requirement for expansion programs. The company also has certain limitations or
environmental constraints which enable it to pay dividend in a limited form.
Limitation on Dividend Payments:

The firm has the following limitations in paying dividends.
The management of the firm while making decision in paying out dividends to its
shareholders should also analyse these problems:
i. Cash Requirements:
Many firms are unable to pay dividends regularly. A company which is going through its
gestation period or is small in nature and is trying to expand its business has the problem of
paying high dividends.
If it does, it will be surrounded by inefficiency because of the insufficiency of cash.

Sometimes, a firm has the problem of tying up all resources in inventories or in the
commitment of purchasing long-term investments. This acts as a restraint of the firm to pay
out dividends.
ii. Limitations Placed by Creditors:

Sometimes, a firm requires funds for long-term purpose and to fulfil this obligation it makes,
the use of funds on long-term loans. While taking these loans the firm makes an arrangement
with the creditors that it will not pay dividends to its shareholders till its debt equity ratio
depicts 2:1.
Sometimes, the firm also makes contractual obligations with its creditors to maintain a certain
pay-out ratio till the time that it is using the loan facilities. Under these contractual
obligations, the firm cannot pay more than the dividends it can, or is allowed to pay, under
the agreement.
iii. Legal Constraints:

In India, there are many legal constraints in payment of dividends. The payment of dividends
is subject to government policy and tax laws. This restraint also covers bonds, debentures and
equity shares.
There are regulatory authorities such as Reserve Bank of India, Securities Exchange Board of
India, Insurance Regulatory Authority of India. Income Tax Act of India and Companies Act

followed in India. These legal constraints should be carefully analysed before paying
dividends to the shareholders.
Dividend Policy: Significance and Concepts (With Formulas)
Significance of Dividend Policy in Business Decisions:

Dividend policy is about the decision of the management regarding distribution of profits as
dividends. This policy is probably the most important single area of decision making for
finance manager. Action taken by the management in this area affects growth rate of the firm,
its credit standing, share prices and ultimately the overall value of the firm.
Erroneous dividend policy may plunge the firm in financial predicament and capital structure
of the firm may turn out unbalanced. Progress of the firm may be hamstrung owing to
insufficiency of resources which may result in fall in earnings per share.
Stock market is very likely to react to this development and share prices may tend to sag
leading to decline in total value of the firm. Extreme care and prudence on the part of the
policy framers is, therefore, necessary.
If strict dividend policy is formulated to retain larger share of earnings, sufficiently larger
resources would be available to the firm for its growth and modernization purposes. This will
give rise to business earnings. In view of improved earning position and robust financial
health of the enterprise, the value of shares will increase and a capital gain will result.
Thus, shareholders earn capital gain in lieu of dividend income; the former in the long run
while the latter in the short run.
The reverse holds true if liberal dividend policy is followed to pay out high dividends to
share-holders. As a result of this, the stockholders’ dividend earnings will increase but
possibility of earning capital gains is reduced.
Investors desirous of immediate income will greatly value shares with high dividend. The
stock market may, therefore, respond to this development and the value of shares may soar.
Thus, it is evident that in retention of earnings lies capital gain while distribution of income
increases dividend earnings.
Owing to varying notions and attitudes of shareholders due to differences with respect to age,
sex, tax bracket, security, income habits, preferences and responsibilities, some are primarily

concerned with the short run returns, others think in terms of long range returns; still others
seek a portfolio which balances their expectations over time.
Concepts of Dividend Policy:

In order to assess the significance of dividend policy in financial decisions one must examine
as to what extent dividend policy influences share prices because the financial objective of
the firm is maximisation of share value. There exists a lot of controversy among finance
scholars in respect of influence of dividend policy on valuation of shares.
Broadly speaking, different view-points of the scholars can be categorized into two
groups:
(i) Irrelevance concept of dividend and
(ii) Relevance concept of dividend.
The following paragraphs will give a brief but full account of these two concepts:
I. Irrelevance Concept of Dividend:
This school of thought is associated with Ezra Solomon, and Modigliani and Miller. The
basic theme of irrelevance approach of dividend is that the dividend policy is a passive
variable which does not, in any way, influence share value.
1. Dividend as a Passive Residual Decision:

