PROJECT FINANCIAL MANAGEMENT

NOTES
BY

SHARIFAH

Tel: 0758656333

2020 -2021

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Financial management is an interesting subject. This book is not only intended to provide
An understanding of how funds are raised and allocated within a company

The purpose of this book is to assist students of DPA, DSWSA AND DPPM prepare for diploma
exams in financial management.
This Financial management notes have been simplified with clear lay out, style, to ensure clear
understanding of the concepts in financial management.

Main topics covered include, Concept of financial management, Time value of money, Capital
Budgeting decision, Investment decision, Financial planning, Working capital, Capital structure,
managing cash, inventory management, and Dividend policy.

Acknowledgment
I wish to thank my colleagues at Makerere University, Lawrence and Abbot Anthony for the
review work they did on this book and the great ideas and suggestions.

Dedications:
I wish to dedicate this book to all students of MISD, MUBS AND MUK. May this book make
the reading quite easy and assist you in passing the exams with flying colures

Copy right
No part of this publication may be reproduced, stored in a retrieval system or transmitted in any
form by any means without prior written permission from the author

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 TABLE OF CONTENTS

Page
UNIT I Overview of Financial Management 5
UNIT 2 Time Value of Money 15
UNIT 3 Investments /Capital Budgeting Decisions 22
UNIT 4 Cash Flow Evaluations 30
UNIT 5 Management of Working capital (Liquidity decisions) 48
UNIT 6 Financing Decision (Sources of Funds) 68
UNIT 7 Management of Cash 81
UNIT 8 Management of Accounts Receivables 91
UNIT 9 Management of Inventories 97
UNIT 10 Dividend policy Decision 119

UNIT 1

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OVER VIEW
Meaning and Definition of Financial Management.
Nature and Scope of Financial Management.
Objectives of Financial Management.
Importance of Financial Management.

What do you understand by financial management? Discuss its scope and importance from
the point of business management
Ans.Meaning and definition of financial management
Financial Management is that managerial activity which is concerned with planning, acquisition,
financing and controlling of the firm’s financial resources in order to achieve the objectives of
the firm/project.
Note
"Sound Financial Management is a key to the success of a project or firm."

THE NATURE AND SCOPE OF FINANCIAL MNANAGEMENT

The role of the financial manager is to make the right decisions in order to achieve the
objectives of the company/firm in the future.
The four key areas that the Financial Manager/management is concerned with are as follows:

Financing decision the raising of long –term finance.

It is the job of a financial manager to decide when, where, and how to acquire funds to meet the
firm’s investment needs of the firm.
It is her/his job to be aware of the different sources of finance and to decide which source to use.
He has to determine the proportion of equity and debt. The mix of equity and debt is called the
firm’s capital structure

The investment decision:

The investment decision is the most important of the firm’s four major decisions when it
comes to value creation.
Decisions have to be made as to where capital is to be invested. This involves the decision of
allocation of capital or commitment of funds to long-term assets which would yield benefits in
the future. For example
The financial manager needs to determine the dollar amount, the composition of the assets, for
example, how much of the firm’s total assets should be devoted to fixed assets.
Disinvestment –must not be ignored. Assets that can no longer be economically justified may
need to be reduced, eliminated or replaced.
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The management of working capital (Liquidity decision)
A financial manager, should , estimate the firm’s needs for current assets and make sure that
funds would be made available when needed, in order to ensure that neither insufficient nor
unnecessary funds are invested in current assets.
Dividend or profit allocation decision;
The Finance Manger has to take decision with regards to the net profit distribution.
The Financial Manager must decide whether the firm should distribute all profits, or retain them,
or distribute a portion and retain the balance.

THE FUNCTIONS OF A FINANCIAL MANAGEMENT

Financial Planning: The manager has to plan ahead for financial requirements and selection of
resources for different projects undertaken by an enterprise.
Procurement/mobilization of funds:This involves activities relating to the raising of required
capital in accordance with the estimated and proposed capital structure for the efficient
functioning of the business.
Organizing Finance Function:Organization of finance department and sub -departments,
determination of functions, powers and responsibilities of treasurer and controller as well as the
activities concerning the maintenance of account books.
Effective Management of Assets:This relates to purchaseof fixed and stock in time as well as
the arrangement of their timely supply. Advise to top management on policies regarding
management of fixed assets, inventory policy, policies regarding determination of sales and their
prices.
Financial Control: Financial manger controls finances by ensuring their availability and
effectively and efficiently used. This can be done through many techniques which include; ratio
analysis, financial forecasting, cost and profit control etc.
Management of Income: It involves the preparation of various statements like balance sheet,
income statement, profit and loss account, etc., in accordance with the existing law and the
prevailing business practices. It also involves the determination of net profit and its allocation as
dividends to shareholders and retained earnings for future investments.
Analysis and Appraisal of Financial Performance:With a view to bring necessary changes in
future policies and procedures, an appraisal of financial performance of the enterprise is made as
against the previous year with the help of modern techniques of financial analysis.
Questions
List and discuss the functions of a financial Manager. Or how would you classify functions of
a financial manager? OrOutline the responsibilities of financial management for maintaining
effective control.
Give and discuss the main objectives that business project/firm target to achieve.
What are the critisms/limitations of profit maximization objectives of a firm?
Explain the scope of finance decisions
Explain the scope of financial management

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Suppose you have been appointed as the new finance manager of IT Consult , anew firm that
has opened a shop along Kampala road .What would be your roles and responsibilities in your
new position?
Ans.
FUNCTIONS OF A FINANCIAL MANAGER
The financial manager occupies a key position in the top management team. The details are as
follows
1) Raising of funds:
The financial manager is concerned with the determination of the need for capital funds for the
efficient operation of the company.
He has to identify different sources of funds and raises the funding requirements of a firm.

2) Wise allocation of funds efficiently and effectively

The Financial Manager allocates funds to different departments and different firm’s activities.
The financial manager is responsible for collecting the relevant information pertaining to
investment proposals competing for capital allocation, forecasting incremental cash inflows
during the future period, comparing the projects against one another and against the criteria of
profitability and risk, and identifying the most profitable projects.

3)Profit planning and control;

The financial manager has to make planning/operational decisions in the areas of pricing, costs,
and volume of output and the firm’s selection of products lines.
Profit planning is, therefore, a pre-requisite for optimizing investment and financing decisions.

4) Dividend Policy, Decisions and Allocation of Net Profits;

The financial manager also plays an important role in the determination of dividend
policy of the company. It involves the determination of dividend payout ratio, i.e., the
proportion of net profit that should be paid in cash to shareholders and what to be retained to be
used for the expansion of the project.
5) Understanding capital markets:
The financial manager should fully understand the operations of capital markets where the firm’s
securities are traded.
A capital market is a market that deals in medium and long term funds/securities, e.g., created or
transferred. It is an institutional arrangement for borrowing medium and long –term funds and
which provide facilities for marketing and trading of securities.

6) Managing funds of the firm

A Financial Manager has a task of managing the funds of the firm by monitoring both funds
inflows and fund outflows.
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7) Budgeting.
The Financial Manager plays an important role in the budgeting process of the financial
resources of the firm.

IMPORTANCE OF FINANCIAL MANAGEMENT

Ensures regular and adequate supply of funds to the organization
Ensures adequate returns to the share holders, which will depend upon earning capacity, market
price, of the share expectations of the shareholders
Ensures optimum fund utilization
Ensures safety on investment, i.e. funds should be invested in safe ventures so that adequate rate
of return can be achieved.
Plans a sound capital structure-

IMPORTANCE OF FINANCIAL MANAGEMENT TO ITS USERS

The importance of financial management may be discussed under the following headings:
Importance to Business Executives: Financial management helps the businesse xecutives in
making all the strategic managerial decision. for example,itassists the managers in determining
the financial needs of (In- enterprise and allocation of funds to specific capital projects,
determination of dividend policy, merger and acquisition decisions, until policy, etc.
Importance to Potential Investors: Investors of different classes are also benefiting by the
subject of financial management by taking. satisfactorydecisions and can safely earn regular
income on their accumulated capital.
Importance to Shareholders:The knowledge of financial management is inevitable for the
shareholders in order to preserveand protect their interest in the company. The shareholders can
make the company earn more profits by persuading and forcing the managers/directors of the
company to follow a suitable financial policy, and consequently they can receive higher
dividends on their investments.
Importanceto Financial Institutions: It is indispensable for financial institutions to be well
versed with every aspect of financial management for the profitable employment of their funds..
Importance to Employees: The main objective of employee's is to know their financial and
non-financial benefits. On the basis of sound financial management, the managers of an
enterprise can protect their interests by raising the productivity and efficiency of the employees.
Importance to Government: It is also essential for the government to have full knowledge of
every aspect of financial management. Government attempts to effectively follow the funds
collected from the public in the form of taxes. In the absence of full knowledge of financial
management, it becomes impossible for the government to attain maximum social welfare out of
the public expenditure.
Importance to Other Parties: All such parties as economists, students of commerce and
management, politicians, sociologists, etc., having interest in the economic problems of the
country, are also benefitted by the knowledge of financial management. In the absence of full
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knowledge of the principles of financial management, it is difficult to undertake reliable studies
on economic problems of a country.
BASIC FINANCIAL MANAGEMENT DECISIONS
In undertaking the above functions, the main/basicfinance decisions taken are;
Investment decisions
Finance decisions
Dividend policy decisions
Working capital/liquidity decisions
Investment Decision/capital budgeting decision
Where do you invest the scarce resources of your Business?
The investment decisions or capital budgeting are concerned with the selection/allocation of
funds to long term and short term assets that would yield benefits in the future.
What makes for a good investment?
The investment is made into two types of assets viz., fixed assets and current assets. Fixed assets
are those assets which yield a return over a period of time
Financing Decision:
This is the decision taken by firms to acquire short term fundsand long term fundsby debt or
equity to finance business operations
It involves the determination as to how the total funds required by the firm will be made
available through the issue of different types of securities, i.e., bonds and debentures, etc.
It involves deterring what mix of owner’s money (equity) or borrowed money (debt) do
you use?
Dividend Decision/earnings management decision:
The third major decision of financial management is the decision relating to the dividend
policy.
The financial manager must decide whether the firm should;
Retainand invest all the profits in the business or
Distribute a portion and retain the balance
Or distribute all profits to the shareholders in the form of dividends
4The Liquidity (Working capital) decision
This is a decision to invest in the short term assets of a business. It is also known as the liquidity
decision of the firm. The financial manager is faced with the following decision
How much should a firm invest in current assets eg, in inventories, receivables (debtors) ,cash
and cash equivalents (liquidity), less payables etc.
What should be the components with their respect proportions? and
How much to manage in the working capital
Liquidity is a term used to refer to assets that are readily convertible into cash like bonds

OBJECTIVES OF FINANCIAL MANAGEMENT

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Financial goals of a firm are a pre-requisite to financial planning, strategic and tactical decisions
and procedures.A business enterprise balances its objectives in such a manner that all those
groups gain optimal satisfaction.
1)PROFIT MAXIMIZATIONOBJECTIVE
Definition of profit maximization
This can be defined as maximizing the income of the firm and minimizing the expenditure. It
means that the company should increase its earnings in the shortest period and minimize its
costs.
A firm can only make profits if it produces a good or delivers a service at a lower cost than the
selling price. For this purpose, the activities that increase profits should be under-taken and those
that decrease profits should be avoided.
The maximization of profit as an objective for firms is in conflict with wealth maximization
objective in that where as wealth maximization objective measures benefits in terms of cash
inflows; this however removes ambiguity associated with accounting profits which ignores time
value of money
Benefits of profits to the firm
The firm is able to make the best use of its resources in a more effective way
The profits are used as a measure of the productivity and efficiency of the firm
A firm making profits is able to survive in the market for a long a time
Firms that are able to earn continuous profits eventually improve on their products according to
the demand
LIMITATIONS OF PROFIT MAXIMIZATION
The profit maximization objectives suffer very many limitations:
The term profit is vagueand ambiguous concept thus not easy to measure.Different people
have different concept for it. It may be a before tax profit or after tax profit; short term or long
term; return on capital employed or return on equity capital, etc.
It ignores the time value of money or does not take into account the time value of money by
focusing at the absolute figure only.
The quality of profiti.e. the certainly in profits is also not considered in this approach.
It ignores the risk factors
Ends up doing unethical work ,e.g. offering poor quality products instead of making profits
It assumes perfect competition, and in the face of imperfect modern markets, it cannot be a
legitimate objective of the firm.
It is also feared that profit maximization behavior in the market economy may tend to produce
goods and services that are wasteful and unnecessary.
Profit maximization might lead to inequality of income and wealth.
The time value of money is often ignored when measuring profits

2) WealthMaximization:Wealth is the net cash flow expected from all the assets in which all
the resources of a firm have been invested.

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A shareholder's wealth in a company is the multiple of the number of shares held by him and the
current market price of the share (Shareholders wealth in the company = Number of shares
owned x Market price per share).
While operating with the objective of wealth maximization the company plans its activities in
such a manner that the shareholders get the highest combination of dividends (i.e., payment out
of profit) and capital gains accruing from increase in the marker price of shares.
Merits:
The wealth maximization criterion is based on the concept of cash flows rather than accounting
profit which is the basis of the measurement of benefits in the case of the profit maximization
criterion. Measuring benefits in terms of cash flows removes the ambiguity associated with
accounting profits.
Money has time value. It implies that benefits received in earlier years should be valued more
highly than the value received later. In applying this worth maximization or value maximization
criterion. This time value of money is used on calculating the worth of the owner.A discount
rate is used to calculate the present value of cash flows for this purpose.
Thirdly: this concept also recommends that less uncertain profits should be valued more
Draw backs of wealth maximization
1.Maximizing the value of a firm may not be necessarily be compatible with meeting other
stakeholders’ objectives; employees in particular; this is because: Employees are often
stockholders in various firms.
2.Firms that maximize stock prices are ones that generally treat their employees well
3) Maximization of earnings per share
Firms aim at maximizing earnings per share by paying dividends to their shareholders
with an aim of improving the welfare of shareholders.
4) Customers satisfaction
The business firm must be mindful of its customers and must seek to retain them and for
this reason the business should provide quality products, fair prices for the goods and
have honest dealings with customer

5) Maximization of employees’ welfare

This is done by firms through motivating in paying them adequately to retain them in
their present positions.
6) Corporate Social welfare
This refers to the obligations of organization to protect and/or enhance the society in
which it functions. It is what a business does to influence the society in which it exists.
Should avoid harmful production processes like pollution.
Should contribute to social causes e.g. donations, public clinics, schools etc.

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7) Maximize efficiency
8) Duty to the Government
The company must pay operation taxes when they fall due and should operate within the
government development plans of its policies
9) Maximizing product quality.
Firms aim at producing quality products compared to their competitors.

UNIT 2
TIME VALUE OF MONEY
Unit objectives
After the unit, you;
Appreciate the concept of Time value
Explain Time value of money
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Understand future value (compounding)
Understand Present value (Discounting)
Demonstrate this knowledge by solving problems
Introduction
Qn;1. Explain the concept ‘Time Value for Money’ as used in Financial Management
Qn;2. Time preference for money is an individual’s preference for possession of a given
amount of money now, rather the same amount at some future time, explain why an
individual would have such preference.
The concept of Time Value of Money refers to the fact that investors and other decision makers
(ega rational economic unit individual firm) in finance prefer to have earlier sum of money (cash
flow) than later if given a chance; hence, the value of money received today is more than the
value received at a future datei.e. money changes value over time.

