1.

The Balance Sheet of Bharat Machinery Ltd., as on December 31, 2009 and 2010 are as follows: Items Assets Plant and Machinery Land and Buildings Stock Sundry Debtors Cash Liabilities and Capital Share Capital Profit and Loss A/c General Reserve Sundry Creditors Bills Payable Outstanding Expenses 5,00,000 1,00,000 50,000 1,53,000 40,000 7,000 8,50,000 7,00,000 1,60,000 70,000 1,90,000 50,000 5,000 11,75,000 5,00,000 80,000 1,00,000 1,50,000 20,000 8,50,000 8,00,000 1,20,000 75,000 1,60,000 20,000 11,75,000 Dec. 31, 2009 Rs. Dec. 31, 2010 Rs.

Additional Information (i) Depreciation of Rs. 50,000 has been charged on Plant and Machinery during the year 2010. (ii) A piece of machinery was sold for Rs. 8,000 during the year 2010. It had cost Rs. 12,000, depreciation of Rs. 7,000 had been provided on it. Prepare a schedule of change in working capital and a statement showing the sources and application of funds for the year 2010.

MS 4 Answer of Q2. From the following cost, production and sales data of Decors Motor Ltd., prepare comparative income statement for three years under (i) absorption costing method, and (ii) marginal costing method. Indicate the unit cost for each year under each method. Also evaluate the closing stock. The company produces a single article for sale.

Question 3. From the following information related to XYZ Ltd.; you are required to find out (a) contribution (b) Break-even point in units (c) Margin of safety, (d) Profit Total Fixed Costs Rs. 6,000 Total Variable Costs Rs. 20,000 Total Sales Rs. 32,000 Units Sold 4,000 Units Also calculate the volume of sales to earn profit of Rs. 12,000. 4. Write short notes on the following: a) Performance budgeting b) Zero base budgeting c) Factors affecting dividend decisions d) Accrual concept 5. What is capital structure? Explain the features and determinants of an appropriate capital structure.

 Answer 3. From the following information related to XYZ Ltd.; you are required to find out (a) contribution (b) Break-even point in units (c) Margin of safety, (d) Profit Total Fixed Costs Rs. 6,000 Total Variable Costs Rs. 20,000 Total Sales Rs. 32,000 Units Sold 4,000 Units Also calculate the volume of sales to earn profit of Rs. 12,000.

(a) contribution contribution = total sales total variable costs = 32000- 20000 = 12000 Contribution ratio = 12000/ 32000= .375 ====================================== (b) Break-even point in units BEP=total fixed cost/[sales price per unit-variable cost = 6000 / [ 8-5] = 6000 / 3 = 2000 =================================== (c) Margin of safety, Mos= current output- break even = 4000 2000 = 2000 4000 -2000/4000 x100= 50% =============================== (d) Profit PROFIT = 32000- [ 6000+20000]= 6000 =============================== Also calculate the volume of sales to earn profit of Rs. 12,000. Keeping the total fixed cost/variable cost, we need to make 4750 units to make a profit of rs 12000

##############################

4. Write short notes on the following: a) Performance budgeting 'Performance Budget' A budget that reflects the input of resources and the output of services for each unit of an organization. This type of budget is commonly used by the government to show the link between the funds provided to the public and the outcome of these services. Decisions made on these types of budgets focus more on outputs or outcomes of services than on decisions made based on inputs. In other words, allocation of funds and resources are based on their potential results. Performance budgets place priority on employees' commitment to produce positive results, particularly in the public sector. Performance budgeting is generally understood as a system of presentation of public expenditure - terms of functions, programmes, performance units, viz. activities1 projects, etc., reflecting primarily, the governmental output and its cost. It is essentially a process which brings out the total governmental operations through a classification by functions, programmes and activities. Through suitable narrative statements and workload data that form an integral part of the presentation, it indicates the work done, proposed to be done and the cost of carrying these out. The main thrust of performance budgeting has been on providing outputoriented budget information within a long range perspective so that resources could be allocated more efficiently and effectively. Its emphasis is on accomplishment rather than on the means of accomplishment. The purpose of government expenditure is more important than the object of expenditure under performance budgeting. Thus performance budgeting is a programme of action for any given year with specific indicators regarding tasks, the means of achieving them

and the cost of achieving them. It tries to define the physical and financial aspects of each programme and activity and thereby establish the relationship between output and inputs. Performance budgeting has to operate within the framework of clearly defined objectives which are to be achieved through successful implementation of various programmes and activities undertaken by the concerned agency. Performance budgeting, therefore, involves the development of more refined management tools, such as work measurement, performance standards, unit costs, etc. Objectives: Performance budgeting seeks to: i) correlate the physical and financial aspects of programmes and activities; ii) improve budget formulation, review and decision-making at all levels of management in the government machinery; iii) facilitate better appreciation and review by the legislature; iv) make possible more effective performance audit; v) measure progress towards long-term objectives as envisaged in the plan; and vi) bring annual budgets and developmental plans together through a common language. Components of Performance Budget The performance budgets have certain vital ingredients that need to be constantly kept in view: i) a programme and activity classification that represents the range of work of each organisation; ii) a framework of specified objectives for each programme; iii) a stipulation of the targets of work or achievement; and iv) suitable workload factors, productivity and performance ratios that justify financial requirements of each programme. Formulation of Performance Budget Each performance budget will in the first instance indicate the organisational structure and the broad objectives that govern the approaches and work of the administrative agency. This is followed by a Financial Requirements Table. This Table

