Financial Management 1

INTRODUCTION TO FINANCIAL MANAGEMENT

1.1 FINANCE
Finance is the art and science of managing money or it may be defined as the provision of money
at the time when it is required. In today’s scenario it may be treated as the lifeblood of an
enterprise. Without adequate finance, no enterprise can possibly accomplish its objectives.

Finance

Public Finance Private Finance

- Personal Finance
-Govt. Institutions
- Business Finance
- State Govt.
- Finance of Non-Profit
-Central Govt. Orgnisation

1.2 FINANCE MANAGEMENT

Financial management is an integrated decision-making process concerned with acquiring,
financing, and managing assets to accomplish some overall goal within a business entity. Other
names for financial management include managerial finance, corporate finance, and business
finance.

Or Financial Management is that area of general management which is concerned with the timely
procurement of adequate finance from various sources and its effective utilization for the
attainment of organizational objective.

Or Financial Management is concerned with the duties of the financial managers in the business
firm. Financial managers actively manage the financial affairs of business.

According Howard and Upton, “Financial Management is the application of planning and control
functions to the finance function”.

According J.F. Bradley “Financial Management is an area of business management devoted to

judicious use of capital and a careful selection of source of capital in order to enable to spending
unit to move in the direction of reaching its goals.”

Financial management refers to the efficient and effective management of money (funds) in such a
manner as to accomplish the objectives of the organization.

1.3 APPROACHES TO FINANCE FUNCTION/ FINANCIAL MANAGEMENT

The approach to the finance function is divided into two broad categories:

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 Financial Management 2

(a) The Traditional Approach

The finance function was treated by the traditional approach in the narrow sense of procurement of
funds by business firm to meet their financing needs.
This approach is concerned with raising of funds used in an organization. It include
i) Instruments, institutions and practice through which funds are arranged.
ii) The legal accounting relationship between a company and its source of funds.
But this approach is criticized by the following reasons/ Limitations.
o Outsider-looking-in approach (completely ignores internal decision making as to the
proper utilization of funds).
o Ignored routine problems.
o Ignored working capital financing.
o No emphasis on allocation of funds.

(b) The Modern Approach

The modern approach views the term financial management in a broad sense and provides a
conceptual and analytical framework for financial decision making. According to it, the finance
function covers both acquisitions of funds as well as their allocations. Thus, apart from the issues
involved in acquiring external funds, the main concern of financial management is the efficient and
wise allocation of funds to various uses.
All these issues, which can also be termed as functions outline the scope of finance management,
are being given below.
i) Investment Decision
ii) Financing Decision
iii) Dividend Decision

Characteristics of Modern Approach

i) More emphasis on financial decisions
ii) Financial management as an important component of business management.
iii) Continuous function
iv) Broader view

1.4 SCOPE OF FUNCTION OF FINANCIAL MANAGEMENT/ FINANCIAL MANAGEMENT

DECISIONS/ FINANCIAL DECISIONS AREA
The finance manager of modern business firm will generally involve in the following three types of
decisions-
(a) Investment Decision
(b) Financing Decision
(c) Dividend Decision

(a) Investment Decisions are those which determine how resources in terms of funds available
are used for the project.
 Determine the total volume of funds available.
 Appraisal and selection of capital investment proposals.
 Measurement of risk and uncertainty in the investment proposals.
 Funds allocation
(b) Financing Decision The finance manager analyzes and selects the source of finance like
Equity or Debt.
 Determining the Debt. Equity mix.
 Raising of funds.
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 Financial Management 3

 Consideration of cost burden on the firm.

 Consideration of various modes of improving the earnings per share.
 Consideration of impact of over capitalization and under capitalization.

(c) Dividend Decision concerned with the determination of amount of profits to be distributed
to the owners or to be retained with the firm.
 Determination of dividend and retention policies of the firm.
 Consideration of impact of levels of dividend
 Consideration of possible requirement of funds.

1.5 OBJECTIVES OF FINANCIAL MANAGEMENT

The objective provides a framework for optimum financial decision making. They are concerned
with designing a method of operating the internal investment and financing of a firm.
A Goal of the firm may be defined as a target against which the firm’s operating performance can
be measured. The objective specifies what the decision maker is trying to accomplish and, by doing
so, by doing so, provides a frame work for analyzing different decision rules. In most cases, the
objective is stated in terms of maximizing some function or variable (profit, size, value, social
welfare, etc.).

The following two are often considered as the objectives of the financial management:
1. The maximization of the profit of the firm, and
2. The maximization of the shareholder wealth.

1.5.1 Profit maximization

For any business firm, the maximization of the profits is often considered as the implied objective.
Profitability objective may be stated in terms of profits, return on investment, or profit-to-sales
ratios. According to this objective, all such actions as increase income and cut down costs should
be undertaken and those that are likely to have adverse impact on profitability of the firm should
be avoided. There are some arguments in favour of profit maximization few of them are given
bellow.
o Measurement of Performance
o Efficient Allocation and Utilization of Resources (move from less profit business to more
profitable one)
o Maximization of Social Welfare
o Source of Incentive
o Helpful in facing adverse Business Conditions
o Helpful in the growth of the firm

Criticisms of Profit Maximization

There are various problems with the profit maximization as the objective of financial management.
Some of these are follows:

o It ignores the risk

The profit maximization does not take into account the amount of risk which the undertake in
attempting to increase the profits. With profit maximization as the objective, the management may
undertake all profitable investment opportunities regardless of the associated risk.

o It is vague and ambiguous

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It is not clear in what sense the term profit has been used. It may be total profit before tax or after
tax or profitability rate. Rate of profitability may again be in relation to share capital, owner’s funds
total capital employed or sales.
o It ignores time value factor
All the monetary benefits and costs are considered in the absolute terms without adjusting for time
value.
o It is a narrow concept
It is a narrow concept which does not take into account social considerations and the interest of
other parities.
o It is a short term approach
It emphasizes the short-term profitability and short-term projects.

1.5.2 Wealth Maximization

In the theory of financial management, it is well accepted that the objective of financial
management is the maximization of shareholder wealth.
The measure of wealth which is used in financial management is the concept of economic value.
The economic value of the shareholders wealth is the market price of the share which is the
present value of all future dividends and benefits expected from the firm.
Therefore, maximization of shareholders wealth as an objective of financial management implies
that the financial decisions will be taken in such a way that the shareholders receive highest future
value benefits.
The wealth maximization goal is advocated on the following grounds:
o It takes into consideration long-run survival and growth of the firm.
o It suggests the regular and consistent dividend payments to the shareholder.
o It considers the risk and time value of money.
o It considers all future cash flows, dividends and earnings per share.
o Profit maximization partly enables the firm in wealth maximization.
o The shareholders always prefer wealth maximization rather than profit maximization.

Criticisms of Profit Maximization

o It is a prescriptive idea. The objective is not descriptive of what the firms actually do.
o The objective of wealth maximization is not necessarily socially desirable.
1.5.3 Profit Maximization V/s Wealth Maximization
The objective of profit maximization measures the performance of a firm by looking at its total
profit. It does not consider the risk which the firm may undertake in maximization of the profits.
This may affect the wealth of the shareholder in future.
On the other hand, the objective of maximization of wealth considers all future cash, dividends,
earnings per share, risk of a decision, etc. for the maximization of wealth firm may sacrifice the
present profit.
On the whole, the maximization of the shareholders wealth seems to be normative goal towards
which the firm should strive. A finance manager though operating with the objective of
maximization of shareholders wealth need not undermine the importance of goals. He must take
decisions only after thinking about the relevant considerations.

1.5.4 Other Maximization Objectives

 Sales maximization
 Growth maximization
 Return on Investment maximization \
 Social Objectives

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1.6 Importance of Financial Management

 Helpful in acquiring sufficient funds
 Proper utilization of funds
 Proper cash management
 Proper use of profits
 Maximization of wealth
 Useful of shareholders
 Useful of Investors
 Useful for Banks Financial Institutions etc.

TIME VALUE OF MONEY

2.1 THE VALUE OF MONEY

The value of money means the purchasing of the money.

Concept of Time Value of Money

The TVM means the value of a unit of money is different in different time period. In other words,
the money receivable in future is less valuable than the money received today.

2.2 REASON OF TIME VALUE OF MONEY

2.2.1 Inflation
Under inflationary conditions the value of money, expressed in terms of its purchasing power over
goods and services, declines.

2.2.2 Risk/ Future uncertainties

Re. 1 now is certain, whereas Re. 1 receivable tomorrow is less certain means involve risk..

2.2.3 Personal Consumption Preference

many individuals have a strong preference for immediate rather that delayed consumption.

2.2.4 Investment opportunities

Everybody has preference for present money because they have investment opportunities available
to them. If they have got the money, they can invest this money to get further returns on this.

To make the logical and meaningful comparisons between cash flows that result in different time
periods it is necessary to convert the sum of money to a same time period. There are two
techniques for doing this:

2.3 TECHNIQUES OF TIME VALUE OF MONEY

o Compounding
o Discounting/ Present Value

2.3.1 Compounding Techniques

The process of calculating future values of cash flows and

It is same as compounding interest technique where the interest of one period is added in the
principal value to find out the principal value for the next period.