Qn; Give reasons why people, investors etc, would prefer to hold money now than in the
future
Factors affecting TMV/Reasons for time value of money
Need for consumption. This would mean that a shilling today will enable immediate
consumption and therefore satisfaction today other than later cash flows.
Need for investment; the amount of money received earlier can be invested to earn more return
in the future. By waiting for later cash flows, the investor forgoes this return.
Uncertainty/Risk surrounding the future; ‘‘a bird in hand is worth more than two in the bush.’
The business world is full of risks and uncertainties. Although there might be a promise of
money to come in the future, it can never be certain that the money will be received until it has
actually been paid
TVM examples1
Company xy ltd has to choose between 2 projects A&B. Project A involves an investment of shs,
10 million with a return of 12% in the period of 10 years. Project B requires the same investment
(shs. 10 million) with a return of 14% p.a for the period of 15 years. Which project should be
chosen?
VALUATION CONCEPTS
Compounding (Future Value concept)
Discounting (Present Value concept)

Future Value of money

This refers to the value of present cash flows on an investment at some future date when
compounded using an appropriate (interest rate) rate of return.
Compounding
This isthe process of finding the future value of a present sum of money using a given interest
rate.
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Future Value (FV) formula
The Formula for the future value of an investment plus accumulated interest after n times or
periods is;
FV = Present Value × ( 1+r )n
FV = PV × ( 1+r )n
Or FV = Po (FVIFin), using tables
Where Fv =Future value of an investment with interest
PV = Present value or the initial of the investment
r = Is the compound rate of return per time period
n = Number of years or time periods.
Note
The term (1 + r)n in the formula is called the future value factor at interest rate ‘r’for ‘n’
periods. Factors for a number of rates and time periods have been worked out in financial tables.
The user can simply refer to the tables and adjust the formula as
FV = Present value x FVF n, r.
Example1
Musiwulu deposited shs. 4m in a bank that pays interest of 16% per annum for 4 years.How
much will her balance be in her account?
Example
Suppose that you have $ 10,000 to invest and that you want a return of 10% on this
investment.What will be the value of this investment moneyafter?
One year
Two years
Three years
Four years
Example;
Ms. Nantongo has $5,000 to invest for 3 years at an annual interest rate of 12%. How much will
she earn at the end of two years period?
FV = 1,000( 1+12 % )2
=1,254.40
Using tables= Present value x FVFn,r.
=1,000 x FVFn,r

Present Value
Refers to the cash equivalent now of a sum of money receivable or payable at a stated future
date, discounted at a specific rate of return
Discounting is a process of converting a future value to a present value.
The discounting formula used to calculate the present value of a future sum of money at the end
of n time periods is;

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 FV
PV =[ ]
( 1+ r )2

Example
If one expects to earn a rate of return of 10% on her investments, how much would she need to
invest now to have the following investments?
Shs, 11,000 after 1 year
Shs. 12,100 after 2 years
Shs. 13,310 after 3 years
Solution
Discounting as follows can get the solutions to the above problems
After 1 year
11,000
PV = [ ]
( 1+ 0.1 )1
PV = shs. 10,000
After 2 years
12,100
PV = [ ]
( 1+ 0.1 )2
PV = 10,000
After 3 years
13310
PV = [ ]
( 1+ 0.1 )3
PV = shs. 10,000
Like in compounding, the term (1 + r)n in the formula is called the present value factor also
obtained from the financial tables.
Example 2
Mr. Ochan wants to know how long of a deposit to make so that the money will grow to shs.
10, 0000 in five years at a discount rate of 10%
Solution
Calculation based on general formula:
FV
PV = [ ]
( 1+ r )n
10,000
PV = [ ]
( 1+ 0.10 )5
= 6,209.21

Calculation based on Tables:

PV = 10,000(PVIF 10%,5)
= 10,000 (0.621)

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 6,210.00 (due to rounding)
Example 1
Joseph’s leg was chopped on while at work. The project manager has decided to compensate him
with shs24million annually for the rest of his life. Joseph has agreed to receive this compensation
at once now at 2% per annum. Give the equivalent of this compensation now.
Example 2
Suppose you have developed a product that will pay you $ 100,000 in 7 years from now at a rate
of 7 percent. What is the value of your investment today?
MULTIPLE COMPOUNDING OR DISCOUTING
When compounding /discounting, you have to do more than ones and the formula has to be
modified, e.g. compounded more than ones in a year such as; Monthly Quarterly, Semi-annually
(half yearly)
a) Multiple Compounding
FV = PV × ( 1+r /m )nxm
b) Multiple discounting
FV
PV = [ ]
( 1+ r /m )nxm
Question
Edina has invested one million shillings for 5 years at an annual rate of 12% .
Required;
Compute the future value if
Interest is compounded yearly/annually
Interest is compounded semi- annually
Interest is compounded quarterly
Interest is compounded monthly
Example 2
Anew trading firm promises to pay you 2 million shillings as a salary and you decide to
invest it now in a fund that pays 6% compounded quarterly per annum. How much will
you have at the end of 2 years?

Question
Explain the difference between the concepts of present value of money and future valueof
moneyas used in financial management:
Solution
Both concepts are used to account for the timing of the cash flows associated with finance
decisions.
Question
With example, Differences between the concepts of present value and future value as used in
financial management

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Solution
Future value refers to the value of present cash flows on an investment at some future date
when compounded using an appropriate rate of return .
Present value on the other hand, refers to the cash equivalent now of a sum of money receivable
or payable at a stated future date, discounted at a specific rate of return.
The process of finding the future value of a present sum of money is known as compounding,
while discounting is a process of converting a future value to a present value.
The formula for the future value of the investment with plus accumulated interest after n time
periods is, FV = PV ×( 1+r )n
Example
Supposing that you have shs 10,000,000 to invest and that you want a return of 10% on this
investment.
The value of the investment with interest (future value) would build up as follows;
After one year, shs 10,000,000 ( 1+0.1 )1= 11,000,000
After 2 years, shs 10,000,000 ( 1+0.1 )2 = 12,000,000
After 3 years, shs 10,000,000 ( 1+0.1 )3 = 13.310,000
Note
The term ( 1+r )n in the formula is known as the future value factor at interest rate r for n
periods.
The factors for a number of rates and time periods have been worked out in financial tables
Fv = present value x FVF n,r.
In the example above, the future value after 3 years is simply got as,
Fv = shs. 10,000,000 x 1.310 = shs. 13,310,000
While the discounting formula used to calculate the present value of a future sum of money at
FV
the end of n time period is PV = [ ]
( 1+ r )2

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UNIT 3
INVESTMENT/CAPITAL BUDGETING DECISION

What you will study in this chapter?

Meaning and Definition of Capital Budgeting.
Basic Features of Capital Budgeting.
Need for Capita! Budgeting.
Procedure of Preparing a Capital Expenditure Budget.
Objectives and Significance of Capital Budgeting.
Factors Affecting Capital Investment Decisions.
Investment Decision making.
Methods of Appraising Project Profitability.
Limitations of Capital Budgeting.
Question
What are investment decisions?
Give the sequence of steps in a investment Process
Introduction
MEANING AND DEFINITION OFINVESTMENT/CAPITAL BUDGETING
This is one of the 4 major decisions for a financial manager
It involves a decision on long term profitable projects
Decisions are based on expected future earnings from the project

Introduction
The efficient allocation of capital is the most important finance function in the modern times. It
involves decisions to commit the firm’s funds to the long-term assets. Such decisions are of
considerable importance to the firm since they tend to determine its value and size by influencing
its growth, profitability and risk.

The investment decisions of a firm are generally known as the capital budgeting , or capital
expenditure decisions
We shall discuss the nature of investment decisions and criteria for investment analysis.
We shall also provide comparison of the various investment s criteria to indicate the most
consistent criterion.
Definition
Acapital budgeting is the process of identifying , analyzing, and selecting investment projects
whose returns (cash flows) are expected to extend beyond one year. Or it may be defined as the
firm’s decision to invest its current funds most efficiently in the long-term assets with
expectation of flow of benefits over a series of years.
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The long term assets are those which affect the firm’s operations beyond the one-year period.
The firm’s investment decisions would generally include the following features; adoption,
disposition, modification and replacement of fixed assets, whose return would be available only
after a period of time longer than one year.
Types of Investment Decisions/Proposals
Question; Give and explain any categories of Capital investments
There are many ways to classify investments. Some classifications are as follows:
Expansion of existing business
New business/products
Replacement and modernization of equipment or building
Research and development
Exploration
Other (for example, safety related or pollution –control devices)
Expansion of existing business
A company adds capacity to its existing product lines to expand existing operations Forexample;
a fertilizer company may increase its plant size to manufacture more urea.
Expansion of a new business or diversification
Expansion of new business requires investment in new products and a new kind of production
activity within the firm. For example, if a package manufacturing company invests in a new
plant and machinery to produce a ball bearing, which the firm has not manufactured before; this
represents expansion of a new business or diversification.
Replacement and modernization
The firm must decide to replace those assets with new assets that operate more economically.
For example, if a cement company changes from semi –automatic drying equipment to fully
automatic drying equipment, it is an example of modernization and replacement.
The main objective of replacement and modernization is to improve operating efficiency and
reduce costs which will increase profits.
Replacement decisions help to introduce more efficient and economical assets and therefore, are
also called cost-reduction investments.

BASIC FEATURES OF CAPITAL BUDGETING

The basic features of capital budgeting are as follows:
Involve exchange of current funds for future benefits
The future benefits will occur to the firm over a series of years
Funds are invested in long term assets
Capital Budgeting decisions involve the exchange of current funds for the benefits to be achieved
in future.
The funds are invested in non-flexible and long-term activities. They have a long-term
and significant effect on the profitability of the concern.
They are irreversible decisions involving huge funds and consequently high degree of risk.
They involve a longer gestation period between the initial outlay and the anticipated returns.
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Question; list and explain the importance of investment decisions, or
Question; explain why capital budgeting decisions need a series of special techniques
Importance of investment decision
It helps determine which permanent asset mix a firm will hold
Irreversibility. Most investments decisions are irreversible. It is difficult to find a market of
such capital items once they have been acquired. The firm will incur heavy losses if such assets
are scrapped.
Complexity; Investment decisions are among the firm’s most difficult decisions .Thus, it
becomes easy to foresee/assess future events which are difficult to predict.
Funding. Investment decisions generally involve large amount of funds which make it
imperative for the firm to plan its investments programmes very carefully and make advance
arrangements for procuring finances internally or externally.
They have long –term implications for the firm, and can influence its risk complexion. Thus,
investment decisions shape the basic character of a firm.
It helpsto know which project /asset should be invested in huge sum of money
Investment decisions help to minimize the costs that would be incurred if the decision made was
wrong
Firm’s decision to invest in long-term assets has decisive influence on the rate and direction of
its growth in the long run
It involves the survival of the firm in the long run.
It helps in increasing capacity, efficiency, effectiveness etc, of the firm
It is a strategic decision, with costs, time, and quality.
Constant and up to date capital budgeting decision enable the firm to acquire the relevant assets
necessary for producing competitively.
Classification of investment proposals
Mutually exclusive proposals
Contingent investments proposals
Independent proposals
Mutually exclusive investments
These investments serve the same purpose and compete with each other.
For example, if one investment is undertaken, others will have to be excluded. A company may,
for example, either use a more labour –intensive, semi-automatic machine, or employ a more
capital –intensive, highly automatic machine for production. Choosing the semi- automatic
machine precludes the acceptance of the highly automatic machine.

Independent investments/proposals
These types of investments serve the same purpose and compete with each other. For example, a
heavy engineering company may be considering expansion of its plant capacity to manufacture
additional excavators and addition of new production facilities to manufacture new product- light

19
commercial vehicles. Depending on their profitability and availability of funds, the company can
undertake both investments.
Contingent investments/proposals
These are dependent projects; the choice of one investment necessitates that one or more other
investments should also be undertaken. For example, if a company decides to build a factory in a
remote, backward area, it may have to invest in houses, roads, hospitals, schools etc., for
employees to attract the work force. Thus building of a factory also requires investment in
facilities for employees. The total expenditure will be treated as one single investment.
Question;
Explain the steps that analysts take when carrying out capital investment projects
The Capital Budgeting Process
Project Generation
Project Screening/ Evaluation
Project Selection
Project Execution
CAPITAL BUDGETING PROCESS OR PROCEDURE OF PREPARING A CAPITAL
EXPENDITURE BUDGET
The following procedure may be adopted in a big firm for preparing a Capital Expenditure
Budget:
1) Project Genera1ion (Origin of the investment proposals);
The first step in preparing a capital budget is to generate enough investment /capital expenditure
proposals in order to make the most efficient use of the firm's funds.
The proposals may originate at any level or departments of the organization
2) Project Screening/Evaluation:The committee screens the proposals by evaluating project
cash flows in terms of their costs and benefits. The proposals found suitable are undertaken for
further-economic analysis
3) Project Selection based on a value –maximizing acceptance criteria:
After proper screening and evaluation of the Capital expenditure proposals, the uneconomic or
unprofitable proposals are dropped. The remaining profitable projects are arranged and approved
in order of their priorities and desirability
Project Execution/implementation
When a project is incorporated in the capital budget, the heads of different departments are
authorized to execute the projects of their respective departments.
5) Review and Follow-up:Reevaluating implemented projects continually and performance post
audits for completed projects. For example, the actual costs are compared with the budgeted
costs at suitable intervals. In case the deviation exceeds the established standard, the reasons for
such variation are explored and removed. At that time, the cost estimates are revised and
effective steps are taken for controlling the costs.
Question

20
Explain why it is important to critically evaluate the capital budgeting decision we should
undertake?
Solution
To identify various opportunities that adds value
Determine the assets mix which will determine the nature of the business
Determine the growth of the firm, to make the best choice that will lead to growth
To assess the risk associated with the investment
To critically asses the most viable so that we don’t invest a lot of money
They require a large initial outlay and hence, it’s important to critically asses the expenditure
decision
To assess whether the return generated will be able to cover the risks incurred.

FACTORS AFFECTING CAPITAL INVESTMENT/BUDGETING DECISIONS

Managerial decision-making in respect of investment proposals is a difficult and complicated
problem. The following considerations other than profitability need to be made in managerial
decisions about investment proposals;
Availability of Funds: Capital projects involving huge amount of investment call for the
managerial consideration of internal and external sources of funds. Since most firms have limited
funds, only such investment projects should be taken which are within their financial capacity.
Additional Funds.
Generally, all capital investment proposals for increasing revenue require additional
funds for meeting working capital needs. Thus, the availability of additional funds for
meeting the increased working capital requirements and contingencies in future
constitutes an important factor affecting the managerial decisions about capital
investment proposals.
Utilization of Funds : Where a firm has large invisible funds, the management considers to
invest them even in capital projects with comparatively lower profitability in order to fully
utilize the firm's funds so as to maximize the total profits of the concern.
Urgency of the Project: Certain capital projects, which are essential for the survival of the
firm, are undertaken irrespective of their profitability. .
For, example, if there is a breakdown in production process, the management has to take
immediate decision to by the available components to resume production.,
Expectations of Future Earnings: Expected rate of return on future investment also affect the
selection of present investment proposals. If management has plans for undertaking more
profitable projects in future, it may presently choose those investment proposals whose economic
life orPayback period is very short, although they may be less remunerative.
Intangible Factors; Statutory obligation, prestige of the firm, employees’ welfare, motive of
power, etc., are other non-economic and intangible factors which are not at all concerned with
the profitability of investment. These non economic factors are duly considered by the
management while taking decisions in respect of investment proposals, although the above
mentioned factors have no relevance to the profitability of the investments.
21
Risk and Uncertainty: Different capital investment proposals have different degrees of risk and
uncertainty. The difference between risk and uncertainty is that while the former involves
situations in which the probabilities of occurrence of a particular event are known, whereas in
case of the later these probabilities are not known. Risk in capital investment decision may be
due to changes in economic conditions, competition, technological developments, labor
conditions consumer preferences, etc..
Q. 4. Describe the Limitations of investment decision. Or
What are the different kinds of Investment Decisions?
LIMITATIONS OF CAPITAL BUDGETING
Capital investment decisions are of great importance to the future success and growth of a firm.
However, decision making in respect of capital investment proposals is a difficult task. Capital
budgeting suffers from the following limitations:
Accuracy of estimates: The estimates of profitability of investment proposals relate to some
future period which is uncertain. Obviously, decisions involving uncertainty also involve an
element of risk. Errors are likely to creep while estimating revenues, costs, economic life span of
assets, etc. Inaccurate forecasts may lead to serious adverse effects on the growth and
profitability of the firm and may also endanger the very survival
Comparability of Costs and Benefits: Capital investment decisions are base on estimates of
future costs and benefits of the alternative investment proposals. But the costs incurred and
benefits received from the capital investment proposals occur at different lime periods and hence
are not logically comparable because of the time value of money.
Quantification of Certain Costs and Benefits : There are certain factors like morale of the
employees, goodwill of the firm etc., which cannot be correctly quantified but which cannot be
correctly quantified but which otherwise substantially influence the capital decision.
Urgency: Urgency is another limitation in the evaluation of capital investment decisions.