is the most important part of the performance budget and has three basic elements: - a programme and activity classification indicating the range of work of the agency in meaningful categories - object-wise classification showing the same amount distributed among the different objects of expenditure such as establishment charges; and - sources of financing indicating the budgetary and account heads under which the funds are being provided in the budget. STEPS IN PERFORMANCE BUDGETING Four basic steps are involved in the introduction of performance budgeting: i) Establishing a meaningful classification of public expenditure in terms of functions, ii) the establishment, improvement and extension of activity schedules for all measurable activities of the government; iii) the establishment of work output, employee utilisation, standard or unit costs by objective methods, i.e. bringing the system of accounting and financial management into accord with the classification; and iv) the creation of related cost and performance recording and reporting system. The important requirement for performance budgeting is a programme of action for any given year with specific indications regarding the tasks, the means of achieving them and the costs of achieving them. This is important even in traditional budgeting process. The distinction, however, is that under performance budgeting the organisations are compelled to think of their future activities not merely in terms of financial plans but in terms of the results, work assignment and organizational responsibilities. It isnormally held that in the context of planningfor economic growth, planning is a thinking process and budgeting is a doing process. Since the physical and financial aspects go together and the programme structure is expected to be the same,

performance budgeting facilitates the functional integration of the thinking and doing process. The formulation of programmes for achieving the organisationuL goals is an important task in the budgetary process. A programme is a segment of an important function and represents a homogeneous type of work. These programmes of work need to be developed for meeting the short-term plans, medium-term plans and long-term plans and involve formulation of schemes, laying down their targets, measuring the financial costs and benefits. The programme has to be assessed in the light of financial and economic factors i.e. ensuring adequate resources for the programme so chosen and examination of the impact of the proposed outlays on the economy as a whole through cost-benefit analysis. Complex programmes are divided into subprogrammes to facilitate execution in specific areas. Each programme or sub-programme further consists of many activities which are shown in the respective budgets. For example immunization programme is a programme under the function 'health'. As each programme has many activities, provision for storage of vaccines could be an activity under the programme. The real commencing point in the budgetary process is allocation of resources. In the conventional system primary emphasis is laid on the previous level of allocations and spendings and no emphasis is laid on its performance in terms of its objectives and the programme of action that it has set out for itself for the next year. Under performance budgeting the primary agency prepares the budget, submits its requirements as per programme classification. It indicates its past activities, their costs, the activities to be taken up during the next year, the results expected and the pattern of assignment of responsibilities. The very basis of the performance budgeting is commitment to achievement and the awareness of accountability. The budget so prepared is reviewed at higher level and resources are allocated

keeping in view the priorities of the proposal. Some times due to financial constraints resources may not be available in full and a cut has to be imposed. However, this may be done in full awareness of the implications of the cut on the programme. Under performance budgeting, the programme classification and the rationale behind it indicate a group of choices with their priorities, already'made. This minimises the dislocational effect of cuts and ensures a better identification of their impact on programme achievement. Resource allocation is followed by budget execution. Budget execution must ensure achievement of objectives and for that the following budgetary and managerial considerations must be kept in view: i) Communication of the grants to the various subordinate agencies well in time ii) Ensuring the initiation of action for implementing the schemes provided for in the budget iii) Overseeing the regular flow of expenditures iv) Prevention of cost over-runs; and v) Time phased plan for expenditure and work. The final stage in the performance budgeting process is appraisal and evaluation. Performance Budgeting l Administration .A.. Under the existing system evaluation of the physical achievements in certain sectors is being undertaken by the Programme Evaluation Organisation. Under performance , budgeting, each programme would lend itself to an evaluation by the agency concerned, even before it is undertaken by an outside organisation. The important ,aspect is that evaluation should, as far as possible, follow the completion of a programme and the administration should be enabled to formulate its future course of action in the light of results obtained.

@@@@@@@@@@@@@@@@@@ b) Zero base budgeting 'Zero-Based Budgeting - ZBB' A method of budgeting in which all expenses must be justified for each new period. Zero-based budgeting starts from a "zero base" and every function within an organization is analyzed for its needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of whether the budget is higher or lower than the previous one. ZBB allows top-level strategic goals to be implemented into the budgeting process by tying them to specific functional areas of the organization, where costs can be first grouped, then measured against previous results and current expectations. Because of its detail-oriented nature, zero-based budgeting may be a rolling process done over several years, with only a few functional areas reviewed at a time by managers or group leadership. Zero-based budgeting can lower costs by avoiding blanket increases or decreases to a prior period's budget. It is, however, a time-consuming process that takes much longer than traditional, cost-based budgeting. The practice also favors areas that achieve direct revenues or production; their contributions are more easily justified than in departments such as client service and research and development.