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The time period for compounding the interest may be annual, semi-annual or any other regular
period of time.
𝐹𝑉 = 𝑃𝑉 (1 + 𝑖)𝑛

Where, FV = Amount at the end of 'n' period

PV = Principle amount at the beginning of the 'n' period
i = Rate of interest per payment period (in decimal)
n = Number payment periods

Example
If Mr. A invested Rs. 100 is invested at 10% compounding interest for 3 Years then calculate the
amount which Mr. A receive after 3 years.
FV = PV (1+ i)n
= 100 (1 + .10)3
= 133.1 Rs.
2.3.2 Present Value/ Discounting Technique

The process of calculating present values of cash flows. In this technique the reverse
compounding process is used to calculate the present value of future cash inflows.

𝐹𝑉
𝑃𝑉 =
(1 + 𝑖)𝑛
Where, FV = Amount at the end of 'n' period
PV = Principle amount at the beginning of the 'n' period
i = Rate of interest per payment period (in decimal)
n = Number payment periods
Example
If Mr. A expects to get Rs. 1000 after 3 year at the rate of 10%. Then calculate the amount he will
have to invest today.

PV = FV / (1+ i)n
= 1000 / (1 + .10)3
= 751.31 Rs.

Calculation of EMI
Example
Suppose you have borrowed a 3 year loan of Rs. 10000 at 9% from a bank to buy a motorcycle. If
your bank requires three equal end-of-year repayments, then the annual installment will be

PV = 𝐴 𝑥 𝑃𝑉𝐴𝐹

PV = Present Value
A = Annuity (EMI)
10000 = A x PVFA3,0.09
10000 = A x 2.531
A = 10000/2.531
= Rs. 3951

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SOURCE OF FINANCE

Sources of
Finance

Ownership Creditorship Internal Loan

Captial Securities Financing Financing

Retained Commercial
Equity Shares Debentures
Earnings Bank

Preference
Depreciation Trade Credit
Shares

Factoring

Advances

Commercial
Papers

Public
Deposits

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 Financial Management 8

3.1 OWNERSHIP SECURITIES

The term ‘ownership securities,’ also known ‘capital stock’ represents shares.

Meaning of Share
A “share” represents a part of capital in a company. A share may be defined as one of the units
into which the share capital of a company has been divided.
The person holding the share is known as a shareholder.

Type of Share

Equity Share Preference Share

3.1.1 Equity Share

Equity shares, also known as ordinary shares or common shares represent the owner’s capital in
the company. The holders of these shares are the real owners of the company. They have a control
over the working of the company. The rate of dividend on these shares depends upon the profits of
the company. Equity share capital cannot be redeemed during the life time of the company.

Features of Equity Share

 Permanent capital
 Claim on Income
 Claim in assets
 Right to control
 Voting right
 Pre-emptive rights (Right to purchase new share)
 Limited liability

Pros/ Merits of Equity financing

 Permanent capital
 No fixed burden for payment
 Borrowing base(Improve borrowing limits)
 In case of profits, equity shareholders are the real gainers

Cons/ Demerits of Equity financing

 More Costly in prosperous periods
 Risky
 Over capitalization
 Uncertainty and irregularity of income
 Possibility of capital loss

3.1.2 Preference Share

Preference share are those which carry the following preferential rights over other class of share:
i) A preferential right in respect of dividend.
ii) A preferential right as to repayment of capital in case of winding up of the company in
priority to other classes of share.

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Types of Preference Shares

 Cumulative Preference Shares

These shares have a right to claim dividend for those years also for which there are no profits.
 Non-Cumulative Preference Shares
The holders of these shares have no claim for the arrears of dividend.
 Redeemable Preference Shares
These shares can be redeemed after a particular time period.
 Irredeemable Preference Shares
Those shares which cannot be redeemed unless the company is liquidated are known as
irredeemable preference shares.
 Participating Preference Shares
The holders of these shares participate in the surplus profits of the company. They are firstly paid a
fixed rate of dividend and then a reasonable rate of dividend is paid on equity shares. If some
profits remain after paying both these dividends, then preference shareholders participate in the
surplus profits.
 Non-Participating Preference Shares
The shares on which only a fixed rate of dividend is paid are known as non-participating preference
shares. These shares do not carry the additional right of sharing of profits of the company.
 Convertible Preference Shares
The holders of these shares may be given a right to convert their holdings into equity shares after
a specific period.
 Non-Convertible Preference Shares
The shares which cannot be converted into equity shares are known as non-convertible preference
shares.

Features of Preference Shares

 Claim on income & assets
 Fixed dividend
 Maturity
 Participation feature (Extraordinary Profit)
 Convertibility
 Voting rights (can vote on resolution which affects the rights attached to his preference
shares like- winding up the company)
 Hybrid form of security (includes some features of equity and other debt financing)

Pros/ Merits of Preference Share

 Long-term capital
 Payment of a dividend is not a legal obligation
 Limited voting rights
 Cushion for debenture holders
 Don’t have direct charge against the assets
 Fix rate of dividend
 Cheaper than Equity

Cons/ Demerits of Preference Shares

 Commitment to pay dividend
 Higher fixed cost

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 Reduce the claim of Equity Share

 Loss of tax benefits (Preference Share dividend is not a deductible expense while calculating
tax while interest is a deductible expense.)
 Pave the way to insolvency (It may open the way for the insolvency of the company in
cases where the directors continue to pay dividends on them in spite of lower profit to
maintain their attractiveness.)

3.2 CREDITORSHIP SECURITIES

The term ‘creditorship securities’, also known as ‘debt capital’, represents debentures and bonds.

3.2.1 Debentures
A debenture is a promissory note issued by a company as an evidence of a debt due from the
company.

It may with or without a charge on the assets of company. Debentures are generally issued by
private sector companies.

Or debt instrument that promises to pay a fixed annual sum as interest for specified period of time.

According to the Companies Act, the term debenture includes “debenture stock, bonds and any
other securities of a company whether constituting a charge of the assets of a company or not.”

Features of Debentures
 Interest rate
 Face value
 Maturity
 Claims on Income (have also priority over stockholder )
 Claims on assets
 Control

Pros/ Merits of Debenture

 Provide a long-term funds
 Lower interest rate
 Interest on debenture is a tax deductible
 No dilution of control
 Trade on Equity
 Redemption is possible with the availability of funds

Cons/ Demerits of Debenture

 Fixed burden of Interest
 Debt financing increase the risk perception of investors
 Cost of raising finance due to high stamp duty
 Not good in case of unstable income

Types of Debentures

 Simple/ Naked/ Unsecured Debenture or Secured/ Mortgaged Debenture

These debentures are not given any security on assets. They have no priority as compared to other
creditors.

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These debentures are given security on assets of the company. In case of default in the payment of
interest or principal amount, debenture holders can sell the assets in order to satisfy their claims.

 Bearer or Registered Debenture

Registered debenture can be registered with the company in the name of debenture holder and
transferable only by a regular transfer deed.
Bearer debentures are payable to the bearer and are transferable by delivery.

 Convertible, Non-convertible and Partly convertible

Convertible debentures can be converted into equity shares of the company as the terms.
Non-convertible Debentures cannot be converted into equity shares of the company.
Partly Convertible Debenture consists of two parts namely convertible and non-convertible. The
convertible portion can be converted into shares after a specific period.

 Redeemable or Irredeemable Debenture

Redeemable debentures are payable after a specified time.
Irredeemable debentures can be redeemed only in the event o f the company’s winding up.

 Zero Coupon Bonds

Zero coupon bonds do not carry any interest but it is sold by the issuing company at deep discount
from its eventual maturity value. The difference between the issue price and the maturity value
represents the gain or interest earned by its investor.

 First Debentures and Second Debentures

From the view of priority in the payment of interest and repayment of principal amount, the
debentures may be first debentures or second debentures. The debentures which have to be paid
back first or who have preference over other debentures in payment of interest or called first
debentures which rank after these are known as second debentures.

 Guaranteed Debentures
These are debentures or bonds on which the payment of interest and principal of is guaranteed by
third parties, generally, banks and govt., etc.

 Collateral Debentures
A company may issue debentures in favour of a lender of money, generally the banks and financial
institutions, as collateral.

Note: Generally private sector companies issue debentures and public sector and financial
institutions issue bonds.
Debentures may be convertible into equity shares while bonds are not

Comparative Picture of Long Term Sources of Finance

(For the point of view of company)

Cost Control Risk

Equity Capital High Yes High
Preference Capital High No Negligible
Debenture Low No Nil
Term Loans Low No Nil

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3.3 LOAN FINANCING

3.3.1 Commercial Banks

Commercial banks are the most important source of short-term capital. They provide a variety of
loans to meet the specific requirements of a concern. For example:
 Loans
 Cash Credits
 Overdrafts
 Purchasing & Discounting of bills

3.3.2 Trade Credit

Trade credit refers to the credit extended by the suppliers of goods in the normal course of
business.

3.3.3 Advances
Some business houses get advances from their customers and agents orders and this source is
source of finance for them. It is cheap source of finance.

3.3.4 Commercial Papers

Commercial paper represents unsecured promissory notes issued by firms raise short-term funds.

3.3.5 Public Deposits

Under some regulation companies can accept public deposits, which is also a source of finance.

3.3.6 Factoring
Factoring is a form of financing in which a business (client) sells its receivables to a third party
called factor (Financial institution/ financing company) at a discounted price.
3.4 INTERNAL FINANCING
Internal financing means arraigning funds from inside the company.

