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AUDACE Financial Smarts for Students 103/75, Meera Marg, Mansarovar Ph 9829 393

505
1
AUDACE
Financial Smarts For Students
Study Center for M.B.A., C.A., C.F.A., M.Com. B.Com (Hons.)
103/76, Meera Marg, Mansarovar, Jaipur-20 - Ph: 9829 393 505 - mailto: Sachin.jpr@gmail.com
Notes on
Financial Management
MBA Par t - 1(Uni ver si t y of Raj ast han)
is a novel venture in the field of additional academic
assistance. We aid students to widen their horizon of
knowledge such that the student conceives every
aspect with utmost clarity and detail. We further help them in their assignments and
projects so that they can give maximum attention to their syllabus and theory without
compromising in their practical understanding. We support them to meet and complete
their hands on training individual projects etc which makes them true masters of
knowledge they acquire. Immense importance is given to the personal development of
student along with academic excellence so that our students get a forehand en ever
possible aspect of competition. Special stress is given in sharpening the communication
skills of students since good communication is at times the only skill that makes a total
loser or the tycoon of the industry. Lively classroom training with more weightage to
interactive study ensures that the student remain interested throughout, however tough
the topic may be. Personal attention is assured and customized plans are plotted to fit in
the needs of every student. We back up student without patronizing them so that they
activate in themselves the shrewdness and knack which is so crucial to emerge winning
in an industry which let survive no one lesser then the best.
Corporate Finance, which is what most commonly know as Financial Management,
is perhaps the finest subject that a professional could aspire to handle to add value to a
company.
This subject is not about law. It is not about reporting. It is not about tax. It is about
none pf the things that the conventional accountant swore by. It is about what actually
counts for a company, viz the bottom line, the profits. It is about how profits are made,
wealth is created and businesses are built. As a subject that deals with the mantra of
money, it can hardly be unexciting. And the great thing about it is that there is
hardly any dichotomy between theory and practice. What you read in the classroom is
what you will practice tomorrow and what is practised today could find a place in the
classroom tomorrow! Don't get waylaid by people who claim that this subject is
difficult to crack. All that it requires is a dose of commonsense.
You might ask why we came out with notes on this subject when there are so many
books in the market place. The reasons aren't far to seek. One, there aren't many in
Audace
AUDACE Financial Smarts for Students 103/75, Meera Marg, Mansarovar Ph 9829 393
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the Indian context which focus exclusively on Rajasthan University syllabus.
Contemporary areas need to be talked in a language that is easy to understand, we felt
that a book that focuses on them wouldn't be out of place. Two, there are some books that
are great when explaining concepts, but fall short when it comes to working out
problems. Finance is a subject that is best understood with a fair dose of application-
oriented problems. There are other books that are great when it comes to a choice of
problems but falls short while explaining concepts. Ours has been an attempt to strike
the golden mean. With compilation of concept problems, in place, it should act as your
one stop for preparing for this subject.
In picking problems we have used myriad sources besides coining our very own. With
the MBA syllabus concentrating a good 50% on theory, we believe, this book would
cater to those requirements as well. All this should give you a sound understanding of
the fundamentals -something as essential as you make your mark in the new world.
We know that this is only the start of the journey. Your feedback that would help
convert it into a work of art would be most welcome.
Every effort has been made to avoid errors or omissions in this compilation. In spite; of
this, errors may creep in. Any mistake, error or discrepancy noted may be brought to my
notice which shall be taken care of. It is suggested that to avoid any doubt the reader
should cross-check all the facts, law and contents of the notes with books of renowned
authors, original Government publication or notifications.
Index

A
Aggressive Policy 29
Annuity 3
Annuity Due 3
Average Rate Of Return 20
B
Baumal Model 39
Business Risk 9
C
Capital Asset Pricing Model 7
Capital Budgeting 19
Capital Cost 34
Capital Rationing 24
Capital Structure Theories 12
Carrying Costs 40
Cash Management 38
Collection Cost 34
Combined Leverage 9
Commercial Papers 36
Compounding 3
Concentration Banking 39
Conservative Policy 29
Conventional Projects 19
Cost Of A Debenture 6
Cost Of A Redeemable Preference Share 6
Cost Of Capital 7
Cost Of Capital 6
Cost Of Debt 6
Cost Of Retained Earning 7
Cost Reduction Projects 19
Credit Terms 31
Cut Off Rate See
D
Default Cost 35
Delinquency Cost 34
Discounting 3
Dividend Decision 1
Dividend Policy 16
E
EBIT-EPS Analysis 10
Economic Order Quantity 41
Effective Interest Rate 4
Explicit Cost 6
AUDACE Financial Smarts for Students 103/75, Meera Marg, Mansarovar Ph 9829 393
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F
Factoring 37
Financial Break Even Point 9
Financial Leverage 9
Financing Decision 1
First-In-First-Out 41
Forfaiting 37
Functions Of Financial Management 1
G
Gordon's Model 16
Gross Working Capital 28
Growing Perpetuity 3
H
Hurdle Rate 22
I
Identification Of Cash Flows 19
Implicit Cost 6
Independent Projects 19
Indifference Point 10
Initial Outflow 19
Interest 3
Internal Rate Of Return 21
Inventory Management 40
Investment Decision 1
L
Last-In-First-Out 41
Leverage 9
Liquidity Decision 1
Lock Box System 39
M
Maximum Permissible Bank Finance (MPBF 36
Miller-Orr Cash Management Model 40
Modigliani And Miller Approach 14
Modigliani And Miller Model 16
Mutually Exclusive Projects 19
N
Net Income Approach 12
Net Operating Income Approach 13
Net Present Value 21
Net Working Capital 28
Non-Conventional Projects 19
O
Operating Cycle 28
Operating Leverage 9
Ordering Costs 40
P
Pay Back Period 20
Permanent Working Capital 29
Perpetuity 3
Planning Of Working Capital 32
Precautionary Motive 38
Profit Maximisation 2
R
Rational Expectations Model 17
Receivables Management 34
Revenue Expanding: Projects 19
Risk Return Trade Off 2
Risk-Return Tangle And Cost Trade-Off 30
S
Size Disparity Problem 22
Speculative Motive 38
Subsequent Cash Inflow 20
T
Tandon Committee 36
Temporary Working Capital 29
Terminal Cash Flows 20
Terminal Value Method 23
Time Disparity Problem 22
Time Value Of Money 2
Time Value Of Money 3
Traditional Approach 13, 16
Transaction Motive 38
W
Walter Model 16
Wealth Maximisation 2
Weighted Average Cost Method 41
Weighted Average Cost Of Capital 7
Working Capital Financing 36
Working Capital Management 28
AUDACE Financial Smarts for Students 103/75, Meera Marg, Mansarovar Ph 9829 393
505
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AUDACE
Financial Smarts For Students
Study Center for M.B.A., C.A., C.F.A., M.Com. B.Com(Hons.)
103/76, Meera Marg, Mansarovar, Jaipur-20 = Ph: 9829 393 505 = mailto: Sachin.jpr@gmail.com
F u n c t i o n s o f F i n a n c i a l M a n a g e m e n t
Some of the most important functions of a business are production, marketing and finance. A firm has to secure capital that it
needs for production and marketing and employ it in its business activities to get return on invested capital and to distribute the
profit among the providers of capital. Now the activities/functions of a financial manager can be divided into four heads.
a. Acquisition of capital i.e. capital mix decision or financing decision.
b. Employment of capital i.e. long term asset mix decision or investment decision.
c. Distribution of profits i.e. dividend or profit allocation decision.
d. Maintenance of working capital i.e. short term asset mix decision or liquidity decision.
a) Financing decision: Here the manager has to determine about the best financing mix or capital structure. Further another factor
to determine is about when, where and how to acquire the fund to meet the monetary requirement of the firm's investment. The
core issue is to determine the proportion of debt/equity mix and this is called the firm's capital structure. Here the manager strives
to obtain the best financing mix i.e. the optimum capital structure. Optimum capital structure is that combination of debt and
equity where the market value of share is maximised.
The equity shares are the best from the risk point of view for the company, since there is no question of repayment of equity
capital except when the company is in liquidation. From the cost point of view, equity share capital is the most expensive source
of fund. This is because the dividend expectation of shareholder's is normally higher than the interest rate and also because
dividends are an appropriation of profit, not allowed as an expense under the Income Tax Act. Further the issue of equity shares
may dilute the control of the existing shareholders. However the debenture as a source of fund is comparatively cheaper. However
debentures entail a higher degree of risk since they have to be repaid as per the terms of the agreement. Also the interest payment
has to be made whether the company makes profit or not. So a finance manager while procuring funds must consider the
following three factors;
a) Cost
b) Control
c) Risk
The cost of the fund has to be at the minimum but with proper balancing of risk and control factors.
Procurement of funds will include the following steps:
1) Identification of sources of finance
2) Determination of finance mix
3) Raising of funds
In the age of globalisation, only the procurement of fund is not enough. The resources must be mobilised through innovative
ways or such financial products, which caters to the needs of investor's viz. multiple option convertible bond. Further funds can
even be raised from abroad. So the pros and cons of resources from abroad must also be considered.
b) Investment decision: The finance manager is also responsible for effective utilisation of funds. Now one thing is very sure
that funds can be procured only after assuming a particular degree of risk and cost. If the funds so procured are not utilised in an
effective way so as to give a return higher than the cost associated with the funds, there is no point in running the business. So the
funds have to be invested in such a way that the company can produce at its optimum level without endangering its financial
solvency. Thus financial implications of each investment decision are to be thoroughly analysed. This is done through techniques
of capital budgeting decision of allocating the capital in the long-term assets that would yield the return in future. The important
aspects to be considered here are;
1) Evaluation of profitability of new investment.
2) Measurement of cut-off rate against which the return on new investment can be compared. Investment decision is very
important as the project is to be evaluated on expected profits and prediction about future is never easy. Further the
importance of investment decision increases as a large amount of money is involved.
c) Dividend decision: This decision involves the idea whether the profit is to be distributed or retained. This also is to be based
on maximisation of the market value of shares of the firm. So that dividend policy is considered the best, which optimises the
market value of shares. At the time of taking this decision availability of cash, legal requirements and certain other factors are also
to be considered.
d) Liquidity decision: This involves the management of cash, debtors, stock and total working- capital that affects the earning
prospects of a firm, liquidity and solvency. Here the. manager has to decide how much fund is to be invested in each and every
item of current assets and to manage those efficiently. This ensures that too much funds are not blocked in stock, debtors and cash
etc.
AUDACE Financial Smarts for Students 103/75, Meera Marg, Mansarovar Ph 9829 393
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Objective of Financial Management
It has traditionally been argued that the objective of the business is to maximise the profits. Hence the objective of financial
management is also considered to be profit maximisation. This implies that finance manager makes his decision in such a manner
that the profits are maximised. However it cannot be the sole objective of the business. There is another objective of finance
manager and that is wealth maximisation. Let us consider these two in the lights of their positive and negative aspects.
Profit maximisation: This means maximisation of the rupee income of the firm. So under this theory the firm has to
produce maximum output from a given amount of input or minimises the input for a given amount of output or the firm has to
increase the market price of its product or services or to reduce the amount of expenditure. In the perfectly competitive market the
above is really difficult and almost impossible to achieve. It is considered as a short-term theory and following are its criticisms.
a) There is a direct relationship between risk and profit. Higher the risk higher is the possibility of profits. If profit maximisation
is the only goal, the risk factor has to be ignored totally. The finance manager will have to accept highly risky proposals, if they
give high profits. But risk factor can not be ignored and have to be balanced with the profit objective.
b) Profit maximisation theory does not take into account the time pattern of returns, which is the most important consideration. If
a project giving more total profits than another project but its profits starts to accrue say after 10 or 15 years, the former project
may be rejected because of time value of money.
c) The objective of profit maximisation is too narrow. It fails to consider the interest of workers, consumers, society as well as
ethical trade practices. If these factors are ignored, a business cannot survive for a longer period. Profit maximisation at the cost of
social and moral obligation is a shortsighted policy.
Wealth maximisation: It means the maximisation of the wealth of the shareholders. The objective of the company is to
create value for its shareholders. According to Van Horne 'Value is represented by the market price of the common stock (equity
shares) which in turn is a function of firm's investment, financing and dividend decisions. The value of the firm takes into account
present and prospective future earnings per share, 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. The market price serves as performance index of the firm's progress and
it indicates how well the management is doing on behalf of its shareholders.
It is again beyond doubt that market price of a stock in the share market is the result of a typical mixture of a lot of factors like,
general economic condition, particular economic condition of the industry to which the stock belongs, technical factors, mass
sentiments and a lot of other factors also. However in the long run, the market price of the share of a company does reflect the
value, which we put on a company. The value is a function of two factors:
a) The likely rate of earning per share (EPS) of the company
b) The capitalisation rate
The likely rate of earning per share depends upon the assessment as to how profitably a company is going to operate in the
nature. The capitalisation rate reflects the expectations of the company's shareholders. If a company earns a high rate of earning
per share through risky operations or risky financing pattern, the investors will not look upon its share with favour. To that extent
the market price of that share will be low. Now the market price per share may be formulated as Ei/Ke.
The finance manager has to ensure that his decisions are such that the market value of the shares of a company in long run is
maximised. This implies that the financial policy has to be such that it optimises the earning per share, keeping in view the risk
and other factors in mind. Wealth maximisation is therefore a better objective for a commercial undertaking since it represents
both return and risk.
Risk-Return-trade off: An investor taking more risk shall definitely expect more return than other investors taking lesser or
no risk. The relationship between risk and return can be illustrated as follows:
Expected Return = Risk free rate + Risk premium
Risk free rate is a compensation for time; and risk premium is the compensation for risk. Higher the risk of an action higher will
be the required rate of return. A proper balance between return and risk should be maintained to maximise the market value of the
firm's shares. Such balance is called risk - return trade-off. The manager should strive to maximise the return for a given amount
of risk. So inflow and outflow of funds should be constantly monitored to ensure that no undue risk is being taken and the funds
are properly safeguarded. However one should not forget to consider the expected rate of inflation. And in that case expected
return should be the above return as adjusted for the effect of inflation rate.
Expected Return = (1 + Desired Rate of Return) (l + inflation rate) - 1
Time Value of money: In accounting the total of the profits is important but in financial management the timing of the profit
is also important along with the total of the profits. Rather it would be appropriate to say that timing is more important than the
total return. Rsl,00,000 earned today can never be equal to Rsl,00,000 earned after one year. The simple reason is that Rsl,00,000
earned today can be invested for one year at a particular rate of interest even in the bank and thereby the principal and interest
together will be more than Rs. l, 00,000 earned after one year. So the time vale of money cannot be ignored in financial
management
AUDACE Financial Smarts for Students 103/75, Meera Marg, Mansarovar Ph 9829 393
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AUDACE
Financial Smarts For Students
Study Center for M.B.A., C.A., C.F.A., M.Com. B.Com(Hons.)
