Financial Management - Notes

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:
Dr. Himanshu Jain, PIET

(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.
 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

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

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.

The time period for compounding the interest may be annual, semi-annual or any other regular
period of time.
= (1 + )
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.
=
(1 + )
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 =
PV = Present Value
A = Annuity (EMI)
10000 = A x PVFA3,0.09
10000 = A x 2.531
A = 10000/2.531
= Rs. 3951

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

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.

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

 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.

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

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.

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.

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
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

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
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
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
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:
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.
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
2 3
 (1+0.10) (1+0.10) (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
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
0 1 2 n n
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r)
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
 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 6th
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.
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
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.
 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.
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 contrasts 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.

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
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
c. Dividend yield + growth in dividend method
DPS
Ce= X 100 +G
MP
Where,
DPS= Current cash dividend 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.
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 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
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
 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.
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
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.
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
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.

( )
= + ℎ
365 360
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
= 4800000 + 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
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
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.
EOQ Model
Financial Modeling
Operating Leverage Financial Leverage

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Financial Management 1

INTRODUCTION TO FINANCIAL MANAGEMENT

Public Finance Private Finance

1.2 FINANCE MANAGEMENT

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

1.3 APPROACHES TO FINANCE FUNCTION/ FINANCIAL MANAGEMENT

Dr. Himanshu Jain, PIET

(a) The Traditional Approach

(b) The Modern Approach

Characteristics of Modern Approach

1.4 SCOPE OF FUNCTION OF FINANCIAL MANAGEMENT/ FINANCIAL MANAGEMENT

 Consideration of cost burden on the firm.

1.5 OBJECTIVES OF FINANCIAL MANAGEMENT

1.5.1 Profit maximization

Criticisms of Profit Maximization

o It ignores the risk

o It is vague and ambiguous

Dr. Himanshu Jain, PIET

1.5.2 Wealth Maximization

Criticisms of Profit Maximization

1.5.4 Other Maximization Objectives

Dr. Himanshu Jain, PIET

1.6 Importance of Financial Management

TIME VALUE OF MONEY

2.1 THE VALUE OF MONEY

Concept of Time Value of Money

2.2 REASON OF TIME VALUE OF MONEY

2.2.2 Risk/ Future uncertainties

2.2.3 Personal Consumption Preference

2.2.4 Investment opportunities

2.3 TECHNIQUES OF TIME VALUE OF MONEY

2.3.1 Compounding Techniques

The process of calculating future values of cash flows and

Dr. Himanshu Jain, PIET

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

Dr. Himanshu Jain, PIET

Ownership Creditorship Internal Loan

Dr. Himanshu Jain, PIET

3.1 OWNERSHIP SECURITIES

Equity Share Preference Share

3.1.1 Equity Share

Features of Equity Share

Pros/ Merits of Equity financing

Cons/ Demerits of Equity financing

3.1.2 Preference Share

Dr. Himanshu Jain, PIET

Types of Preference Shares

 Cumulative Preference Shares

Features of Preference Shares

Pros/ Merits of Preference Share

Cons/ Demerits of Preference Shares

Dr. Himanshu Jain, PIET

 Reduce the claim of Equity Share

3.2 CREDITORSHIP SECURITIES

Pros/ Merits of Debenture

Cons/ Demerits of Debenture

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

Dr. Himanshu Jain, PIET

 Bearer or Registered Debenture