3.4.1 Retained Earnings or Ploughing Bank of Profits

Under this technique of financial management under which all profits of a company are not
distributed amongst the shareholders as dividend, but a part of profits is retained or reinvested in
the company.

3.4.2 Depreciation as a Source of Funds

In simple words depreciation is the gradual decrease in the value of an asset due to wear & tear, use and
passage of time. In real sense, depreciation is simply a book entry having the effect of reducing the book value of
the asset and the profits of the current year for the same amount. Depreciation is an operating cost there is no
actual outflow of cash.

INTERNAL FINANCING
Source of Finance

External Source Internal Source

Debenture Retained Earning
Loan etc. Depreciation

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Internal Finance
Financing an enterprise through its internal sources is known as internal financing. Such internal
resources comprise of earnings retained and depreciation.
Main Sources of Internal Financing
1. Retained earnings
2. Deprecation fund

Factors Affecting Source of Internal Financing

1. Dividend Policy
2. Level of earnings
3. Depreciation Policy
4. Taxation Policy of Government

Source of Finance
 According to Time Period
 Long-Term Source
Share, Debenture, Long-term loans, etc.
 Short-Term Source
Advances from commercial banks, public deposits, advances from customers and trade
creditors.
 According to Ownership
 Own Capital
Share Capital, Retained Earnings and Surplus, etc.
 Borrowed Capital
Debentures, public deposits and loans, etc.
 According to Source of Generation
 Internal Sources
Retained Earnings and depreciation funds, etc.
 External Sources
Securities such as shares and debentures, loans, etc.

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INVESTMENT DECISION/ CAPITAL BUDGETING

Meaning of Project
The term project refers to current outlay of funds in the expectation of a stream of benefits/
returns in the future.

Capital Budgeting

The Capital Budgeting is the process of evaluation and selecting long-term investment. It includes
heavy initial cash outflow and returns are expected over a long period.
Example New machine installation, new projects, or expansion of existing business.

Milton H. Spencer “Capital budgeting involves the planning of expenditures for assets the returns
from which will be realized in future time periods.”

Features or Significance
 Long-term effects
 Major effect on the profitability
 Irreversible decision
 Affect the capacity and strength to compete

Types of Capital Budgeting Decisions

(1) New Firm (2) Existing Firm

(a) Expansion
(b) Diversification
(c)Replacement and modernization
Factors affecting investment decision
a) Technological change
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b) Competitor’s strategy
c) Type of management
d) Govt. Policy
e) Cash flow
f) Return expected from investment

Difficulties in Capital Budgeting

a) Future uncertainty
b) Involvement of heavy funds
c) Long-term implications
d) Measurement problem

Key Words
Cash Flow This is the flow of cash into the firm or out of the firm.
Discount Rate The rate at which cash flows are discounted. This rate may be taken as
required rate of return on capital or cost of capital.

Capital Budgeting Decision Process

Project Project Project Project Follow-up

Generation Evaluation Selection Execution

Payback Period
Accounting Rate of Return
Cash Flow Estimates Selection of Net Present Value
Appraisal Methods Profitability Index
Internal Rate of Return

Risk Return

Trade-off

Market value per share

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Capital Budgeting Process

Project Generation

Project Evaluation

Techniques of
Evaluation
Estimation of costs and benefits of a proposal 1. Payback
Period
2. Accounting
Estimation of the required rate of return Rate
of Return
3. Net Present
Using the capital budgeting decision criterion Value
4. Profitability
Index
5. Internal Rate
of
Return

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Project Selection

Project Execution

INTRODUCTION TO EVALUATION TECHNIQUES

Capital Budgeting Techniques

Traditional / Non- Time adjusted /

discounting discounted

Payback Period Net Present Value

Accounting Rate of Return Profitability Index
Internal Rate of Return
TRADITIONAL/ NON-DISCOUNTING TECHNIQUE
The traditional techniques of average rate of return (ARR) and payback methods are simple and
not considering the time value of money aspect.

(1)PAYBACK PERIOD it is defined as number of years required to recover the cost of the
project.

(I)WHEN ANNUAL CASH INFLOWS ARE EQUAL

Payback Period= Cash Outlay (Investment)
Annual Cash Flow

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Illustration:- A project requires an outlay of Rs.50,000/- and annual cash inflow of Rs.12,500/-
for 7 Years. Calculate the Payback period for the project.

Payback Period = 50000 / 12500 = 4 Years Ans.

(II)WHEN ANNUAL CASH INFLOWS ARE NOT EQUAL

Payback Period= Previous Year + Investment – CCF up to previous year

Cash inflow in Present year
Illustration:
The following are the details relating to the project:
Cost of the project is 200000/-
Year Cash Flow Cumulative Cash Flow
1 40000 40000
2 60000 100000
3 70000 170000
4 50000 230000
5 35000 265000

3 Yrs + 30000/ 50000 = 0.6

= 3.6 Yrs

The Decision Rules:

Accept PB < Standard Payback
Reject PB > Standard Payback

Advantages
 Simplicity
 Cost effective
 Short-term effects
 Risk shield
 Liquidity
Disadvantages
 It fails to account of the cash flows earned after the payback period.
 It is not appropriate method of measuring the profitability of an project.
 It ignore time value of money
 It ignore cost of capital

(2)ACCOUNTING RATE OF RETURN It is also known as Rate of Return (ROI). It is a return on

investment by using accounting profit of a project. It may be defined as the net income earned on
the average funds invested in a project. It is computed as follows:

ARR= Average annual profit (after tax)

Average investment X100
Where,
Average Investment= ½ (Initial cost of Machine – Salvage value) + Additional working
capital+ Salvage value
Decision Rule
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Accept project when ARR > minimum rate

Reject project when ARR < minimum rate

Illustration
Bharat Electricals Ltd. Is thinking to buy a machine:

Machine A
Life 3 Years
Investment 200000
Income (After tax)
I year 60000
II Year 40000
III Year 20000

Calculate the average rate of return on investment and advice on the selection of the machine.
Project will be accepted if ARR is more than 25%.
Solution:
Mach. A
Average Income after tax= 60000+40000+20000
3
= 40000/-
Average Investment= ½ (Initial cost of Machine – Salvage value)+ Additional working capital+
Salvage value
= ½ (200000-0)+0+0
=100000/-
Average Rate of Return= 40000
100000 X100 = 40%

Advantages
 Simplicity
 Accounting profitability
 Consider all the profits received during the life of the project.
Disadvantages
 Cash flows ignored
 Time value ignored
 Ignore other factors affecting the profitability
 No consideration for the amount invested in different projects

TIME ADJUSTED / DISCOUNTED Technique

The distinguishing characteristics of the discounted cash flow capital budgeting is that they take
into consideration the time value of money while evaluating the costs and benefits of a project. All
the methods under this require cash flows to be discounted at a certain rate.

(1)NET PRESENT VALUE

In this method the sum of the present value of all the cash outflows are deducted from the sum of
the present value of all the future cash inflows.

A rate of discount is used to calculate the present value of inflows and outflows.
It may be calculated as follows:
Dr. Himanshu Jain, PIET
 Financial Management 20

NPV= PV of cash inflow – PV of cash outflow

Decision Rule
 Accept the project when NPV is positive NPV > 0
 Reject the project when NPV is negative NPV < 0
 May accept the project when NPV is zero NPV = 0
WHEN CASH INFLOWS ARE EVEN
Illustration
Calculate NPV of an initial investment of Rs. 200000/- which periods a net cash inflow of 60000/-
every years. Assume required rate of return to be 8%. There is no scrape value.
=Cash inflows X PVAF6,8% - cash outflow
= (60000 x4.63)- 200000/-
= 77380/-
Thus NPV 77380/- is positive value the proposal should be accepted.

WHEN CASH INFLOWS ARE UNEVEN

Illustration:
A proposal having initial investment of Rs.2500/- Expected annual cash inflows.

Year Cash
inflows
1 900/-
2 800/-
3 700/-
4 600/-
5 500/-
Find out the proposal should be accepted or not. If the discount rate or required rate of return is
10% P.A.
Year Cash Flows PVF @ 10% Present
Value
1 900 0.909 818
2 800 0.826 661
3 700 0.751 526
4 600 0.683 410
5 500 0.621 310
Total 2725

NPV= PV of cash inflow – PV of cash outflow

= 2725-2500
= 225

Thus NPV 225 is positive value the proposal should be accepted.

Dr. Himanshu Jain, PIET

 Financial Management 21

Or

NPV= CFo + CF1 + CF2 ---------CFn + SV + WC -CO

(1+ r)0 (1+ r)1 (1+ r) 2
(1+ r)n (1+ r)n

Where
CO =Cash outflow at time 0
CF1 =Cash inflow at different

r = Rate of interest
SV = Salvage Value
WC = (1+r) n

 Rs 900 Rs 800 Rs 700 Rs 600 Rs 500 

NPV        Rs 2,500
 (1+0.10) (1+0.10)
2 3
(1+0.10) (1+0.10) 4
(1+0.10)5 
NPV  [Rs 900(PVF1, 0.10 ) + Rs 800(PVF2, 0.10 ) + Rs 700(PVF3, 0.10 )
+ Rs 600(PVF4, 0.10 ) + Rs 500(PVF5, 0.10 )]  Rs 2,500
NPV  [Rs 900  0.909 + Rs 800  0.826 + Rs 700  0.751 + Rs 600  0.683
+ Rs 500  0.620]  Rs 2,500
NPV  Rs 2,725  Rs 2,500 = + Rs 225

Advantages
a) Consider time value
b) Measure of true profitability
c) Consider the entire life of project
d) Easier to calculate among the discounting techniques

Disadvantages
a) Difficult to determine discount rate
b) Difficult then PBP & ARR
c) Sensitive to discount rate

(2)Profitability Index
Profitability index is the ratio of present value of the inflows to the cash outflows of the investment.
PI measures the present value of return per rupee invested.
This is another time-adjusted capital budgeting technique. It is also benefits cost ratio. It is similar
to NVP technique.
PI= Present value of cash inflows
Present value of cash outflows
Decision Rule
 When PI > accept the project
 When PI < reject the project
 When PI = Proposal may or may not accepted
Illustration:
A proposal having initial investment of Rs.2500/- Expected annual cash inflows.