103/76, Meera Marg, Mansarovar, Jaipur-20 = Ph: 9829 393 505 = mailto: Sachin.jpr@gmail.com
T i m e V a l u e o f M o n e y
Additional compensation required for parting with say Rs. 1,000 now is called interest
There are two methods by which the time value of money can be taken care of compounding and discounting.
Under the method of compounding, we find the Future Values (FV) of all the cash flows at the end of the time horizon at a
particular rate of interest.
Under the method of discounting, we reckon the time value of money now i.e. at time zero on the time line. So, we will be
comparing the initial outflow with the sum of the Present Values (PV) of the future inflows at a given rate of interest.
To determine the accumulation of multiple flows as at the end of a specified time horizon, we have to find out the
accumulations of each of these flows using the appropriate FVIF and sum up these accumulations.
Annuity is the term used to describe a series of periodic flows of equal amounts at the end of the year for n number of year.
Annuity due is the term used to describe a series of periodic flows of equal amounts at the beginning of the year for n number of
year.
Perpetuity is he term used for the Annuity of infinite period.
Growing Perpetuity I the annuity with the constant growth.
To determine the present value, we have to first define the relevant rate of interest. For determining the rate of the interest
following three things must be considered
The real risk-free rate
The expected rate of inflation (loss of purchasing power)
The amount of risk taken (a risk premium)
Formulae
Compounding
F
n
= P X F V F
r , n
Wh e r e F V F
r , n
= ( 1 + r )
n
On Calculator FVF
r,n
1+r= 1
X= 2
= 3
= 4 and so on
Discounting
P = F
n
X P V F
r , n
Wh e r e P V F
r , n
= 1 / ( 1 + r )
n
On Calculator PVF
r,n
1+r / = 1
= 2
= 3 and so on
Annuity
F
n
= A X F V A F
r , n
On Calculator F V A F
r , n
1 M+ MR f o r 1 s t y e a r
1 + r M+ MR f o r 2 n d y e a r
X = M+ MR f o r 3 r d Y e a r
= M+ MR f o r 4 t h y e a r
= M+ MR f o r 5 t h y e a r a n d s o o n
AUDACE Financial Smarts for Students 103/75, Meera Marg, Mansarovar Ph 9829 393
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P = A X P V A F
r , n
On Calculator P V A F
r , n
1 + r / = M+ MR f o r 1 s t y e a r
= M+ MR f o r 2 n d y e a r
= M+ MR f o r 3 r d Y e a r
= M+ MR f o r 4 t h y e a r
= M+ MR f o r 5 t h y e a r a n d s o o n
Annuity Due: Annuity factor X (1 + r)
Perpetuity
P = A / r
Growing Perpetuity
P = A / r - g
Effective Interest Rate
E.I.R. = (1 + r/m)
m
1
Handout 1
1. Today you deposited Rs.5000 into a savings account paying 12% interest. How much should you have in 15 years?
2. A loaf of bread today costs Rs.1.28. If grocery prices are going up at the rate of 8% per year, how much will a loaf of bread cost
in 6 years?
3. The average price of new homes is Rs.138, 500. If new home prices are increasing at a rate of 15% per year, how much will a
new home cost in 12 years?
4. You deposit Rs.3, 500 into an account every year for 6 years. The account pays 7% interest. How much will you have at the end
of that time?
5. You deposit Rs.4, 000 each year into a retirement account paying 8% interest. How much will you have in 25 years when you
retire?
6. What is the present value of Rs.5, 000 to be received in 7 years at an interest rate of 7%?
7. You can buy a parcel of real estate today that you estimate will bring Rs.15, 000 in 9 years. Assuming your money is worth 9%,
how much would you be willing to pay for the property?
8. An insurance company is willing to settle a dispute with you. They will pay you Rs.7, 000 per year for the next 8 years, or one
lump sum right now. Assuming your money is worth 5%, how much would you be willing to settle for?
9. You currently receive Rs.10, 000 per year on a contract. You expect it to run another 7 years. Someone wants to buy the
contract from you. If you can earn 12% on other investments of this quality, how much would you be willing to sell the contract
for?
10. Real estate values in your area are going up at the rate of 14% each year. You want to buy an average house. Today the
average price of homes is Rs.128, 000. Lenders require 20% down payment. You figure you'll be ready to make the balance in 6
annual installments. How much should it be?
11. You can buy a share of ownership in a partnership right now and you have been assured that you will be able to sell it for
Rs.15, 000 five years from now. Assuming your money is worth 5%, how much would you be willing to pay for this share?
12. If you deposit Rs.6, 000 per year into an account paying 16% interest, how much should you have in that account eight years
from now?
13. You are considering the purchase of two different insurance annuities: Annuity A will pay you Rs.10, 000 each year for eight
years.; Annuity B will pay you Rs.8, 000 per year for 12 years.
Assuming your money is worth 10% and that each cost the same to purchase today, which annuity would you prefer?
Handout 2
1. You're trying to save up for a big vacation. You want to take a trip around the world when you graduate in three years. If you
can earn 16% on your investments, how much would you have to deposit in order to have Rs.20, 000 when you graduate?
2. Would you rather have Rs.463 now or Rs.1000 10 years from now? You can earn 6% on any investments.
3. You can buy a mortgage from a mortgage broker. Mortgage payments are Rs.30, 000 per year and there are 16 years to
maturity. The broker is asking Rs.325, 000 for the note. You already hold similar mortgages and they yield 12%. Should you buy
AUDACE Financial Smarts for Students 103/75, Meera Marg, Mansarovar Ph 9829 393
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this note?
4. At an interest rate of 12% how long would it take a sum of money to double?
5. At 8% how long would it take to triple your money?
6. Your uncle lends you Rs.1000 today with the promise that you pay him back Rs.1728 in three years. What rate of interest is he
charging you?
7. Your company is required to pay into a sinking fund each year in order to meet an obligation which matures in 10 years. The
amount of the obligation is Rs.100, 000 and you can earn 4% on your deposits. How much must your company deposit each year
in order to meet these needs?
8. Your company borrows Rs.150, 000 agreeing to pay the balance in 10 equal installments to include principal plus 8% interest.
What should the payments be?
9. Your aunt is 80 years old. Over the years she has accumulated savings of Rs.1,70,000. She estimates that she will live another
10 years at the most and wants to spend her savings. She places her money in an account earning 7%. She will make 10 equal
annual withdrawals. How much will she be able to withdraw each year?
10. A firm purchases 100 acres of land for Rs.200, 000 and agrees to remit 20 equal annual installments of Rs.41, 067 each. What
is the annual interest rate on this loan?
11. Find the interest rates or rates of return on each of the following:
a. You borrow Rs.200 and promise to pay back Rs.210 at the end of one year.
b. You borrow Rs.20, 000 and promise to pay back Rs.32, 578 at the end of 10 years.
c. You borrow Rs.2000 and promise to make payments of Rs.514.18 per year for five years.
12. You borrow Rs.15, 000 and agree to repay the balance in five equal annual installments to include principal plus 8% interest.
What should the payments be?
13. Your company has an Rs.1, 000,000 bond issue that matures in 15 years. The bond indenture requires annual payments into a
sinking fund. You figure that you can earn 10% on all deposits. What must the sinking fund payments be, assuming they are
equal?
14. You are paying into a sinking fund that earns 6%. If the payments are Rs.15, 000 per year, how much will be in the fund in 15
years?
Handout 3
1. Construct a loan amortization schedule for a 3-year 5% loan of Rs.10, 000.
2. You plan to retire in 15 years. After retirement you will need Rs.20, 000 per year. You think you will live 10 years after
retirement. If interest remains at 8%, how much will you need to deposit until retirement?
3. You will deposit Rs.4000 per year for the next 12 years. Then you will start drawing money out of the account. If interest is 7%,
how much could you draw out if you make equal annual withdrawals for three years?
4. You will deposit Rs.5000 per year for five years at 4%. Then you will just let the money sit there and draw interest. If interest in
this second stage is 7%, how much would you have four years after the second stage starts?
5. You invest Rs.4000 today at 6% interest and let accumulate for seven years. Interest will be compounded semiannually. If after
that you make 3 annual withdrawals of Rs.2305, what annual rate of interest are you earning?
Annuities due
6. You deposit Rs.4000 at the beginning of the year for 10 years at 4% interest. How much will your investment be after 10 years?
7. How much must you deposit today in order to make five equal annual withdrawals of Rs.6000 if withdrawals are made at the
beginning of the year?
Intra year compounding
8. You deposit Rs.300 every six months for three years. Interest is 6%, compounded semiannually. How much will you have in
three years?
9. What is the present value of Rs.5000 to be received in five years if interest is 12%, compounded quarterly?
10. If you deposit Rs.100 every month for two years and interest is 12%, compounded monthly, how much will you have at the
end of that time?
11. If you deposit Rs.500 now and earn 8% interest compounded semiannually, how much will you have in four years?
13. If you deposit Rs. 5000 which is continuously compounded, what amount u will get after two years if rate of interest is 5%.
AUDACE
Financial Smarts For Students
AUDACE Financial Smarts for Students 103/75, Meera Marg, Mansarovar Ph 9829 393
505
6
Study Center for M.B.A., C.A., C.F.A., M.Com. B.Com(Hons.)
103/76, Meera Marg, Mansarovar, Jaipur-20 = Ph: 9829 393 505 = mailto: Sachin.jpr@gmail.com
C o s t o f C a p i t a l
The cost of capital to a company is the minimum rate of return that it must earn on its investments in order to satisfy the
various categories of investors who have made investments in the form of shares, debentures or term loans.
A company's cost of capital is nothing but the weighted arithmetic average of the cost of the various sources of finance that
have been used by it.
Explicit Cost: The Explicit Cost of any source of capital is the discount rate that equates the present value of the cash
flows that are incremental to the taking of the financing opportunity with the present value of its incremental cash flows.
(A cost that is represented by lost opportunity in actual cash payments.)
n
t
0
t
t = 1
C O
( 1 + k )
=
C I
Implicit Cost :A cost that is represented by lost opportunity in the usage of a company's own resources, excluding cash
For calculating the cost of capital of the firm, you have to first define the cost of various sources of finance used by it.
The sources of finance that are typically tapped by a firm are (a) debentures (b preference capital (c equity capital and
(d retained earnings.
The cost of a debenture is defined as that discount rate which equates the net proceeds from issue of debentures to the
expected cash outflows in the form of interest and principal repayments.
n
t
t n
t=1
RV
I
+
(1 + kd) (1 + kd)
=

NP
Short Cut Approximation for computing of Cost of Debt
R V - N P
I +
n
K d = ( 1 - t )
R V + N P
2
If Debentures are irredeemable
I ( 1 - t )
K d =
N P
The interest is multiplied by (1 - tax rate) as interest on Debts is tax deductible.
The cost of a redeemable preference share (Kp) is defined as that discount rate which equates the proceeds from
preference capital issue to the payments associated with the same i.e., dividend payment and principal payment.
n
t
t n
t=1
RV
D
+
(1 + kp) (1 + kp)
=

NP
According to the dividend forecast approach, the intrinsic value of an equity stock is equal to the sum of the present values
of the dividends associated with it.
Assumptive Study
o Dividend Pay out ratio is 100%
o Dividend Pay out ratio is not 100% but constant throughout the life
D
k e =
N P
o Dividend Pay out ratio is not 100% but constant throughout the life which lead to constant growth rate
1 D
k e =
NP
+ g
o When there are more then 1 growth rate, those situations are discussed in problems
Earnings Price Ratio Approach: According to this approach, the cost of equity can be calculated as El/P Where El =
expected EPS for the next year, P = current market price per share, El can be arrived at by multiplying the current EPS by
(1 + growth rate).
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1
ke =
P/E Ratio
Realized Yield Approach: According to this approach, the past returns on a security are taken as a proxy for the return
required in the future by the investors. The assumptions behind this approach are that (a) the actual returns have been
in line with the expected returns and (b) the investors will continue to have the same expectations from the security.
Capital Asset Pricing Model: The logic behind this approach is that the return required by the investors is directly based on
the risk profile of a company. This risk profile is adequately reflected in the return earned by the bondholders. Since the
risk borne by the equity investors is higher than that of risk free Securities, the return earned by them should also be higher.
ke = rj = rf + ( rm - rf )
The cost of retained earning (k
r
) is equally difficult to calculate in theoretical terms. Since, retained earnings essentially
involves use of funds, it is associated with an opportunity/ implicit cost. The alternative to retained earnings is the
investment of the funds by the firm itself in a homogeneous outside investment. Therefore, k
r
is equal to k
e
. However, it
might be slightly lower than k
e
in the case of new equity issue due to flotation costs or because of Persnal Tax and
Brokerage.
The measurement of the weighted average/overall cost of capital (k
o
) involves the choice of appropriate weights. The two
systems of assigning weights, namely, historical and marginal, have their own suitability but historical weights appear to
be superior to marginal weights as the former take into account the long-term implications of the firm's current financing.
With historical weights, a choice is to be made between book value and market value weights. While the book value
weights are operationally convenient, the market value basis is theoretically consistent and sound, and therefore, a better
indicator of firm's capital structure. The ko is computed based on the following equation:
Ko = KdWd x KpWp x KeWe x KrWr
Percentage of debt to total capital = Wd
Percentage of preference shares to total capital = Wp
Percentage of Equity to total capital= We
Percentage of retained earnings to total capital =Wr
The Weighted Average Cost of Capital increases with the level of financing required. The supplies of capital generally
require a higher return as they supply more capital.
A schedule showing the relationship between additional financing and the weighted average cost of capital is referred to as
the weighted marginal cost of capital schedule.
The use of this measure for appraising new investments will depend upon two important assumptions:
(a) Risk characterizing the new project under consideration is not significantly different from the risk characterizing
the existing investments of the firm, and
(b) The firm will continue to pursue the same financing policies.
Handout 4
P.1 Assuming tax rate of 50 % Compute the after tax cost of capital in following cases.
1. A ten-year, 8 per cent, Rs 1000 par bond sold at Rs 950 less 4 per cent underwriting commission,
2. A preference share sold at Rs 100 with a 9 per cent dividend and a redemption price of Rs 110 if the company redeems it in
five years,
3. An ordinary share selling at a current market price of Rs 120, and paying a current dividend of Rs 9 per share which is
expected to grow at a rate of 8 per cent,
4. An ordinary share of a company which engages no external financing is selling for Rs 50. The earnings per share are Rs
7.50 of which sixty per cent is paid in dividends. The company reinvests retained earnings at a rate of 10 per cent.
P.1 Investors require a 12 per cent rate of return on equity shares of company Y. What would be the market price of the shares if
the previous dividend (D
0
) was Rs 2 and investors expect dividends to grow at a constant rate of (a) 4% (b) 0% (c) -4 (d) 12% (e)
14%?