Zero based budget Start each budget period afresh-not based on historical data Budgets are zero unless managers make the case for resources-the relevant manager must justify the whole of the budget allocation It means that each activity is questioned as if it were new before any resources are allocated to it. Each plan of action has to be justified in terms of total cost involved

and total benefit to accrue, with no reference to past activities. Zero based budgets are designed to prevent budgets creeping up each year with inflation Advantages of ZBB Forces budget setters to examine every item. Allocation of resources linked to results and needs. Develops a questioning attitude. Wastage and budget slack should be eliminated. Prevents creeping budgets based on previous years figures with an added on percentage. Encourages managers to look for alternatives. Disadvantages of ZBB It a complex time consuming process Short term benefits may be emphasised to the detriment of long term planning Affected by internal politics - can result in annual conflicts over budget allocation

c) Factors affecting dividend decisions A company pays out dividends as a way of rewarding its current shareholders and convincing new investors to purchase its stock. Dividends are optional for most companies. The company can also delay paying a regular dividend if it has a bad year, but its preferred shareholders get the right to receive new dividend payments in future years before common shareholders get dividends. 1. Stock Price o Paying out a dividend affects the company's stock price. When investors expect to receive a dividend, they add this dividend to the amount they believe a share of stock is worth. After the date of record for a dividend, when the company records the stockholders who will receive the dividend, a new shareholder will have to wait to receive the next dividend, so the price of the stock drops by the value of the dividend payment. If a company announces a future dividend, the price of the stock rises, and if the company announces it will not pay a

dividend this year, the stock price drops. Mandatory Dividend o Some companies have to pay out dividends. A real estate investment trust must distribute 95 percent of its taxable earnings to shareholders to keep its tax advantages, according to the Journal of Real Estate Portfolio Management. This restriction makes it difficult for a real estate investment trust to use its own equity to buy property, although the dividend payout requirement also helps the trust find investors. Rate of Return o A dividend policy can keep the company from making bad investment decisions. A company determines the rate of return on each project and uses this rate to select the most profitable project. If the company can't find any projects that provide the minimum acceptable rate of return, it can give its excess cash back to investors as a dividend. The investors can invest in other companies, and then buy back more of the company's stock to give it cash when it finds a more profitable project. Financial Health o Dividends show the health of a company. If a company can pay a dividend, it has enough money to pay for inventory, utilities, wages, and the rest of its bills. The dividend also shows that the company can borrow money at low rates, because most companies have some debt so they can deduct the interest payments. The dividend suggests that the company is established, instead of a rapidly growing company, because a rapidly growing company needs to use money to expand, according to Ohio State University.

Dividend Decision Dividend Meaning: Dividend is that part of the profits of a company which is distributed amongst its shareholders. "Dividend is a distribution to shareholders out of profits or reserves available for this purpose."

Nature of Dividend Decision The dividend decision of the firm is crucial for the finance manager because it determines: 1. the amount of profit to be distributed among the shareholders, and 2. the amount of profit to be retained in the firm. There is a reciprocal relationship between cash dividends and retained earnings. While taking the dividend decision the management take into account the effect of the decision on the maximization of shareholders' wealth. Maximizing the market value of shares is the objective. Dividend pay out or retention is guided by this objective.

Dividend Policy Factors Affecting Dividend Policy: 1. External Factors 2. Internal Factors

External Factors Affecting Dividend Policy 1.General State of Economy: In case of uncertain economic and business conditions, the management may like to retain whole or large part of earnings to build up reserves to absorb future shocks. In the period of depression the management may also retain a large part of its earnings to preserve the firm's liquidity position. In periods of prosperity the management may not be liberal in dividend payments because of availability of larger profitable investment opportunities. In periods of inflation, the management may retain large portion of earnings to finance replacement of obsolete machines. 2. State of Capital Market: Favourable Market: liberal dividend policy.

Unfavourable market: Conservative dividend policy.

3.Legal Restrictions: Companies Act has laid down various restrictions regarding the declaration of dividend: Dividends can only be paid out of: ** Current or past profits of the company. Money provided by the State/ Central Government in pursuance of the guarantee given by the Government. Payment of dividend out of capital is illegal. A company cannot declare dividends unless: ** It has provided for present as well as all arrears of depreciation. Certain percentage of net profits has been transferred to the reserve of the company. Past accumulated profits can be used for declaration of dividends only as per the rules framed by the Central Government 4.Contractual Restrictions: Lenders sometimes may put restrictions on the dividend payments to protect their interests (especially when the firm is experiencing liquidity problems) Example: A loan agreement that the firm shall not declare any dividend so long as the liquidity ratio is less than 1:1. The firm will not pay dividend more than 20% so long as it does not clear the loan.