Year Cash
inflows

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 Financial Management 22

1 900/-
2 800/-
3 700/-
4 600/-
5 500/-
Find out the proposal should be accepted or not. If the discount rate or required rate of
return is 10% P.A.
Year Cash Flows PVF @ 10% Present
Value
1 900 0.909 818
2 800 0.826 661
3 700 0.751 526
4 600 0.683 410
5 500 0.621 310
Total 2725

PI= Present value of cash inflows

Present value of cash outflows

=2725
2500 = 1.09

Advantages
 Simple and very easy to understand
 Consider the time value of money
 Consider the all cash flows during the life of the project.
Disadvantages
 Not useful when small projects are to be compared with large project.

(3)INTERNAL RATE OF RETURN The IRR of a project is defined as the discount rate which
produces a zero NPV (NPV= 0). The IRR is the discount rate which will equate the present value of
cash outflows. It is also known as Marginal Rate of Return or Time Adjusted Rate of Return.
NPV (0)= CFo + CF1 + CF2 ---------CFn + SV+WC -CO
(1+ r)0 (1+ r)1 (1+ r)2 (1+ r)n (1+ r)n

Where
CO =Cash outflow at time 0
CF1 =Cash inflow at different
r = Rate of interest
SV = Salvage Value
WC = Working Capital

Advantages
 No pre-determination of discounting rate
 Consider the time value of money
 It considers all cash flows.
 It is a good measure of profitability.
Disadvantages
Dr. Himanshu Jain, PIET
 Financial Management 23

 Calculations are tedious and time consuming

 Does not differentiate satisfactorily between projects of different lives.

WHEN CASH IS FLOWS ARE EQUAL

Illustration
A firm is evaluating a proposal costing Rs. 100000/- and having annual inflows of Rs. 25000/-
occurring at the end of each of next 6 years.

Step-I
The payback period in the given case is 4 years. Now, search for a value nearest to 4 in the 6 th
year row of the PVAF table. The closest figures are given in rate 12% (4.111) and the rate 13%
(3.998) means that the IRR of the proposal is expected to lie between 12% & 13%.

Step-2
In order to make a precise estimate of the IRR, find out the NPV of the project for both these rates
as follow:
At 12%, NPV = (Rs. 25000/-x 4.111)- Rs. 100000/-
= 2775/-
At 13%, NPV = (Rs. 25000/-x 3.997)- Rs. 100000/-

IRR= L + A x (H-L)
(A-B)

= 12%+ 2775 x (13-12)

2775-(-50)

=12.98% Ans
Where,
L= Lowest discount rate
H= Highest discount rate
A= NPV at L rate
B =NPV at H rate

WHEN CASH FLOWS ARE UNEQUAL

Illustration
A project costing Rs. 160000/-
Estimate life 5 Yrs
Year Cash
1 Inflows
40000
2 60000
3 50000
4 50000
5 40000

Solution
Step-1 Find out weight average of cash inflows.
Dr. Himanshu Jain, PIET
 Financial Management 24

Year Cash Weight CF x W

1 Inflow
40000 5 200000
2 60000 4 240000
3 50000 3 150000
4 50000 2 100000
5 40000 1 40000
15 730000

Weight Average = 730000

15 = 48667
Step-2 Consider the weighted average as the annuity of cash inflow and find out payback period
i.e.

= 160000
48667 = 3.288
Step-3
Now search the value 3.288 in 5 Yrs row of eh PVAF table. The closest figure is at 15% [3.352] &
16% [3.274]. This means IRR of the proposal is expected to be b/w 15% & 16%.

Step-4 Find out the NPV of the project on both of these rates
Year Cash Inflow PVF Present Value PVF (15%) Present
(16%) (16%) Value (15%)
1 40000 0.862 34480 0.870 34800
2 60000 0.743 44580 0.756 45360
3 50000 0.641 32050 0.658 32900
4 50000 0.552 27600 0.572 28600
5 40000 0.476 19040 0.497 19880
157750 161540

At 16% NPV = 157750- 160000 = -2250

At 15% NPV = 161540- 160000 = 1540

Step-5
IRR= L + A x (h-L) = 15 + 1540 x (16-15) = 15.40% Ans
A-B 1540-(2250)

Where,
L= Lowest discount rate
H= Highest discount rate
A= NPV at L rate
B =NPV at H rate

Risk and Uncertainty in Capital Budgeting Decision

Risk and uncertainty are quite inherent in capital budgeting decision. Future is uncertain and
involves risk. The risk associated with a project may be defined as the variability that is likely to

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 Financial Management 25

occur in the future cash inflows from the project. All the capital evaluation techniques are based on
cash inflow related with a project. The cash flows are uncertain till its occurrence.
Types and source of Risk in capital budgeting
1. Project specific risk [management]

2. Competition risk

3. Industry specific risk [Legal risk, technological risk ]

4. International risk [Exchange rate movement, political change]

5. Market risk [Change in interest rate, Inflation, economic condition]

TECHNIQUES OF HANDLING RISK AND UNCERTAINTY IN CAPITAL BUDGETING

So it is mandatory to consider risk factors while evaluating different investment proposal. There are
several technique to available to handle the risk perception of capital budgeting proposal. Few of
them are given below:

A. Traditional/ Conventional Techniques

 Payback Period
 Risk adjusted Discount Rate
 Certainty Equivalents
 Sensitivity Approach
 Financial Break-Even
B. Statistical Techniques
 Probability Distribution Approach
 Simulation Analysis
 Decision Tree Approach
Traditional Techniques
These techniques are also known as traditional or non-mathematical technique techniques to
evaluate risk. These approaches are simple and based on theoretical assumptions.

 Payback period In PB method the preference goes to that project which have shorter time
period for recovery of investment. The shortening of the target payback period is based on
the assumption that larger the recovery period, more risky the proposal would be. But PB
method reduces only that risk which arises due to time period and thus allows for other
risks.

 Risk adjusted Discount Rate The amount of risk in the project is inbuilt in the discount
rate to make the present value calculation. The discount rate would be high when the risk is
high and the discount rate is comparatively lower when the risk is low.
Dr. Himanshu Jain, PIET
 Financial Management 26

 Certainty Equivalents The CE approach attempts at adjusting the future cash flows
instead of adjusting the future cash flows instead of adjusting the discount rates. The
expected future cash flows which are taken as risky and uncertain are converted into
certainty cash flows.

 Sensitivity Approach it provides information as to how sensitive the estimated project

parameters, namely, the expected cash flow, the discount rate and the project life. Means
Sensitivity analysis takes care of estimation errors by using a number of possible outcomes
in evaluating projects.

For exp. Sensitivity analysis provides different cash flow estimates under three assumption.
(i) the worst (i.e. the most pessimistic), (ii) the expected (i.e. the most likely), and (iii)
the best (i.e. the most optimistic) outcomes associated with the project.
Statistical Technique
 Decision-tree Approach is a pictorial representation in tree form which indicates the
magnitude, probability and inter-relationship of all possible outcomes. Every possible
outcome is weighted in probabilistic terms and then evaluated. The DT approach is
especially useful for situations in which decision at one point of time also affect the decisions
of the firm at some later date.

 Probability distribution

COMPARISON BETWEEN NPV AND IRR

NPV and IRR are similar in the sense that both are time adjusted value method/ discounted cash
flow techniques.
Difference
 In NPV method a predetermined discount rate is used and IIR method, the cash flows
are discounted at a suitable rate by hit and trial method which equates the present value
so calculated to the amount of the investment.

 The NPV method recognizes the importance of market rate of interest or cost capital
and IIR method does not consider the market rate of interest and seeks to determine the
maximum rate of interest at which funds invested in any project could be repaid with the
earnings generated by the project.

 The basic presumption of NPV method is that intermediate cash inflows are reinvested
at the cut off rate whereas, in the case of IRR method intermediate cash flows are
presumed to be reinvested at the internal rate of return

 The results shown by NPV method are similar to that of IRR method under certain
situations, whereas, the two give contradictory results under some other circumstances.

Similarities
Both methods would show similar results in terms of accept or reject decisions in the following
cases:
 Independent investment proposals which do not compete with one another and which may
be either accepted or rejected on the basis of a minimum required rate of return.

 Conventional investment proposals which involve cash outflows in the initial period followed
by a series of cash inflows.