P.2 An investor is contemplating the purchase of equity shares of a company which had paid a dividend of Rs 5 per share last
year. The dividends are expected to grow at 6 per cent for ever. The required rate of return on the shares of this company in the
capital market is 12 per cent. What will be the maximum price you will recommend the investor to pay for an equity share of the
company? Will your answer be different if he wants to hold the equity share for 3 years and 6 years?
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P.3 A mining company's iron ore reserves are being depleted, and its cost of recovering a declining quantity of iron ore are rising
each year. As a consequence, the company's earnings and dividends are declining, at a rate of 8 per cent per year. If the previous
year's dividend was Rs 10 and the required rate of return is 15 per cent, what would be the current price of the equity share of the
company?
P.4 A large sized chemical company has been expected to grow at 14 per cent per year for the next 4 years and then to grow
indefinitely at the same rate as that of the national economy, that is, 5 per cent. The required rate of return on the equity shares is
12 per cent. Assume that the company paid a dividend of Rs 2 per share last year. Determine the market price of the shares today.
P.5 The Chemicals and Fertilisers Ltd. has been growing at a rate of 18 per cent per year in recent years. This abnormal growth
rate is expected to continue for another 4 years; then it is likely to grow at the normal rate of 6 per cent. The required rate of return
on the shares by the investment community is 12 per cent, and the dividend paid per share last year was Rs 3. At what price,
would you, as an investor, be ready to buy the shares of this company now (t = 0), and at the end of years 1, 2, 3 and 4,
respectively? Will there be any extra advasntage by buying at t = 0, or in any of the subsequent four years, assuming all other
things remain unchanged?
P.6 A Company is contemplating an issue of new equity shares. The firms equity shares are currently selling at Rs 125 a share.
The historical pattern of dividend payments per share, for the last 5 years is given below:
Year Dividend
1
2
3
4
5
10.7
11.45
12.25
13.11
14.20
The flotation costs are expected to be 3 per cent of the current selling price of the shares. You are required to determine the
following: 1) growth rate in dividends; 2) cost of equity capital, assuming growth rate determined under situation (1) continues
for ever; 3) cost of new equity shares.
P.7 An investor has invested in a company which is growing at an above average rate, translated to an annual increase in
dividends of 20 per cent for 15 years. Thereafter, dividend growth returns to an average rate of 7 per cent. The capitalisation rate
of the company is 9 per cent and the current dividend per equity share is Re 1 per share. Determine the value of the equity shares.
P.8 A company has on its books the following amounts and specific costs of each type of capital.
Type of capital Book value Market value Specific Cost
Debt
Preference
Equity
Retained earnings
Rs4,00,000
1,00,000
6,00,0001
2,00,000
Rs3,80,000
1,10,000
12,00,000
5
8
15
13
13,00,000 16,90,000
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Determine the weighted average cost of capital using (a) Book value weights and, (b) Market value weights. How are they
different? Can you think of a situation where the weighted average cost of capital would be the same using either of the weights?
P.9 The Servex Company has the following capital structure on 30 June 2004
Ordinary shares (200,000 shares) Rs 40,00,000
10% Preference shares 10,00,000
14% Debentures 30,00,000
80,00,000
The share of the company sells for Rs 20. It is expected that company will pay next year a dividend of Rs 2 per share which
will grow at 7 per cent for ever. Assume a 50 per cent tax rate. You are required to:
(a) Compute a weighted average cost of capital based on existing capital structure.
(b) Compute the new weighted average cost of capital if the company raises an additional Rs 20,00,000 debt by issuing
15 per cent debenture. This would result in increasing the expected dividend to Rs 3 and leave the growth rate
unchanged, but the price of share will fall to Rs 15 per
share.
(c) Compute the cost of capital if in (b) above growth rate increases to 10 per cent.
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L e v e r a g e
Leverage is the influence which an independent financial variable has over a dependent/ related financial variable.
Operating leverage
DOL =
Contribution
EBIT
or
% Change in EBIT
% Change in Contribution or Sales
Operating leverage examines the effect of the change in the Sales/ Quantity Produced on the EBIT of the company and is
measured by calculating the Degree of Operating Leverage (DOL).
A large DOL indicates that small fluctuations in the level of Output / Sales will produce large fluctuations in the level
of operating income.
DOL is a measure of the firm's business risk. Business risk refers to the uncertainty or variability of the firm's EBIT.
So, every thing else being equal, a higher DOL means higher business risk and vice-versa.
Financial leverage
DFL =
EBIT
EBT for Shareholders
or
% Change in EBT for shareholders or in EPS
% Change in EBIT
The financial leverage measures the effect of the change in EBIT on the EPS of the company. Financial leverage refers to
the mix of debt and equity in the capital structure of the company. The measure of financial leverage is the Degree of
Financial Leverage (DFL)
If the management decides to finance a part of the total investment required of through debt financing, the following two
factors are important: The proportion of total investment which the management decides to finance through debt (Debt
Equity Ratio the firm aspires to) and the interest rate on borrowed funds.
The greater the tax rate, the more is the tax shield available to a company which is financially leveraged.
As the company becomes more financially leveraged, it becomes riskier, i.e., increased use of debt financing will lead to
increased financial risk which leads to: Increased fluctuations in the return on equity and increase in the interest rate on
debts.
The greater the use of financial leverage, the greater the potential fluctuation in return on equity.
As the interest rate increases, the return on equity decreases. Even though the rate of return diminishes, it might still exceed
the rate of return obtained when no debt was used, in which case financial leverage would still be favorable.
Combined leverage
DCL =
Contribution
EBT for Shareholders
or
% Change in EBT for shareholders or in EPS
% Change in Contribution of Sales
EBT for Shareholders =
Preference Divident
EBIT Interest
1-T

A combination of the operating and financial leverages is the total or combined leverage. Thus, the Degree of Combined
Leverage (DCL) is the measure of the output/sales and EPS of the company. DCL is the product of DOL and DFL
There is a unique DCL for every level of output. At the overall break-even point of output the DCL is undefined. If the level
of output is less than the overall break-even point, then the DCL will be negative. If the level of output is greater than the
overall break-even point, then the DCL will be positive. DCL decreases as the quantity of sales increases and reaches a
limit of one.
DCL measures the changes in EPS to a percentage change in quantity of sales.
DCL measures the total risk of the company since it is a measure of both operating risk and total risk.
Financial Break Even Point
Financial Break even Point is when EBIT is just equal to fixed financial Cost which implies EPS is zero.
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Preference Divident
Interest
1 - Tax Rate
+
Indifference Point
The EBIT level at which the EPS is the same for two alternative financial plans is referred to as the indifference,
point/level. The indifference point may be defined as the level of EBIT beyond which the benefits of financial leverage
begin to operate with respect to earnings per share (EPS). In operational terms, if the expected level is to exceed the
indifference level of EBIT, the use of fixed-charge source of funds (debt) would be advantageous from the viewpoint of
EPS, that is, financial leverage will be favourable and lead to an increase in the EPS available to the shareholders. The
capital structure should include debt. If, however, the expected level of the EBIT is less than the indifference point, the
advantage of EPS would be available from the use of equity capital.
Calculation of EPS for Indifference point (EBIT-EPS Analysis)
(X - Int ) ( 1 - t ) - Pref. Div ( 1 + Dt)
No. of Shares
Handout 5
1 From a factory records you obtain the following information:
Fixed Costs Rs.20,000
Sales Price per unit 20
Variable Cost per unit 16
Estimate the impact of the following on the break-even point:
(a) 20% increase in Fixed Costs.
(b) 10% increase in Variable Costs.
(c) 10% increase in Fixed Costs and 5% decrease in Variable Costs.
(d) 10% decrease in Fixed Costs and 20% increase in Variable Costs.
2 The following particulars are obtained from the records of a factory manufacturing Products A and B :
Product A Product B
(per unit) (per unit)
Rs. Rs.
Selling Price 100 200
Material Cost @ Rs. 10 per kg. 20 50
Wages Rs. 3 per Hour 30 60
Variable Overheads
10 20
Total Fixed Costs Rs. 5,000
State which product is better to be produced and why in the following cases:
(a) If total sales in units is key factor,
(b) If total sales in value is key factor,
(c) If raw material is in short supply,
(d) If labour hour is the limiting factor,
(e) If raw material available is 2,000 kg. and maximum sale of each product is 500 units.
3 Fixed Cost Rs.15,000 Variable Cost Rs. 5 per unit Selling Price Rs. 8 per unit. From the given information, calculate:
(a) Break-even point in Units and Rupees.
(b) Sales Volume for a planned profit of Rs. 45,000.
(c) Break-even point in units when selling price is increased by 25%.
(d) Break-even point in units when fixed cost is increased by 20% and variable cost is reduced by 20%.
4 Variable Cost per unit Rs. 15; Selling price per unit Rs.20; Fixed Expenses Rs. 1,08,000 Calculate Break Even Point. What
should be the Selling Price per unit if the break-even point should be brought down to 12,000 units?
5 A company budgets a production of 5,00,000 units at a variable cost of Rs. 20 each. The fixed costs are Rs. 20,00,000. The
selling price is fixed to yield 25% profit on cost. You are required to calculate: (1) P/V Ratio, (2) Break-even Point. If the selling
price is reduced by 20%, find (a) the effect of the price reduction on the Break-even Point, and (b) P/V Ratio.
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6 The turnover and total costs during two periods were as follows :
Period I Period II
(Rs.) (Rs.)
Sales 5,00,000 7,50,000
Total Cost 4,50,000 6,50,000
Calculate :
(i) P/V Ratio;
(ii) Break even sales;
(iii) Sales required to earn a profit of Rs. 1,25,000; and
(iv) Profit earned when sales are Rs. 3,50,000.
. 7 Mr. X has a sum of Rs. 3,00,000 invested in business. He wants a 15% return on his money. From an analysis of recent cost
figures, he finds that his variable cost of operation is 60% of sales and fixed costs are Rs. 75,000 per annum. On the basis of this
information, answer the following:
(a) What sales must be obtained to break even?
(b) What sales must be obtained to earn 15% return on his investment?
(c) What sales will be needed to earn 30% profit on sales?
8 X Ltd. furnishes the following information for the year 2002:
January to June July to December
Rs. Rs.
Sales 13,50,000 15,00,000
Total Cost 12,00,000. 12,90,000
Assuming that fixed expenses are incurred uniformly in both periods, calculate the following for the year 2002: (i) Break-even
sales, (ii) Fixed Expenses, (iii) Margin of Safety, (iv) Sales to earn a profit of 10% on sales.
9 Directors of a company prepared the following budget for the coming year 2003-2004:
Sales 10,000 units @ Rs. 10 per unit Rs.1,00,000
Variable Costs @ Rs. 5 per unit 50,000
Fixed Cost 40,000
Find out:
(a) The P/V Ratio; Break-even point and Margin of Safety.
(b) Evaluate the effects of :
(i) 10% increase in selling price;
(ii) 20% decrease in physical sales volume;
(iii) 10% decrease in selling price and 10% increase in physical sales volume;
(iv) 5% decrease in variable costs; (v) 10% increase in fixed costs.
10 Position of XYZ Ltd. for the year 2002 is as under: Rs.
Sales 2,00,000
Variable overheads 1,50,000
Gross profit 50,000
Fixed overheads 15,000
Net profit 35,000
From the above information, find out the following: (i) Profit-Volume Ratio (ii) Break-Even Point (iii) Profit for Sales of Rs.
3,00,000 (iv) Margin of Safety from the Sales of Rs. 3,00,000 (v) Required Sales to earn a profit of Rs. 70,000 (vi) Additional
sales required to cover an increase of Rs. 3,000 per annum in the sales manager's salary.
11 The P/V Ratio of Rajeev Ltd. is 50% and margin of safety is 40%. The firm sold 500 units amounting to Rs. 5,00,000. You are
required to calculate the following: (i) B.E.P. (ii) Net Profit (iii) Sales in Units to earn a net profit of 10% on sales, (iv) Profit on
80% of capacity of the firm if BEP is at 40% of full capacity of the firm.
12 Variable cost per unit: - Rs. 12 selling price per Unit Rs. 18 Fixed Expenses Rs. 60,000 Find out the following: (i) The
Break-even point. (ii) What should be the selling price per unit if the break even point is to be brought down to 6,000 units? (iii)
At what selling price would the sale of 15,000 units yield the net profit of Rs. 45,000?
13 Fixed cost of PQR Ltd. is Rs. 2,00,000. The ratio of variable costs to sales is given to be 60%. The Break-Even point occurs at
80% of sales. Calculate the following : (i) Total Sales, (ii) Profit at 90% of sales, (iii) Sales to earn a profit of 10% on sales, (iv)
Margin of safety sales and M/S Ratio to earn profit of Rs. 50,000
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Capital Structure Theories
The capital structure of a company refers to the mix of the long- term finances used by the firm. It is the
financing plan of the company.
The objective of any company is to mix the permanent sources of funds used by it in a manner that will
maximize the company's market price. In other words companies seek to minimize their cost of capital. This
proper mix of funds is referred to as the Optimal Capital Structure.
The capital structure decision is a significant managerial decision which influences the risk and return of the
investors. The company will have to plan its capital structure at the time of promotion itself and also
subsequently whenever it has to raise additional funds for various new projects. Wherever the company needs
to raise finance, it involves a capital structure decision because it has to decide the amount of finance to be raised
as well as the source from which it is to be raised.
The use of fixed charges sources of funds such as preference shares, debentures and term loans along with
equity capital in the capital structure is described as financial leverage or trading on equity.
The term trading on equity is used because it is the equity that is used as a basis for raising debt.
Increased use of leverage increases the fixed commitments of the company in the form of interest and
repayments and thus increases the risk of the equity shareholders as their returns are affected.
The other factors that should be considered whenever a capital structure decision is taken are:
1. Cost of capital
2. Cash flow projections of the company
3. Size of the company
4. Dilution of control
5. Floatation costs.
Profitability, Flexibility, Control and Solvency are the features of an optimal capital structure.
Assumptions on basis of which capital structure theories are based on
1. There are only two sources of funds used by a firm: perpetual riskless debt and ordinary shares.
2. There are no corporate taxes. This assumption is removed later.
3. The dividend-payout ratio is 100. That is, the total earnings are paid out as dividend to the shareholders and
there are no retained earnings
4. The total assets are given and do not change. The investment decisions are, in other words, assumed to be
constant.
5. The total financing remains constant. The firm can change its degree of leverage (capital structure)
either by selling shares and use the proceeds to retire debentures or by raising more debt and reduce the
equity capital.
6. The operating profits (EBIT) are not expected to grow.
7. All investors are assumed to have the same subjective probability distribution of the future expected
EBIT for a given firm.
8. Business risk is constant over time and is assumed to be independent of its capital structure and
financial risk.