Internal Factors affecting dividend decisions 1. Desire of the Shareholders: Though the directors decide the rate of dividend, it is always at the interest of the shareholders. Shareholders expect two types of returns: [i] Capital Gains: i.e., an increase in the market value of shares. [ii] Dividends: regular return on their investment. Cautious investors look for dividends because,

[i] It reduces uncertainty (capital gains are uncertain). [ii] Indication of financial strength of the company. [iii] Need for income: Some invest in shares so as to get regular income to meet their living expenses. 2. Financial Needs of the Company: If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings. 3. Nature of earnings: A company which has stable earnings can afford to have an higher divided payout ratio 4.Desire to retain the control of management: Additional public issue of share will dilute the control of management. 5. Liquidity position: Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends

Stability of Dividends The term stability of dividends means consistency in the payment of dividends. It refers to regular payment of a certain minimum amount as dividend year after year. Even if the company's earnings fluctuate from year to year, its dividend should not. This is because the shareholders generally value stable dividends more than fluctuating ones. Stable dividend can be in the form of: 1. Constant dividend per share 2. Constant percentage 3. Stable rupee dividend plus extra dividend

Significance of Stability of Dividend 1. Desire for current income 2. Sign of financial stability of the company 3. Requirement of institutional investors 4. Investors confidence in the company

Danger of Stable Dividend Policy Stable dividend policy may sometimes prove dangerous. Once a stable dividend policy is adopted by a company, any adverse change in it may result in serious damage regarding the financial standing of the company in the mind of the investors.

Forms of Dividend 1. Cash Dividend: The normal practice is to pay dividends in cash. The payment of dividends in cash results in cash outflow from the firm. Therefore the firm should have adequate cash resources at its disposal before declaring cash dividend. 2. Stock Dividend: The company issues additional shares to the existing shareholders in proportion to their holdings of equity share capital of the company. Stock dividend is popularly termed as 'issue of bonus shares.' This is next to cash dividend in respect of its popularity. 3. Bond Dividend: In case the company does not have sufficient funds to pay dividends in cash it may issue bonds for the amount due to shareholders. The main purpose of bond dividend is postponement of payment of immediate dividend in cash. The bond holders get regular interest on their bonds besides payment of the bond money on the due date. [Bond dividend is not popular in India] 4. Property Dividend: This is a case when the company pays dividend in the form of assets other than cash. This may be in the form of certain assets which are not required by the company or in the form of company's products. [This type of dividend is not popular in India]

Bonus Shares When the additional shares are allotted to the existing shareholders without receiving any additional payment from them, is known as

issue of bonus shares. Bonus shares are allotted by capitalizing the reserves and surplus. Issue of bonus shares results in the conversion of the company's profits into share capital. Therefore it is termed as capitalization of company's profits. Since such shares are issued to the equity shareholders in proportion to their holdings of equity share capital of the company, a shareholder continues to retain his/ her proportionate ownership of the company. Issue of bonus shares does not affect the total capital structure of the company. It is simply a capitalization of that portion of shareholders' equity which is represented by reserves and surpluses. It also does not affect the total earnings of the shareholders 1. Stability of Earnings. The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods. 2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. 3. Liquidity of Funds. Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend. 4. Extent of share Distribution. Nature of ownership also affects the

dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group, would face a great difficulty in securing such assent because they will emphasise to distribute higher dividend. 5. Needs for Additional Capital. Companiesretain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits. 6. Trade Cycles. Businesscycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up. 7. Government Policies. The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises.

8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of dividend beyond a

certain limit. It also affects the capital formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %. 9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements too into consideration. In order to protect the interests of creditors an outsiders, the companies Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend. Moreover, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case. Likewise, contractual obligation should also be fulfilled, for example, payment of dividend on preference shares in priority over ordinary dividend. 10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rat. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organisation. 11. Ability to Borrow. Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources if there arises any need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend pay out ratio for meeting any obligation requiring heavy funds. 12. Policy of Control. Policy of control is another determining factor is so far as dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programmes of the existing management. So they prefer to meet the needs through retained earing. If the directors do not bother about the control of affairs they will follow a liberal dividend policy. Thus control

is an influencing factor in framing the dividend policy. 13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of retention earnings, unless one other arrangements are made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution still such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend payout. 14. Time for Payment of Dividend. When should the dividend be paid is another consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a time when is least needed by the company because there are peak times as well as lean periods of expenditure. Wise management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances. 15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because each investor is interested in the regular payment of dividend. The management should, inspite of regular payment of dividend, consider that the rate of dividend should be all the most constant. For this purpose sometimes companies maintain dividend equalization Fund. @@@@@@@@@@@@@@@@@@@@@@@@@@ d) Accrual concept