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 Financial Management 27

The reason for similarity of results in the above cases lies in the basis of decision making in the two
methods. Under NPV method, a proposal is accepted if its net present value is positive, whereas,
under IRR method it is accepted if the internal rate of return is higher than the cut off rate. The
projects which have positive net present value, obviously, also have an internal rate of return
higher than the required rate of return.

Conflict between NPV and IRR Results

In case of mutually exclusive investment proposals, which compete with one another in such a
manner that acceptance of one automatically excluded the acceptance of the other, the NPV
method and IRR method may five contradictory results, the net present value may suggest
acceptance of one proposal whereas, the internal rate of return may favour another proposal. Such
conflict in ranking may be caused by any one or more of the following problems:
 Significant difference in the size (amount) of cash outlays of various proposals under
consideration.

 Problem of difference in the cash flow patterns or timings of the various proposals, and

 Difference in service life or unequal expected lives of the projects.

In such cases, while choosing among mutually exclusive projects, one should always select the
project giving the largest positive net present value using appropriate cost of capital or
predetermined cut off rate. The reason for the same lies in the fact that the objective of a firm is to
maximize shareholder’s wealth and the project with the largest NPV has most beneficial effect on
share prices and shareholder’s wealth. Thus, the NPV methods are more reliable as compared to
the IRR method in ranking the mutually exclusive projects. In fact NPV is the best operational
criterion for ranking mutually exclusive investment proposals.

Conventional Cash Flow

Initial cash outflow is followed by only a series of inflows.
A series of inward and outward cash flows over time in which there is only one change in the cash
flow direction. A conventional cash flow for a project or investment is typically structured as an
initial outlay or outflow, followed by a number of inflows over a period of time. In terms of
mathematical notation, this would be shown as -, +, +, +, +, +, denoting an initial outflow at time
period 0, and inflows over the next five periods.

'Unconventional Cash Flow'

A series of inward and outward cash flows over time in which there is more than one change in the
cash flow direction. This cdiviontrasts with a conventional cash flow, where there is only one
change in cash flow direction. In terms of mathematical notation - where the - sign represents an
outflow and + denotes an inflow - an unconventional cash flow would appear as -, +, +, +, -, + or
alternatively +, -, -, +, -.

IRR method does not tell about how much return the firm is going to earn from a project whereas
NPV tells about the exact amount of return from a project.

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 Financial Management 28

COST OF CAPITAL

First of all we need to understand the meaning of cost.

The term cost refers the expenditure which has been incurred or to be incurred.
Form this definition of cost we can say that the cost of capital means that expenditure which has
been incurred or to be incurred for acquiring that particular capital. Or
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its
market value and attract funds.
M.J. Gordon
“Cost of capital means the rate of return that a company must earn on investments to maintain its
worth.”
Importance of the concept of cost of capital

 Designing the optimal capital structure

 Assisting in investment decisions
 Helpful in evaluation of expansion projects
 Rational allocation of national resources
 Evaluation of financial performance of top management
 Basis of other financial decisions
Computation of cost of capital

1. Cost of debt
Usually rate of interest payable on debentures is treated as its cost but it is not correct. The
floatation cost should be considered.
a. Perpetual or irredeemable Debt
Cd = i / NP x 100
Where
i= Amount of annual interest
NP= Net Proceeds
Illustration
A company issues 10% debentures of Rs. 1000/- at par and expenses of issue are 4%.
Sol. 1000 – 40 = 960
Cd = 100/ 960 x 100
= 10.42%
b. Redeemable Debt
MV-NP
I+
n
Cd=
MV+NP
2
Where,
i= annual interest payment
MV= Maturity value
NP= Net proceeds
n= number of years to maturity

Illustration
Dr. Himanshu Jain, PIET
 Financial Management 29

Above question with redemption period of 10 years.

Cd (after tax) = Before tax cost (1- Tax rate)

2. Cost of Preference Share Capital
a. Irredeemable preference share capital

PD
Cp= X 100
NP
Where,
PD= preference dividend amount per share
NP= net proceeds per share

b. Redeemable preference share capital

MV-NP
PD+
n
Cp= x 100
MV+NP
2
Where,
PD= amount of annual preference dividend
MV= Maturity value
NP= Net proceeds
n= number of years to maturity
Cp (before tax) = after tax cost / (1- tax rate)
3. Cost of equity share capital
a. Dividend yield method

DPS
Ce= X 100
MP
Where,
DPS= Current cash dividend per share
MP= Market price per share

b. Earnings yield method

EPS
Ce= X 100
MP
Where,
EPS= Earning per share
MP= Market price per share
c. Dividend yield + growth in dividend method

DPS
Ce= X 100 +G

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 Financial Management 30

MP

Where,
DPS= Current cash dividend per share
MP= Market price per share
G= Growth rate in dividend
Ce (before tax) = after tax cost / (1- tax rate)

d. Realized yield method

According to this approach, the cost of equity capital should be determined on the basis of return
actually realized by the investor in a company on their equity shares. Thus, according to this
approach the past records in a given period regarding dividends and the actual capital appreciation
in the value of the equity shares held by the shareholders should be taken to compute the cost of
equity capital.

4. Cost of retained
Many people feel that such retained earnings are absolutely cost free. This is not the correct
approach because the amount retained by company, if it had been distributed among the
shareholders by way of dividend, would have given them some earning. The company has deprived
the shareholders of these earnings by retaining a part of profit with it. Thus, the cost of retained
earning is the earning forgone by the shareholders. In other words, the opportunity cost of
retained earnings may be taken as the cost of retained earnings.

This can be understood in the following manner. Suppose the earnings are not retained by the
company and passed on to the shareholders, are invested by the shareholders in the new equity
shares of the same company, the expectation of the shareholders from the new equity shares
would be taken as the opportunity cost of the retained earnings
Adjustment Required
 Income Tax Adjustment

 Brokerage Cost Adjustment.

The cost of retained earnings after making adjustment for income tax and brokerage cost payable
cost payable by the shareholders can be determined according to the following formula:
Cr = Ce (1-T) (1- B)
Where,
Cr = cost of retained earnings
Ce = cost of equity
T = Tax rate
B = Brokerage cost
Cr (before tax) = after tax cost / (1- tax rate)
Weighted Average Cost of capital
A company finances its projects by different sources, although the specific cost of each sources of
finance is different. Some are cheaper and some are dearer. There are two objectives of this
policy- firstly, to balance the capital structure and secondly to increase the return of equity
shareholders. These objectives can be achieved only when firm’s average cost of financing is lower
than its return on investment. This requires the computation of overall or average cost of capital.

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 Financial Management 31

The average can be a simple average or weighted average. However, weighted average is more
reasonable and appropriate as it gives due emphasis to different sources of capital in the capital
structure of a firm.
Process of Computation of Weighted Average Cost of Capital
(a) The computation of specific costs of various sources. It has already been explained in the
preceding pages in this chapter.

(b) Assignment of weights to each type of funds. It is explained in detail hereafter.

(c) Each specific cost is multiplied by the corresponding weight and in this way weighted cost of
each source is determined.

(d) Finally, weighted cost of all sources of capital as calculated in (3) are added together to get
an overall weighted average cost of capital.

Book Value Weights

This is most convenient to be used. In this method proportion of each source in total capital
structure is determined on the basis of the book value of securities.

Market Value
In this, market value of invested capital funds of each type of security is calculated on the basis of
their prevailing market values and proportion of each type of security to the total of market values
of all securities is used as weight.

COST OF CAPITAL
Capital Asset Pricing Model or CAPM Approach
This model takes Risk-free rate of return (Rf) as the benchmark and to that is added the risk premium
required to cover the risk for investing in a specified firm. Risk premium is measured by beta (β). If the
beta of the firm is also 1, it means that the returns of the firm will change by the same percentage as the
returns of the market. On the other hand, if the firm has a beta of 2, its returns change as much as twice
of the market of the market returns either way. Beta may be positive or negative.
The Cost of Equity, according to CAPM, can be calculated as below:
Ce = Rf + Bi (Rm - Rf)
Where, Ce = Cost of Equity
Rf = Risk- Free Rate of Return
Rm = Market Return
β f = Beta co-efficient

Cost of Equity based on CAPM Model

In capital budgeting, corporate accountants and finance analysts often use the capital asset pricing
model, or CAPM, to estimate the cost of shareholder equity. The CAPM formula requires only three
pieces of information: the rate of return for the general market, the beta value of the stock in question
and the risk-free rate.
Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)
The rate of return refers to the returns generated by the market in which the company's stock is traded. If
company CBW trades on the Nasdaq and the Nasdaq has a return rate of 12%, this is the rate used in the
CAPM formula to determine the cost of CBW's equity financing. The beta of the stock refers to the risk
level of the individual security relative to the wider marker. A beta value of 1 indicates the stock moves
Dr. Himanshu Jain, PIET
 Financial Management 32

in tandem with the market. If the Nasdaq gains 5%, so does the individual security. A higher beta
indicates a more volatile stock and a lower beta reflects greater stability. The risk-free rate is generally
defined as the rate of return on short-term U.S. Treasury bills, or T-bills, because the value of this type
of security is extremely stable and return is backed by the U.S. government.
Numerous online calculators can determine the CAPM cost of equity, but calculating the formula by
hand or in Microsoft Excel is simple. Assume CBW trades on the Nasdaq, which has a rate of return of
9%. The company's stock is slightly more volatile than the market, with a beta of 1.2. The risk-free rate
based on the three-month T-bill is 4.5%. Based on this information, the cost of the company's equity
financing is 4.5 + 1.2 * (9 - 4.5), or 9.9%.
The cost of equity is an integral part of the weighted average cost of capital, or WACC, which is widely
used to determine the total anticipated cost of all capital under different financing plans.