9. Perpetual life of the firm.
Net Income Approach
According to Net Income Approach, the cost of equity capital (Ke) and the cost of debt capital (Kd) remain
unchanged when B/S, the degree of leverage varies. This means that ko, the average cost of capital, declines as
B/S increases. This happens because when B/S increases, kd, which is lower than ke receives a higher weight in
the calculation of ko.
The following is the graphical representation of net income approach. B/S, degree of leverage is plotted on the
x-axis, ko, ke, and kd are plotted on the y-axis.
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From the graph it is clear that as B/S increases, ko decreases because the proportion of debt, the cheaper source
of finance, increases in the capital structure.
Net Operating Income Approach
According to the net operating income approach, the overall capitalization rate Ko and the cost of debt Kd
remain constant for all degrees of leverage.
The critical assumption with this approach is that ko is constant, regardless of the degree of leverage. The market
capitalizes the value of the firm as a whole and therefore, the breakdown between debt and equity is
unimportant. An increase in the use of supposedly "cheaper" debt funds is compensated exactly by the increase
in the required equity return, ke Therefore, the weighted average cost of capital ko. and kd remains unchanged
for all degrees of leverage. As the firm increases its degree of leverage, it becomes more risky. Investors penalize
the stock by raising required equity return with the view of increase in the debt-to-equity ratio. As long as ko
remains constant, ke is a constant linear function of the debt-to-equity ratio. Because the cost of capital of the
firm, ko, cannot be altered through leverage, the net operating income approach implies that there is no optimal
capital structure.
The net operating income position has been advocated eloquently by David Durand. According to him, the
market value of a firm depends on its net operating income and business risk. The change in the degree of
leverage employed by a firm cannot change these underlying factors. Changes take place in the distribution of
income and risk between debt and equity without affecting the total income and risk which influence the market
value of the firm. Hence the degree of leverage cannot influence the market value or the average cost of capital of
the firm.
Traditional approach
The traditional approach has the following propositions:
The cost of debt capital, kd, remains more or less constant up to a certain degree of leverage but rises thereafter
at an increasing rate.
The cost of equity capital, ke remains more or less constant or rises only gradually up to a certain degree of leverage
and rises sharply thereafter.
The average cost of capital, ko as a consequence of the above behavior of ke and kd (a) decreases up to a
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certain point; (b) remains more or less unchanged for moderate increases in leverage thereafter and (c) rises
beyond a certain point.
The principal implication of the approach is that the cost of capital is dependent on the capital structure and there is
an optimal capital structure which minimizes the cost of capital. In the above graph, it is the point X which is the
optimal capital structure. At the optimal capital structure, the real marginal cost of debt and equity is the same.
Before the optimal point the real marginal cost of debt is less than the real marginal cost of equity and beyond the
optimal point the real marginal cost of debt is more than the real marginal cost of equity. Thus, the traditional
approach implies that the cost of capital is not independent of the capital structure of the firm and that there is
an optimal capital structure.
Modigliani and Miller Approach
Modigliani and Miller have stated that the relationship between leverage and the cost of capital is explained by the net
operating income approach in terms of three basic propositions. They argue against the traditional approach by offering
behavioral justification for having the cost of capital, ko, remain constant throughout all degrees of leverage.
Assumptions
1. Capital markets are perfect. Information is costless and readily available to all investors. There are no
transaction costs, and all securities are infinitely divisible. Investors can borrow without restrictions on the same
terms and conditions as the firm can. Investors are rational and behave accordingly.
2. Investors are assumed to be rational and behave accordingly i.e., choose a combination of risk and return that is
most advantageous to them.
3. The average expected future operating earnings of a firm are subjected by random variables. It is assumed
that the expected probability distribution values of all the investors are the same. The MM theory implies
that the expected probability distribution values of expected operating earnings for all future periods are the same as
present operating earnings.
4. Firms can be grouped into "equivalent return" classes on the basis of their business risks. All firms falling
into one class have the same degree of business risk.
5. There is no corporate or personal income tax. This assumption was removed later
Arbitrage Process: The "arbitrage process" is the operational justification of MM hypothesis. The term 'Arbitrage' refers to
an act of buying an asset or security in one market having lower price and selling it in another market at a higher
price. The consequence of such action is that the market price of the securities of the two firms, exactly similar in all respects
except in their capital structures, cannot for long remain different in different markets. Thus, arbitrage process restores
equilibrium in value of securities. This is because in case the market value of the two firms, which are equal in all respects
except their capital structures, are not equal investors of the overvalued firm would sell their shares, borrow additional
funds on personal account and invest in the undervalued firm in order to obtain the same return on smaller investment
outlay. The use of debt by the investor for arbitrage is termed as 'home made' or 'personal leverage.
Handout 6
P.1. Two firms A and B are identical in all respects except that the firm A has 10% Rs. 5,00,000 debentures. Both the firms
have the same earnings before interest and tax amounting to Rs. 1,00,000. The equity capitalisation rate of firm A is 16%
while that of firm B is 12.5%. You are required to calculate the total market value of each of the firms and explain with an
example the working of the 'arbitrage process'. How would the arbitrage process worked if the equity capitalisation rate of firm A is
20%?
P.2. Company X and Company Y are in the same risk class, and are identical in every respect except that company X uses debt,
while company Y does not. The levered firm has Rs 9,00,000 debentures, carrying 10 per cent rate of interest. Both the firms
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earn 20 per cent operating profit on their total assets of Rs 15 lakhs. Assume perfect capital markets, rational investors and so on;
a tax rate of 35 per cent and capitalisation rate of 15 per cent for an all-equity company.
(a) Compute the value of firms X and Y using the Net Income (NI) Approach.
(b) Compute the value of each firm using the Net Operating Income (NOI) Approach.
(c) Using the NOI Approach, calculate the overall cost of capital (k
Q
) for firms X and Y.
(d) Which of these two firms has an optimal capital structure according to the NOI Approach? Why?
P.3 Companies U and L are identical in every respect, except that U is Un-levered while L is levered. Company L has Rs 20
lakh of 8 per cent debentures outstanding. Assume (1) that all the MM assumptions are met, (2) that the tax rate is 35 per cent (3)
that EBIT is Rs 6 lakh and that equity-capitalisation rate for company U is 10 per cent.
(a) What would be the value for each firm according to the MM Approach?
(b) Suppose V
u
= Rs 25, 00,000 and V, = Rs 35, 00,000. According to MM do they represent equilibrium values? If not, explain
the process by which equilibrium will be restored.
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D i v i d e n d P o l i c y
Firms can either plough back the earnings by retaining them or distribute the same to the shareholders as dividends.
The second option of declaring cash dividends out of the after tax profits will lead to maximization of the
shareholders wealth.
The returns to the shareholders either by way of the dividend receipts or capital gains are affected by the dividend policies
of the firms.
1 0
0
Div + (P - P )
Re turn =
P
The dividend policy of the firm gains importance especially due to unambiguous relationship that exists between the
dividend policy and the equity returns.
Traditional approach
The traditional approach to the dividend policy, which was given by B Graham and D L Dodd lays a clear
emphasis on the relationship between the dividends and the stock market. According to this approach, the stock
value responds positively to higher dividends and negatively when there are low dividends.
The traditional approach, states that the P/E ratios are directly related to the dividend pay-out ratios.
E
P = m(D + )
3
Walter Model
The dividend policy given by James E Walter also considers that dividends are relevant and they do affect the share price.
In this model he studied the relationship between the internal rate of return (r) and the cost of capital of the firm (k), to
give a dividend policy that maximizes the shareholders' wealth.
According to the Walter Model, when the return on investment is more than the cost of equity capital, the earnings can
be retained by the firm since it has better and more profitable investment opportunities than the investors.
0
e
r
D + (E - D)
Ke
P =
K
Firms which have their r > ke are the growth firms and the dividend policy that suits such firms is the one which has a
zero pay-out ratio. This policy will enhance the value of the firm.
When the firm has a rate of return that is equal to the cost of equity capital, the firms' dividend policy will not affect
the value of the firm. The optimum dividend policy for such normal firms will range between zero to a 100% pay-out ratio,
since the value of the firm will remain constant in all cases.
Gordon's Model
Gordon's Model assumes that the investors are rational and risk- averse. They prefer certain returns to uncertain returns
and thus put a premium to the certain returns and discount the uncertain returns. Thus, investors would prefer current
dividends and avoid risk. Retained earnings involve risk and so the investor discounts the future dividends. This risk will
also affect the stock value of the firm.
0
e
E (1 - b)
P =
K - br
Gordon explains this preference for current income by the bird- in-hand argument.
Modigliani And Miller Model
Miller and Modigliani have propounded the MM hypothesis to explain the irrelevance of the firms' dividend policy.
1. Value of the firm when dividends are paid
Step 1: Price per share at the end of year 1
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1 1
0
e
D + P
P =
1 + K
Step 2: Amount to be raised by the issue of new shares
1 1 1 n P = I - (E - nD )
Step 3: Number of additional shares to be issued
1
1
1
I - (E - nD )
n =
P
Step 4: Value of the Firm
1 1
0
e
(n + n )P - 1 + E
nP =
1 + K
2. Value of the firm when dividends are not paid is also calculated at above
We can observe that value of firm in both 1 and 2 are same.
According to the model, it is only the firms' investment policy that will have an impact on the share value of the firm
and hence should be given more importance.
Rational Expectations Model
According to the rational expectations model, there would be no impact of the dividend declaration on the market price of
the share as long as it is at the expected rate.
The rational expectations model suggests that alterations in the market price will not be necessary where the dividends meet the
expectations and only in case of unexpected dividends will there be a change in the market price.
Handout7
1 following are the details regarding three companies A Ltd, B Ltd, C Ltd:
A Ltd B Ltd C Ltd
r 15% 5% 10%
Ke 10% 10% 10%
E Rs 8 Rs 8 Rs 8
Calculate the value of an equity share of each of three companies applying Walters formulae when dividend pay out ratio is: a)
25%, b) 50%, and c) 75%
2 The following information is available in respect of ABC Ltd.
EPS Rs. 10
Rate of return 20%
Required rate of return 16%
of equity investment, k
e
Find out the market price of the share under Gordon model if the firm follows a payout of 50% or 25%.
3 Diamond Engineering Company has 10,00,000 equity shares outstanding at the start of the accounting year 1997. The ruling market
price per share is Rs. 150. The Board of Directors of the Company contemplates declaring Rs. 8 per share as dividend at the end of the
current year. The rate of Capitalization appropriate to the risk-class to which the company belongs is 12%.
a) Based on Modigliani-Miller Approach, calculate the market price per share of the company when the contemplated
dividend is (i) declared and (ii) not declared.
b) How many new shares are to be issued by the company at the end of the accounting year on the assumption that the
Net Income for the year is Rs. 2 crores? Investment budget is Rs. 4 crores and (i) the above dividends are distributed
and (ii) they arc not distributed.
c) Show that the total market value of the shares at the end of the accounting year will remain the same whether dividends
are either distributed or not distributed. Also find out the cur rent market value of the firm under both situations.
4 A company belongs to a risk-class for which the appropriate capitalization rate is 10%. It currently has outstanding 25,000 shares
selling at Rs. 100 each. The firm is contemplating the declaration of dividend of Rs. 5 per share at the end of the current financial year. The
company expects to have a net income Rs. 2.5 lacs and a proposal for making new investments of Rs. 5 lacs. Show that under the MM
assumptions, that the payment of dividend docs not affects the value of the firm.
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AUDACE
Financial Smarts For Students
Study Center for M.B.A., C.A., C.F.A., M.Com. B.Com(Hons.)
103/76, Meera Marg, Mansarovar, Jaipur-20 - Ph: 9829 393 505 - mailto: Sachin.jpr@gmail.com
LONG TE R M I NV E S T ME NT DE CI S I ON
CAPITAL BUDGETING:
Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e.,
potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital
Budgeting project depends on an analysis of the cash flows generated by the project and its cost
PROJECT CLASSIFICATION:
MUTUALLY EXCLUSIVE PROJECTS: Mutually Exclusive Projects are a set of projects from which at most one will be
accepted. For example a set of projects which are to accomplish the same task. Thus, when choosing between "Mutually Exclusive
Projects" more than one project may satisfy the Capital Budgeting criterion. However, only one, i.e., the best project can be
accepted.
INDEPENDENT PROJECTS: Those projects project whose cash flows are not affected by the accept/reject decision for other
projects. Thus, all Independent Projects which meet the Capital Budgeting criterion should be accepted..
CONVENTIONAL PROJECTS: This consists of an initial outflow followed by a series of cash inflows.
NON-CONVENTIONAL PROJECTS: This project refers to cash flow pattern in which an initial cash outflow is not followed by
a series of cash inflows i.e. alternative cash inflows and outflows may occur.
REVENUE EXPANDING: PROJECTS: Those projects which are expected to bring in additional revenue, thereby raising the size
of the firms total revenue.
COST REDUCTION PROJECTS: These Projects add to total earning of the firm by reducing cost.
TECHNIQUES OF CAPITAL BUDGETING
Traditional Techniques
1. Average Rate of Return
2. Pay Back Period
Discounted Cash Flow, Time-Adjusted Techniques
1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Profitability Index (PI)
4. Terminal Value Method
Note:
Average Rate of Return method is the only method based on Profits and all other methods are based on cash flows
Pay Back Period method does not consider total benefits of the projects
IDENTIFICATION OF CASH FLOWS:
1. New Investment Decision
2. Replacement Decision
INITIAL OUTFLOW
Cost of the new plant
+ Installation expenses
+ Other capital expenditure
+ Additional working capital
Tax benefit on account of capital loss on sale of old plant (if any) salvage value of old plant
+ Tax liability on account of capital gain on sale of old plant (if any)
Subsidy received from government
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SUBSEQUENT CASH INFLOW
Profit after tax + depreciation +financial charge (1 t)
TERMINAL CASH FLOWS:
Annual Cash inflow + working capital released + scrap of the proposal
POINTS TO BE NOTED:
1. Cash inflows are assumed to be at end of year unless specifically mentioned to be at beginning of the year.
2. Cash outflow are assumed to be at year zero, i.e. at the beginning for first year.
3. Working Capital is assumed to be released at the end of project life unless specific period of recovery mentioned in the
question.
4. Allocated Expenses are not taken into account for purpose of project evaluation
5. Depreciation
i. If income tax rate is not given: Depreciation is irrelevant.
ii. If more the one asset exist in the SAME BLOCK
I. Depreciation is available in the terminal year on opening WDV minus Salvage Value
II. No Capital gain or Capital Loss arises in terminal year.
iii. If no other asset exists in same block
I. No Depreciation is available in terminal year.
II. Capital gain or loss arise in terminal year
iv. If SLM method is used for depreciation, depreciation is also available in terminal year.
v. In absence of information, it may be assumed that both the asset, i.e. old and new , belongs to the same block
vi. In the case of block of assets, full depreciation is allowed in the year of the acquisition irrespective of the period
of use, (however, if asset is ready for use for less then 180 days in the year of acquisition, 50 percent of eligible
depreciation is allowed) and no depreciation is allowed in the year of disposal.