Accruals Before the final accounts of a business are completed, it is usually necessary to make adjustments to the trial balance. For example, some transactions may not yet have been completed (e.g. a supplier has not sent an invoice for goods or services that have

already been received). Some transactions recorded in the accounts may relate to a future accounting period (e.g. a payment has been made for an advertising campaign that will run several months in the future). Accruals are a common example of the adjustments made before the accounts can be finalized. Accruals arise out of the process of matching expenditure or income to the accounting period in which it was incurred rather than paid. The accruals concept one of the fundamental accounting concepts requires that costs and revenues are recognised in the accounts when incurred or earned not when the money is received or paid. An accrued cost is an estimate of the cost of something that has been incurred and is owed but which has not yet been recorded by the accounting system. Accrued income is an estimate of the income that is due from a transaction but which has not yet been recorded (e.g. a sales invoice has not yet been raised). So: - Any money that is owed by a business in the current accounting period must be accrued and added to expenses in the profit and loss account - Any money that is owed to a business in the current accounting period must be accrued and added to income in the profit and loss account ACCRUAL CONCEPT The meaning of accrual is something that becomes due especially an amount of money that is yet to be paid or received at the end of the accounting period. It means that revenues are recognised when they become receivable. Though cash is received or not received and the expenses are recognized when they become payable though cash is paid or not paid. Both transactions will be recorded in the accounting period to which they relate. Therefore, the accrual concept makes a distinction between the accrual receipt of cash and the right to receive cash as regards revenue and actual

payment of cash and obligation to pay cash as regards expenses. The accrual concept under accounting assumes that revenue is realised at the time of sale of goods or services irrespective of the fact when the cash is received. For example, a firm sells goods for Rs 55000 on 25th March 2005 and the payment is not received until 10th April 2005, the amount is due and payable to the firm on the date of sale i.e. 25th March 2005. It must be included in the revenue for the year ending 31st March 2005. Similarly, expenses are recognised at the time services provided, irrespective of the fact when actual payment for these services are made. For example, if the firm received goods costing Rs.20000 on 29th March 2005 but the payment is made on 2nd April 2005 the accrual concept requires that expenses must be recorded for the year ending 31st March 2005 although no payment has been made until 31st March 2005 though the service has been received and the person to whom the payment should have been made is shown as creditor. In brief, accrual concept requires that revenue is recognised when realized and expenses are recognised when they become due and payable without regard to the time of cash receipt or cash payment. Significance ?It helps in knowing actual expenses and actual income during a particular time period. ? It helps in calculating the net profit of the business ======================================== Accrual Concept Business transactions are recorded when they occur and not when the related payments are received or made. This concept is called accrual basis of accounting and it is fundamental to the usefulness of financial accounting information. Examples: 1. An airline sells its tickets days or even weeks before the flight is

made, but it does not record the payments as revenue because the flight, the event on which the revenue is based has not occurred yet. 2. An accounting firm obtained its office on rent and paid $120,000 on January 1. It does not record the payment as an expense because the building is not yet used. While preparing its quarterly report on March 31, the firm expensed out three months worth of rent i.e. 30,00 [$120,000/12*3] because 3 months equivalent of time has expired. 3. A business records its utility bills as soon as it receives them and not when they are paid, because the service has already been used. The company ignored the date when the payment will be made. Accounting standards strictly require accounting on accrual basis. However, there is an alternative called cash basis of accounting. Under the cash basis events are recorded based on their underlying cash inflows or outflows. Cash basis is normally used while preparing financial statements for tax purposes, etc. ################################## 5. What is capital structure? Explain the features and determinants of an appropriate capital structure.

3. The term working capital is commonly used for the capital required for day-to-day operations of a business. Generally, two concepts of working capital are the gross working capital and the net working capital. Gross refers to the firm's total investment in the current assets. Net supports the view that working capital is the difference of current assets and current liabilities. Net working capital may be positive or negative although gross working capital is always positive. According to the other school of thought (Net concept), the working capital refers to the difference between current assets and current liabilities. It is the excess of current assets over current liabilities. Current liabilities refer to the claims of outsiders which are expected to mature for payment within an accounting year and include creditors for goods, bills payable, bank overdraft, accrued expenses, etc. A

positive net working capital arises when current assets exceed current liabilities and a negative net working capital arises when current liabilities exceed current assets. 4. Both aspects have equal importance for management the first focuses the attention on the optimum investment in and financing of the current assets whereas the second indicates the liquidity position of the firm and suggests the extent to which working capital needs may be financed by permanent sources of funds. 5. A company starting with purchases of raw materials, components on a cash or credit basis. These materials will be converted into finished goods after undergoing the stage of work in process. For this purpose, the company has to make payments towards wages, salaries and other manufacturing costs. Payments to suppliers have to be makde on purchase in the case of cash purchases and on the expiry of credit period in the case of credit purchases. Further, the company has to meet other operating costs such as selling and distribution costs, general, administrative costs and non-operating costs as well as financial costs. In case the company sells its finished goods on a cash basis, it will receive cash along with profit with least delay. When it sells goods on a credit basis, it will pass through one more stage, viz., accounts receivable and gets back cash along with profit on the expiry of the credit period. 6. 7. Once again, the cash will be used for the purchase of materials and/or payment to suppliers and the whole cycle termed as working capital or operating cycle repeats itself. This process also indicates the dependence of each stage or component of working capital on its previous stage or component. 8. The dependence of one component of working capital on its previous stage/component is described above highlighting the interdependence among the components of working capital. However, there can be other kinds of inter-dependence which are not dictated by the usual sequence of manufacturing and selling operations. For example,