CAPITAL STRUCTURE

Capital structure refers to the mix of long-term source of funds, such as debentures, long-term debts, preference
share capital, equity share capital and reserve & surplus (i.e. retained earnings)

Capital Structure of ……………… Ltd.

Source of Funds Amount

Equity Share 5,00,000

Debenture 3,00,000

Preference Share 1,00,000

Retained Earnings 1,00,000

Total Capital 10,00,000

Factors determining the Capital Structure

 Control
 Risk
 Income
Dr. Himanshu Jain, PIET
 Financial Management 33

 Company Size
 Cost of Capital
 Investor’s Attitude
 Legal Provision
 Marketability
 Tax Consideration
 Nature of Business
 Stability of earnings
 Amount of funds

Theory of Optimal Capital Structure

Capital structure theories seek to explain the relationship between capital structure decision and the market value
of the firm.
Different views have been expressed on the relationship between capital structure, cost of capital and value of the
firm. Some says that capital structure decisions have affect on the value of the firm and some says that don’t
have. These different views on such relationship, known as theories of capital structure.
Assumptions
1) That there are only two sources of funds i.e., the equity and the debt.
2) That the total assets of the firm are given and there would be no change in the investment decisions of
the firm.
3) That the firm has a policy of distribution the entire profits among the shareholders means there is no
retained earnings.
4) The operating profits of the firm are given and are not expected to grow.
5) The business risk complexion of the firm is given and is constant and is not affected by the financing mix.
6) That there is no corporate or personal tax.
Net Income Approach
This approach has been suggested by Durand. According to this approach capital structure affect the cost of
capital and value of the firm.

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 Financial Management 34

In other words, a change in the debt-equity mix will lead to a corresponding change in the overall cost of capital
as well as the total value of the firm.
Justification:
This approach says that change in financing mix of a firm will lead to change in overall cost of capital of the firm
resulting in the change in the value of the firm. As cost of debt is less than cost of equity the increasing use of
cheaper debt will reduce the overall cost of capital. This will increase the return to equity share holder. And this
will increase the value of the firm. And Vice-versa.

Additional Assumption
1. That the total capital requirement of the firm is given and remains constant.
2. That cost of debt is less than cost of equity.
3. Both cost of debt and cost of equity remain constant.
4. Investor’s perception about the risk doesn’t change with the change in Debt- Equity Mix.

Computation of the Value of the Firm

The value of the of the firm on the basis of NI approach can be ascertained as follows:-
V= S+B
Where V= value of the firm
S= Market value of the Debt
B= Market value of Debt
Market value of Equity can be calculated as follows:
S= NI/ ke
Where S= Market value of equity
NI= earnings available for equity shareholders
ke= Equity Capitalization Rate

Net Operating Income Approach

The NOI approach is opposite to the NI approach. The Capital structure decision does not affect the value of the
firm.
Justification
The reason is that the increased use of debt increases the financial risk of the equity shareholders and hence the
cost of equity increases. Hence, the advantage of debt (a cheaper source of funds) is exactly off set by the
increased cost of equity and so the overall cost of capital remains constant at every level of debt-equity mix.

Assumption
1. The market capitalizes the value of the firm as a whole and, therefore, the split between debt and equity is
not relevant.
2. The overall cost of capital of the firm is constant and depends upon the business risk which also is
assumed to be unchanged.
3. That there is no tax, and
4. The use of more and more debt in the capital structure increases the risk of the shareholders and thus
results in the increase in the cost of equity capital. The increase in is such as to completely off set the
benefits of employing cheaper debt.

Computation of the Value of the Firm

The value of the of the firm on the basis of NOI approach can be ascertained as follows:-
V= EBIT /
Where
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 Financial Management 35

V= value of firm
ko= overall cost of capital
EBIT= Earnings before interest and tax

Traditional Approach
The Traditional approach is a compromise between the two extremes of Net Income approach and Net Operating
Income approach. It is also known as ‘Intermediate Approach’.
According to this approach, the value of the firm can be increased or cost of capital can be decreased by
increasing debt content of capital structure as debt is a cheaper source of funds than equity. Beyond a particular
point, the cost of equity increases because increase increasing proportion of debt increases the financial risk of
equity shareholders. The advantage of cheaper debt is thus offset by increased cost of equity.

Modigiliani-Millar Approach
MM approach is similar to the Net Operating Income Approach in its conclusions. In other words, according to this
approach, the value of a firm is independent of its capital structure.

However, there is one basic difference between the two. The NOI approach is purely conceptual and does not
provide operational justification for irrelevance of the capital structure in the valuation of the firm. On the hand,
MM approach provides operational justification for irrelevance.
Assumptions
1. Perfect capital Market
a. The investors are free to buy and sell securities.
b. The investors can borrow on the same terms on which the firm can borrow.
c. The investors are well informed and they behave rationally.
d. There are no transaction costs.
2. Homogeneous Risk Class
The firms can be classified into homogeneous risk classes and all firms within the same class will
have the same degree of business risk.
3. Expectations about the net operating income
All investors have the same expectation of a firm’s net operating income (EBIT) with which to evaluate
the value of any firm
4. No taxes
There are no retained earnings(This assumption was relaxed later.)
5. Full Pay-out
Means there is no retained earnings

Justification
The term ‘Arbitrage’ refers to an act of buying an asset or security in one market having lower process and selling
it in another market.
The consequence of such action similar in all respects except in their capital structures cannot for long remain
different in different market.
Limitation
1. Rate of interest are not same for individuals and the firms.
2. Transaction costs involved.
3. Institutional Restrictions (The switching option from one firm to another firm is not available to all
investors.)
4. Corporate Tax frustrate MM hypothesis.
5. Availability of complete information.

OPTIMAL CAPITAL STRUCTURE

Dr. Himanshu Jain, PIET
 Financial Management 36

Optimum capital structure is the capital structure at which the weighted average cost of capital is
minimum and there by maximum value of the firm.
In the words of Solomon Ezra “Optimum capital structure can be define as that mix of debt and equity
which will maximize the firm’s market value of a company and minimize its cost of capital.”
Objectives of Optimum Capital Structure
 Minimization of capital cost
 Minimization of Risk
 Maximization of Return
 Preservation of control
Considerations
 The capital structure should be flexible.
 The company should involve minimum possible risk of loss of control.
 If the return on investment is higher than the fixed cost of funds (i.e., interest and preference
dividend), the company should prefer to raise funds having a fixed cost to increase the return of
equity shareholders. This known as taking the advantage of favorable financial leverage.
 The company should take advantage of the leverage offered by high corporate taxes. The higher
cost of equity financing can be avoided by using debt as a source of finance as interest on dev is
an allowable deduction in computation of taxable income.
 The company should avoid a perceived high risk capital structure because excessive debt
financing reduces market price of equity shares. Hence, the use of debt should be within the
capacity of the company. The company should be in a position to meet its obligations in paying
the loan and interest charges as and when due.

WORKING CAPITAL MANAGEMENT

METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS

1. Percentage of Sales Method
2. Regression Analysis Method (Average relationship between sales and working capital)
3. Cash Forecasting Method
4. Operating Cycle Method
5. Projected Balance Sheet Method
1. Operating Cycle Method

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 Financial Management 37

Operating cycle is the time span the firm requires in the purchase of raw materials, conversion of
raw materials into work in progress and finished goods, conversion of finished goods into sales and
in collecting cash from debtors. Larger the time span of operating cycle, larger the investment in
current assets.

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑦𝑐𝑙𝑒 (𝑑𝑎𝑦𝑠)

𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 𝑋 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝐶𝑎𝑠ℎ 𝐵𝑎𝑙𝑎𝑛𝑐𝑒
365 𝑜𝑟 360 𝑑𝑎𝑦𝑠
Illustration
Details of X Ltd. For the year 2014-2015, are given as under:
Cost of Goods sold Rs. 4800000
Operating Cycle 60 days
Minimum desired level of cash balance Rs. 75000
You are required to calculate the expected working capital requirement by assuming 360 days in a
year.

60
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 = 4800000 𝑋 + 75000
360
= 875000/-
For proper computation of working capital under this method, a detailed analysis is made for
following individual component of working capital:
(i) Stock of raw material
(ii) Stock of work-in-process
(iii) Stock of finished goods
(iv)Investment in debtors/ receivables
(v) Cash & bank balance
(vi)Prepaid expenses
(vii) Trade creditors
(viii) Creditors for wages and other expenses
(ix)Advanced received
Dr. Himanshu Jain, PIET
 Financial Management 38

2. Percentage of Sales Method

This method of estimating working capital requirements is based on the assumption that the level
of working capital for any firm is directly related to its sales value. Certain ratios based on past
year’s experience are established.
For Example if sales for the year 2014 amounted to Rs. 30 lacs and working capital required was
Rs. 6 Lacs (20% of sales); the requirement of working capital for the year 2015 on estimated sales
of Rs. 40 lacs shall be Rs. 8 lacs (20% of sales).

3. Cash Forecasting Method

Under this method, an estimate is made of cash receipts and payments for the next period.
Estimated cash receipts are added to the amount of working capital which exists at the beginning
of the year and estimated cash payments are deducted from this amount. The difference will be the
amount of working capital.