According to Ezra Solomon, the dividend policy of a firm is a residual decision and dividend
is a passive residual. Dividend policy is basically a financing decision which is primarily
conditioned by available investment opportunities and investors are indifferent between
dividends and capital gains. Their principal desire is to earn higher return on their capital.
If a firm has in hand array of investment opportunities promising higher return (r) than cost of
capital (k), stockholders will be inclined to more and more retention so that ploughed back
funds may finance profitable investment outlets to generate higher earnings.
However, if expected return on potential projects is likely to be less than what it would cost,
they would be least interested in reinvestment of income and instead, immediate distribution
of income will be insisted upon.

II. Relevance Concept of Dividend:
James E waiter and Myron J. Gordon were amongst the two prominent scholars who
propounded relevance of dividend decision in valuation of a firm.
Theories of Dividend: Walter’s model, Gordon’s model and Modigliani and Miller’s
Hypothesis
Some of the major different theories of dividend in financial management are as follows: 1.
Walter’s model 2. Gordon’s model 3. Modigliani and Miller’s hypothesis.
On the relationship between dividend and the value of the firm different theories have been
advanced.
They are as follows:

1. Walter’s model
2. Gordon’s model
3. Modigliani and Miller’s hypothesis
1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost always affects
the value of the enterprise. His model shows clearly the importance of the relationship
between the firm’s internal rate of return (r) and its cost of capital (k) in determining the
dividend policy that will maximise the wealth of shareholders.
Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is not
issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately
4. Beginning earnings and dividends never change. The values of the earnings pershare (E),
and the divided per share (D) may be changed in the model to determine results, but any
given values of E and D are assumed to remain constant forever in determining a given value.

5. The firm has a very long or infinite life.
Walter’s formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K
The above equation clearly reveals that the market price per share is the sum of the
present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
ii) The present value of the infinite stream of stream gains.
[r (E-D)/K/K]
Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm
under different assumptions about the rate of return. However, the simplified nature of the
model can lead to conclusions which are net true in general, though true for Walter’s model.
The criticisms on the model are as follows:

1. Walter’s model of share valuation mixes dividend policy with investment policy of the
firm. The model assumes that the investment opportunities of the firm are financed by
retained earnings only and no external financing debt or equity is used for the purpose when
such a situation exists either the firm’s investment or its dividend policy or both will be sub-
optimum. The wealth of the owners will maximise only when this optimum investment in
made.
2. Walter’s model is based on the assumption that r is constant. In fact decreases as more
investment occurs. This reflects the assumption that the most profitable investments are made
first and then the poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to
optimise the wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly
with the firm’s risk. Thus, the present value of the firm’s income moves inversely with the
cost of capital. By assuming that the discount rate, K is constant, Walter’s model abstracts
from the effect of risk on the value of the firm.

2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is
equal to the present value of an infinite stream of dividends to be received by the share. Thus:
The above equation explicitly shows the relationship of current earnings (E,), dividend
policy, (b), internal profitability (r) and the all-equity firm’s cost of capital (k), in the
determination of the value of the share (P0).
3. Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does
not affect the wealth of the shareholders. They argue that the value of the firm depends on the
firm’s earnings which result from its investment policy.