UNIT 4
CASH FLOWEVALUATION
METHODS USED WHEN APPAISING/EVALUATING AN INVESTMENT
Introduction
In this chapter we will be looking at how the Financial Manager should go about making capital
investment decisions. For example, they may have to decide whether or not it is worthwhile
22
investing $1,000,000 in a new factory. Alternatively they may have to make the choice between
several available investments.
Characteristics of a sound investment evaluation criterion
A good appraisal method should provide the following:
It should consider Accept/reject criterion
It should consider all cash flows to determine the true profitability of the project.
It should provide for an objective and unambiguous way of separating good projects from bad
projects.
It should help ranking of projects according to their true profitability and desirability.
It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash
flows are preferable to later ones.
It should help to choose among mutually exclusive projects which maximize the shareholders’
wealth.
It should be a criterion which is applicable to any conceivable investment project independent of
others.
Methods /Techniques
Question; A number of investments techniques are used in practice and grouped into two
major categories, name these two categories of investment techniques and the investment
techniques under each category.
We evaluate cash flows because it helps us determine viability of an investment and we
determine viability by applying techniques of appraisal.
Techniques of appraisal or evaluating cash flows are categorized into the following two groups,
namely; Traditional or non-discounted cash flow technique and Discounted cash flow technique:
Traditional Methods/Non - discounting Cash Flow Technique
Payback Period (PBP)
Accounting Rate of Return (ARR)
Discounted Cash Flow (DCF) technique/criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Traditional methods/Non Discounted Cash Flow techniques
These are the techniques that do not put into consideration the time value of money
concept; they include
Payback period (PBP)
Average or Accounting rate of return (ARR)
Payback period (PBP) method
Definition of PBP;
It is defined as the number of years required to recover the original cash outlay invested in a
project. Or it is the time it takes for a project to recoup or bring back the original investment in
cash terms.

23
This means that the payback period of an investment tells us the number of years required to
recover/recoup our initial investment based on the the project’s expected cash. Or is the time it
takes the cash inflows from a capital investment project to equal the cash out flows. It is usually
expressed in years.
Features of PBP technique
When deciding between two or more competing projects, the usual decision is to accept the one
with the shortest payback period.
PBP method is often used as a first screening method. This means that when a capital investment
project is being considered, the first question to ask is, how long it will take to pay its costs.
The firm may have a target pay back period, and so it will reject a capital project unless its pays
back period is less than the target pay back period.
The pay back period is compared with a target period – if the project pays for itself sooner than
late, then it should be accepted , if not , then it should be rejected.
It should be noted that when calculating the payback period, take cash flows or profits before
depreciation because we are trying to estimate the cash returns from the project.
Computation:
The computation of payback period involves two situations, namely where the Cash Inflows
arein Uniform amounts and where the amounts of Cash Inflows Vary:
1) Where the Cash Inflows are in Uniform amounts
Where the cash inflows are in the nature of a series of uniform/ amounts or if a project generates
constant annual cash inflows over it economic life, the payback period can be computed by
dividing cash outlay by the annual cash inflows.
If the project generates constant/even/uniformannual cash flows, as in the first case, the Payback
Period of an investment proposal can be computed by the following formula:
Payback Period = Initial Investment
Annual Cash Inflow
Initial Investment (Cashoutlay)
PBP =
Annual cash inflow
Example, 1
If a project requires $. 30,000 as initial investment which is expected to generate an annual net
cash inflow of $ 10.000 for a period of 10 years, then the Payback Period will be 3 Years ($
30,000/$ 10,000) = 3 Years.
The original investment will be paid early/sooner than the targeted period of 10 years, so the
project should be accepted.
Example 2
Given the Initial out lay of investment as $400,000,its annual Cash inflows as $ 100,000 and its
useful life is 6 years, compute the payback period of the investment
Solution
Initial Investment (Cashoutlay)
PBP =
Annual Cash Inflows

24
 400,000
PBP =
100,000
= 4years
Example
An investment initially requiresshs. 800m. It generates uniform cash inflows of 200million
shillings per year and the useful life of this investment is 7 year. What is the payback period for
the investment?

Acceptance Rule/ Criteria

Under this technique, the PBP determined for the investment should be shorter or at least equal
to the PBP desired by the firm.
Question;
Assume that the project requires an outlay of $ 50,000 and yield an annual cash inflow of $
12,500 for 7 years.
Required;
Compute the payback period for the project
Projects with unequal or varying cash inflows
Where the net cash inflows are in the nature of a series of uneven amounts, i.e., the annual cash
inflows differ from year to year over the life span of the project, the payback period can be
calculated by cumulating the net cash inflows until the total becomes equal to the amount of
original investment
Steps
Accumulate the cash flows occurring after the initial outlay in a cumulative inflows column.
Look at the cumulative inflows column and note the last year (a whole figure) for which the
cumulative total does not exceed the initial outlay.
Compute the fraction of the following year’s cash inflow needed to payback the initial cash
outlay as follows: Take the initial outlay minus the cumulative total from step 2 , then divide this
amount by the following year’s cash inflows, for example
(30,000 – 29,000)/4,0000 = 3.25
Eaxample1
If the net cash outlay of an investment project is $ 30,000 and the annual cash inflows for 5 years
are $ 9,000, $ 12,000, $ 8,000, $ 4,000 and $ 4,000 respectively, the payback Period will be
computed as follows:

COMPUTATION OF PAYBACK PERIOD

Year Net Cash Outlay Annual Net Cumulative
($) Cash Inflows ($) Cash Inflows ($)

1 30,000 9,000 9,000

25
2. — 12,000 21,000
3. — 8,000 29,000
4 __ 4,000 33,000
5 __ 4,000 37,000

It is clear from the above table that in the first three years $ 29,000 out of the original investment
of $ 30,000 has been recovered. The remaining unrecovered amount of $ 1,000 has to be
recovered from the cash inflows of $ 4,000 in the fourth year. It means the Payback Period is
more than three years but less than four year. The net cash inflow for the fourth year is $ 4,000
out of which $ 1,000 have to be recovered. Thus, the total Payback Period for the recovery of the
initial investment will be computed as follows:
Payback Period - 3 Years + $ 1000
$ 4,000 = 3.25Years
Or Payback Period = 3 Years + [30,000-29000=$ 1,000 x 12 months]
$4,000
= 3 Years and 3 Months
Trial Question
A machine will cost $80,000
It has an expected life of 4 years and expected net operating cash inflows each year as follows:
20,000
30,000
40,000
10,000

Required:
Calculate the Pay Back Period (PBP) of the project.
Example 2
Mutually exclusive investment proposal
This method can also be used for ranking in case of mutually exclusive investment proposals. All
investment proposals are ranked in an ascending order according to their respective payback
periods.
The project having the shortest payback period will be accepted provided it does not exceed the
pre-determined payback period.

Consider the cash flows of two mutually exclusive projects Pand Q

Project P Project Q
Capital $ 60,000 $ 60,000
Cash inflows $ $
Year1 20,000 50,000
Year 2 30,000 20,000

26
 Year 3 40,000 5,000
Year 4 50,000 5,000
Year 5 60,000 5,000

Given a target payback period of 2 years, we can select the project to be undertaken as follows
Project P
($ 60,000−50,000)
PBP = 2years + x12months
$ 40,000
PBB=2years and 3 months
Project Q
$ (60,000−50,000)
PBP = 1 year + x12 months
20,000
PBP = 1 year and 6 months.
Suitability of Payback Period Method:
Payback period method of capital projects evaluation is suitable for firms which are .subject to
rapid technological changes such as ;
pharmaceuticals,
electronics and
space industries, or
rapid consumer taste changes such as clothing industry. Since such firms have to make huge
investments in research and development, production facilities and marketing, they are keen to
recover it before their products become obsolete.
Qn; Give the advantages of payback period
Merits or Advantages of Payback Period Method:
Simplicity: The most outstanding merit of the payback period method is that itis simple to
understand and easy to work out.
Liquidity: This method measures the recovery period of the original investment involved in
capital projects. It reflects the liquidity of a project, and hence the risk of recovering the original
investment is taken into consideration.
Safety: This method alsominimizes the possibility of losses on account of obsolescence due to
rapid technological changes or changes in consumer preferences..
Reliability: In case of projects with uncertain returns, this method of project evaluation is
considered to be more reliable. Since it is possible to accurately forecast costs and sales in the
short-run, more reliable conclusion may be drawn under this method.
Calculations: The payback criteria are a good approximation to the reciprocal of the internal
rate of return in case the cash flows are uniform.
It is similarly helpful in communicating information about minimum requirements to mangers
responsible for submitting projects.
It can be used as a screening device as a first stage in eliminating obvious inappropriate projects
prior to more detailed evaluation.

27
 If a project gets through the payback test, it ought then to be evaluated with a more
sophisticated investment appraisal technique.
The fact that it tends to bias in favor of short term projects means that it tends to minimise both
financial and business risk,
It can beusual where there is capital rationing situation to identify those projects that generate
additional cash for investment more quickly.

Demerits or Drawback of Payback Period Method;

Although this method occupies an important place as an investment criterion due to its wide
usage, it suffers from serious limitations. Its major drawbacks are as follows:
Ignorance of Post-payback Cash Inflows: Payback period method cannot be regarded as a
measure of profitability as it fails to consider the alternative investment proposals in terms of
their relative total benefits over their respective life spans.
It ignores the timing of the cash flows within the payback period, the cash flows after the end of
the payback period, and the total projectreturn.
3) The method is unable to distinguish between projects with the same payback period
4) The choice of any cut off (target) payback period by an organization is arbitrary.
5) It takes account of the risk of the timing of cash flows but not the variability of those cash
flows.
6) Disregard to the Time Value of Money: It does not take into consideration the time
value of money. This means that it does not take into account of the fact that. Shs, 1 today is
worth more than shs 1 in one year’s time. It does not differentiate between the alternative
investments projects in terms of the minimum and magnitude of cash inflows. It does not
discount the future cash inflows..
7) Disregard to the Productivity of Capital: It gives undue emphasis to quick recovery of
funds over emphasis on the liquidity of investment and disregard to the -profitability of
investment.
8) Disregard to the Cost of Capital: This method also ignores the cost of capital which
constitutes tothe basis for sound capital investment decisions.
Despite its limitations, the payback period method occupies an important place in any discussion
of investment decision criteria, not because of its merits but due to its popularity and wide usage
among businessmen.

Question;
"Payback Period Method of Project Evaluation is a test of liquidity and profitability."
Discuss.

28
Or Discuss the Payback Criterion of Investment Decisions. What are its strengths and
weaknesses?

AVERAGE/ACCOUNTING RATE OF RETURN (ARR)METHOD

The Average Rate of Return (ARR) Method of evaluating investment proposals is also known as
Accounting 'Rate of Return Method’, or Return on Capital Employed (ROCE) or 'Unadjusted
Rate of Return Method’ or 'Return on Investment Method*.
This method is based on accounting income measure and considers the expected profitability of
an investment instead of cash inflows.
It attempts to measure the rate of return 'in investment on the basis of the accounting information
contained in financial statements instead of cash flows.
It estimates the accounting rate of return that the project should yield. A given project is taken if
its ARR exceeds the firm’s target rate of return.
ARR= Estimated Annual Average profits/-(After Taxes or depreciation) x 100%
Estimated initial/original Investment
Total Depreciation of initial out lay = depreciate the cost of capital by expected life of the
investment
Annual Average net profits=
Cash in flows-initial out lay depreciation
Number of years of an investment (expected life)
The average investment =:
Original Investment + Scrap
2
Note; If there is no scrap value, then only the original investment is divided by '2'.
Taxes are also deducted from profits where they exist
The average investment is the average of the initial capital cost and the estimated salvage value.
Example
Bangihas a target accounting rate of return of 25%, he is considering the following project.

Capital cost of assets $100,000

Estimated life 5 years

Estimated profit before depreciation

Year 1 $ 50,000
Year 2 $ 45,000
Year 3 $ 35,000
Year 4 $ 25,000

29
The capital asset would be depreciated by 20% of its costs, and will have no residual value. We
can assess whether the project should be undertaken as follows
Further, if there is additional investment in working capital, it will be added to average
investment calculated in the above manner.
Solution/fill in the missing information
The annual depreciation will be ……?….of $ 100,000 = $ …?…….
Total depreciation over the years is …?….. x 4 = $ ……?….
Total profits before depreciation over the years is $ …………
Total net profits after depreciation over the years is ………- $ 80,000 = $ ……..
Average annual profits $ ……../4 = ……….
Average investment over the years is the average of the original cost and the residual value.
Average investment = ($ ……?.. + 0)/2 = $.....?......
$( …? … .)
x 100% = ……?…%
$ …? … … .
Comment
The project should …?….undertaken because it fails to yield the target rate of return of 20%
Remark
The ARR method of capital investment appraisal can also be used to compare two or more
projects, which are mutually exclusive.
The project with highest ARR is selected provided that the expected ARR is higher than the
company’s target ARR.
Merits of the ARR Method: The advantages or merits of this method are as follows:
Simplicity: It is easy and quick to understand and simple to work out.
Comparability: This method takes into account the saving of capital assets over their entire
economic life and hence provides better comparability criteria of the projects than the payback
period method.
It involves a familiar concept of a percentage return.
It looks at the entire project life.
Net Earnings Concept: This method duly recognizes, the concept of net earnings while
appraising capital investment projects, which is absent in case of the other methods. The concept
of net earnings' is considered to be a significant factor in evaluating; capital investment
proposals.
Profitability: It gives due weight age to the profitability of the alternative projects, which is a
vital factor of evaluating and selecting the most profitable investment proposals.