in case the manufacturing process may require a raw material which is in short supply. Then the company may have to make advance payment in anticipation of the receipt of that raw material. This will cause an immediate drain on cash resources unlike a situation where credit purchase of raw materials can be made. Similarly, if there is an excessive accumulation of finished goods inventory, the company may have to provide more liberal credit period and/or relax its existing credit standards which will increase sundry debtors. In situations of greater need for cash even providing cash discount as part of the credit terms for sale which is likely to boost the cash resources, may have to be resorted to. In such cases, the relative benefits and costs may have to be taken into consideration before taking decisions. 9. TYPES OF WORKING CAPITAL Working capital can be classified on the basis of its concept or on the basis of periodicity of its requirements. 10. (A) On the basis of Concept On the basis of its concept, the working capital may be divided into gross working capital and net working capital. Gross working capital is represented by the total current assets and Net working capital is the excess of current assets over current liabilities. Net working capital can be positive or negative. If current assets are in excess of current liabilities, it is positive net working capital and if current liabilities are in excess of current assets, it is negative net working capital. 11. (B) On the basis of Periodicity of Requirements Working capital can also be classified into Fixed or Permanent Working Capital and Temporary or Variable Working capital. 12. Permanent or Fixed Working Capital It represents that part of working capital which is permanently locked up in the current assets to carry out the business smoothly and efficiently. This investment in current assets is of a permanent nature and will increase as the size of the business expands. Examples are the investments required to maintain the minimum stock of raw

materials, work in progress, finished products, loose tools and equipments. It also requires minimum cash balance to be kept in reserve for the payment of wages, salaries and all other current expenditure throughout the year. The permanent fixed working capital can again be subdivided into Regular working capital and Reserve Margin or Cushion Working Capital. 13. Regular working capital is the minimum amount of liquid capital needed to keep up the circulation of the capital from cash to inventories, to receivable and again to cash. This would include sufficient minimum bank balance to discount all bills, maintain adequate supply of raw materials, etc. Reserve Margin or Cushion working capital is the excess over the needs or regular working capital that should be kept in reserve for contingencies that may arise at any time. These contingencies include rising prices, business depression, strikes, experiments with new products, etc. 14. Temporary or Variable Working Capital Variable working capital changes with the increase or decrease in the volume of business. It can also be sub-divided into Seasonal and Special. The working capital required to meet the seasonal liquidity of the business is seasonal working capital. On the other hand, special working capital is that part of the variable working capital which is required for financing the special operations such as extensive marketing campaigns, experiments with products or methods of production, special jobs, etc. 15. FACTORS AFFECTING WORKING CAPITAL The need of working capital is not always the same. It varies from year to year or even month to month depending upon a number of factors. There are no set rules or formulae to determine working capital needs of the firm. Each factor has its own importance and the importance of factor changes for a firm over time. In order to determine the proper amount of working capital of a concern, the following factors should be considered carefully:-

16. Nature of business: The amount of working capital is basically related to the nature and volume of the business. In concerns where the cost of raw materials to be used in the manufacture of a product is very large in proportion to its total cost of manufacture, the requirements of working capital will be large. On the contrary, concerns having large investments in fixed assets require lesser amount of working capital. 17. Size of the business unit: Size of the business unit is also a determining factor in estimating the total amount of working capital. The general principle in this regard is that the bigger the size, the larger will be the amount of working capital required since the larger business units are required to maintain larger inventories for the flow of the business. 18. Seasonal Variations: Strong seasonal movements create special problems of working capital in controlling the financial swings. A great many companies have to carry out seasonal business such as sugar mills, oil mills or woollen mills, etc. and therefore they require larger amount of working capital in the season to purchase the raw materials in large quantities and utilize them throughout the year. 19. Time Consumed in Manufacture: The average time taken in the process of manufacture is also an important factor in determining the amount of working capital. The longer the period of manufacture, the larger the inventory required. Though capital goods industries manage to minimise their investment in inventories or working capital by asking advances from the customers as work proceeds on their orders. 20. Turnover of Circulating Capital: Turnover means the ratio of gross annual sales to average working assets. In simple words, it means the speed with which circulating capital completes its rounds or the number of times the amount invested in working assets have been converted into cash by sale of the finished goods and re-invested in working assets during a year. The faster the sales, the larger the turnover. Conversely, the greater the turnover, the larger the volume

of business to be done with given working capital. 21. Labour v/s Capital Intensive Industries: In labour intensive industries, larger working capital is required because of regular payment of heavy wage bills and more time taken in completing the manufacturing process. The capital intensive industries require lesser amount of working capital because of the heavy investment in fixed assets and shorter period in manufacturing process. 22. Need to Stockpile Raw Material and Finished Goods: In industries, where it is necessary to stockpile the raw materials and finished goods, it increases the amount of working capital tied up in stocks and stores. In certain lines of business where the materials are bulky and best purchased in large quantities such as cement, stockpiling is usual. Such concerns require larger working capital. 23. Terms of Purchase and Sale: Terms (cash or credit) of purchase and sales also affect the amount of working capital. If a company purchases all goods in cash and sells its finished product on credit also naturally, it will require larger amount of working capital. On the contrary, a concern having credit facilities and allowing no credit to its customers, will require lesser amount of working capital. Terms and conditions of purchase and sale are generally governed by prevailing trade practices and by changing economic conditions. 24. Conversion of Current Assets into Cash: The need of having cash in hand to meet the day-to-day requirements, e.g. payment of wages and salaries, rents, rates, etc. has an important bearing in deciding the adequate amount of working capital. The greater the cash requirements, the higher will be the need of working capital. 25. Growth and Expansion: Growing concerns require more working capital than those which are static. It is logical to expect larger amount of working capital in a growing concern to meet its growing needs of funds for its expansion and/or diversification programmes though it varies with economic conditions and corporate practices.