6. Interest on Loan should not be detected in calculating cash inflows or should not be treated as cash outflow, as project is
analysed as a whole and not for shareholders point of view and K
o
is used for discounting, if the project is analysed with
view point of shareholders Ke will be the discounting rate and interest will be treated as cash outflow.
AVERAGE RATE OF RETURN
ARR =
annual profit after taxes
Average Investment over the life of the project
Average
X 100
Average investment =
Net Working Capital + Salvage Value + 1/2 (Initial cost of machine salvage value)
Or Net Working Capital + 1/2 (Initial cost of machine + salvage value)
Accept the project if the ARR calculated above is greater then the required ARR
PAY BACK PERIOD
The payback method simply measures how long (in years and/or months) it takes to recover the initial investment.
Suitable in industry of fast technological and market changes, political instability, and scarcity of capital.
The maximum acceptable payback period is determined by management.
If the payback period is less than the maximum acceptable payback period, accept the project.
If the payback period is greater than the maximum acceptable payback period, reject the project.
Project having lowest pay back period is selected in mutually exclusive projects
Pros and Cons of Payback Periods
The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most
projects.
It is simple, intuitive, and considers cash flows rather than accounting profits.
It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such
as Net Present Value and Internal Rate of Return.
One major weakness of the payback method is that the appropriate payback period is a subjectively determined number.
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It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus
provides no indication as to whether a project adds to firm value.
Thus, payback fails to fully consider the time value of money.
Calculation of Pay Back Period
If cash flows are even:
Pay Back Period =
Initial Outflows
Annual Cash Inflows
If cash flows are uneven:
Calculate cumulative cash inflow and ascertain the year in which cash inflow becomes equal or more then the initial sash
outflow. If cash inflow becomes exactly equal to cash outflow then that will be the payback period. If cumulative cash inflow
becomes excess of cash outflow then months in that year shall be calculated using interpolation.
NET PRESENT VALUE
Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax
inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, indifferent
NPV =
n
t
0
t n
t=1
S.V.+W.C.
CI
+
(1+R) (1+R)
CO

Where
t CI
= Cash flow recd at the end of year t
0 CO
= cash outflow at time zero
R = Cost of capital or required rate of return
n = life of the project
Evaluation
For independent project Accept project if NPV is positive
For mutually exclusive project Accept the project with higher NPV
PROJECTS WITH UNEQUAL LIVES OF PROPOSAL
In case of mutually exclusive proposals, if the lives of the different proposals are different, then these proposals are not
directly comparable. The NPV of different proposals cannot be compared; however they can be made comparable by applying the
Equivalent Annuity Method which attempts to equalize the life span of different proposals. The mutually exclusive proposals with
different economic lives can be compared by annulising there NPVs over the respective lives to arrive at an annual equivalent
benefits.
INTERNAL RATE OF RETURN
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present
value of the inflows.
The IRR is the projects intrinsic rate of return
DECISION CRITERIA
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, indifferent
n
t
0
n n
t=1
S.V.+W.C.
CI
+
(1+R) (1+R)
CO
=

Accept /Reject Decision: The project would qualify to be accepted if the IRR (R) exceeds the cut-off rate (K). If the IRR and
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the required rate of return are equal, the firm is indifferent as to whether to accept or reject the project.
CUT OFF RATE OR HURDLE RATE IS REQUIRED RATE OF RETURN in a discounted cash flow analysis,
above which an investment makes sense and below which it does not. Often, this is based on the firm's cost of
capital or weighted average cost of capital, plus or minus a risk premium to reflect the project's specific risk
characteristics .
CONFLICTING RANKINGS
Conflicting rankings between two or more projects using NPV and IRR sometimes occurs because of
differences in the timing and magnitude of cash flows.
SIZE DISPARITY PROBLEM
Project A Project B Project B-A
Cash Outlay
Cash Inflow
IRR
K
NPV
(Rs 5000)
6250
25 percent
10
681.25
(Rs 7500)
9150
22 percent
817.35
(Rs 2500)
2900
16 percent
TIME DISPARITY PROBLEM
Year Project A Project B
0
1
2
3
4
IRR
NPV (0.08)
(105000)
60000
45000
30000
15000
20 percent
23970
(105000)
15000
30000
45000
75000
16 Percent
25455
This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of
intermediate cash inflows cash inflows received prior to the termination of the project.
NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are
reinvested at the IRR.
WHICH APPROACH IS BETTER?
On a purely theoretical basis, NPV is the better approach because:
NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are
reinvested at the IRR The assumption that you can reinvest at the IRR rate is most likely to send misleading
signals when the computed IRR differs sharply from a realistic estimate of the market rate of interest and also
where the project lives are different.
Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more
than one real IRR.
Example 1
Cash Outflow (Year 0)
CFAT (Year 1)
Cash Outflow (Year 2)
RS. 1
2
2
IRR=
2
2 2
1
(1 ) (1 ) R R
+ =
+ +
which leads R
2
= -1
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Clearly Irr is indeterminate. On the other hand NPV of the project given k as 10 percent can be ascertained. This would be
negative (Rs. 0.834)
Example 2
Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates
of return.
Initial cost
Net cash flow
Net cash flow
Year 0
1
2
(Rs 20 000)
90 000
(80 000)
The required equation is:
2
90, 000 80, 000
20, 000
(1 )
1
Rs Rs
Rs
R
R
| |
=
|
+
\ + . ( )
2
90, 000 80, 000
20, 000
(1 )
1
Rs Rs
Rs
R
R
| |
= |
|
+
+
\ .
let (1+R) be X and divide both sides of equation by Rs 10,000
2
9 8
2
X
X
= 2X
2
9X + 8 = 0
Substituting the values of a, b, c into the quadratic formulae
Value of X i.e. IRR is 21.9 and 228 percent The problem with IRR is that if two rates of return
make present value of project zero, which rate should be used for decision making.
TERMINAL VALUE METHOD
The terminal value approach even more distinctly seprates the timing of the cash inflows and outflows. The assumption
behind the TV approach is that each cash inflow is reinvested in another asset at a certain rate of return from the moment it is
received until the termination of the project.
Example:
Original outlay: Rs 10,000
Life of the project: 5 years
Cash Inflows: Rs. 4,000 for 5 years
Cost of Capital (k) 10 percent
Expected interest rate at which cash inflows will be reinvested
Year end Percent
1 6
2 6
3 8
4 8
5 8
Year Cash inflow Rate of interest Years for
investment
Compounding
factor
Total
compounded
sum
1
2
3
4
5
4000
4000
4000
4000
4000
6
6
8
8
8
4
3
2
1
0
1.262
1.191
1.166
1.080
1.000
5048
4764
4664
4321
4000
22796
2
4
X=
2
b b ac
a

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Now, we have to find the present value of Rs. 22796. The discount rate would be the cost of capital K (.10). the sum of Rs 22796
would be received at the end of year 5. Its present value =22796 x 0 .621 = 14156
CAPITAL RATIONING.
A Capital Rationing is a situation where the firm has constrain in respect of the funds and may not be able to take up all the
projects (which are otherwise desirable). The capital Rationing may be either a single period capital rationing or multi period
capital Rationing. If the Capital Rationing is restricted to single period only then the follow approaches are available to make
a decision
a. Feasibility set Approach
b. Incremental Outlay Approach
c. Profitability Index Approach
The divisibility or non divisibility of the project is also to be considered in case of Capital Rationing situation. A multi period
Capital Rationing situation can be tackled with the help of mathematical model.
Example1. ABC Company is considering the following six proposals:
Project Cost NPV
1 Rs. 1,000 Rs. 210
2 6,000 1,560
3 5,000 850
4 2,000 260
5 2,500 500
6 500 95
You are required to calculate the Profitability Index for each project and rank them. Which projects would you choose if
the total funds are Rs. 8,000.
Solution:
Calculation of Profitability Index:
Project Cost NPV Total Inflows PI
1 Rs. 1,000 Rs. 210 Rs. 1,210 1.21
6,000 1,560 7,560 1.26
2 5,000 850 5,850 1.17
3 2,000 260 2,260 1.13
4 2,500 500 3,000 1.20
6 500 95 595 1.19
Ranking as per PI method is Project 2,1,5,6,3,4.
If the total funds are restricted to Rs. 8,000, the best combination of projects may be found with the help of Feasibility Set
Approach as follows:
Combination Outlay NPV
1,2,6 Rs. 7,500 Rs. 1,865
2,4 8,000 1,820
1,3,4 8,000 1,320
3,4,6 7,500 1205
3,5,6 8,000 1,445
1,4,5,6 6,000 1,065
The best combination is projects 1, 2 and 6 and it gives the highest NPV of Rs. 1,865.
Example2. ABC Ltd. has a capital budget of Rs. 20,00,000 for the year 1999. It has before it the following 6 proposals for which
the necessary information is provided here under.
Proposal Outlay (Rs.) NPV (Rs.) IRR
A Rs. 7,00,000 Rs. 3,00,000 20.0%
B 2,50,000 1,60,000 17.0%
C 5,00,000 2,00,000 19.0%
D 2,00,000 1,00,000 17.5%
E 5,50,000 4,50,000 18.0%
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F 7,50,000 -2,50,000 12.0%
Find out the ranking of the proposals given that
1) The projects are indivisible, and
2) The projects are divisible.
Also evaluate the ranking and make a final selection
Solution:
Proposal Outlay (Rs) NPV (Rs.) Inflow PI IRR
(1) (2) (1+2) (1+2) / 1
A 7,00,000 3,00,000(2) 10,00,000 1.428(4) 20%(l)
B 2,50,000 1,60,000(4) 4,10,000 1.640(2) 17%(5)
C 5,00,000 2,00,000(3) 7,00,000 1.400(5) 19%(2)
D 2,00,000 1,00,000(5) 3,00,000 1.500(3) 17.5%(4)
E 5,50,000 4,50,000(1) 10,00,000 1.818(1) . 18 %( 3)
F 7,50,000 -2,50,000(0) 5,00,000 .667(0) 12%(0)
(NOTE: The integers in the brackets denote the ranking of different proposals as per different methods).
It may be noted from the above that different techniques given different ranking to different proposals. The proposal F has not
been assigned any ranking because it is having negative NPV and its PI is also less than 1. Now the firm has to select out of these
proposals so that the total capital outlay is within the budget constraint of Rs. 20,00,000.
a) When the projects are indivisible: The indivisible projects are those
which can be taken up in totality and the part acceptance is not possible. Further that after selecting a few project in a
particular order, if the firm does not have sufficient funds to take up next project then in such a situation, the firm can move
on to the next project if it can be taken up within the remaining available funds. The selection of different projects subject
to capital rationing of Rs. 20,00,000 has been presented here under.
Feasibility Set Incremental Outlay Profitability Index
(Based on NPV) (Based on IRR)
Project Selected E,A,C,B A,C,E,D E,B,D,A
'Total Outlay Rs.20,00,000 Rs. 19,50,000 Rs. 17,00,000
Total NPV 11,10,000 10,50,000 10,10,000
The firm should select the proposals on the basis of Feasibility Set approach because it is resulting in selecting of those proposals
which are expected to bring maximum contribution to the wealth i.e. Rs. 11,10,000.
b) When the project are Divisible: In this case, the firm should invest full budgeted amount of Rs. 20,00,000 and should
take up the proposals even in parts. It is however implied that (i) a fraction of a part can be undertaken and (ii) the
relationship between the capital outlay and the NPV is linear. For example, if 30% of a project is undertaken, then the NPV
generated by part implementation will be 30% of the total NPV of that proposal.
i) Feasibility Set Approach:
Proposal Outlay (Rs.) Cumulati ve Outlay NPV (Rs.)
E 5,50,000 5,50,000 4,50,000
A 7,00,000 12,50,000 3,00,000
C 5,00,000 17,50,000 2,00,000
B 2,50,000 20,00,000 1.60.000
Total 11.10.000
ii) Incremental Outlay Approach:
Proposal Outlay (Rs.) Cumulative Outlay NPV (Rs.)
A 7,00,000 7,00,000 3,00,000
C 5,00,000 12,00,000 2,00,000
E 5,50,000 17,50,000 4,50,000
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D 2,00,000 19,50,000 1,00,000
B (50/250) 50,000 20,00,000 32.000
Total 10.82.000
Iii) Profitability Index Approach:
Proposal Outlay(Rs.) Cumulative Outlay NPV(Rs.)
E 5,50,000 5,50,000 4,50,000
B 2,50,000 8,00,000 1,60,000
D 2,00,000 10,10,000 1,00,000
A 7,00 ,000 17,00,000 3,00,000
C(30O/50O) 3,00,000 20,00,000 1.20.000
Total 11.30.000
Thus if the projects are divisible, the firm can achieve higher NPV of Rs 11,30,000 by selecting proposal as per profitability
index approach
Handout 8
Identification of Cash Flows
1. The cost of a plant is Rs. 5,00,000. It has an estimated life of 5 years after which it would disposed off (scrap value nil).
Profit before depreciation, interest and taxes (PBIT) is estimated be Rs. 1,75,000 p.a.. Find out the yearly cash flow
from the plant. Tax rate 30%.
2. Following is the income statement of a project, on the basis of which calculate the annual cash inflows.
Income Statement of the project
(Figures In Rs.)
Net Sales revenue 4,75,000
- Cost of goods sold 2,00,000
- General Expenses 1,00,000
- Depreciation 50.000 3.50.000
Profit before interest and taxes 1,25,000
- - Interest 25.000
Profit before tax 1,00,000
- Tax @ 40% 40.000
Profit after tax 60.000
3 ABC Ltd. is evaluating a capital budgeting proposal for which relevant figures are as follows:
Cost of the Plant Rs11,00,000
Installation cost Rs. 3,400
Economic life 7 Years
Scrap value Rs. 30,000
Profit before depreciation and tax Rs. 2,00,000
Tax rate 50%
4. ABC Instruments Ltd. is considering the purchase of a machine to replace an existing machine that has a book value of Rs.
24,000, and can be sold for Rs. 12,000. The salvage value of the old machine in four years is zero, and it is depreciated on a
straight-line basis. The proposed machine will perform the same function the old machine is performing; however
improvements in technology will enable the firm to reap cash benefits (before depreciation and taxes) of Rs. 56,000 per year in
materials, labor, and overhead. The new machine has a four year life, costs Rs.. 1,12,000 and can be sold for an expected Rs.
16,000 at the end of the fourth year. Assuming straight-line depreciation and a 40% tax rate, compute cash flows associated
with this replacement.