4. Projected Balance Sheet Method

Under this method, an estimate is made of assets and liabilities for a future date and projected
balance sheet is prepared for that future date. The difference in current liabilities shown in
projected balance sheet will be the amount of working capital.

5. Regression Analysis Method (Average relationship between sales and working

capital)
This method of forecasting working capital requirements is based upon the statistical technique of
estimating or predicting the unknown value of a dependent variable from the known value of an
independent variable. It is the measure of the average relationship between two or more variables,
i.e. sales and working capital, the terms of the original units of the data.
The relationship between sales and working capital is represented by the equation:
y = a + bx
Where,
y = Working capital (dependent variable)
a = Intercept of the least square
b = Slope of the regression line
x = Sales (independent variable)

• Concentration banking is a given is a system of decentralizing collections of accounts

receivable in case of large firms having their business spread over a large area. According to
this system, a large number of collection centers are established by the firm in the different
areas where it has its collection centers. The collection centers are required to collect
cheques from their customers and deposit them in the local bank account. Instructions are
daily telegraphically to the bank at the head office. This facilitates fast movement of funds.
• Lock-box system is a further step in speeding up collection of cash. In case of concentration
banking cheques are received by collection centers who, after processing, deposit them in
the local bank accounts. Thus, there is time gap between actual receipt of cheques by a

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 Financial Management 39

collection centre and its actual depositing in the local bank account. Lock-box system has
been devised to eliminate delay on account of this time gap. According to this system, the
firm hires a post-office box and instructs its customers to mail their remittances to the box.

Types of Working Capital

On the basis of concept On the basis of Need

Gross working Net working Permanent Temporary

Capital Capital Working Working
Capital Capital

Permanent and Temporary Working Capital

Permanent Working Capital : A minimum amount which is required to ensure effective circulation of
current assets, utilization of fixed facilities, day to day operating activities of the business, a minimum
level of Raw Material, work in progress, finished goods and cash must be maintained on a continuous
basis. The amount needed to maintain current assets on this minimum level is called permanent or
regular working capital. This amount has to be met from long term sources of finance i.e. capital,
debentures, long term loans etc.

Temporary Working Capital : Any amount over and above the permanent level of working capital is
called temporary working capital or fluctuating working capital. Due to seasonal changes, level of
business activities is higher than the normal time, therefore, additional working capital will be required
along with the permanent working capital. It is so because during peak season, demand rises and more
stock is to be maintained to meet the demand. Similarly the amount of debtor increases due to excessive
sales. Additional working capital thus needed is known temporary working capital because once the
season is over, the additional demand will be no more. This need for temporary working capital should
be met from short term sources of finance. Both types of working capital is necessary to run the business
smoothly.

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 Financial Management 40

Above diagram shows that permanent working capital remains the same through out the year. While
temporary working capital is fluctuating in accordance with the seasonal demand.

However in case of expanding concern, the need for working capital may not be constant and it would
be increasing. Then the permanent working capital line may not be horizontal and it will go on rising as
illustrated in the following diagram.

Factors affecting Working Capital :

1. Nature of Business : Requirement of working capital are largely influenced by the nature of the
business. In case of trading unit requirement of working capital is high because these unit sale
and purchase of goods. For instance public utilities such as Railways, Transport water, electricity
etc. have a very limited need of working capital because they have to invest large amount in
fixed assets. They have to maintain a lower level of working capital for immediate payment for
their services. Financial enterprise have to invest less amount in fixed assets and large amount in
working capital.
2. Size of Business : Larger the size of business, greater would be the need for working capital.
The size of business may be measured in terms of scale of its operation.
3. Growth and Expansion : As a business enterprises grows, it is logical to expect that a larger
amount of working capital will be required. Growth industries required more working capital
than these that are static.

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 Financial Management 41

4. Production Cycle : It means time gap between the purchase of raw-material and its conversion
into finished goods larger the production cycle, larger will be the need for working capital
because the funds will be tied up for a longer period in work in progression if the production
cycle is small the need for working capital will also be small.
5. Business Fluctuations : It may be in the direction of boom and depression. During boom period
the firm will have to operate at full capacity to meet the increased demand which in turn, leads to
increase the level of inventories and book debts. Hence the need of working capital in boom
conditions is bound to increase and in case of depression period the requirement of working
capital is low.
6. Production Policy : The demand for certain products is seasonal. Two types of production
policy may be adopted for such products. Firstly, the goods may be produced in the month of
demand and secondly the goods may be produced throughout the year. If the second alternative
is adopted, the stock of finished goods will accumulate up to season of demand which requires
on increasing amount of working capital that remains tied up in the stock of finished goods for
some months.
7. Credit Policy Relating to Sale : If a firm adopt liberal credit policy in respect of sales, the
amount tied up in debtors will also be higher. Obviously higher book debts mean more working
capital vice versa.
8. Credit Policy Relating to Purchase : If a firm purchase more goods on credit, the requirement
for working capital will be less. In the other words, if liberal credit terms are available from the
suppliers of the goods the requirement for working capital will be reduce.
9. Availability of Raw Material : If the raw material is easily available on a continuous basis,
there will be no need to keep a large inventory of such material and hence the requirement of
working capital will be less. On the other hand, if the supply of raw-material is irregular the firm
will be compelled to keep on excessive inventory of such material which will result in high level
of working capital.
10. Availability of Credit from Books : If a firm can get easy bank credit facility in case of need, it
will operate with less working capital on the other hand, if such facility is not available, it will
have to keep a large amount of working capital.
11. Other Factors :
a. Volume of Profit.
b. Dividend Policy
c. Depreciation Policy
d. Price level Changes
e. Efficiency of Management.

Economic Order Quantity

The economic order quantity (EOQ) is a model that is used to calculate the optimal quantity that can be
purchased or produced to minimize the cost of both the carrying inventory and the processing of
purchase orders or production set-ups.

In this technique manager wants to reduce the cost of carrying and cost of ordering.
Manager try to find out the quantity which should be purchased in a lot.
Which result reduction in the cost of the inventory.

√2xRxCp/ Ch
Where R = Annual Requirement
Dr. Himanshu Jain, PIET
 Financial Management 42

Cp = Cost of order placing

Ch = Cost of holding

Assumptions

 That there is a known, constant stockholding cost

 That there is a known, constant ordering cost,
 That rates of demand are known,
 That there is a known constant price per unit
 That replenishment is made instantaneously, ie the whole batch is delivered at once.
 That costs to be used in EOQ calculations must be marginal costs. Fixed costs are excluded.

Limitations

 It assumes that the firm makes an exact estimate of its future requirements. It is difficult to
predict that exact usage.
 The model assumes a very unrealistic issue it state that there is no time gap between order of an
item and its future supply.
 The EOQ does not consider the order of units in fractions. Goods can be ordered only in multiple
figures.
 The EOQ model assumes that cost order does not change. This means that they do not consider
the economics of scale or discounts that are offered for bulk purchases.

Models for cash management

Miller-Orr Model
In order to manage its cash balance, the company can employ a mathematical model, one of which is
the Miller-Orr model. The Miller-Orr model helps the company to meet its cash requirements at the
lowest possible cost by placing upper and lower limits on cash balances. The operation of the model is
as follows:
(i) A company should have its desired cash level, an upper limit and lower limit on cash
balances.
(ii) (ii) When the cash balance reaches the upper limit, the company has too much cash.
It then should use its cash to buy marketable securities in order to bring the cash
balance back to its desired cash level.
(iii) (iii) When the cash balance hits the lower limit, the company lacks cash. It then sells
its securities in order to bring the cash balance back to its desired cash level.
(iv) (iv) If the cash balance lies between the upper and lower limits, there will be no
transaction in securities.

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 Financial Management 43

The Miller-Orr model increases its practicability by incorporating an assumption that cash balances
randomly fluctuate and therefore are uncertain. The formula in determining the desired cash level is as
follows:

Baumol’s Model
Most firms try to minimise the sum of the cost of holding cash and the cost of converting marketable
securities to cash.
Baumol’s cash management model helps in determining a firm’s optimum cash balance under certainty.
As per the model, cash and inventory management problems are one and the same.
There are certain assumptions that are made in the model. They are as follows:
1. The firm is able to forecast its cash requirements with certainty and receive a specific amount at
regular intervals.
2. The firm’s cash payments occur uniformly over a period of time i.e. a steady rate of cash outflows.
3. The opportunity cost of holding cash is known and does not change over time. Cash holdings incur an
opportunity cost in the form of opportunity foregone.
4. The firm will incur the same transaction cost whenever it converts securities to cash. Each transaction
incurs a fixed and variable cost.
For example, let us assume that the firm sells securities and starts with a cash balance of C rupees. When
the firm spends cash, its cash balance starts decreasing and reaches zero. The firm again gets back its
money by selling marketable securities. As the cash balance decreases gradually, the average cash
balance will be: C/2.