Thus, when investment decision of the firm is given, dividend decision the split of earnings
between dividends and retained earnings is of no significance in determining the value of the
firm. M – M’s hypothesis of irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As
a result, the price of each share must adjust so that the rate of return, which is composed of
the rate of dividends and capital gains, on every share will be equal to the discount rate and
be identical for all shares.
Thus, the rate of return for a share held for one year may be calculated as follows:
Where P^ is the market or purchase price per share at time 0, P, is the market price per share
at time 1 and D is dividend per share at time 1. As hypothesised by M – M, r should be equal
for all shares. If it is not so, the low-return yielding shares will be sold by investors who will
purchase the high-return yielding shares.
This process will tend to reduce the price of the low-return shares and to increase the prices
of the high-return shares. This switching will continue until the differentials in rates of return
are eliminated. This discount rate will also be equal for all firms under the M-M assumption
since there are no risk differences.
From the above M-M fundamental principle we can derive their valuation model as follows:
Multiplying both sides of equation by the number of shares outstanding (n), we obtain the
value of the firm if no new financing exists.

If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at
time 0 will be
The above equation of M – M valuation allows for the issuance of new shares, unlike
Walter’s and Gordon’s models. Consequently, a firm can pay dividends and raise funds to
undertake the optimum investment policy. Thus, dividend and investment policies are not
confounded in M – M model, like waiter’s and Gordon’s models.
Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical
relevance in the real world situation. Thus, it is being criticised on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This cannot be true if
the costs of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm
pays dividends or not. But, because of the transactions costs and inconvenience associated
with the sale of shares to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k)
should be same whether firm uses the external or internal financing.
If investors have desire to diversify their port folios, the discount rate for external and internal
financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of writers,
dividends are relevant under conditions of uncertainty.

Determinants of Dividend Policy
some of the most important determinants of dividend policy are: (i) Type of Industry (ii) Age
of Corporation (iii) Extent of share distribution (iv) Need for additional Capital (v) Business
Cycles (vi) Changes in Government Policies (vii) Trends of profits (vii) Trends of profits
(viii) Taxation policy (ix) Future Requirements and (x) Cash Balance.
The declaration of dividends involves some legal as well as financial considerations. From
the point of legal considerations, the basic rule is that dividend can only be paid out profits
without the impairment of capital in any way. But the various financial considerations present
a difficult situation to the management for coming to a decision regarding dividend
distribution.
(i) Type of Industry:

Industries that are characterised by stability of earnings may formulate a more consistent
policy as to dividends than those having an uneven flow of income. For example, public
utilities concerns are in a much better position to adopt a relatively fixed dividend rate than
the industrial concerns.
(ii) Age of Corporation:

Newly established enterprises require most of their earning for plant improvement and
expansion, while old companies which have attained a longer earning experience, can
formulate clear cut dividend policies and may even be liberal in the distribution of dividends.
(iii) Extent of share distribution:

A closely held company is likely to get consent of the shareholders for the suspension of
dividends or for following a conservative dividend policy. But a company with a large
number of shareholders widely scattered would face a great difficulty in securing such assent.
Reduction in dividends can be affected but not without the co-operation of shareholders.
(iv) Need for additional Capital:

The extent to which the profits are ploughed back into the business has got a considerable
influence on the dividend policy. The income may be conserved for meeting the increased
requirements of working capital or future expansion.

(v) Business Cycles:
During the boom, prudent corporate management creates good reserves for facing the crisis
which follows the inflationary period. Higher rates of dividend are used as a tool for
marketing the securities in an otherwise depressed market.
(vi) Changes in Government Policies:

Sometimes government limits the rate of dividend declared by companies in a particular
industry or in all spheres of business activity. The Government put temporary restrictions on
payment of dividends by companies in July 1974 by making amendment in the Indian
Companies Act, 1956. The restrictions were removed in 1975.
(vii) Trends of profits:

The past trend of the company’s profit should be thoroughly examined to find out the average
earning position of the company. The average earnings should be subjected to the trends of
general economic conditions. If depression is approaching, only a conservative dividend
policy can be regarded as prudent.
(viii) Taxation policy:

Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce
the residual profits after tax available for shareholders and indirectly, as the distribution of
dividends beyond a certain limit is itself subject to tax. At present, the amount of dividend
declared is tax free in the hands of shareholders.
(ix) Future Requirements:

Accumulation of profits becomes necessary to provide against contingencies (or hazards) of
the business, to finance future- expansion of the business and to modernise or replace
equipments of the enterprise. The conflicting claims of dividends and accumulations should
be equitably settled by the management.
(x) Cash Balance:

If the working capital of the company is small liberal policy of cash dividend cannot be
adopted. Dividend has to take the form of bonus shares issued to the members in lieu of cash
payment.
The regularity of dividend payment and the stability of its rate are the two main objectives
aimed at by the corporate management. They are accepted as desirable for the corporation’s
credit standing and for the welfare of shareholders.

High earnings may be used to pay extra dividends but such dividend distributions should be
designed as “Extra” and care should be taken to avoid the impression that the regular
dividend is being increased.
A stable dividend policy should not be taken to mean an inflexible or rigid policy. On the
other hand, it entails the payment of a fair rate of return, taking into account the normal
growth of business and the gradual impact of external events.

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Unit-I: Financial management: meaning, nature and scope of finance; financial goals:

profit maximization, wealth maximization; finance functions,- investment, financing

Financial Management is a related aspect of finance function. In the present business

Financial management includes adoption of general management principles for financial

It acts as guidance where more opportunities for investment is available. Financial

BBA FINANCIAL MANAGEMENT GVP

Aims of Financial Management:

The following aspects have place in maximising firm’s value:

BBA FINANCIAL MANAGEMENT GVP

5. Long run value:

SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT:

i) Forecasting of cash flow:

ii) Rising of funds:

iii) Managing the flow of internal funds:

BBA FINANCIAL MANAGEMENT GVP

iii) Forecasting of future profits:

iv) Measuring the cost of capital:

BBA FINANCIAL MANAGEMENT GVP

1. To ensure regular and adequate supply of funds to the concern.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

BBA FINANCIAL MANAGEMENT GVP

BBA FINANCIAL MANAGEMENT GVP

The fundamental differences between profit maximization and wealth maximization is

1. Evaluation of new investment in terms of profitability

BBA FINANCIAL MANAGEMENT GVP

It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s

BBA FINANCIAL MANAGEMENT GVP

Nature of Capital Budgeting:

The following are some of the examples of capital expenditure:

(2) Cost of addition, expansion, improvement or alteration in the fixed assets.

(3) Cost of replacement of permanent assets.

(4) Research and development project cost, etc.

Capital expenditure involves non-flexible long-term commitment of funds. Thus, capital

BBA FINANCIAL MANAGEMENT GVP

In the words of Lynch, “Capital budgeting consists in planning development of available

(5) They involve, generally, huge funds;

(6) They are irreversible decisions.

BBA FINANCIAL MANAGEMENT GVP

(b) Analyze the proposal for expansion or creating additional capacities.

(d) To make financial analysis of various proposals regarding capital investments so as to

(2) Long-term Commitment of Funds:

BBA FINANCIAL MANAGEMENT GVP

(4) Long-Term Effect on Profitability:

(5) Difficulties of Investment Decisions:

The long term investment decisions are difficult to be taken because:

(ii) Uncertainties of future and

(iii) Higher degree of risk.

(6) National Importance:

BBA FINANCIAL MANAGEMENT GVP

Capital budgeting techniques suffer from the following limitations:

(4) Urgency is another limitation in the evaluation of capital investment decisions.

BBA FINANCIAL MANAGEMENT GVP

• Estimation of cash flows

• Estimation of the required rate of return (the cast of capital)

Investment decision rule

The investment decision rules may be referred to as capital budgeting techniques, or

• It should help ranking of projects according to their true profitability.

• It should be a criterion which is applicable to any conceivable investment project

Investment Appraisal Criteria

A number of investment appraisal criteria or capital budgeting techniques are in use of

1. Discounted cash flow criteria 2. Not discounted cash flow criteria