5. A cosmetic company is considering to introduce a new lotion. The manufacturing equipment will cost Rs. 5,60,000. The
expected life of the equipment is 8 years. The company is thinking of selling the lotion in a single standard pack of 50 grams at
Rs. 12 each pack. It is estimated that variable cost per pack would be Rs. 6 and annual fixed cost Rs. 4,50,000. Fixed cost
includes (straight line) depreciation of Rs. 70,000 and allocated overheads of Rs. 30,000. The company expects to sell 1,00,000
packs of the lotion each year. Assume that tax is 45% and straight line depreciation is allowed for tax purpose. Calculate the
cash flows.
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6 ABC and Co. is considering a proposal to replace one of its plants costing Rs. 60,000 and having a written down value of Rs.
24,000. The remaining economic life of the plant is 4 years after which it will have, no salvage value. However, if sold today, it
has a salvage value of Rs. 20,000. The new machine costing Rs. 1,30,000 is also expected to have a life of 4 years with a scrap
value of Rs. 18,000. The new machine, due to its technological superiority, is expected to contribute additional annual benefit
(before depreciation and tax) of Rs. 60,000. Find out the cash flows associated with this decision given that the tax rate
applicable to the firm is 40%. (The capital gain or loss may be taken as not subject to tax)
7 XYZ is interested in assessing the cash flows associated with the replacement of an old machine by a new machine. The old
machine bought a few years ago has a book value of Rs. 90,000 and it can be sold for Rs. 90,000. It has a remaining life of five
years after which its salvage value is expected to be nil. It is being depreciated annually at the rate of 20 per cent (written down
value method.) The new machine costs Rs. 4,00,000. It is expected to fetch Rs. 2,50,000 after five years when it will no longer
be required. It will be depreciated annually at the rate of 33 1/3 per cent (written down value method.) The new machine is
expected to bring a saving of Rs. 1,00,000 in manufacturing costs. Investment in working capital would remain unaffected. The
tax rate applicable to the firm is 50 per cent. Find out the relevant cash flow for this replacement decision. (Tax on capital
gain/loss to be ignored)
8 XYZ Ltd. is trying to decide whether it should replace a manually operated machine with a fully automatic version of the same
machine. The existing machine, purchased ten years ago, has a book value of Rs. 2,40,000 and remaining life of 20 years.
Salvage value was Rs. 40,000. The machine has recently begun causing problems with breakdowns and is costing the company
Rs. 20,000 per year in maintenance expenses. The company has been offered Rs. 1,00,000 for the old machine as a trade-in on
the automatic model which has a deliver price (before allowance for trade-in) of Rs. 2,20,000. It is expected to have a ten-year
life and a salvage value of Rs. 20,000. The new machine will require installation modifications costing Rs. 40,000 to the existing
facilities, but it is estimated to have a cost savings in materials of Rs. 80,000 per year. Maintenance costs are included in the
purchase contract and are borne by the machine manufacturer. The tax rate is 40% (applicable to both revenue income as well as
capital gains/losses). Straight line depreciation over ten years will be used. Find out the relevant cash flows.
9 BS Electronics is considering a proposal to replace one of its machines. In this connection the following information is
available: The existing machine was bought 3 years ago for Rs 10 Lakh. It was depreciated at 25 percent per annum on reducing
balance method. It has remaining useful life of 5 years, but its annual maintenance cost is expected to increase by Rs 50,000 from
the sixth year of its installation. Its present realisable value is Rs 6 Lakhs. The company has several machines having 25 percent
depreciation. The new machine costs Rs15 Lakhs and is subject to same rate of depreciation. On sale after 5 years it is expected to
net Rs 9 Lakhs. With the new machine, the annual operating cost (excluding depreciation) is expected to decrease by Rs 1 Lakh.
In addition the new machine would increase productivity on account of which net revenues would increase by Rs 1.5 Lakh
annually. The tax rate applicable is 35%. Identify annual Cash Flows.
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W o r k i n g C a p i t a l Ma n a g e m e n t
MEANING AND CONCEPTS OF WORKING CAPITAL
Working capital refers to the funds invested in current assets, i.e. investment in stocks, sundry debtors, cash and other current
assets. Current assets are essential to use fixed assets profitably. For example, a machine cannot be used without raw material. The
investment on the purchase of raw material is identified as working capital. It is obvious that a certain amount of funds is always
tied up in raw-material inventories, work-in-progress, finished goods, consumable stores, sundry debtors and day-today cash
requirements. However, the businessman also enjoys credit facilities from his suppliers who may give the raw material on credit.
Similarly, a businessman may not pay immediately for various expenses. For instance, the labourers are paid only periodically.
These constitute current liabilities. However the requirements of current assets are usually greater than the amount of funds
available through current liabilities.
PRINCIPLES OF WORKING CAPITAL MANAGEMENT
The basic questions involved in Working Capital Management are:-
What is the need to invest funds in current assets?
How much funds to be invested in each type of Current Assets
Proportion of long-term & short-term funds to finance Current Assets
CONCEPTS OF WORKING CAPITAL
Gross working capital - firms investment in Current Assets
Net working capital is current assets - Current liabilities
NEED FOR WORKING CAPITAL
Need for funds arise due to increase in the level of business activities arrangement of funds should be made quickly. Similarly if
surplus funds arise then should be invested in short-term securities. The need for working capital to run the day-to-day business
activities cannot be overemphasised. We will hardly find a business firm which does not require any amount of working capital.
Indeed, firms differ in their requirements of the working capital. We know that firms aim at maximising the wealth of
shareholders. In its endeavour to maximise shareholder wealth, a firm should earn sufficient return from its operations. Earning a
steady amount of profit requires successful sales activity. The firm has to invest enough funds in current assets for the success of
sales activity. Current assets are needed because sales do not convert into cash instantaneously. There is always an operating cycle
involved in the conversion of sales into cash.
WORKING CAPITAL CYCLE OR OPERATING CYCLE
Operating Cycle - mainly has 3 phases
1. Acquisition of resources - like raw material, labour, power, fuel etc.
2. Conversion of raw material into work-in-progress and finished goods
3. Sales of finished goods into cash or credit
GOC = ICP + BDCP
NOC = GOC PDP,
Where
GOC is Gross Operating Cycle ; NOC is Net Operating Cycle.
ICP is Inventory Conversion Period: BDCP is Book Debt Conversion Period
PDP is Payables Deferred Period (time the payment is deferred on various resource purchases for e.g. Creditors)
The working capital cycle is depicted below:
Working capital cycle indicates the length of time between companiess paying for materials, entering into stock and receiving the
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cash from sales of finished goods. It can be determined by adding the number of days required for each stage in the cycle.
Long - term and Short - term funds Mix
There is a minimum amount of net working capital which is considered to be permanent. This is normally financed with long-term
funds.
Permanent and Variable Working Capital
Operating cycle is a continuous process and the need for current assets is continuously felt. But the magnitude of current assets
needed is not always the same. It increases and decreases over time. However, there is always a minimum level of current assets
which are continuously required by the firm to carry business operations. This is the permanent or fixed working capital.
Permanent working capital: It also refers to the Hard core working capital. It is that minimum level of investment in the current
assets that is carried by the business at all times to carry out minimum level of its activities.
Temporary working capital: It refers to that part of total working capital which is required by a business over and above
permanent working capital. It is also variable working capital. Since the volume of temporary working capital keeps on fluctuating
from time to time according to the business activities it may be financed from short term sources.
ADEQUACY OF WORKING CAPITAL
Sound working capital position is necessary to run business operations smoothly and profitably. A concern needs funds for its
day-to-day running. Adequacy or inadequacy of these funds would determine the efficiency with which the daily business may be
carried on. Management of working capital is an essential task of the finance manager. He has to ensure that the amount of
working capital available with his concern is neither too large nor too small for its requirements. A very big amount of working
capital would mean that the company has idle funds. Since funds have a cost, the company has to pay large amounts as interest on
such funds. If the firm has inadequate working capital, it is said to be under-capitalised. Such a firm runs the risk of insolvency.
This is because paucity of working capital may lead to a situation where the firm may not be able to meet its liabilities.
OPTIMUM WORKING CAPITAL
Level of current assets
The financial manager should determine the optimum level of current assets so that the wealth of shareholders is maximised. A
firm needs fixed and current assets to support a particular level of output. However to support the same level of output, the firm
can have different levels of current assets. As the firms output and sales increase, the need for current assets increases but not at
the direct proportion to the output; C.A increases at a decreasing rate with output. The level of C.A can be measured by relating it
to F.A. A higher C.A/F.A ratio indicates a conservative C.A. policy and a lower ratio means an aggressive C.A. policy. A
conservative C.A policy implies greater liquidity and lower risk & lower returns and aggressive policy implies lower liquidity and
greater risk & greater returns. Most firms fall between these two extreme policies.
Dangers of excessive working capital
Unnecessary accumulation of inventory
Defective credit policy and recovery
Makes management complacent and results in managerial inefficiency
Dangers of inadequate working capital
Cannot undertake profitable projects due to non-availability of working capital funds
Impedes operations firms profit target suffers
Operating inefficiencies and difficulty in meeting day-to-day commitments
Fixed assets are not efficiently utilised due to lack of WC funds
Paucity of funds lead to inability to avail attractive credit opportunities
Losses reputation as it cannot honour its short-term obligations
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LIQUIDITY VS PROFITABILITY
Risk-Return tangle and cost trade-off.
The two important aims of the WC management are profitability and solvency. If the firm maintains a relatively large investment
in CA, it will have no difficulty in paying creditors when they become due, will have less risk of insolvency and will hardly
experience cash shortage or stock-outs. However there is cost associated with maintaining sound liquidity and the firms profit
will suffer. This can best be illustrated with the help of the following eg. A firms data is given below:
Sales (1,00,000 units) Rs. 15,00,000
EBIT 1,20,000
Fixed Assets 5,00,000
The three possible C.A. holdings of the firm are Rs.5Lakhs, 4Lakhs and 3Lakhs. It is assumed that F.A are constant and profits do
not vary with C.A. Levels.
The cost trade-off: a different way of looking into the risk-return trade-off is in terms of cost of maintaining a particular level of
C.A. There are two types of costs cost of liquidity and cost of illiquidity. The cost of illiquidity is the cost of holding insufficient
current assets thereby forcing the firm to borrow at high rates of interest which in turn affects credit worthiness, loss of sales (due
to low stock levels) etc. In determining the optimum level of CA, the firm should balance the profitability solvency tangle by
minimising to costs-costs of liquidity and illiquidity
DETERMINANTS OF WORKING CAPITAL
Nature and size of Business: Working capital requirements of a firm are basically influenced by the nature of its business.
Trading and financial firms have a very small investment in fixed assets, but require a large sum of money to be invested in
working capital. Retail stores, for example, must carry large stocks of a variety of goods to satisfy varied and continuous demand
of their customers. Some manufacturing businesses, such as tobacco manufacturers and construction firms, also have to invest
substantially in working capital and a nominal amount of fixed assets. In contrast, public utilities have a very limited need for
working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they may
have cash sales only and supply services, not product. The size of the business also has an important impact on its working capital
needs. Size may be measured in terms of the scale of operation. A firm with larger scale of operation will need more working
capital than a small firm.
Manufacturing Cycle: The manufacturing cycle comprises of the purchase and use of raw materials and the production of
finished goods. Longer the manufacturing cycle, large will be the firms working capital requirements.
Sales Growth: The working capital needs of the firm increase as its sales grow. It is difficult to precisely determine the
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relationship between volume of sales and working capital needs. In practice, current assets will have to be employed before
growth takes place. It is, therefore, necessary to make advance planning of working capital for a growing firm on a continuous
basis.
Demand Conditions: Most firms experience seasonal and cyclical fluctuations in the demand for their products and services.
These business variations affect the working capital requirement, specially the temporary working capital requirement of the firm.
When there is an upward swing in the economy, sales will increase.
Production Policy: A steady production policy will cause inventories to accumulate during the off-season periods and the firm
will be exposed to greater inventory costs and risks. Thus, if costs and risks of maintaining a constant production schedule are
high, the firm may adopt policy of varying its production schedules in accordance with changing demand. Those firms, whose
productive capacities can be utilised for manufacturing varied products, can have the advantage of diversified activities and solve
their working capital problems.
Price Level Changes: The increasing shifts in price level make functions of financial manager difficult. He should anticipate the
effect of price level changes on working capital requirements of the firm. Generally, rising price levels will require a firm to
maintain higher amount of working capital. Same levels of current assets will need increased investment when prices are
increasing.
Operating Efficiency and Performance: The operating efficiency of the firm relates to the optimum utilisation of resources at
minimum costs. The firm will be effectively contributing to its working capital if it is efficient in controlling operating costs. The
use of working capital is improved and pace of cash cycle is accelerated with operating efficiency. Better utilisation of resources
improves profitability and, thus, helps in releasing the pressure on working capital.
Firms Credit Policy: The credit policy of the firm affects working capital by influencing the level of book debts. The credit
terms to be granted to customers may depend upon norms of the industry to which the firm belongs. But a firm has the flexibility
of shaping its credit policy within the constraint of industry norms and practices. The firm should be discretionary in granting
credit terms to its customers. Depending upon the individual case, different terms may be given to different customers. A liberal
credit policy, without rating the credit-worthiness of customers, will be detrimental to the firm and will create a problem of
collecting funds later on. In order to ensure that necessary funds are not tied up in book debts, the firm should follow a
rationalised credit policy based on the credit standing of customers and other relevant factors.
Credit terms: Credit terms have three components:
1. Credit period, in terms of the duration of time for which trade credit is extended-during this period the amount due
amount must be paid by the customer;
2. Cash discount,
3. Cash discount period, which refers to the duration during which the discount can be availed of.
These terms are usually written in abbreviations, for instance, '2/10 net 30'. The three numerals are explained below:
2 signifies the rate of cash discount (2 per cent), which will be available to the customers if they pay
the amount due within the stipulated time;
10 represents the time duration (10 days) within which a customer must pay to be entitled to the
discount;
30 means the maximum period for which credit is available and the amount must be paid in any case before the expiry of
30 days.
In other words, the abbreviation 2/10 net 30 means that the customer is entitled to 2 per cent cash discount (discount rate) if
he pays within 10 days (discount period) after the beginning of the credit period (30 days). If, however, he does not want to take
advantage of the discount, he may pay within 30 days. If the payment is not made within a maximum period of 30 days, the
customer would be deemed to have defaulted.
Availability of Credit: The working capital requirement of a firm is also affected by credit terms granted by its creditors. A firm
will need less working capital if liberal credit terms are available to it.
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Planning Of Working Capital
The computation of working capital is summarised in format.
(1) Estimation of Current Asset:
(a) Minimum desired cash and bank balances
(b) Inventories
Raw material
Work-in-process
Finished Goods
(c) Debtors
Total Current Assets
(2) Estimation of Current Liabilities:
(a) Creditors
(b) Wages
( c) Overheads
Total Current Liabilities
(3) Net Working Capital [(1-2)]
Add margin for contingency
(4) Net Working Capital Required
If payment is received in advance, the item would be listed in CL. In advance payment is to be made to creditors, the item would
appear under CA. The same would be the treatment for advance payment of wages and overheads.