Holding cost = k (C/2)

Whenever the firm converts its marketable securities to cash, it incurs a cost known as transaction cost.
Total number of transactions in a particular year will be total funds required (T), divided by the cash
balance (C) i.e. T/C. The assumption here is that the cost per transaction is constant. If the cost per
transaction is c, then the total transaction cost will be:
Transaction cost = c (T/C)
The total annual cost of the demand for cash will be:
Total cost = k (C/2) + c (T/C)
Optimum level of cash balance
As the demand for cash, ‘C’ increases, the holding cost will also increase and the transaction cost will
reduce because of a decline in the number of transactions. Hence, it can be said that there is a
relationship between the holding cost and the transaction cost.
Dr. Himanshu Jain, PIET
 Financial Management 44

The optimum cash balance, C* is obtained when the total cost is minimum.
Optimum cash balance (C*) = Ö2cT/k
Where, C* is the optimum cash balance.
T is the total cash needed during the year.
k is the opportunity cost of holding cash balances.
With the increase in the cost per transaction and total funds required, the optimum cash balance will
increase. However, with an increase in the opportunity cost, it will decrease.
Limitations of the Baumol model:
1. It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.

DIVIDEND DECISION

Dividends are payments made by a company to its shareholder from its earnings. When a company earns
a profit , that money can be put to two uses:
 It can either be it can be paid to the shareholders as a Dividend or
 Can be re-invested in the business called Retained Earnings or plough back of profits.

Dividend Payout Ratio:

The DP ratio is the ratio between dividends to equity shareholder and the ratio between dividends to
equity shareholder and the profits after tax. In other words, it is the ratio between dividends distributed
out of the total profit after tax. And can be calculated as following:
Dividend paid to shareholders/ Net profits after tax
Dividend Policy
Dividend Policy refers to the policy regarding quantum of profits to be distributed as dividend.
Factors affecting Dividend Policy or Dividend Decision
I. Internal factors
1. Stability of earnings
2. Age of company
3. Liquidity Position
4. Requirement of funds (Redemption, Expansion, others)
5. Expectation of share holders
6. Desire of control
7. Past dividend rates
II. External Factors
1. Legal Restrictions
2. Position of capital market
3. Taxation Policy
4. Public Opinion
5. Dividend Policy of other companies
Dr. Himanshu Jain, PIET
 Financial Management 45

Essentials of sound dividend policy

1. Stability of dividend
2. Gradual increase in dividend
3. Moderate dividend during initial years

Theories of Dividend Decision

I. Relevant theory of dividend policy
1. Walter’s Model
2. Gordon’s Model
II. Irrelevant theory of dividend policy
1. MM approach

DIVIDEND POLICY THEORIES

1. WALTER’S MODEL
This model supports that dividend policy is relevant for the value of the firm. According to Walter,
the investment policy of the firm and its dividend policy are interlinked.
Walter’s model is based on relationship between the following two factors:
(i) The return on firm’s investment or its internal rate of return (r) and
(ii) Its cost of capital or the required rate of return (Ke).
If the firm’s return on investments is more than the cost of capital, i.e. r > Ke, the firm should retain
the earnings rather than distributing it to the shareholders because of the reason that the money is
earning more profits in the hands of the firm than it would if it was paid to shareholders.
Such firms are called the growth firms. The optimum dividend policy would be given by Dividend
Payout Ratio (D/P ratio) of zero. The market value of the shares will be maximized as a result.
Declining Firm If r < Ke, the firm should pay off the money to the shareholders in the form of
dividends because of the reason that the shareholders can earn higher return by investing it
elsewhere.
In this case market price of shares will be maximized by the distribution of the entire earnings as
dividend. For such firms the optimum dividend policy would be given by D/P ratio of 100%.
Normal Firm If r = Ke, it is a matter of indifference whether the earnings are retained or distributed,
it will not affect the market price of the shares.

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 Financial Management 46

Assumptions
1. Constant return and cost of capital
The Walter’s model assumes that the firm’s rate of return r, and its cost of capital, K, is constant
2. Internal financing
All financing is done through the retained earnings; that is, external sources of funds like debt or new
equity capital are not used.
3. 100% payout or retention
All earnings are either distributed as dividends or reinvested internally immediately.
4. Constant earnings per share and constant dividends per share
There is no change in the key variables, namely, beginning earnings per share E and dividends per share
D. the values of E and D may be changed in the model to determine results, but any given value of E and
D are assumed to remain constant forever in determining a given value.
5. Infinite time
The firm has perpetual (very long) or infinite life.

Criticism or Limitations of Walter’s Model

1. No External Financing
If it was so then the model would be applicable to only those firms in which equity was the only source
of finance.
2. Constant Rate of Return (r)
This is not a realistic assumption because when increased investments are made by the firm, r also
changed.
3. Constant Equity Capitalization Rate (Ke)
This is not a realistic assumption because equity capitalization rate changes directly with the change in
risk complexion of the firm. By assuming a constant Ke, Walter’s model ignores the effect of risk on the
value of the firm.

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 Financial Management 47

2. GORDON’S MODEL
Gordon’s Model is another theory which contends that dividend policy is relevant for the value of the
firm. Gordon’s argument is a twofold assumption:
(i) Investors are risk averse, and
(ii) The investors put a premium on a certain return and on the other hand they discount
uncertain returns.
Investors are rational in their approach and they want to avoid risk. There are two possible actions
for the firm:
(a) It can distribute the current dividends, or
(b) Can retain its earnings
Out of both these actions of the firm the investor would always prefer the first, i.e. distribution of the
current dividends rather than its retention by the firm for distribution of dividend in the future.

This is because of the reason that the future dividend is uncertain, both with respect to the amount as
well as the timing.

Thus, the investors would discount future dividends, that is, they would place less importance on it as
compared to current dividend. They considered being risky option. Therefore, if the earnings are
retained, the market price would be adversely affected.

This is also described as a bird-in-the-hand approach. That a bird in hand is better than two in the
bush, i.e., what is available at present is preferable to what may be available in the future.

Investor would be inclined to pay a higher price for shares on which current dividends are pain and they
would discount the value of shares of a firm which postpone dividend.

Gordon’s model is based on the following assumptions:

1. No External Financing
No external financing is available and retained earnings are the only source of finance.
2. All-Equity Firm
The firm is an all-equity firm, and it has absolutely no debt.
3. No Taxes
There is no corporate tax.
4. Perpetual Earnings
It is assumed that the firm has perpetual life and its streams of earnings are also perpetual.
5. Constant Internal Rate of Return
The internal rate of return, r, of the firm is assumed to be constant.
6. Constant Retention Ratio
The retention ratio, b, once decided upon, is constant.
7. Cost of Capital Greater than Growth Rate
The cost of capital is greater than growth rate.

(1 − 𝑏)
𝑃=𝐸
𝐾𝑒 − 𝑏𝑟
Where, P = Market Price per Share
E = Earnings per Share
r = Firm’s rate of return
b = Retention ration or percentage of earnings retained
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 Financial Management 48

br = g = Growth Rate
(1 - b) = D/P ratio
Ke = Cost of Capital/ Capitalization rate

3. MODIGLIANI AND MILLER

According to this theory dividend policy does not affect the value of the firm. The dividend policy is
residual decision which depends upon the availability of investment opportunities to the firm. If a firm
has sufficient investment opportunities, it will not pay dividends and retain the earnings to finance them.
If it does not have adequate investment opportunities, dividends will be declared to distribute the
earnings.

Assumptions:
1. Perfect Capital Market
The firm operates in perfect capital markets where investors behave rationally, information is freely
available to all, there are no transaction and flotation costs and no investor is large enough to influence
the market price of securities.
2. No Taxes
There are no taxes.
3. Fixed Investment Policy
The firm has a fixed investment policy which does not change. It means that the risk complexion of the
firm will not change due to new investments out of the retained earnings.
4. Certainty of Earnings
There is prefect certainty as to future profits of the firm. Investors are able to forecast future share prices
and dividends with certainty. This assumption is dropped by MM later.
Logic behind MM Theory
MM claim that since the value of the firm depends upon its earnings and is not affected by the dividend
decision, shareholders are also indifferent between dividend and retention of earnings.

There are two possible alternatives:

(a) Firm can retain its earnings to finance investment programme, or
(b) Firm can distribute the earnings to the shareholders as dividend and raise an equal amount
externally through issue of new shares for financing its investment programme.

If the firm selects the first alternative, it will not pay any dividends and will retain the earnings to
finance investment programme. If a shareholder wants cash, he can create a ‘home-made dividend’ by
selling a part of his shares at market price. The shareholder will have less number of shares. He has
exchanged a part of his holding in the firm to a new shareholder for cash. Neither the firm nor the
shareholder loses or gains due to this transaction. The value of the firm remains the same due to
exchange of shares among shareholders.

If the firm selects alternative, if will pay dividends to the shareholders. Shareholders get cash in their
hands, but the firm’s assets reduce because of reduction in its cash balance. As a result, present value per
share will decline. Thus what is gained by the investors in the form of dividends will be neutralized
completely by a decline in the value of their shares. hence, he will be indifferent between dividend and
retention of earnings which implies that the dividend decision is irrelevant. Firm also will not be
affected by payment of dividends because the effect of dividend payment will be exactly offset by the
effect of raising additional share capital.

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 Financial Management 49

Criticism of MM Approach
Because of unrealistic assumptions the MM approach is alleged to lack practical relevance.
(a) Tax Effect
(b) Flotation Cost
(c) Transaction Cost
(d) Institutional Restrictions
(e) Near V/s Distant Dividend
(f) Informational Utility of Dividends
(g) Sales of New Shares at Lower Prices

Dr. Himanshu Jain, PIET