26. Business Cycle Fluctuations: Business cycles affect the requirement of working capital. At times, when the prices are going up and boom conditions prevail, the tendency is to pile up a large stock of materials and to maintain a large stock of finished goods with an expectation to earn more profits. The other type of business cycle, i.e. depression involves in locking up of a big amount in working capital as the inventories remain unsold and book debts uncollected. 27. Profit Appropriation: Some firms enjoy dominant position in the market due to quality product or good marketing. On the other hand, a firm facing extremely tough competition may earn low margins of profits. A high net profit margin contributes towards working capital provided it is earned in cash. The working capital requirement will be estimated on how the cash available is used rightfully. The contribution towards working capital is affected by the way in which profits are appropriated and therefore it is affected by taxation, depreciation, reserve policy, etc. 28. Price Level Changes: The financial manager should also anticipate the effect of price level changes on working capital requirements of the firm. Generally, rising price levels will require higher amount of working capital since to maintain the same level of current assets, higher investment will be required. The effects of rising price levels will be different for different firms depending upon their price policies, nature of the product, ability to pass on the increase to the customer, etc. 29. Dividend Policy: There is a well established relationship between dividend and working capital in companies where conservative dividend policy is followed. The changes in working capital position bring about an adjustment in the dividend policy. A shortage of cash may induce the management for reducing cash dividend. On the other hand, strong cash position may justify higher cash dividend. 30. Other Factors: In addition to the above, there are a number of

other factors which affect the requirement of working capital. Some of them are the production and distribution policies, absence of specialisation in the distribution of products, means of transportation and communication infrastructure, hazards and contingencies inherent in a particular business, etc. THE PATTERN OF CAPITAL STRUCTURE VARIES WITH TIME AND ALSO THE ON THE ATTITUDE OF THE MANAGEMENT AT THE GIVEN TIME. The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds. The cost of equity is the return that ordinary stockholders expect to receive from their investment. The cost of loan stock is the rate, which the company must provide its lenders. The weighted average cost of capital (WACC) firms capital structure is the average of the cost of its equity, preferred stocks and loan stocks. An ideal mix of debt, preference stocks and common equity can maximizes the share prices. Debt capital is regarded, as cheap source of finance to the business but will also increase the finance risk of the company. Common stocks regarded as less risky but might lead to loss of voting rights if bought by outsiders. FACTORS INFLUENCING CAPITAL STRUCTURE Business risk Risk associated with the nature of the industry the business operates and if the business risk is higher the optimal capital structure is required. Tax position Debt capital is regarded as cheaper because interest payable is deductible for tax purposes. Advantage not much for businesses with unrelieved tax losses, depreciation tax shield as they already have an existing lower tax burden. Financial flexibility

Depends on how easy a business can arrange finance on reasonable terms under adverse conditions. Flexibility in raising finance will be influenced by the economic environment (availability of savers and interest rates) and the financial position of the business. Managerial style How much to borrow also depend on managers approach to finance risk. Conservative managers will usual try to keep the debt equity ratio low. BUSINESS AND FINANCE RISK Business risk The variability in operating income caused but inherent factors of the business other than debt financing. Can be influenced by changes in prices, variability of inputs, sales volume, and competition levels. Finance risk Additional variability in return that arises because the financial structure contains debt. Finance risk measured through gearing/leverages ratios. FINANCIAL GEARING Extent to which debt finances firms total capital structure Debt equity ratio: Total debt Total assets TIMES INTEREST EARNED Measures the firms ability to meet its annual finance interest payments. TIE RATIO = Earnings before interest and tax Interest charges OPERATIONAL GEARING Measures to what extent are fixed costs used in firms operations. Breakeven point analysis will measure the relationship between sales

volume, variable cost and the fixed costs. Breakeven point is the level of sales where the firm is neither making profits nor losses i.e. Sales value equals costs. Financial gearing can reach very high levels, with companies preferring to raise additional capital for expansion by means of loans rather than issuing new equity, but there are limits. Restrictions on further borrowing might be contained in the denture trust deed for a companys current debenture stocks in issue. Occasionally, there might be borrowing restriction in the articles of association. Lenders might want security for extra loan which the would be borrowers cannot provide. Lenders might simply be unwilling to lend more to a company with high gearing or low interest cover. Extra borrowing beyond a safe level will cost more interest. Companies might not be willing to borrow at these rates. Apart from the limitations stated above, there are other side effects associated with high gearing which may include the following: Financial distress where obligations to the conditions are not met or they are met with difficulties Costs: - Loss of key suppliers Uncertain customers Low asset value Loss of staff moral Legal costs Agency costs in trying to negotiate additional loan facilities through an agent. High interest rates Need to sign loan covenants thereby loosing financial freedom Borrowing cap Limits set by lenders on amount available Financial slack Highly geared firms fail to seize opportunities as they arise due to unwillingness of lenders for more fund advancements. High gearing might send bad signals on companys liquidity to employees as well as lenders Loss of decision making on certain areas to lenders due to loan