Handout
1. While preparing a project report on behalf of a client you have collected the following facts. Estimate the net working capital
required for that project. Add 10 per cent to your computed figure to allow contingencies:
Amount per unit
Estimated cost per unit of production is:
Raw material Rs 80
Direct labour 30
Overheads (exclusive of depreciation, Rs 10 per unit) 60
Additional information:
Selling price, Rs 200 per unit
Level of activity, 1,04,000 units of/ production per annum
Raw materials in stock, average 4 "weeks
Work in progress (assume 50 per cent completion stage in respect of conversion costs and 100 per cent completion in respect of
materials), average 2 weeks
Finished goods in stock, average 4 weeks
Credit allowed by suppliers, average 4 weeks
Credit allowed to debtors, average 8 weeks
Lag in payment of wages, average 1.5 weeks
Cash at bank is expected to be, Rs 25,000.
You may assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads accrue
similarly. All sales are on credit basis only.
2. A newly formed company has/Applied for a loan to a commercial bank for financing its working capital requirements. You are
requested by the bank to prepare an estimate of the requirements of the working capital for the company. Add 10 per cent to your
estimated figure to cover unforeseen contingencies. The information about the projected profit and loss account of this company
is as under:
Sales
Cost of gods sold
Rs21,00,000
Rs.15,30,000
Gross profit Rs. 5,70,000
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Administrative expenses
Selling expenses
Rs1,40,000
Rs.1,30,000
2,70,000
Profit before tax 3,00,000
Provision for tax 1,00,000
Note: Cost of goods sold has been derived as follows:
Materials used
Wages and manufacturing exp. Depreciation
8,40,000
6,25,000
2,35,000.
Loss stock of finished goods (10 per cent not yet sold)
17,00,000
1,70,000
15,30,000
The figures given above relate only to the goods that have been finished and not to work in progress; goods equal to 15 per cent of
the year's production (in terms of physical units) are in progress on an average, requiring full materials but only 40 per cent of
other expenses. The company believes in keeping two months consumption of material in stock; Desired cash balance, Rs 40,000.
Average time-lag in payment of all expenses is 1 month; suppliers of materials extend 1.5 months credit; sales are 20 per cent
cash; rest are at two months credit; 70 per cent of the income tax has to be paid in advance in quarterly installments. You can
make such other assumptions as you deem necessary for estimating working capital requirements.
3. X Ltd sells goods at a gross profit of 20 per cent. It includes depreciation as a part of cost of production. The following figures
for the 12 month-period ending March 31, current year are given to enable you to ascertain the requirements of working capital of
the company on a cash cost basis. In your working, you are required to assume that:
(i) A safety margin of 15 per cent will be maintained;
(ii) Cash is to be held to the extent of 50 per cent of current liabilities; (iii) There will be no work-in-progress;
(iv) Tax is to be ignored; (v) Finished goods are to be valued at manufacturing costs.
Stocks of raw materials and finished goods are kept at one month's requirements.
Sales at 2 month's credit, Rs 27,00,000
Materials consumed (suppliers' credit is for 2 months), Rs 6,75,000
Wages (paid on the last day of the month), Rs 5,40,000
Manufacturing expenses outstanding at the end of the year (cash expenses are paid one month in arrear), Rs 60,000
Total administrative expenses (paid as above), Rs 180,000
Sales promotion expenses (paid quarterly in advance), Rs 90,000
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Receivables Management
The average balance in the receivables account is average daily credit sales multiplied by average collection period.
The objective of receivables management is to promote sales and profits until that point is reached where the returns that the
company gets from funding of receivables is less than the cost that the company has to incur in order to fund these receivables.
The credit policy of a company can be regarded as a kind of trade off between increased credit sales leading to increase in
profit and the cost of having larger amount of cash locked up in the form of receivables and the loss due to the incidence of bad
debts.
The objective of collection policy is to achieve timely collection of receivables, thereby releasing funds locked up in
receivables for a longer period than they should have been under the credit terms and to minimize bad debt losses.
In judging the creditworthiness of an applicant, three basic factors the three C's have to be considered. And they are character,
capacity, and collateral. ^
Character refers to the willingness of the customer to honor his obligations. It reflects integrity, a moral attribute considered
very important by credit managers.
Capacity refers to the ability of the customer to pay on time. It depends on the financial situation (particularly the working
capital position and profitability) and the general business conditions affecting the performance of the customer.
Collateral represents the security offered by the firm in the form of mortgages.
Credit evaluation of the prospective customer involves obtaining information from which the financial capacity as also the paying
habits can be evaluated.
An important aspect of receivables management is to monitor the payment of receivables. Several measures are employed by
the credit manager for this purpose; (i) Days Sales Outstanding, (ii) Ageing Schedule and (iii) Collection Matrix are some
of the measures employed.
The average number of days' sales outstanding at any time, say end of the month or end of the quarter, is same as for an average
collection period.
In case, the days' sales outstanding is within a pre-specified norm linked to the credit period followed by the company then the
status of receivables is regarded to be under control. In case it is found to be higher, then the collection policy has to be
strengthened as the collections are slow.
The age-wise distribution of accounts receivable at a given time is depicted in the ageing schedule. The ageing schedule can be
compared with the credit period extended by the company. When the percentage of receivables belonging to higher age groups is
above a stipulated norm, action has to be initiated before they turn into bad debts.
If sales are decreasing, average collection period and the ageing schedule will differ from what they would be if sales are
constant.
From the collection matrix, one can judge whether the collection is improving, stable, or deteriorating. A secondary benefit of
such an analysis is that it provides a historical record of collection percentages that can be useful in projecting monthly receipts
for each budgeting period.
Costs associated with Receivables
The major categories of costs associated with the extension of credit and accounts receivable are: (i) collection cost, (ii) capital
cost, (iii) delinquency cost, and (iv) default cost.
Collection Cost Collection costs are administrative costs incurred in collecting the receivables from 'the customers to whom
credit sales have been made. Included in this category of costs are: (a) additional expenses on the creation and maintenance of a
credit department with staff, accounting records, stationery, postage and other related items; (b) expenses involved in acquiring
credit information either through outside specialist agencies or by the staff of the firm itself. These expenses would not be incurred
if the firm does not sell on credit.
Capital Cost The increased level of accounts receivable is an investment in assets. They have to be financed thereby involving
a cost. There is a time-lag between the sale of goods to, and payment by, the customers. Meanwhile, the firm has to pay employees
and suppliers of raw materials, thereby implying that the firm should arrange for additional funds to meet its own obligations while
waiting for payment from its customers. The cost on the use of additional capital to support credit sales, which alternatively could
be profitably employed elsewhere, is, therefore, a part of the cost of extending credit or receivables.
Delinquency Cost This cost arises out of the failure of the customers to meet their obligations when payment on credit sales
becomes due after the expiry of the credit period. Such costs are called delinquency costs. The important components of this cost
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are: (i) blocking-up of funds for an extended period, (ii) cost associated with steps that have to be initiated to collect the overdues,
such as, reminders and other collection efforts, legal charges, where necessary, and so on.
Default Cost Finally, the firm may not be able to recover the overdues because of the inability of the customers. Such debts
are treated as bad debts and have to be written off as they cannot be realised. Such costs are known as default costs associated
with credit sales and accounts receivable.
Handout
1 A firm is currently selling a product @ Rs 10 per unit. The most recent annual sales (all credit) were 30,000 units. The
variable cost per unit is Rs .6 and the average cost per unit, given a sales volume of 30,000 units, is Rs 8. The total fixed cost is
Rs 60,000. The average collection period may be assumed to be 30 days.
The firm is contemplating a relaxation of credit standards that is expected to result in a 15 per cent increase in units sales; the
average collection period would increase to 45-days with no change in bad debt expenses. It is also expected that increased sales
will result in additional net working capital to the extent of Rs 10,000. The increase in collection expenses may be assumed to be
negligible: The required return on investment is 15 per cent. Should the firm relax the credit standard?
2 A firm is contemplating stricter collection policies. The following details are available:
1. At present, the firm is selling 36,000 units on credit at a price of Rs 32 each; the variable cost per unit is Rs 25 while the
average cost per unit is Rs 29; average collection period is 58 days; and collection expenses amount to Rs 10,000; bad debts
are 3 per cent,
2. If the collection procedures are tightened, additional collection charges amounting to Rs 20,000 would be required, bad
debts will be 1 per cent; the collection period will be 40 days; sales volume is likely to decline by 500 units.
Assuming a 20 per cent rate of return on investments, what would be your recommendation? Should the firm implement the
decision?
3 Suppose, a firm is contemplating an increase in the credit period from 30 to 60 days. The average collection period which is at
present 45 days is expected to increase to 75 days. It is also likely that the bad debt expenses will increase from the current level
of 1 per cent to 3 percent of sales. Total credit sales are expected to increase from the level of 30,000 units to 34,500 units. The
present average cost per unit is Rs 8, the variable cost and a sale per unit is Rs 6 and Rs 10 per unit respectively. Assume the firm
expects a rate of return of 15 per cent.
Should the firm extend the credit period?
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Wo r k i n g C a p i t a l F i n a n c i n g
Accrued Expenses, Provisions, Trade credit are important sources of financial current assets.
The Reserve Bank of India (RBI) constituted in July, 1974, a study group to frame guidelines for follow up of bank credit under
the chairmanship of P.L.Tandon. The report submitted by the committee in August, 1975 is popularly referred to as the Tandon
Committee Report.
The Tandon Committee Report had made some recommendations regarding the style of credit.
Maximum Permissible Bank Finance (MPBF) (as per Tondon Committee) suggests the following three methods
a) .75 ( CA CL)
b) .75 CA - CL
c) .75 (CA - CCA) - CL
Bank finance may be either direct or indirect.
Under direct financing the bank not only provides the finance but also bears the risk. Cash credit, overdraft, note lending,
purchase/discounting of bills belong to the category of direct financing.
When the bank opens a Letter of Credit in favor of a customer, the bank assumes only the risk of default by the customer and
the finance is provided by a third party.
Examples of indirect financing are letter of credit, security, hypothecation and pledge.
The deposits mobilized from public by non-financial manufacturing companies are known as 'Public Deposits' or 'Fixed
deposits'. These are governed by the regulations of public deposits under the Companies (Acceptance of Deposits)
Amendment Rules, 1978.
Commercial Papers (CPs) are short-term usance promissory notes with a fixed maturity period, issued mostly by the leading,
reputed, well-established, large corporations who have a very high credit rating. They can be issued by body corporate whether
financial companies or non-financial companies. Hence, they are also referred to as Corporate Papers.
COMMERCIAL PAPER
Commercial Paper (CP) is a short-term unsecured negotiable instrument, consisting of usance promissory notes with a fixed
maturity. It is issued on a discount on face value basis but it can also be issued in interest-bearing form. A CP when issued by a
company directly to the investor is called a direct paper. The companies announce current rates of CPs of various maturities, and
investors can select those maturities which closely approximate their holding period. When CPs are issued by security
dealers/dealers on behalf of their corporate customers, they are called dealer paper. They buy at a price less than the commission
and sell at the highest possible level. The maturities of CPs can be tailored within the range to specific investments.
A CP has several advantages for both the issuers and the investors. It is a simple instrument and hardly involves any
documentation. It is additionally flexible in terms of maturities which can be tailored to match the cash flow of the issuer. A well-
rated company can diversify its short-term sources of finance from banks to money market at cheaper cost. The investors can get
higher returns than what they can get from the banking system. Companies which are able to raise funds through CPs have better
financial standing. The CPs are unsecured and there are no limitations on the end-use of funds raised through them. As negotiable/
transferable instruments, they are highly liquid. The creation of the CP market can result in a part of intercorporate funds flowing
into this market which would come under the control of monetary authorities in India.
Framework of Indian CP Market
The CPs emerged as sources of short-term financing in the early nineties. They are regulated by the RBI. The main elements of
the present framework are given below.
CPs can be issued for periods ranging between 15 days and one year. Renewal of CPs is treated as fresh issue.
The minimum size of an issue is Rs 25 lakh and the minimum unit of subscription is Rs 5 lakh.
The maximum amount that a company can raise by way of CPs is 100 per cent of the working capital limit.
A company can issue CPs only if it has a minimum tangible net worth of Rs 4 crore, a fund-based working limit of Rs 4
crore or more, at least a credit rating of P2 (CRISIL), A2 (ICRA), PR-2 (CARE) and D-2 (DUFF & PHELPS) and its
borrowal account is classified as standard asset.
The CPs should be issued in the form of usance promissory notes, negotiable by endorsement and delivery at a discount rate
freely determined by the issuer. The rate of discount also includes the cost of stamp duty (0.25 to 0.5 per cent), rating
charges (0.1 to 0.2 per cent), dealing bank fee (0.25 per cent) and stand by facility (0.25 per cent).
The participants/investors in CPs can be corporate bodies, banks, mutual funds, UTI, LIC, GIC, NRIs on non-repatriation
basis. The Discount and Finance House of India (DFHI) also participates by quoting its bid and offer prices.
The holder of the CPs would present them for payment to the issuer on maturity.
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Factoring
Factoring is a service of financial nature involving the conversion of credit bills into cash. Accounts receivables, bills
recoverable and other credit dues resulting from credit sales appear in the books of accounts as book credits. Here the
risk of credit, risk of credit worthiness of the debtor and a number of incidental and consequential risks are involved.
These risks are taken by the factor which purchases these credit receivables without recourse and collects them when
due. These balance sheet items are replaced by cash received from the factoring Agent.
Factoring is also called "Invoice Discounting" or purchase and discount of all "Receivables." Although these can be
with recourse or without recourse, normally the risk is taken by the factoring agent. The discount rate includes the
loss of interest, risk of credit and risk of loss of both principal and interest on the amount involved.
Many banks have set up subsidiaries for undertaking the factoring service. The factor buys the bills receivables or
other book accounts, only if they are considered good for credit and are acceptable to him for the risk he takes. This
service of buying the Credit Instruments may be a continuous or an ad-hoc service varying from Bill discounting to
total take over of administration of sales ledger and collection of credit sales ledger and collection of credit sales.
Credit functions involving granting of limits for cash in conversion of credit receivables include administration of
sales ledger, credit control, credit approval, collection of credit bills, credit insurance etc.