Demerits of the ARR Method:

The unadjusted rate of return method or ARR method suffers from several serious limitations
which are as follows:
Disregard to Time Value of Money;
This method of project evaluation also does not take into account the time valueof money
like the payback period method. It does not discount the future cash- inflows. It treats all
30
 the streams of cash-inflow to have the same value whether received now or after two year
or ten year.
Fear of Over-valuation;
It does not reveal a true and fair view of long-term investment, as there is always a
chance of over-valuation of the position.
Accounting Income:
This method is based on accounting income rather than cash flows. It treats depreciation
as a deduction before arriving at the additional net income, whereas it is only a book
entry and does not involve any cash outflow. Cash flows are, in fact, a better measure of
the net economic benefits or costs associated with a project.
Disregard to the Size of Investment:
This method does not differentiate the alternative investment proposals in terms of their
magnitude of investments. This method becomes useless for the firm to firmly decide
upon the implementation of a particular project.
Determination of the Minimum Rate of Return:
Determination of the minimum acceptable rate of return is another problem associated
with this method. Generally, an arbitrary minimum rate of return on investment is fixed
by the management as it is very difficult to determine a reasonable rate of return..
It does not take into account of the timing of the profits from an investment
It does not account for the length of project.
On account of the above short comings, this traditional method the ARR method of evaluating
capital expenditure proposals is not much in use these days.
Question
Explain the benefit of applying discount cash flow methods of investment appraisal
Why DISCOUNTED CASH FLOW METHODSare preferred than traditional or non-
discounted cash flow methods
The traditional methods do not provide a meaningful tool for financial decision-making. The
Average Rate of Return (ARR) and Payback Period Methods suffer from a number of
shortcomings.
The Discounted Cash Flow Methods or Time-adjusted Methods of evaluating capital projects
take into account the time value of money, interest factor (i.e., cost of capital) and all costs and
benefits occurring during the entire life period of the project.
They look at the cash flows of a project and not the accounting profits, and thus they are
concerned with the project’s liquidity and not profitability.
Cash flows are considered because they show the costs and benefits of the project when they
actually occur.
The timing of the cash flows is taken into account by discounting them. The effect of discounting
is to give a bigger value per shs 1 for cash flows that occur earlier. That is, shs, 1 earned after
one year will be worth more thanshs. 1 earned after two years, which in turn will be worth more
than shs. 1 earned after five years, and so on

31
Cost of capital (rate of return):
This is the marketing determined rate and reflects compensation to investors for time value of
money and riskiness of the investment project.
Discounted Cash Flow (DCF)method/criteria
The time-adjusted methods of evaluating .capital expenditure proposals include:
(1) Net Present Value method,
(2) Profitability Index method,
(3) Internal Rate of Return method,
This approach looks at the expected cash flows from the investment in Question. If over the life
of the investment there is an expected cash surplus, then the project will be accepted, where as if
The profitability index technique of appraising capital project is superior to the NPV method as
the former evaluates the worth of projects in terms of their relative rather than absolute
magnitudes. However, in cash of certain mutually exclusive projects, the NPV method would be
superior to the PI method as it always gives a better mutually inclusive choice.
[i] Net Present Value (NPV) Method:
Introduction
The Present Value Method is one of the Discounted Cash Flow (DCF) or Time-Adjusted
Methods. It is also known as 'Discounted Benefit-cost Ratio Method.
Definition
The Net present value (NPV) is defined as the value obtained by discounting all cash outflows
and inflows of a capital investment project by a chosen discount rate (rate of return) or cost of
capital.
Features of NPV method
This method is the classic economic method of evaluating the investment proposals. It takes into
account (recognizes) the time value of money.
For example, all the benefits and costs occurring throughout the useful life time of a project are
expressed in forms of the present value.
It correctly postulates that cash flow arising at different time periods differ in value and are
comparable only when their equivalents (present values) are found.
For example,
The method compares the present value of all the cash inflows from an investment with the
present value of all the cash outflows from the same investment.
This method is based on the assumption that the value of present investments cannot be
compared with the future amounts of cash inflows from this investment. This problem can be
solved by converting the future amounts of earnings to their present values. This will make the
values of investment and earnings comparable.

32
Thus, the present value method is based on a comparison of present value of an investment with
the present value of the streams of its cash inflow.
The NPV is thus calculated as the present value cash inflows minus the present value of cash
outflows
FV
PV [ ]-Io
( 1+ r )2
Steps involved the calculation of NPV
The steps involved in computing the present values of investment outlays and cash inflows are
described below:
Determination of the rate of discount, i.e., cut-off rate. This discount rate is the cost of capital of
the firm or the rate of return desired by the firm on its investment. (This is generally
given in the question i.e. 15%).
The appropriate discount rate is the firm’s opportunity cost of capital which is equal to the
required rate of return expected by investors on investments of equivalentrisk
Determination of cash outlays, both initial and subsequent and cash inflows for different years
are given.
For computing the present value of cash flows at different periods, present value factor may be
given in tables.
Multiply present value factors with all the cash inflows and add them to find total present value
Present values of all cash inflows are added together.
Find the Net present value bysubtracting the total present value of cash inflow with cash out
flows from present value of cash inflows. The project should be accepted if NPV is positive
(i.e. NPV > 0)
In case the present value of cash inflows is more than the present value of cash outflow, the
project will be accepted, otherwise rejected. The net present value is the difference between the
present value of the future cash inflows and the present value of cash outflow
NPV = Cash inflow- cash out flow = NPV

Accept if cash in flows are greater than cash out flow

Example 1
Assume that Project X costs $80,000 in years 1 through 4 or it has an expected life of 4 years
with an anticipated scrap value of $10,000. It is expected to generate net operating cash inflows
each year are as follows:
20,000
30,000
40,000
10,000
The opportunity costs of the capital is assumed to be 10 percent p.a..

33
Required:
Calculate the Net Present Value (NPV) of the investment and determine whether or not it should
be accepted.
Acceptance /Rejection criteria
Accept if it’s Positive NPV or (NPV >0)
This means the cash inflow from the capital investment will yield a return in excess of the cost of
capital, and so the project should be undertaken if the cost of capital is the organization’s target
rate of return.
Reject if it’s Negative NPV or (NPV< 0
This means, that the cash inflows from a capital investments will yield a return below the cost of
capital, and so the project should not be undertaken if the cost of capital is the organization’s
target rate of return.
May accept if it’s A zero NPV or (NPV = 0)
This means that the cash inflows from a capital investment yield a return that is exactly the same
as the cost of capital, and so if the cost of capital is the organization’s target rate of return, the
project will be only just worth undertaking.
Question
Kabonge is considering a capital investment, where the estimated cash flows are as follows;

Year Cash flows

$
0 (100,000)
1 60,000
2 80,000
3 40,000
4 20,000

The company’s cost of capital is 15%. You are required to calculate the NPV of the project and
so assess whether it should be undertaken
Solution
We tabulate our working as follows
Year Cash Discount factors Present
flow rate Value
$ at 15 %
0 (100,000) 1.00 (100,000)
1 60,000 0.870 52,200

34
 2 80,000 0.756 60,480
3 40,000 0.658 26,320
4 30,000 0.572 17,160
Xxxx Xxxxx Xxxx NPV=56,160

The discount factor for any cash flow now (year 0) is always = 1, regardless of the cost of
capital.
Comment
The net [resent value is positive implying that the present value of the cash inflows exceeds that
of the cash out flows by $56,160.
This means that the project will earn a DCF yield in excess of 15% and should therefore be
undertaken
Merits of the NPV Method: The NPV technique of evaluating investment opportunities has
the following merits:
NPV is the true measure of an investment’s profitability. The NPV method , therefore,
provides the most acceptable investment rule.
First,
It recognizes the Time Value of Money: This method explicitly recognizes the time' value of
money, which is inevitable for making meaningful financial decisions. A shilling received today
is worth more than a shilling received tomorrow.
Consideration to total cash inflows: It uses all cash flows occurring over the entire life of the
project in calculating its worth.
Best Decisions Criteria for Mutually Exclusive projects: This method is particularly useful for
the selection of mutually exclusive projects.
The discounting process facilitates measuring cash flows in terms of present values; that is in
terms of current shilling.
Changing Discount Rate: Since discounting rate changes due to time variations in cash
inflows, a changing discount rate can be used for the NPV calculations by altering the
denominator.
Maximization of the Shareholders Wealth: Finally, This method is logically consistent with
the company's objective of maximizing shareholders' wealth in terms of maximizing market
price of shares and theoretically correct for the selection of investment proposals.

Demerits of NPV Method:

The NPV method suffers from the following limitations or weaknesses:
Cumbersome Calculation: This method is difficult to understand and use as it involves
cumbersome calculation in comparison to the payback period method and the ARR method.
This drawback of the NPV method is, of course, due to unfamiliarity rather than its complexity.
Determination of Desired Rate of Return: The determination of the required rate of
return is a complicated problem. The cost of capital is generally the basis of the discount rate.
But there is a difference of generally the basis of the discount rate.

35
Static Method and Unrealistic Calculations: The method is static like other methods of
evaluating capital projects insofar as it freezes the situation at a point of time. In fact, business
situations are dynamic and to that extent all calculations may be unrealistic.
Dependable Results: This method, therefore, fails to give satisfactory and dependable results
where the alternative investment projects involve different investment outlays.
Determination of Economic Life Periods: The NPV method does not take into account the life
investment projects as it favors the project with a higher present value which may also have a
larger economic life. Thus, NPV method may not reflect the real worth of the alternative
investment proposals.
PI method
(II) Profitability Index (PI) Or Benefit-cost Ratio (B/C RATIO)
Brief Notes
This is yet another time-adjusted method of evaluating the investment proposals.
It is defined as the ratio of the present value of cash inflows, at the required rate of return, to the
initial cash out flows of the investment.
(a) PI or B/C Ratio = PV of Cash Inflows
Initial Cash Outflows
The Acceptance rule:
Accept the Project. PI >1
Reject the Project. PI <1
May accept PI = 1
When PI is greater than 1, the NPV will be positive
if the PI is less than 1, then NPV will be negative,
if profitability index is equal to 1, the firm is indifferent to the project.
In case of mutually exclusive projects, the project with the highest PI will be given the first rank,
followed by others in the same order.

Why PI method is superior to the NPV Method:

The present value of cash inflows under the NPV method is not comparable unless the
investments are of the same size.
The profitability index technique of appraising capital project is superior to the NPV method as
the former evaluates the worth of projects in terms of their relative rather than absolute
magnitudes. However, in cash of certain mutually exclusive projects, the NPV method would be
superior to the PI method as it always gives a better mutually inclusive choice.
The profitability index (PI) provides a solution to this problem. This is done by dividing the
present value of future cash inflows by the present value of cash outlays.
36
Profitability index approach measures the present value of earnings per shilling invested, hence it
is relative measure.
This approach is also known as benefit-cost ratio because the numerator measures benefits and
the denominator measures costs.
Effective Tool of Ranking Alternative Projects: The profitability index serves as an effective tool
of ranking the alternative investment project and provides a sound basis for the selection of the
most profitable project. Since benefit-cost ratio indicate the per rupee return from a project, the
PI method provides the most useful tool of ranking the mutually exclusive projects in a situation
of capital rationing.
Merits of PI method
Like the NPV and IRR rule, PI is a sound method of appraising investment projects. It gives due
consideration to the time value of money.
It is a relative measure of a project’s profitability since the present value of cash inflows is
divided by the initial cash outflows.
Consideration of Time Value: It also gives due consideration to the time value of cash flows over
the entire economic life-period of a project.
It considers all the essential elements of capital budgeting such as the time value of money,
totality of cash flows, etc.
Demerits of Profitability Index (PI):
The PI method of evaluating investment proposals suffers from the following limitations:
Difficult Method : This method is more difficult to understand and involves more
calculations than the traditional methods but less than the Internal Rate of Return Method
discussed hereafter.
Mutually Exclusive Projects: In some eases of mutually exclusive projects, the NPV method
would give the best choice than the PI method.
Illustration 6: A company is considering the following three investment proposals requiring a
net cash outlay of $ 120,000, $ 180,000 and $ 240,000 respectively. The after cash inflows are
tabulated below.
Required:
Rank these projects in order of their profitability according to the profitability index method.
Assume that the firm's cost of capital is 15%.
Year Project X Project Y Project Z
$ $ $
1 10,000 50,000 90,000
2 30,000 65,000 120,000
3 45,000 85,000 70,000
4 65,000 50,000 50,000
5 45,000 35,000 20,00

37
INTERNAL RATE OF RETURN (IRR) METHOD
Definition of IRR
The IRR is that rate of return which equates the aggregate present value of investment outlays
with the aggregate present value of the net cash inflows CCFAT) of a project. or
It is a discount rate that equates the present value of the future net cash flows from an investment
project with the project’s initial cash outflow.
In nutshell, the IRR is that rate which gives the zero NPV to the project.
IRR seeks to find out the breakeven point.
Where PV inflow = PV out flow
NPV = 0
This method is used when investment outlays and annual cash inflows are known but discount
rate is unknown.
The IRR or the discount rate at which the present values of investment outlays and inflows are
equal is generally found in trial and error. The technique of computing the IRR can be examined
under two heads—

Computing the IRR

Without a competitor or calculator program, the calculation of the internal rate of return is made
using a hit –and-miss technique known as the interpolation method.
Steps
The first step is to calculate two net present values both as close as possible to zero using the
rates for the cost of capital which are whole numbers.
One NPV should be positive and the other negative.
Choosing rates for the cost of capital which will give an NPV close to zero (that is , rates that are
close to actual rate of return) is also a hit- to- miss excise, and several attempts may be needed to
find satisfactory rates.
But as a rough guide, try starting at a return figure which is about two thirds or three quarters of
the accounting rate of return on investment.
Ie 2/3, OR ¾(ARR)
If the first NPV is positive, choose a higher rate for the next calculate to get a negative NPV,
If the first NPV is negative, choose a lower rate for the next calculation.
Having got the two NPVs we then estimate IRR using the interpolation method.
The formula to apply is as follows;

a
IRR=A +[ x ( B− A)]%
( a−b )

A is the lower rate of return with a positive NPV

B is the higher rate of return with a negative NPV
38
a is the amount of the positive NPV
b is the absolute amount of the negative NPV
Example 1
Elvis is trying to decide whether to buy a machine for $ 80,000, which will save costs of
$20,000per annum for 5 years and which will have a resale value of $ 10,000at the end of year 5.

If it is his company’s policy to take projects only if they are expected to yield a DCF return of 10
% or more, ascertain whether this project should be undertaken.

Solution
We determine the ARR of the project first so that it can be used to estimate the rates of return to
use in the interpolation method.
Annual depreciation is $ (80,000 – 10,000)/5 = $ 14,000
Since the profits before depreciation are equal throughout the life of the project, the average
annual profits after depreciation is,
($20,000- 14,000 = 6,000)
The estimated average investment is
½($80,000 + $10,000) = 45,000.
The IRR is$6000x100% = 13.3%.
$45,000
Two thirds of the ARR is 2/3(13.3) =8.9%
So we can start by trying r= 9%
Year Cash flow ($) PV. Factors at 9 % PV. Of cash flows ($)
0 (80,000) 1.00 (80,000)
1 20,000
2 10,000
3 25,000
4 40,000
5 50,000

Give Comment
Since it is his company’s policy to undertake investments that are expected to yield 10% or
more, this project should be undertaken
Acceptable criteria
IRR > RRR = accept
IRR < RRR = reject

39
UNIT 5
MANAGEMENT OF WORKING CAPITAL
1. Meaning and Definition of Working Capital.
2. Classification of Working Capital.
3 Need and Significance of Working Capital.
4.Factors Determining Working Capital.
6.Sources of Working Capital.
6.Methods of Working Capital Analysis.
Introduction
The purpose of this chapter is to explain the nature of working capital and the importance of it to
the financial manager. We will also consider various ratios and measures which may be useful to
the Financial Manager in assessing how well it is being controlled.