covenants Despite mentioning all the limitations and cost of high gearing mentioned above companys still uses debt capital. Apart from being cheaper than share capital the following attributes compels the company to use the debt capital. Motivation Regarded as cheaper source of income New issue stocks may dilute holding Operational and strategic staff more cautious on utilization of funds Flexibility in arrangement than equity =========================================== ===== The capital structure diagrams The capital structure consists of three parts; Short-Term Debt, Long-Term Debt and Equity. Below is how the proportional weight of the companys total capital is calculated. Short-term debt Where short-term debt is current liabilities, expiring within one year, including: accounts payables, current tax-liabilities as well as accrued expenses and deferred revenues SHORT TERM DEBT %= short term debt / debt+equity Long-term debt Long-term debt is the intermediate and long-term liabilities, expiring after one year, such as bank loans added with 28 % of the untaxed reserves which will be taxed once they are used for investments

LONG TERM DEBT % = long term debt + .28 [untaxed reserves] / debt + equity] EQUITY% = equity + .72 [untaxed reserves ] / debt + equity ]

the factor which determines the capital structure of a firm. Capital Structure - Presentation Transcript Capital Structure Meaning Factors influencing capital structure Optimal capital structure Point of Indifference Leverages Types of leverages Definition Capital structure of a company refers to the composition of its capitalisation and it includes all long term capital sources i.e., loans, reserves, shares and bonds. gerestenbeg the Capital structure of business can be measured by the ratio of various kinds of permanent loan and equity capital to total capital. Schwarty Factors affecting capital structure INTERNAL Financial leverage Risk Growth and stability Retaining control Cost of capital Cash flows Flexibility Purpose of finance Asset structure EXTERNAL Size of the company Nature of the industry Investors Cost of inflation Legal requirements

 Period of finance Level of interest rate Level of business activity Availability of funds Taxation policy Level of stock prices Conditions of the capital market Optimal capital structure The OCM can be defined as that capital structure or combination of debt and equity that leads to the maximum value of the firm OCM maximises the value of the company and hence the wealth of its owners and minimise the companys cost of capital. the following consideration should be kept in mind while maximising the value of the firm in achieving the goal of the optimal capital structure: If ROI > the fixed cost of funds, the company should prefer to raise the funds having a fixed cost, such as, debentures, Loans and PSC. It will increase EPS and MV of the firm. If debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductible expense in computation of tax. It should also avoid undue financial risk attached with the use of increased debt financing The Capital structure should be flexible. Point of indifference / Range of earnings The earnings per share, equivalent point or point of indifference refers to that EBIT, level at which EPS remains the same irrespective of Different alternatives of Debt-Equity mix. At this level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also known as the break-even level of EBIT for alternative financial plans Capital Gearing CG means the ratio between the various types of securities in the capital structure of the company. A company is said to e high-gear when it has proportionately higher/larger issue of Debt and PS for raising the LT resources. Whereas low-gear stands for a

proportionately large issue of equity shares. Leverage Leverage-an Increased means of accomplishing some purpose In financial management, it is the firms ability to use fixed cost assets or funds to increase the returns to its owners; Financial leverage- the use of long term fixed income bearing debt and preference share capital along with the equity share capital is called financial leverage or trading on equity A Firm is known to have a favourable leverage if its earnings are more than what debt would cost. On the contrary, if it does not earn as much as the debt costs then it will be known as an unfavourable leverage. Impact of financial leverage When the d/f b/w the earnings from assets financed by fixed cost funds and cost of these funds are distributed to the equity stockholders, they will get additional earnings without increasing their own investment. Consequently, the EPS and the Rate of return on ESC will go up. On the contrary, if the firm acquires fixed cost funds at a higher cost than the earnings from those assets then the EPS and return on equity capital will decrease. Significance of financial leverage Planning of capital structure Profit planning Limitations of FL/ trading on equity Double-edged weapon Beneficial only to companies having stability in earnings Increases risk and rate of interest Restriction from financial instruments Operating leverage Operating leverage results from the presence of fixed costs the help in magnifying net operating income fluctuations flowing from small variations in revenue. The changes in sales are related to changes in the revenue. The fixed costs do not change with the changes in sales, any increase in sales, FC remaining the same, will magnify operating revenue

 OL shows the ability of a firm to use fixed operating cost to increase the effect of change in sales and the charges in fixed operating income. Combined leverage The OL affects the income which is the result of production. On the other hand, FL is the result of financial decisions. The CL focuses attention on the entire income of the concern This leverage shows the relationship between a change in sales and the corresponding variation in taxable income. Working capital leverage This leverage measures the sensitivity of ROI of changes in the level of current assets.