Factoring services rendered are the following
1. Purchase of book debts and receivables.
2. Administration of sales ledger of the clients.
3. Prepayment of debts partially or fully.
4. Collection of book debts or receivables with or without documents.
5. Covering the credit risk of the suppliers.
6. Dealing in book debts of customers without recourse.
Mechanics of operation of factoring
1. Assess the credit standing of the client.
2. Set a credit risk limit and open a line of credit.
3. Factor fixes the limits to credit exposure and time periods.
4. Client sells the goods to the customer and invoices the bills assigning them to be paid to the factor.
5. Copies of invoice and receipted delivery challans are handed over to the factor for further action.
6. Factor provides the payment up to 80% of value of invoice after scrutiny of the documents.
7. Customer who purchased has to provide the rest of 20% of the value.
8. Factor sends statements for the bills purchased and collections made and charges debited to the client.
What is Forfaiting?
Forfaiting is the conversion of credit bills into cash by discounting them. Only foreign bills are involved in the
transactions: Bills for the supply of raw materials include:
of inputs
of capital goods
Handout
1. The Reliance Industries Ltd (RIL) is presently managing its accounts receivable internally by the sales and credit and
collection department. Its credit terms for sales are 2/10 net, 30. The past experience of RIL has been that on an average 30 per
cent of the customers avail of the discount, while the balance of the receivables is collected on an average 60 days after the
invoice date. Further, 2 per cent of the sales turnover results in bad debts.
The firm is financing its investments in receivables through a mix of bank- finance and long-term finance (own funds) in the ratio
of 2:1. The effective rate of interest on bank finance is 22 per cent and the cost of own funds is 30 per cent.
The projected sale for the next year is Rs 500 lakh. The sales credit and collection department spends on an average one-fourth of
its time on collection of receivables.
A proposal to avail of factoring service from Fairgrowth Factors Ltd (FFL) as an alternative to in-house management of
receivables collection and credit monitoring is under the consideration of the Board of Directors of the RIL. If the proposal,
details of which are given as follows, is accepted, it is expected that the projected sales for the next year can increase by Rs 50
lakh as a result of the diversion of the time of the executives of the sales, credit and collection department to sales promotion. For
the type of product the RIL is producing, the gross margin on sales in the past has been 20 per cent. Moreover, there would be a
saving in administrative overheads amounting to Rs 2.5 lakh due to discontinuance of sales ledger administration and credit
monitoring.
According to the factoring proposal, the FFL offers a guaranteed payment of 30 days. The other details are listed as follows:
The FFL would advance 80 per cent and 85 per cent in case of recourse and non-recourse factoring deals respectively, the
balance would be retained as factor reserve. The discount charge in advance (up-front) would be 22 per cent of recourse type and
21 per cent for non-recourse type of service. The FFL would also charge a commission @ 2 per cent (recourse) and 4 per cent
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(non-recourse). The commission is payable up-front.
Before taking a decision on the proposal, the Board seeks your advice as a financial consultant, on the course of action. What
advice would you give? Why?
C a s h Ma n a g e m e n t
What is Cash Management?
Cash is the important current assent for the operations of the business. Cash is the basic input needed to keep the business running
on a continuous basis; it is also the ultimate output expected to be realized by selling the service or product manufactured by the
firm.
The firm should keep sufficient cash, neither more nor less. Cash shortage will disrupt the firms manufacturing operation while
excessive cash will simply remain idle, without contributing anything towards the firms profitability. Thus, a major function of
the financial manager is to maintain a sound cash position. Cash is the money which a firm can disburse immediately without any
restriction. The term cash includes. coins, currency and cheques held by the firm, and balances in its bank accounts. Sometimes
near-cash items, such as marketable securities or bank time-deposits, are also included in cash. The basic characteristic of near-
cash assets is that they can readily be converted into cash, it invests. This kind of investment contributes some profit to the firm.
Management of cash involves three things -
1. Managing cash flows into and out of the firm,
2. Managing cash flows within the firm
3. Financing deficit or investing surplus cash and thus, controlling cash balance at a point of time.
Cash management cycle.
WHY DO COMPANIES HOLD CASH?
The firms need to hold cash may be attributed to the following three motives
The transactions motive
The precautionary motive
The speculative motive
Transaction Motive
The transactions motive requires a firm to hold cash to conduct its business in the ordinary course. The firm needs cash primarily
to make payments for purchases, wages and salaries, other operating expenses, taxes, dividends etc. the need to hold cash would
not arise if there were perfect synchronization between cash receipts and cash payments, i.e. enough cash is received when the
payment has to be made. But cash receipts and payments are not perfectly synchronized. For those periods, when cash payments
exceed cash receipts, the firm should maintain some cash balance to be able to make required payments. For transactions purpose
a firm may invest its cash in marketable securities usually, the firm will purchase securities whose maturity corresponds with
some anticipated payments, such as dividends, or taxes in future. Notice that the transactions motive mainly refers to holding cash
to meet anticipated payments whose timing is not perfectly matched with cash receipts.
Precautionary motive
The precautionary motive needs to hold cash to meet contingencies in future. It provides a cushion or buffer to withstand some
unexpected emergency. The precautionary amount of cash depends upon the predictability of cash flows. If cash flows can be
predicted with accuracy, less cash will be maintained for an emergency. The amount of precautionary cash is also influenced by
the firms ability to borrow at short notice when the need arises. The precautionary balance may be kept in cash and marketable
securities. Marketable securities play an important role here.
Speculative Motive
Some firms may hold cash for speculative purposes. By and large, business firms do not engage in speculations. Thus, the primary
motive to hold cash and marketable securities are: the transactions and the precautionary motive. Cash planning is a technique to
plan and control the use of cash. It protects the financial condition of the firm by developing a projected cash statement through a
forecast of expected cash inflows and outflows for a given period. The forecasts may be based on the present operations or the
anticipated future operations. Cash plans are very crucial in developing the overall operating plans of the firm.
STRATEGIES OF CASH MANAGEMENT
1. Cash Planning: Cash planning is a technique to plan and control the use of cash. It protects the financial condition of the
firm by developing a projected cash statement through a forecast of expected cash inflows and outflows for a given
period. The forecasts may be based on the present operations or the anticipated future operations. Cash plans are very
crucial in developing the overall operating plans of the firm. Cash inflows and outflows should be planned to project cash
Surplus or deficit for each period. Cash budget should be prepared for this purpose.
2. Managing cash flows-cash inflows should be accelerated; decelerating Cash Outflows.
3. Optimum cash level -firm should decide appropriate level of cash balances
4. Investing surplus cash or financing deficit
CASH BUDGET
The cash budget is the most important tool in planning cash resources. It is a device which helps a firm plan for, and control, the
use of cash. It is a statement showing the estimated cash inflows and outflows over the cash planning horizon (period). The
principal aim of cash budget, as a tool for predicting cash flows over a period of time is to ascertain whether at any time there is
likely to be an excess or shortage of cash.
The preparation of a cash budget involves several steps. The first element of a cash budget is the planning horizon. The planning
horizon of a cash budget should be determined in the light of the circumstances and requirement of a particular case. The second
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element of cash budget is the selection and identification of factors that have a bearing on the cash flows. The factors that generate
cash are generally divided into two broad categories namely
(i) Operating and
(ii) Financial
A. Cash inflows:
Cash sales
Collection from debtors (specify month-vise)
Other sources (say interest / dividends received rent received, sale of fixed assets/investment, share issues etc.
B. Cash Outflows:
Cash purchase of raw material & finished goods
Payment to creditors (specify month wise)
Direct labour
Variable manufacturing overheads (items wise)
Cash fixed manufacturing overheads (item wise)
Selling & administrative overheads (items wise)
Interest paid, dividends paid, taxes paid
Purchase of plant & machinery or any other fixed assets
Any other stipulated payment (redemption of securities)
Total
C. Surplus and (Deficiency) [A-B]:
Beginning balance
Closing Balance
Desired minimum cash balance
Budgeted (borrowing)/ surplus
MANAGING CASH FLOWS
The financial managers must devise a system whereby each division of an organisation retains enough cash to meet its day-today
requirements without having surplus balances on hand. For this methods have to be employed to accelerate cash inflows. Two
very important methods to speed up collection process are (i) concentration banking and (ii) lockbox system.
Concentration Banking
In this system of decentralized collection of accounts receivable large firms which have a large number of branches at different
places, select some of the strategically located branches as collection centers for receiving payment from customers. Instead of all
the payments being collected at the head office of the firm, the cheques for a certain geographical area are collected at a specified
local collection center. Under this arrangement, the customers are required to send their payments (cheques) to the collection
center covering the area in which they live and these are deposited in the local account of the concerned collection center, after
meeting local expenses, if any. Funds beyond a predetermined minimum are transferred daily to a central or disbursing or
concentration bank or account. Interest received and paid.
Lock Box System
Under this arrangement, firms hire a post office lock-box at important collection centers. The customers are required to remit
payments to the post office lock-box The local banks of the firm , at the respective places, are authorized to open the box and pick
up the remittances (Cheques) received from the customers. Usually, the authorized banks pick up the Cheques several times a day
and deposit them in the firms accounts. After crediting the account of the firm, the banks send a deposit slip along with the list of
payments and other enclosures, if any, to the firm by way of proof and record of the collection.
Thus, the lock-box system is like concentration banking in that the collection is decentralized and is donate the branch level. But
they differ in one very important respect. While the customer sends the cheques, under the concentration banking arrangement, to
the collection centers, he sends them to a post office box under the lock-box system.
Decelerating cash flows:
A firm estimates accurately the time when the cheques issued will be presented for encashment and thus utilises the float period to
its advantage by issuing more cheques but having in the bank account only so much cash balance as will be sufficient to honour
those cheques which are actually expected to be presented at a data.
Four kinds of float with reference to management cash are:
Billing float: An invoice is the formal document that sellers prepares and send to the purchaser as the payment request for goods
sold or services provided. The time between the sale and the mailing of the invoice is the billing float.
Mail float: This is the time when a cheque is being processed by post office, messenger service or other means of delivery.
Cheque processing float: This is the time required for the seller to sort, record and deposit the cheque after it has been received
by the company.
Bank processing float: This is the time from the deposit of the cheque to the crediting of funds in the sellers account.
OPTIMUM CASH LEVEL
Baumal model
J.Baumals Economic Order Quantity model; According to this model, optimum cash level is that level of cash were the carrying
costs and transactions costs are the minimum. The carrying cost refers to the cost of holding cash, namely, the interest foregone on
marketable securities. The transaction cost refers to the cost involved in getting the marketable securities converted into cash. This
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happens when the firm falls short of cash and has to sell the securities resulting in clerical, brokerage, registration and other costs.
The optimum cash balance according to this model will be that point where these two costs are equal. The formula for
Miller-orr Cash Management Model:
The model is designed to determine the time and size of transfers between an investment account and cash account. In this model
control limits are set for cash balances. These limits may consist of has upper limit, Z as the return point; and zero as the lower
limit. When the cash balance reaches the upper limit, the transfer of cash equal to h-z is affected in marketable securities account.
When it touches the lower limit, a transfer from marketable securities account to cash account is made. During the period when
cash balance stays between h & Z, i.e. high and low limits no transactions between cash and marketable securities account is
made. The high and low limits of cash balance are set up on the basis of fixed cost associated with the securities transactions, the
opportunity cost of holding cash and the degree of likely fluctuations in cash balances. These limits satisfy the demands for cash at
the lowest possible costs.
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Financial Smarts For Students
Study Center for M.B.A., C.A., C.F.A., M.Com. B.Com(Hons.)
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Inventory Management
Inventory Management involves the control of assets being produced for the purposes of sale in the normal course of the company's
operations.
Inventories include raw material inventory, work-in-process inventory and finished goods inventory.
The goal of effective inventory management is to minimize the total costs i.e., the direct and indirect cost that are associated with
holding inventories.
Liquidity Lag: Inventories are tied to the firm's pool of working capital in a process that involves three specific lags, namely,
Creation Lag, Storage Lag and Sale Lag.
Creation Lag: In most cases, inventories are purchased on credit, creating an account payable. This liquidity lag offers a benefit to
the firm.
Storage Lag: Once goods are available for resale, they will not be immediately converted into cash. First, the item must be sold. Even
when sales are very active, a firm will hold inventory as a back-up. Thus, the firm will usually pay suppliers, workers, and
overhead expenses before the goods are actually sold. This lag represents a cost to the firm.
Sale Lag: Once goods have been sold, they normally do not create cash immediately. Most sales occur on credit and become
accounts receivable. The firm must wait to collect its receivables. This lag also represents a cost to the firm.
Raw Materials Inventory: This consists of basic materials that have not yet been committed to production in a manufacturing firm.
The purpose of maintaining raw material inventory is to uncouple the production function from the purchasing function so that
delays in shipment of raw materials do not cause production delays.
Stores and Spares: This category includes those products which are accessories to the main products produced for the purpose of
sale.
Work-in-Process Inventory: This category includes those materials that have been committed to the production process but have not
been completed. The more complex and lengthy the production process, the larger will be the investment in work-in-process
inventory.
Finished Goods Inventory: These are completed products awaiting sale. The purpose of finished goods inventory is to uncouple
the productions and sales functions
Material Costs: These are the costs of purchasing the goods including transportation handling costs.
The ordering costs refer to the costs associated with the preparation of purchase requisition by the user department, preparation of
purchase order and follow-up measures taken by the purchase department, transportation of materials ordered for, inspection and
handling at the warehouse for storing.
Carrying Costs: These are the expenses incurred in storing goods. Once the goods have bee accepted, they become part of the
firm's inventories. These costs include insurance, rent/depreciation of warehouse, salaries of storekeeper, his assistants and
security personnel, financing cost of money locked-up in inventories, obsolescence, spoilage and taxes.
Cost of Funds Tied up with Inventory: Whenever a firm commits its resources to inventory, it is using funds that otherwise might be
available for other purposes. The firm has lost the use of funds for other profit making purposes. This is its opportunity cost.
Whatever be the source of funds inventory has a cost in terms of financial resources. Excess inventory represents unnecessary
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cost.
Cost of Running out of Goods: These are costs associated with the inability to provide materials to the production department
and/or inability to provide finished goods to the marketing department as the requisite inventories are not available.
Economic Order Quantity (EOQ) refers to the optimal order size that will result in reduction of total ordering and carrying
costs for an item of inventory given its expected usage, carrying costs and ordering cost. By calculating an economic order
quantity, the firm attempts to determine the order size that will minimize the total inventory costs.
A firm using the ABC system segregates its inventory into three groups: A, B and C. The A items are those in which it have
the largest rupee investment. These are the most costly or the slowest turning items of inventory. The B group consists of the
items accounting for the next largest investment. The 'C group consists of least rupee investment.
There are different ways of valuing the inventories and knowledge of these methods of valuing stocks is essential for an efficient
inventory management process.
First-In-First-Out (FIFO): When a firm adopts the FIFO method to price its raw material, the issue of material from the stores will
be in the order in which it was received. Thus the pricing will be based on the cost of material that was obtained first.
Last-In-First-Out (LIFO): In the LIFO method, the material issued will be priced based on the cost of the material that has been
purchased recently.
Weighted Average Cost Method: The pricing of materials will be on weighted average basis (weights will be given based on the
quantity).