40
"Inadequate working capital is disastrous, whereas redundant working capital is a criminal
waste."
QNS;
What do you understand by working capital? Discuss the need and significance of working
capital?
WRITE SHORT NOTES ABOUT WORKING CAPITAL
ANS
MEANING AND DEFINITION OFWORKING CAPITAL
Working capital is the short term capacity that enables the business (available for) to conduct/ in
the day to day operations of the project’s long term assets (activities)in order to produce the
desired goods and services and it is represented by its net current assets.
Working capital is the money used for producing goods and services and attracts sales. In short,
working capital refers to short-term assets such as cash, stock and debtors minus short term
creditors.
It refers to the management of short term assets (current assets and current liabilities.) that enable
the firm to operate its long term assets on a continuous basis in order to produce the desired
goods and services.
Working capital is an excess of current assets over current liabilities and it shows strength of a
business in short period of time. In other words, the amount of current assets is more than current
liabilities.
Working capital normally includes (current assets) e.g. inventories, receivables, cash (and
equivalent), bills receivables less payables (current liabilities) like marketable securities and bills
payables, notes payable and miscellaneous accruals
If the company has some amount in the form of working capital, it means the company has liquid
assets and is in the position to face every crisis in the market.
Working capital is an investment which affects cash flows. For example, when stocks are
purchased, cash is paid out for them
Debtors represent the cost of selling goods and services to customers. Including the labour and
cost of materials incurred.
Investing in working capital has a cost which can be expressed as either:
The cost of funding it or
The lost investment opportunities because cash is tied up and unavailable for other uses
Formula for calculating working capital
WC = Current Assets – Current liabilities
Working capital = receivables (debtors) + cash + inventories, - payables
Current assets are those assets which are normally converted into cash within an accounting
year (within one year or less than one).
Current Assets include cash at hand, cash at bank, debtors, bills receivables, prepaid expenses
and outstanding incomes.
Current liabilities are those liabilities which can be paid to respective parties within an
accounting year or less than a year at their maturity.
41
Current Liabilities include creditors, outstanding bills, bank overdraft, bills payable and short
term loans, outstanding expenses and advance incomes.
Net working capital is the excess of current assets over current liabilities.
Investment in working capital
Working capital needs financing, just as does investment in machines.
However, it is the investment in fixed assets that (hopefully) earns profits for the company.
Investment in working capital does not directly earn profits.
Working capital management
Working capital is related to the management of all aspects of both current assets and current
liabilities to minimize the risk of going bankrupt and at the same time increasing returns on
assets.
Current assets represent more than half the assets of a project and they intend to be particularly
of small projects/firms. Most often small business projects fail because they fail to control
working capital investments and business liquidity.
Mechanism used to manage working capital
Stretch out payments (creditors) as long as possible by negotiating longer terms with suppliers.
Collect debts as quickly as possible by making it easy for customers to pay (offer them discounts
for early payments)
Avoid holding too much stock by using Just In Time (JIT) inventory method since holding stock
will tie up cash which earn no interest.
Reduce the level of investment in working capital by reducing the length of cash operating cycle

SIGNIFICANCE/USES/IMPORTANCE OF WORKING CAPITAL

How and why working capital should be acquired by project owners;
Meeting creditors’ demands with ease: They need to allow customers to buy on credit otherwise
they would lose business to competitors.
Reputation: Company can easily pay off the creditors and create its reputation in the market.
Efficient operations: Positive working capital enables a firm pay day to day expense like wages,
salaries, overheads, and other operating expenses
Creating goodwill in the market: Company managers try to keep some amount of working capital
for creating good will in the market.
Take up risky tasks: positive working capital will enable a company do every risky work without
any tension of self insecurity
For raising funds easily for purchasing long term investments::A firm applies its working capital
funds for acquiring or purchasing long-term investments like shares, bonds/debentures , etc
WC is used for purchasing tangible fixed assets, like land, building, plant, machinery,
equipment, etc.
42
It’s used for purchasing intangible fixed assets, like goodwill, patents, copyrights, etc.
WC is used for repayments of long-term debt (debentures or bonds) and short –term debt (bank
borrowing).
It’s used in payment of cash dividend.
They need to have short – term cash balances in order to pay their bills.
The primary objective of a business corporation is to maximize shareholders' wealth by earning
sufficient profit through effective operations and increased sales.
A firm needs working capital for, its daily operations.
Raw materials inventories are needed for manufacturing. Due to the time lag between
manufacturing of finished goods and sales, a firm needs cash for financing inventories; bills
receivables and other routine business expenses.
If an adequate, amount of working capital is not available for this gap period, the firm will not be
in a position to sustain its business operations. Further, the time gap between the sales and their
actual realization in cash is technically termed as 'operating cycle' of the business. Working
capital needs of a company, therefore, depend on the length of its operating cycle.
Question
Explain how much working capital a firm should keep and how it should be financed;
Solution
Define working capital and the question how much working capital a firm should keep is
answered basing on the factors that influence the working capital
Discuss the factors that influence the working capital and needs of a business;
Working capital requirements of a concern depend on a number of factors, each of which should
be considered carefully for determining the proper amount of working capital. These factors
have been discussed below:

Question;
How does each of the following determine the level of working capital to keep in a firm?
The stability of business’ sales; If the sales revenue can be easily predicted and stable, the
business can maintain low working capital . On the other hand , where the business ‘s sales are
not stable , then a business may need to maintain substantial amount of working capital to cater
for uncertainties.
The nature of the business; there are some businesses that may not require holding substantial
amount of working capital for example, consultancy firms. On contrary, there are some there are
some businesses, for example manufacturing firms which require maintenance of high working
capital such inventories and cash for its efficient operations.
The size of the firm; usually big businesses will require more working capital than small firms
for efficient operations.
The length of the cash cycle; cash cycle is the period it takes from acquisition of inputs, their
conversation into finished goods /products and finally selling them and collecting the proceeds
Where the business has got a long cash cycle then the more working capital it will be needed as
daily r regularly collection s cannot be relied upon to meet short term obligations.
43
Availability of credits; where the business can easily obtain credit from elsewhere to finance its
operations then it requires that maintaining low working capital is of advantage.
Price level changes; for example, where the price of inventories is expected to increase then the
more inventory is to be maintained.
Operating efficiency and performance; if a business has got good record of efficiency and
performance then less working capital is to be maintained.
Production Policies: More working capital is required by those industries which produce or sale
goods in a particular season. For example, sugar and woolen textile industries require more
working capital in winter season than during dry season.
Credit Policy: Companies allowing liberal (weak) credit to their customers require more
working capital as against the companies which have efficient debt collection machinery and
observe strict credit terms.
Turnover of Circulating Capital. Companies with higher rate of turnover or faster sales will
need less amount of working capital as against the companies with low turnover ratio.
Business Fluctuations: Cyclical changes in the economy also influence the level of working
capital. During boom period, the tendency of management is to pile up inventories of raw
materials and finished goods to avail the advantage of rising prices. Similarly, during depression
when the prices and demand for manufactured goods constantly reduce, the industrial and
trading activities reduce. Hence, the demand for working capital is low.
Growth and expansion of Business: In the beginning, the working capital requirements of a
company are low. However, with the gradual growth and expansion of a company, its working
capital needs also increase hence, large amount of working capital will be required for its
expansion programmes.
Economies of Scale: Need for working capital is also influenced by a company's desire to take
advantage of the economies of scale. For example, in purchasing inventories, working capital is
required for balancing the ordering costs against carrying costs so as to arrive at the optimum
order quantity. Similarly, working capital balances the transaction costs of borrowed funds
against their interest costs.
Current Assets Policies: The quantum of working capital of a company is significantly
determined by its current assets policies. A company with conservative assets policy may
operate with a relatively high level of working capital than its sales volume. On the contrary,
companies pursuing an aggressive current assets policy operate with a relatively lower level of
working capital.
Fluctuations of Supply: Certain companies have to maintain large reserves of raw material due
to their irregular sales and intermittent supply.

SOURCES OF WORKING CAPITAL

Question;
What strategies can a firm use to finance its working capital needs?
The financing of working capital

44
Whatever level of working capital the business decides to hold, it has to be financed from
somewhere.
The business must decide whether to use short- term or long- term finance.
Long-term financing: For example;
Long term finance is either raised from equity in the form of shares issues (owners’
contributions) etc.
Long-term borrowings (institutional loans, debentures, bonds etc.)
Issuance of preference shares
Short-term financing such as bank borrowing: For example
Short term financing generally involves overdraft borrowing and / or delaying payments to
payables
Sale of non-current assets: These include;
Sale of long-term investments (shares, bonds/debentures etc.)
Sale of tangible fixed assets like land, building, plant, or equipments
Sale of intangible fixed assets like goodwill, patents, or copyrights.
Funds from operations (adjusted net income)
The major source of working capital is the firm’s net profit from operations. For example, the
expenses that do not involve working capital should be added to net profits.

Permanent working capital, being long -term, should be financed long- term sources of
finance.
Temporary working capital should be financed by short- term sources of finance.

CONCEPT/CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified on the basis of its concepts as well as on the basis of its
requirement or time.
On the basis of quantitative and qualitative concepts working capital can be classified into two
categories,
Gross Working Capital,
Net Working Capital.
Classification Net working capital:
Permanent Working Capital.
Temporary Working Capital.
Gross Working Capital: This refers to the company's total investments in current assets.
Current assets are assets that can be converted into cash within one accounting year/period or
operating circle.
Current assetsinclude, cash, short termmarketable securities, debtors (accounts receivables),
bills receivables and stock (inventories), etc., which are normally converted into cash within an
accounting year or period.
Net Working Capital: This refers excess of current assets over current liabilities).
45
In other words, it is that portion of a company's current assets which is financed by long-term
funds.
Current liabilities are the claims of outsiders that are expected to mature for payment within an
accounting period
Current liabilities include, creditors (accounts payable), bills payable, and outstanding expenses
(accruals).
Net working capital can be positive or negative.
A positive net working capital will arise when current assets exceed current liabilities.
A negative working capital occurs when current liabilities exceed current assets.
The net working capital focus;
It focuses on the Liquidity position of the firm and
the extent to which working capital needs may be financed by permanent sources of
funds and temporary sources of funds

Liquidity position of the firm

Liquidity is the ability of the firm to meet its current obligations as they fall due.
In order to meet liquidity requirements, the firm should have its current assets to be sufficiently
in excess of its current liabilities.
Short term creditors always prefer firms that maintain current assets at a higher level than current
liabilities, in order to protect their interests.
A weak liquidity position poses threat to the solvency of the company and makes it unsafe and
unsound which proves to be harmful for the company’s reputation
Permanent Working Capital:
It refers to that portion of investment in current assets which is required at all times to carry on
the business operations at all levels.
Permanent working capital is permanent in the same way as the long term (fixed) assets.
Temporary Working Capital:
This is the extra working capital needed to support the changing production and sales activities.
The amount of temporary working capital keeps on fluctuating with the increase or decrease in
business activities.
It represents additional current assets needed at different times during the operating year because
it is required for carrying out seasonal or special operations of short duration such as extensive
marketing campaigns,
It should be financed from the short-term sources of finance like bank credit.
For example,
Extra inventory in finished goods will have to be maintained to support the peak periods of sale,
which also increases the investment in receivables during such periods
Question
What is the difference between permanent working capital and seasonal /temporary working
capital?
Profitability
46
To have higher profitability, the firm may sacrifice liquidity and maintain a relatively low level
of current assets.
Thus a risk-return off is achieved when the firm adopts an average current assets policy that
optimizes investments in working capital.
The optimum level of investment in working capital is that which balances the profitability and
liquidity objectives to ensure that not only is the firm able to meet short term obligations (less
risks) it is also able to generate returns to its investors
The Operating Cycle
The operating cycle (cash operating cycle or working capital cycle) of a business is the length of
time between the payment for materials entering into inventory and the receipts of the proceeds
of sales.
It is useful to compare the operating cycle of a company from year to year , or with similar
companies –
a lengthening operating cycle will normally be a cause of concern.
Overcapitalization and Overtrading
Overcapitalization is where the overall level of working capital is too high.
The solution is to reduce, the level of working capital by better management of receivables, cash,
inventory.
As a result, the company will need less financing or alternatively will have more finance
available for profit –earnings investments in fixed assets.

Overtrading (or under – capitalization)

Is where the level of working capital is too low.
The advantages and importance of adequate working capital are enumerated as follows;
1) Increase in Debt Capacity and Goodwill:
Adequate working capital represents the financial soundness of a company hence this creates
goodwill and increases the debt capacity of the firm.
1.2) Creates confidence among investors;
Regular availability of adequate working capital creates confidence among investors and lenders
that they will get their due interest, and principal in time.
Thus, a firm with adequate working capital can raise the requisite funds from market, borrow
short-term credit from banks and purchase inventories of raw materials, etc., for the smooth
operations of its business.
2. Facilitating in Obtaining Loans from Financial Institutions:
Adequate working capital representing excess of current assets over current liabilities is
considered as an ideal security for trade credits.
Thus, the presence of adequate working capital and current assets help a company to raise
unsecured and secured loans from financial institutions.
3. Increase in Production Efficiency:

47
If adequate working capital is maintained in the business, the firm can successfully carry out its
operations, research and development programmes etc., which would lead to increased
production efficiency.
Production efficiency, in turn, will increase the efficiency of the employees and boost up their
morale.
4. High Executive Morale:
Maintenance of adequate working capital also boosts up the morale of the executive insofar as
they have an environment of creativity, security and confidence, which is an important
psychological factor in improving the efficiency and morale of the business executives who are
at the helm of affairs in the firm.
5. Exploitation of Favorable Opportunities:
In the presence of adequate working capital, a company can avail the benefits of favorable
opportunities like bulk supply orders, bulk purchases of raw materials, off season purchases, etc.
6. Meeting Contingencies and Adverse Changes:
Business crises like oscillations, financial crisis arising from heavy losses etc., can be
successfully met by a company having adequate working capital.
7. Availing Cash Discount: maintenance of adequate working capital enables a company
to avail the advantage of cash discount by making cash payments to the suppliers of raw
materials and merchandise. Obviously it will reduce the cost of production and increase the
profits of the company.
8. Attractive Dividend to Shareholders: Adequate working capital enables a company to
declare and distribute attractive dividend to its shareholders.
Conversely a company not having adequate working capital cannot distribute attractive dividend
in spite of sufficient profits.
9. Sense of Security and Confidence: Adequate working capital creates a sense of security and
confidence not' only among the business executives but also the customers, creditors and
business associates.
10. Solvency and Efficiency of Fixed Assets : Adequate working capital also increases the
efficiency of fixed assets insofar as their proper maintenance depends upon the availability of
funds.
Question; “Inadequate working capital is disastrous; whereas redundant working capital is a
criminal waste." In the light of this statement, analyze carefully the working capital situation in
Ugandan Companies.
Or "The fate of large scale investment in fixed assets is often determined by a relatively
small amount of current assets." comment

Solution
Large investment in fixed assets is not sufficient to run a business successfully.
Adequate working capital, i.e., investment in current assets is equally important for meeting the
day-to-day expenditure on raw materials, salaries, wages, rents, advertisements and maintenance
of fixed assets.
48
Without working capital fixed assets are like a. gun which cannot shoot as there are no
cartridges. Working capital is the heart of a business. If it is weak, the business cannot prosper
and survive although there is a large body of fixed assets. It is, therefore rightly said, "The fate of
large scale investment in fixed assets is often determined by a relatively small amount of current
assets.
Not only the existence of working capital is essential for survival and progress of the industry,
but it must be adequate also. Adequacy of working capital implies that it should neither be
excessive nor inadequate of the firm's requirements.
Excessive working capital means that the firm has funds which earn no profit for the firm. while
Inadequate working capital means the company does not have sufficient funds for carrying out
its operations, which ultimately result in production interruptions and decreasing the
profitability. Thus, both the situations of inadequate and redundant working capital are
dangerous

DANGERS OF INADEQUATE WORKING CAPITAL

Question; explain how inadequate working capital is a danger to the progress of a firm
Solution
Inadequate working capital is bad and has the following dangers
It will slow down growth.
It becomes difficult for the firm to undertake profitable projects because of non- availability of
working capital.
It becomes difficult to implement operating plans and achieve the firm’s target
It leads to deterioration of the firm’s profitability since the fixed assets are not efficiently utilized
for lack of working capital.
The firm loses it reputation when it is not in a position to honor its short term obligation.
Others include:
The Firm Cannot Avail the FavorableOpportunities:The firm with inadequate working
capital fails to undertake the profitable projects,.
Operational Inefficiencies: Inadequacy of working capital leads to operating inefficiencies as
day-to-day commitments cannot be met.
Low Rate of Return on Fixed Assets: Inadequacy or shortage of working capital also results in
lowering down the rate of return on fixed assets because fixed asset cannot be efficiently utilized
or maintained due to inadequacy of working capital.

49
Increase in Business Risks: Inadequate working capital increases the risk of the firm. For the
example, in the absence of ample working capital, the firm cannot discharge its current liabilities
and is liable of being declared as insolvent. The adequate wonting capital, therefore, poses a
serious threat to the survival of the firm.
Adverse Effect on the Morale of Business Executives: Inadequacy of working capital also
adversely affects the morale of the firm's executives because they do not have an environment of
certainty, security and confidence, which is a great psychological factor in improving the overall
efficiency of the business.
DANGERS OF REDUNDANT WORKING CAPITAL
Excessive working capital is dangerous in the following ways

It results into unnecessary accumulation of inventories thus, chances of inventory mishandling,

waste, theft and losses increase.
It is an indication of a defective credit policy and slack collection period.
It makes management co placement that degenerates into managerial inefficiency

More dangers include the following

Low Rate of Return on Capital:

Excessive or redundant working capital implies the presence of idle funds which earn profit for
the firm.
Thus, the firm with excessive working capital cannot earn a proper rate of return on its total
investments, whereas profits are distributed on the whole of its capital.
This would ultimately result in bringing down the rate of return to the shareholders Lower
dividend, in turn, reduce the market value of shares and causes capital loss to the shareholders
Decline in Capital and Efficiency: Due to low rate of return and low dividend to shareholders,
companies often adopt some objectionable devices to inflate profits to maintain or increase (the
rate of dividend.
Sometimes, unearned divides are paid out of (the company's capital to keep up the show of
prosperity by window dressing of accounts.
In order to make up the deficiency of reduced earnings, certain provisions, such as provision for
depreciation, repairs and renewals are not made. This leads to decline in operating efficiency and
fall in profits.
Loss of Goodwill and Confidence:
Excessive working capital leads to lower rate of return on the company’s total
investments.
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Shareholders also get lower dividend.
Lower rate of dividend leads to reduce the market value of the company's shares much less than
the book value. The shareholders lose confidence in the company.
The goodwill or credit or the company suffers a .serious setback. The financial stability of the
company is jeopardized.
4. Misapplication of Funds:
Companies with excessive working capital do not utilise the society’s resources prudently.
In case of excessive working capital, it becomes difficult to control the purchases of many things
which are not required in the business. Often excessive in inventories and fixed assets are
purchased by the company, which do not add to the profitability of the company but adds to its
maintenance costs and losses due to theft, waste and mishandling.
5. Evils of Over-Capitalization:
Excessive working capital is often responsible for giving birth to the situation of
overcapitalization.
Over-capitalization is not only disastrous to the smooth survival of the company but also affects
the interests of those associated with the company.

6) Inefficient Management:
Existence of excessive working capital is an indication of inefficient management of the
company.
It shows that the management is not interested in expanding the business, otherwise the
excessive working capital might have been utilised in expanding the business,
7) Destruction of Turnover Ratio:
Redundant working capital often destroys the control of turnover ratio, which is commonlyused
in the conduct of an efficient business.
Excessive working capital also eradicates all other guides and sign posts commonly employed in
conducting and operating a business.

51
UNIT 6
FINANCING DECISION (SOURCES OF FUNDING)
INTRODUCTION
A large scale manufacturing concern taps various sources to meet its working capital
requirements. A company may choose to finance its current assets by long-term or short-term
sources, or a combination of them.
The selection of the sources of funds to be used by the firm largely depends on the purpose for
which such funds are required. If funds are required for short term purposes then short term
financing should be considered and if the funds are for long term financing, then long term
sources of fund with useful life should be considered.
Long-term and short-term sources of working capital have been examined below:
This is the decision taken by financial manager/firms to acquire long-term and short-term assets
by debt and equity to finance business operations.
Broadly, there are two sources of finance i.e. long – term and short –term sources.
Sources of Short – term financing
The selection of the source of funds to be used by the firm/project depends on the purpose for
which funds are required.
If the funds are for short – term purposei.e. for acquiring short term assets, or funds available for
operation of one year or less, then the short term financing is considered.

However, if the funds are for long – term purpose .i.e. for acquiring long – term assets, then the
long term sources should be used. (i.e. Matching principle.)
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Question;
Give and explain at least eight sources of finance
SOURCES OF FUNDING (FINANCING WORKING CAPITAL)
The working capital financing mix should be designed in such a way that the overall cost of
working capital is the lowest, and the funds are available on time and for the period they are
really required.

Sources where decisions are undertaken to acquire funds are explained below
Short-term Sources for Working Capital
Short term finance refers to funds available for a period of one year or less. Short term finance is
basically used to finance working capital, purchase of stock and inventory, paying wages, etc
The financing of working capital through short-term sources has the benefits of lower cost and
establishing close relationship with the banks.

There are various sources of short term finance that include the following;
Trade credit
Accrued expenses
Differed payments income
Bank finance
Commercial paper
Factoring

1. Funds from operations

Retained profits
Retained profits are earnings which are internally generated from accumulated reserves
Spontaneous source (NB-do not involve movement of money)
This accrues to the firm as long as the business is operational. Such sources include the
following:
Trade credit
It is an informal agreement whereby a supplier sends goods to the buyer
(ie. firm or project) on credit, which the buyer accepts and agrees to pay the amount due as per
the sales.
The firm/project does not have to pay cash for the purchase of goods made
Under this arrangement, trade creditors or the suppliers of goods, inventories and equipment
provide short-term finance to the company on the basis of deferred payments of their supplies

53
This source of funding is popular with small firms/projects since they find it difficult to raise
funds from banks or capital markets.
Advantages of trade on credit include the following;
Trade credit is very easy to obtain and it require minimal negotiations
Flexible
Trade credit grows with the growth in the firm’s sales. This is because, the expansion of the
firm’s sales causes its purchases of goods and services to increase which are financed by credit.
Accrued expenses
These are liabilities that the project or a firm has to pay for the services it has already received.
The most important examples are wages, taxes, and salaries.
If salaries and wages have to be paid this month and its not paid, becomes the source of finance
to the project. It can be used for short period then paid later.
The longer the payment interval, the greater the amount of funds provided by the employees.
For accrued wages and salaries become liabilities when the employees render services to the
project or firm yet they are paid afterwards, say, at some fixed interval time like one month or
two.
This source of finance is advantageous in that it has :
No explicit costs…no interest charged.
It’s easy to obtain
It involves no formalities

Differed income
This refers to the funds received by the project or a firm for goods and services that have agreed
to supply in the future.
These receipts increase the firm’s liquidity in the form of cash and therefore constitute a very
important source of financing.
Advance payments made by customers constitute the main item of deferred income.
Payment for goods and services is made before delivery of the same. This is slightly cheap and
flexible e.g .Rental income.
2. The bank credit.
Overdraft,
Bank loans,

3. Money markets based credits.

These markets offer short-term funding through buying and selling of short-term securities.
Funds in these markets cab obtained by designing financial instruments such as :
Commercial papers,
Certificate of deposit,
54
Bills of exchange
Short-term government bonds
Treasury bills
Commercial papers
This is ashort-term and unsecured promissory note issued by large financial sound and high rated
companies to raise short-term funds. The issuer promises to pay the buyer some fixed amount
and interest at some future date. The issuer pledges no assets other than liquidity and well
established earnings power to guarantee a good promise.

4. Factoring of Debtors
Factoring financing
This is when the firms undertake to collect the amounts due from debtors by use of factoring
method.
Factoring is a method of converting a non productive and in active assets like receivables into a
productive asset like cash by selling receivables to a company (factor) that specializes in their
collection and administration.
The firm passes on its account receivables to a factor or agent who advances the amount in cash
of these receivables to the firm after deducting the factoring commission.
The factor then undertakes to collect the amount from the debtors and also bears the bad debts if
they occur.
The debtors are notified of this arrangement and asked to make payments directly to the factor.
The factor maintains an account for all customers of all items owing to them, so that collections
could be made on due date or before.
Responsibilities of a factor in credit administration
A factor provides full credit administration services to his clients
He helps and advices them from the stage of deciding credit extension to customers to the final
stage of book debt collection.
He helps the clients to decide whether or not and how much credit to extend to customers.
He provides clients with information about market trends, competition and customers and helps
them to determine the credit worthiness of customers.
He makes a systematic analysis of the information regarding credit for its proper monitoring and
management.
He prepares number of reports and, collection and supplies them to clients for their perusal and
action .
BENEFITS OF FACTORING
The benefits which result from factoring receivables (debts) include the following
Factoring provides specialized service in credit management and thus helps the firm’s
management to concentrate on manufacturing and marketing.
Factoring helps the firm to save the costs of credit administration
The costs of factoring
There are two types of costs involved in credit administration
55
Factoring commission or service fee
The factoring commission is paid for credit evaluation and collection and other services and to
cover bad debts losses.
It is usually expressed as a percentage of the full net face value of receivable factored, and ranges
between 1 and 3 percent.
There is interest on advances granted by the factor to the client
The interest on the advance is higher than the prevailing prime rate of interest or the bank over
draft.
It is usually between 2 to 3 percent over and above the prime rate of interest.
Customers’ Credit: Advances from customers against the contracts entered into with the
project or firm, also constitute a source of short-term working capital.
Advances from customers are generally asked for by the project that has long production cycle,
e.g., ship building industry

6Miscellaneous sources
Indigenous Bankers: Indigenous Bankers: Short- term working capital requirements of
business concerns in Uganda are also financed by the indigenous banks, which have recently
taken from the finance companies.
Loan from Managing Director and Directors: Sometimes, the managing director and director
also provide the short-term working capital to the company in the form of loan at a negligible
rate of interest.
Depreciation Funds :The depreciation funds created out of the company's profits also provide
a reliable source of working capital so long as they are not invested in assets or distributed as
dividend.,
Financial Institutions: Financial institutions, such as Investment Companies, Life Insurance
Corporation, Unit Trust of Uganda, etc., are also an important source of working capital.
Commercial Banks: Commercial banks constitute a significant source of short-term or
temporary working capital. Normally companies obtain short-term working capital from these
funds in the form of short-term loans, cash credit, overdraft and through discounting the bills of
exchange.
Government Assistance:
Central governments as well as local district authorities also provide short-term financial
assistance to project and business concerns by allowing them tax concessions and granting loans.

The methods used to finance business gives rise to the financing list.
The financing list is the uncertainties that occur when businesses finance their operations by use
of debt equity.

LONGTERM SOURCES
Long-term Sources are for financial capital/ Permanent Working Capital
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These sources are normally sought to finance assets for long term nature such as expansion of a
product line, Research and development, Replacement of fixed assets etc
The long-term sources of working capital
Include;
Ordinary share capital
Preference shares, retained earnings,
Debentures and
Lease financing
Term loans
Project financing
Venture Capital financing
Hire purchase purchasing

Explanation of the sources of funding

Issue of Shares:
An ordinary share represents equity ownership in a company and entitles the owner a vote in
matters put before shareholders in proportion to their percentages of ownership
It is the primary and most important source of regular permanent working capital. Permanent
working capital should preferably be raised by issuing equity shares as it does not create any
burden on the income of the concern, nor the concern is under any obligation to refund the
capital.
Advantages of equity financing
There is no need to pay it back, and it is good option if you cannot afford to take on debt
You tap into the investor’s network, which may add more credibility to your business.
Investors take long term view, and most don’t expect a return on their investment immediately
Controls of company are retained in the hands of new existingshareholders.
The expenses are avoided if shares are offered to the general public.
There is more certainty of getting capital when fresh issue of shares is made to existing
shareholders remain satisfied
Disadvantages of equity financing
It may require returns that could be more than the rate you pay for a bank loan.
The investor would require some ownership of your company and the percentage of the profits.
You may not want to give up this type of control.
You will have to consult with investors before making big decisions and you may also disagree
with your investors.
It takes time and effort to find the right investor for your company.
2. Retained Earnings:
Retained earnings or accumulated profits are permanent source of regular working capital. It is a
regular and cheapest source of capital.
It does not create any charge on future profits of the enterprise,
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For any company, the amount of earnings retained within the business has a direct impact on the
amount of dividends (profits). Profits reinvested as retained earnings are a profit that could have
been paid as a dividend.
The major reason for using retained earnings to finance new investments, rather than to pay
higher dividends and then raise new equity for the new investments, is as follows
Advantages of retained earnings
The use of retained earnings as a source of funds does not lead to a payment of cash
The dividend policy of the company is in practice determined by the directors . From their point
of view, retained earnings are an attractive source of finance because investment projects can be
undertaken without involving either the shareholders or any outsiders.
The use of retained earnings as opposed to new shares or debentures ; avoids issue costs
The use of retained earnings avoids the possibility of a change in a control resulting from an
issue of new shares.
Disadvantage of retained earnings
Using retained earnings to finance projects reduces the amount paid out to shareholders as
dividends.
3) Issue of Debentures: This is a written acknowledgment of debt by a company, normally
containing provisions as to payment of interest and terms or repayment of principle.
Debentures are traded on stock markets in much the same way as shares and may be secured or
unsecured, and redeemable or irredeemable.
Ordinary shares provide ownership rights to the holders (investors).
However, tapping of this long-term source of regular working capital depends upon the view
point of management, nature of business, conditions of capital market, etc.
But issue of debentures as a means of regular working capital creates a fixed charge on the future
earnings of the concern.
Advantages of debentures from the view point of the investor
It is a permanent source of capital available for use as long as a company exists.
Equity capital increases
It has a definite maturity and the holder has priority in interest payment and liquidation
Income is fixed, so the holder receives the same interest whatever the earnings of the company.
Debt is more attractive because it is more secured against the assets of the company.
Disadvantage
Debt holders do not usually have voting rights. Only if the debts are not paid, will the holders
take control of the company
Advantages of debentures from the view point of the company
Debt is cheap, because it is less risky than equity for an investor, debenture holders will accept
lower rates of return than shareholders.
Debt interest is an allowable expense for tax
Issue costs are normally lower for debts than for shares.
Costs are limited to the stipulated interest payments.
There is no dilution of control when debt is issued.
58
Lenders do not participate in profits as it is the case with shares
Disadvantages of debentures from the view point of the company
Interest must be paid whatever the earnings of the company, unlike dividends which can be paid
in goods years.
With fixed maturity dates, provision must be made for repayment of debts.
Heavy borrowing increases financial risks to shareholders.
Debt might come out with restrictions on a company’s powers to borrow.
4. Long-term Debts: Another important source of regular working capital is long-term
debts from public deposits and specialized financial institutions, such asthe
Development Bank of Uganda, the Life Insurance Corporations of Uganda and
commercial Banks,

5) Lease Financing
Lease is a contract between two parties, a leaser (the owner of asset) and the lessee (the
user of asset).
This is where the leaser, owner of asset gives other party, lessee(the user) exclusive rights to use
the asset over agreed period of time for a consideration called lease rental in return.
The lessee makes payments under the terms of lease to the leaser, for a specified period of time.
Leasing is a form of rental. Leased assets have usually been plant and machinery, cars and
commercial vehicles, but might also be computers and office equipment.
There are two basic terms of lease: “operating leases” and “finance leases”
Operating leases
Operating lease are rental agreements between the leaser and the lessee whereby;
The leaser supplies the equipment to the lesser
The leaser is responsible for servicing and maintaining the leased equipment.
The period of the lease is fairly short, less than the economic life of the asset, so that at the end
of the lease agreement, the leaser can either
Lease the equipment to someone else, and obtain a good rent for it, or
Sell the equipment second hand
Finance leases
Finance leases are lease agreements between the user of the leased asset (the lessee) and the
provider of finance (the leaser) for most, or all, of the assets expected useful life.
The lessee is responsible for the upkeep, servicing and maintenance of the asset. The leaser is not
involved in this at all.
The lease has a primary period, which covers all or most of the economic life of the asset. At the
end of the lease, the leaser would not be able to lease the asset to someone else, as the asset
would be worn out.

Advantages of leasing include the following

It offers convenience to the users as lease financing is less restricted and can be negotiated faster.

59
It provides flexible to tailor lease payments to the lessee’s cash flows. Such tailored payment
schedules are helpful to a lessee who has fluctuating cash flows.
A lease can shift the risk of obsolescence to the lear.se
Hire purchase financing
This is a form of installment credit. It is similar to leasing, with the exception that the
ownership of the goods passes to the hire purchase customer on payment of the final credit
installment, where as a lessee never becomes the owner of the goods. Hire purchase usually
agreements involve a finance house
This is a very popular financing mechanism especially in automobile sector.
It involves three parties; the manufacturer, the hiree and the hirer. The hiree may be a
manufacturer or a finance company.
The manufacturer sells the asset to the hiree who sells it to the hirer in exchange for payment to
be made over a specified period of time.
The hire purchase agreement between the hirer and the hiree involves the following three
conditions;
The supplier sells goods to the finance house
The supplier delivers the goods to the customers who will eventually purchase them
The hire purchase arrangements exists between the finance house and the customers
The owner of the assets (the hiree or manufacturer) gives the possession of the asset to the hirer
with the understanding that the hirer will pay the agreed installments over a specified period of
time.
The ownership of the asset will transfer to the hirer on the payment of all installments
The hirer will have the option of terminating the agreement anytime before the transfer of the
ownership of the asset.
6) Project financing
This is a form of debt financing for large economic units.
The lender looks at the cash flows and the earnings of the economic unit as a source of funds
from which the loan can be repaid and also considers the assets of the economic unitas a
collateral security for the loan.
This method of financing is particularly suitable for large infrastructure projects usually
characterized by large investments, long gestation periods and very specific domestic market.
7) Venture capital financing
Venture capital provides finance for high growth potential unquoted firms in exchange of equity
stake.
Venture financing is the investment of long term equity finance where the venture capitalist
earns her returns primarily in the form of capital gain. Venture capitalists take high risks by
investment in the equity of young companies often with a limited (or no) track record.
Venture capital financing is usually thought of as an early stage financing for new and young
enterprises seeking to grow rapidly.
The main features of Venture capital financing can be as follows;
a) Equity participation
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Venture capital financing is an actual or potential participation through direct purchase of shares
options or convertible securities. The objective is to make capital gain.
b) Long term investment
Venture capital financing is a long term illiquid investment. It is not repayable on demand. It
requires long term investment attitude that necessitate the venture capital firms to wait for a long
period to make large profits
c) Participation in management
Venture capital financing ensures continuing participation of the venture capitalist in the
management of the entrepreneur’s business. This approach of management helps him to protect
and enhance her investment by actively being involved in supporting the entrepreneur.

PREFERENCE SHARES
Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary
shareholders. They do not carry voting rights. As with ordinary shares a preference dividend can
only be paid if sufficient distributable profits are available, although with cumulative preference
shares the right to an unpaid dividend is carried forward to later years. The arrears of dividend on
cumulative preference shares must be paid before any dividend is paid to the ordinary
shareholders.
Advantages of preference shares
From the company point of view, preference shares are advantageous in that:
Dividend does not have to be paid in a year in which profits are poor, while this is not the case
with interest payments on long term debts (loan on debentures).
Since they do not carry voting rights, preference shares avoid diluting the control of existing
shareholders while an issue of equity shares would not.
The issue of preference shares does not restrict the company’s borrowing power.
The nonpayment of dividend does not give the preference shareholders the right to appoint a
receiver, a right which is always given to the debenture holder.
Disadvantages of preference shares
However, dividend payments on preference shares are not tax deductible in the way that interest
payments on debt are.
Furthermore, for preference shares to be attractive in investors, the level of payment needs to be
higher than for interest on debt to compensate for the additional risks.
For the investor, preference shares cannot be secured on the company’s asset hence, not
attractive.

61
UNIT7
MANAGEMENT OF CASH
What will you study in this Unit?
1. Management of Cash: reasons/ Motives for holding Cash balances.
2. Problems of Cash Management.
3. Ways of managing cash balances; Cash Planning and Control: Tools of Cash Planning, Tools
of Cash Control.
Introduction
The purpose of this unit is to discuss the reasons for holding by a company of short term cash
balances, and to consider ways of managing theses cash balances effectively. It should be
noted that. Inadequate cash is disastrous whereas redundant cash is a criminal waste.
Qns
What do you understand by Cash Management? Broadly discuss the problems associated with it.
Point out the factors that influence the motive for holding cash by a firm.
What do you understand by controlling the level of cash? Discuss in brief.
Discuss the different methods of controlling cash inflows in a large firm.
Discuss ways of dealing with cash shortages
Ans.
MANAGEMENT OF CASH
Cash is the most important current asset required for the operation of the business .
Cash is the basic input needed to keep the business running on a continuous basis and it is also
the ultimate output expected to be realized from the sale of the service or product manufacture by
the firm.
The major task of the Finance Manager is to maintain adequate cash position for all
departments of the organization.
It should be noted that;
Cash shortage disrupts the firm’s operations while excess cash will simply remain idle without
contributing anything towards the firm’s profitability
Meaning of Cash Management:

62
The term cash management refers to the management of cash and 'near cash assets'.
The term cash includes
Coins, currency notes, cheques held by the firm.
The Balances at the firm’s bank account.
Near-cash items, such as marketable securities or bank times, deposits with banks. Such
securities and deposits are easily convertible into cash.
It should be noted that, when a firm has excess cash, it invests it in marketable securities, which
in turn contribute some profits to the firm.
The cash management concerns
The financial manager when performing the task of cash management should address the
following issue;
Managing cash flows into out of the firm
Managing cash balances held by the firm at any one point of time by financing deficits or
investing surplus cash.
Achieve liquidity and control
Importance of cash management
Cash management assumes more importance than other current assets in the following ways;
Cash is significant because it is used to pay the firm’s obligations.
We need cash because it is difficult to predict cash flows accurately, particularly the inflows as
there is no perfect coincidence between the cash inflows and the cash requirements.
Surplus cash can be invested in profitable opportunities
Cash is used for safeguarding unforeseeable problems, eg machine breakage, floods
Cash is used by firms for meeting banks’ minimum balances which they use for earning interests
and compensations customers

MOTIVES FOR HOLDING CASH

In spite of the fact that cash does not earn any substantial return for the business, it is held by the
concern with the following motives:
1. Transaction Motive: is the desire to have cash in the business in order to carry out daily
business transactions like making purchases, payment for labor, utilities and other services. At
times the cash outflows exceed the cash inflows. In order to meet the business obligations in
such situations, it is necessary to maintain adequate cash balance. Thus, cash balance is
maintained by a firm with the motive of making routine business payments.
2. Precautionary Motive :Is the desire to hold cash in the business in order to safeguard
against unforeseen problems like machine breakdown, emergence work force problems, power
and water failures and other unexpected contingencies such as floods, strikes, obsolescence,
sharp increase in prices of raw materials, presentation of bills for payment earlier than the
expected date, etc. More amounts of cash will be kept by the firm if there is more possibility of
such contingencies.
3. Speculative Motive: A firm also keeps cash balance to take advantage of unexpected
business opportunities or take advantages of any profitable ventures that come up in the market.
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Such motive is, therefore, of speculative nature. For instance, a firm may like to take advantage
of an opportunity of buying raw materials at the reduced price of rash down payment or postpone
purchase of materials in anticipation declining prices.
4. Compensation Motive: Banks provide certain services to their customers free of charge.
So, they usually require the customers to keep minimum cash balances with them, which enables
customers earn interest and banks use some of it to compensate themselves for the free services
they render.

Concepts/key issues in Cash management

The following are the key issues involved in cash management.
Cash Planning
This requires the preparation of forecasts of cash receipts and cash payments soas to get an idea
of the business’s future cash flow position.
Managing the cash flows
This requires proper management of the flow of cash
The cash inflows should be accelerated while, as far as, possible, the cash out flows should be
decelerated.
Optimum cash level
The firm should decide about the appropriate level of cash balances.
The cost of excess cash and danger of cash deficiencies should be should be matched to
determine the optimum level of cash balances.
Investing surplus cash
The surplus cash balances should be properly invested to earn profits.
The firm should decide about the division of such cash balance between alternative short term
investment opportunities such as bank deposits, market securities or inter corporation lending

PROBLEMS OF CASH MANAGEMENT

Challenges involved in Cash Management:
1. Controlling Level of Cash; One of the basic objective of cash management is to minimise
the level of cash balances with the firm. This objective is sought to be achieved by means of the
following :
Preparing Cash Budget:
Providing for Unpredictable Discrepancies:.
Consideration of Short Costs:
2. Controlling Inflows of Cash: In order to prevent fraudulent diversion of cash receipts and
speeding up collections of cash, an adequate control on cash inflow is necessary. A properly
installed internal check system can, to a great extent, minimise the possibility of fraudulent
diversion of cash.
3. Controlling Outflows of Cash: An effective control over cash outflow is equally important
for conserving cash and reducing financial requirements.

64
In order to control the outflows of cash efficiently, a firm should keep in view the following
considerations:
(i) Centralised System for Cash Payments should be followed as compared to decentralized
system.,
(ii) Payment should be made on the due dates neither before nor after.
(iii) 'Playing Float Technique should be used by the company for maximizing the availability of
funds.
4. Investment of Surplus Cash: While determining the quantum of surplus cash, the financial
manager should take into account the minimum amount of cash balance that must be kept in the
business to avoid any risk or cost of running out of funds. Such minimum level of cash is termed
as 'safety level for cash'.
Q. 2. What do you understand by cash planning and control? What are the different tools of cash
planning and cash control? Explain briefly.
Ans.
CASH PLANNING AND CONTROL
Cash planning
Definition; Cash planning refers to a technique of planning and controlling the use of cash. This
involves cash forecast and cash projection of future cash receipts and cash disbursements of the
firm over various intervals of time.
The objective of cash planning is to procure adequate cash to the firm to meet its current
obligations and expenses as well as to minimise the amount locked up as cash balance.
Large firms prepare daily and weekly forecast, medium sized firms usually prepare weekly and
monthly forecasts.
Small firms may not prepare formal cash forecasts because of the non-availability of information
and small scale operation
Cash control,
Definition Cash control involves, proper implementation of policies and procedures regarding
receipts and payments of cash.
Tools of Cash Planning:
The following below are the tools of cash planning;
Net cash forecast
Cash budget
Working capital analysis
1) Net Cash Forecast: Net cash forecast involves a projection of the net cash availability of the
firm in future. There are two methods of forecasting cash position in a given period, namely, (a)
Cash flow method, which projects expected cash receipts and cash disbursements and (b)
Adjusted earning method, which predicts the net cash availability on the basis of estimated cash
inflows and outflows.
2. Cash Budget: Cash budget is the most significant tool of cash planning. It is a systematic
forecast of cash inflows and cash expected cash receipts and cash payments. The technique and
methods of preparing the cash budgethas been explained in a question that follows.
65
3. Working Capital Analysis: It is another significant tool of cash planning. It involves
forecasting of the value of current assets and current liabilities to know the overall cash position
of the firm.

Tools of Cash Control

1. Cash Budget: It is the most significant tool of controlling the use of cash. It provides a
comparison between actual and budgeted cash receipts and disbursements locating the points of
deviations, if any. The financial manager, after ascertaining the reasons for deviations between
the actual and budgeted figures, can take the necessary action to remove them.
2.Inflows and Outflows of Cash: In order to check the change in cash position of the firm one
period to another, a cash flow statement is prepared. It helps management in controlling
inflows and outflows of cash.
3. Ratio Analysis: Ratio analysis is also an important tool of cash control. Different financial
ratios are used for this purpose. These ratios include current ratio, liquidity or acid test ratio,
receivable turnover ratio, inventory turnover ratio and cash position ratio. These ratios have been
fully explained in the chapter 'Ratio Analysis'.

Managing cash out flows

Cash flows a rise due to trade credits to the firm, which is a source of funds to the firm and it is
interest free.
The effective controls of cash outflows (disbursements) can result in delaying payments as much
as possible in order to make maximum use of trade credit with the firm.
Methods of proper control of cash out flows (disbursements)
1) In this system, payments of bills are made from a single central account
2) Predicting banking habits of the work force and paying out wages accordingly.
For example, wages should not be paid in advance when workers are willing to accept delayed
payments
3) Payments should be made by the use of cheques, as bank clearance will always delay for some
days.
4) Taking advantage of all credit facilities available to the firm.
5) Maximizing the outflow/disbursement or payment float.
The payment float is the difference between the firm’s actual bank balance and the balance
shown in the firm’s books.

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For example,
Cheques may be remitted prior to weekends or long public holidays
An intelligent financial manager can estimate this payments float and invest it during period to
earn a return.
The time float period is the time lag between depositing the cheques and collecting the cash.
However,
This is a risky game and should be played very cautiously.
Managing surplus cash balances
The purpose of managing cash balances is to avoid having idle cash reserves or having deficits
that cannot be covered easily.
Excess cash should be invested in short term investments which can be conveniently and
promptly converted into cash.
These investments alternatives are always marketable securities which are regarded are near
money.
There are a number of marketable securities available in the market.
There are three basic features of marketable securities that financial managers need to
consider.
Safety
The financial manager should invest excess cash in safe securities as cash balances invested I
them are needed in the near future.
Safety here implies highest yielding marketable securities subject to the constraint that the
securities have acceptable level of risk
The risk referred here is the default risk.
The default risk refers to the possibility of failure to pay interest or principle on time and in the
amount promised.
Maturity
Maturity refers to the time period over which interest and principle are to be made.
In practice, long term securities are relatively more risky, and therefore, short term securities
should be preferred by the firm for the purposes of investing excess cash in the firm.
Marketability

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Marketability refers to convenience and speed with which a security or an investment can be
converted into cash.
Funds invested in marketable securities are needed by the firm in the near future , therefore,
excess cash should invested in the securities that are readily marketable.
A security is highly liquid or marketable if it can be sold quickly without loss of price , like
government treasury bills.
A security is highly illiquid if it needs a lot of time to be sold without loss of price
Types of short term investment opportunities available to firms to invest their temporary
cash surplus;
Treasury bills
These are short term government securities.
The usual price is to sell a treasury bill at a discount and redeem them at par on maturity.
The difference between the issue price and the redemption price, adjusted for the time value of
money, is the return on the treasury bills.
Treasury bills can be bought and sold at any time and thus they are highly liquid.
They also do not have default risk.
Commercial papers
These are short term and unsecured securities issued by highly credit worthy large companies.
They are issued with a maturity of three months to one year.
They are marketable securities whose liquidity is not a problem.

Certificate of deposits
These are papers issued by banks acknowledging fixed deposits for a specified period of time.
They are negotiable instruments which make them marketable securities.
Bank deposits
A firm can deposit its temporary cash in a bank for a fixed period of time.
The interest rates depend on maturity period, whereby, the longer the period, the higher is the
interest.
Inter- corporate deposits

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Inter- corporate deposits lending or borrowing or deposits are a short term investment for most
large companies.
Generally large surplus company will deposit (lend) its funds in a sister or associate companies
with a high credit standing.
UNIT 8
MANAGEMENT OF ACCOUNTS RECEIVABLES OR DEBTORS
Introductions
The purpose of this Unit is to look at ways in which receivables and payables maybe managed
more efficiently and investments in them may be kept at the optimum level and thus reduce the
level of working capital.
QNS:
Write short notes on receivables
Receivables/Trade credits
The reason for the existence of receivables is that the business is prepared to sell to customers on
credit.
A firm grants trade credits to protect its sales from the competitors and to attract the potential
customers to buy its products at favorable terms.
Trade credits arise when a firm sells its products or services on credit and does not receive cash
immediately.
The higher the receivables, the more cost there is for the company, both in terms of the interest
cost and in terms of greater risk of losses through bad debts.
An easy solution is to stop selling on credit and to insist on immediate cash payment, but this
would risk losing customers if competitors offer credit.
Trade credits creates “receivable” or “book debts” which the firm is expected to collect in the
near future.
The customers from which the receivables have to be collected in the future are called trade
debtors or simply debtors and are one of the firm’s claims or assets.
Receivables constitute portion of the current assets
Granting of credit and creation of debtors results into blocking of the firm’s funds

69
OBJECTIVES OF ACCOUNT RECEIVABLES
Promoting sales
The basic objective of credit sale resulting in the creation of accounts receivables is to promote
the firm’s volume of sales. This is done by offering credit facilities to customers by allowing
them a reasonable time for making deferred payments
Increasing Profits
The firm offering trade credits usually charge a higher margin of profits on credit sales as
compared to cash sales.
Meeting Competition
Credit facilities are offered by firms to eliminate any fall in the volume of sales or profits
because of similar facilities being granted to its customers by the competing firm.
FACTORS DETERMINING THE SIZE OF INVESTMENT IN RECEIVABLES:
Investment in accounts receivables constitute a significant portion of the total current assets of a
firm.
Some of the important factors that determine the size of investment in account receivables are
discussed below;
Volume of Sales
Terms of Sales
Credit policy
Period of Credit
Cash Discount
Facility of Discounting Bills
Volume of Sales
Other things constant, accounts receivables vary directly with the volume of sales. A firm can
therefore, forecast the size of investment in account receivables by predicting changes in the
volume of sales.
Terms of Sales

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Majority of firms are obliged to sell on credit, depending upon trade customs, business practices
and competition.
Credit policy
If a firm follows a liberal credit policy, it will have a higher investment in account receivables as
compared to a firm with stringent credit policy.
Period of Credit
A firm that extends a longer credit period will have to invest more amounts in account
receivables as compared to the firms which allow short credit period.
The term credit period refers to the time duration for which credit is granted to the customer.
Cash Discount
The more stringent the terms of cash discount to customers, the bigger will be the size of
investment in account receivables.
Offering cash discount to customers is a direct loss to the firm.
Facility of Discounting Bills
The size of investment in account receivables will be large if the firm has no arrangement with
the banks to get the bills discounted.
POINTS TO CONSIDERE AS PART OF EFFICIENT MANAGEMENT OF
RECEIVABLES
Credit checks and credit limits – before granting credit, customers should be assessed as to their
ability to pay, and credit limits set for all accounts
How to assess customers before granting credit:
Use credit rating agencies (Dunn and Bradstreet UK)
Ask for trade and bank references from new customers
Analyze the payments record of existing customers
Assess the financial statements of large customers
Review credit limits regularly
Credit terms and settlement discounts
How to use credit terms and settlement discounts to improve management of receivables:
These will be greatly be influenced by competition and trade customs
The company must quantify the cost of any settlement discounts and decide whether the benefits
outweigh the costs.

71
Ensure that customers are aware of the terms and settlement discounts by printing them on
orders, invoices and settlements.
Ensure that any discounts policy is enforced – most customers will attempt to take the discount
as a matter of course, whether or not they have paid on time.
Collection procedures:

Procedures to be followed for efficient collection of receivables

Set clearly defined procedures to be followed. Set timings for issuing demand letters, making
chasing telephone calls, and stopping deliveries.
Decide when outside assistance is needed (e.g. the use of collection agencies or lawyers)
Compare the costs of taking direct legal action with that of using outside help.
Charge interest on overdue invoice
Characteristics of receivables
1) They involve an element of risk that should be carefully analyzed due to difficulty in their
collection.
2) They involve economic value
To the buyer, the economic value in goods and services passes immediately at the time of sale,
While the seller expects an equivalent value to be received later on.
3) They are futuristic
The cash payments for goods or services received by the buyer are made in the future period.
Importance of Trade credit
QN: Why do companies in Uganda grant Credit?
Give reasons why service firms offer services on credit
Firms in practice feel the necessities of granting credit for several reasons, amongst are the
following;
Competition
The higher the degree of competition, the more credit is granted by the firm.
Buyer’s requirements
Buyers usually require firms to extend credits to them especially in the case of industrial
products.

72
Company’s bargaining power
If the firm has a higher bargaining power vis-à-vis its customers, it may grant not or less credit
The firm will have a strong bargaining power if it has a strong product.
Buyer’s status
Large buyers demand for easy credit terms because of bulk purchases and higher bargaining
power and don’t give many credits to small retailers.
Relationships with the dealers
Firms give credits to dealers to build long term relationships with them or to reward them for
their loyalty.
Marketing tool
Firms use credit as a marketing tool, particularly when a new product is launched or when a
company wants to push its weak product.
Industrial practice.
It may be a practice for firms within a given industry to grant a credit .There fore , new entrants
in this industry find it inevitable to offer credit.
Transit delays
This is a forced reason for extended credit where firms use banks to control cash flows so as to
avoid paying suppliers in time.
9. To increase the market share especially in a declining market
Question
Explain the costs associated with giving credit
The costs associated with receivables
As much as extending credit is beneficial, it also involves some costs that are inevitable.
The costs involved include the following;
Production and selling costs
As it offers more credits, its sales increase which in turn lead to an increase in production and
selling.
Administrative costs

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There are two types of administration costs that a firm incurs when it offers credit.; These
include credit supervision or investigation costs, and collection costs for outstanding bills and
supervising large number of accounts
Bad debt losses
Bad debts losses arise when the firm is unable to collect its accounts receivables or delay to pay
in time.

Opportunity costs
This is when the firm forgoes some businesses opportunities during the time its funds are tied up
in receivables.

CREDIT POLICY
The credit policy is defined as the set of parameters and principles that govern the extension of
credit to the customers
Determinants of credit policy
Credit Standards
Credit Terms
Collection Procedures
Credit Standards
Credit standards are the criteria a firm follows in selecting customers for the purposes of credit
extension
The firm’s credit standards are generally determined by five Cs ; Character, Capacity, Capital,
Collateral, and Conditions
Character: This denotes to the integrity of the customer, i.e., his willingness to pay for the
goods purchased.
Capacity: It means his ability to manage the business
Capital: It means his financial soundness/power
Collateral: It refers to the assets which the customer can offer by way of security.

Conditions

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Credit Terms: These are the conditions under which the firms sells on credit to customers .
These conditions include:
Credit Period: This is the length of time which a credit is extended to customers
Credit limit: Credit limit means maximum amount of credit to be extended. It mainly depends
upon the category of customers and industry norms
Cash Discount: A company short of cash resources and facing liquidity problems may consider
the use of cash discounts to influence its customers to pay promptly.
Collection Procedures: These are steps followed by the firm to collect its debtors from
customers

TERMS
Intangible assets
These are assts that lack physical existence and are not included in the current asset or
investment categories. They consist of rights, such as the following;
Patent– the exclusive right to use an idea or invention for seventeen years .
Copyright- the exclusive right to a literary, musical, or artistic work for the life of the creator
plus fifty years
Trade mark-an exclusive symbol or logo; protected while in constant use
Trade name- an exclusive name or phrase for an entity, product, or service; protected while in
constant use
Franchise- an exclusive right (usually within a limited area) to sell a product or a service and/or
use a certain identifiers (trade names trade marks) and ideas
License- a right to operate in a certain locality or to use a specific idea or technology
Asset
This is a future economic benefit obtained or controlled by a particular entity as a result of past
transactions or events.
Asset can provide decision makers with a better understanding of a company’s financial position
and its activities.
Decision makers on finances, need to make comparisons of amount and types of assets to
determine whether cash will be available to pay debts as they come due.

75
76
 UNIT 9
MANAGEMENT OF INVENTORIES
What will you study in this Chapter?
The purpose of this Unit is to examine approaches to managing inventories efficiently. The two
most important approaches are the EOQ model and the ‘Just in Time’ approach.

The scope of this Unit will include the following

1. Meaning of Inventories, Benefits, Risks and Costs of Holding Inventories.
2. Inventory Control, Objectives and Importance of Inventory Management.
3. Essentials of a Good Inventory Control System.
4. Inventory Control Techniques: Determination of Economic Order Quantity. Minimum and
Maximum Approach, Determination of Re-ordering Or Ordering level, Two-Bin System,
Perpetual Inventory System, Inventory Turnover Ratios, Inventory Control through A.B.C.
Analysis Aging Schedule of Inventory Budgetary Control System.
5. Factors Determining optimum Investment in Inventory.
6. Role of Financial Manager in Inventory Control.
Question;
What do you understand by the term 'Inventories'? What are the benefits of holding
inventories by a firm? Bring out the possible risks and costs of holding inventories.
Ans.
MEANING OF INVENTORIES
Inventories are the stocks of goods held by a firm for eventual sale or use in manufacturing
goods meant for sale. It includes raw materials, work-in-progress and finished goods.
BENEFITS OF HOLDING INVENTORIES
Holding of inventories help in smooth production and marketing operations of
enterpriseProductive operations cannot flow smoothly without having inventories of raw
materials, work-in-progress and finished goods. The specific benefits of holding adequate
inventories are as follows:
Avoiding Loss of Sales: If a firm maintain adequate inventories, it can execute the customers'
orders without any delay and thus avoid any possible of losing the patronage of customers and
hence sales.
Availing Quantity Discount: If a firm maintains sufficient inventories by making bulk
purchases, it can avail the benefit of large quantity discount.
Reducing Ordering Cost: If a firm places only a few large orders in place of numerous mail
order, it can reduce the variable ordering cost associated with individual order$
Reducingthe Set-up Costs: Maintenance of large inventories helps the firm in making
substantially high production runs resulting in reducing the set-up costs..
Avoiding Interruptions inProduction: Production operations cannot flow smoothly in
the absence of sufficient inventories. Thus, maintenance of adequate inventories helps the
firm in avoiding delays or halts in production giving rise to production losses.

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RISKS AND COSTS OF HOLDING INVENTORIES
Holding of inventories exposes the manufacturing and merchandising firms to a number of risks
and costs.
There are three risks arising from holding of sufficient inventories, via;
1. Risk of price decline due to increase in market supplyof the product, introduction of a new
product, price cutting by the rival firms, etc.;
2.risk of product deterioration, which may arise due to holding a product for a too long period
or careless storage;
3.risk of obsolescence, which may be due to change in consumers' taste, production technique,
improvement in the product design, specifications, etc.
Costs of Holding Inventories:
The costs of holding inventories include (1) Ordering costs and (2) Carrying Costs.
1.Ordering Costs: This category of costs is associated with the acquisition or ordering of
inventory. Included in the ordering costs are costs involved in requisitioning, purchase
ordering, transporting, receiving, inspecting.
These costs are generally fixed per order placed, irrespective of the amount of the order.
2.Carrying Costs: The second broad categories of costs associated with inventory are the
carrying costs. They are involved in maintaining or carrying inventory. This may be further
divided into two categories.

(a)Storage Costs of Inventory:

The main components of this category of carrying costs are:
Storage space cost that is, depreciation, insurance, maintenance of the building.
Insurance of inventory against fire and theft.
deterioration in inventory because of pilferage, fire, technical obsolescence, style obsolescence
and price decline;
Serving costs, such as, labor for handling inventory, clerical and accounting costs.
(b)Opportunity Cost of Funds:
This consists of expenses in raising funds (interest on capital) to finance the acquisition of
inventory. If funds were not locked up in inventory, they would have earned a return. This is
theopportunity cost of funds.
Summary
Benefits Risks and Costs of Holding Inventories:
Benefits of Holding Inventories:
(1) Avoiding loss of sales;
(3) Reducing ordering cost;
(4) Reducing set-up cost;
(5)Avoiding interrupting in production.

Risks of Holding Inventories:

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(1) Risk of Price Reduction;
(2) Risk ofProduct Deterioration;
(3) Risk of Obsolescence.

Costs of Holding Inventories:

(l)_Ordering costs;
(2) Carrying costs.

TYPES/CLASSIFICATION OF INVENTORY
In a manufacturing enterprise inventory might be classified as follows;
1) Raw materials are those goods which have not yet been committed to production in a
manufacturing concern. They consist of basic raw materials or components.
2) Work-in-progress includes those materials which have been committed to production process
but have not yet been converted into finished products.
3)'Finished Goods' are the completed products awaiting sale. They are the final output of the
production process in a manufacturing concern. In case of wholesale and retail trade, the finished
goods inventory is referred to as merchandise inventory.
4) Components and sub-assemblies;
To be incorporated into an end product e.g. ball bearings, gear boxes.
5) Consumables;
These are supplies in which are classified as indirect and do not form part of a saleable product.
Consumables may be sub-classified into;
Production e.g. detergents,
Maintenance, e.g. lubricating oil
Office, e.g. stationary,
Welfare, e.g. first aid supplies etc
Question:
What do you understand by the term 'Inventory Control'? Explain its objectives and importance
in a manufacturing organization.
Or "If you are in need of money, look to your inventory first". What is the significance of this
statement for a finance manager?’’
Ans.

INVENTORY CONTROL

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The term inventory/stock control refers to systematic procedures which are required in order to
ensure that stock is ordered, purchased, delivered, stored and otherwise handled with efficiency
so as to have the minimum possible cost of inventories.

This means the management functions relating to acquisition, storage, handling and use of
inventories so as to minimize wastage and losses, achieve maximum economy and
establish responsibility for various operations through physical checks, record keeping
accounting and other devices.
The scope of inventory management:
To determine the size of inventory to be carried
To establish timing schedules, procedures, and lot of size
for new orders
To co-ordinate sales, production and inventory policies; ascertaining minimum safety levels;
providing proper storage facilities; arranging the receipts, disbursements and procurement of
inventories and developing forms of recording these transactions;
To assign responsibilities for carrying out inventory control functions;
Provide the report necessary for supervising the overall activity.
IMPORTANCE OF INVENTORY MANAGEMENT
Inventories constitute the most significant part of a firm’s total working capital and form a major
element of manufacturing cost.
It enables a firm procure inventories at the right time from the right source in right quantities at
right prices and
A firm can be able to avoid over or under-investment in inventories.
It ensures Continuous Supply of Material
It permits the manufacturing operations to continue smoothly without interruptions
Be able to point out the cases of unused items purchased against purchase requisitions received
from various department
There will be efficient utilization of production facilities: To achieve the most efficient
utilization of the installed production facilities.
Inventories will allow continuous use of such common-purpose machines and other production
facilities.
Controlling Production and Purchase Levels:
Maintenance of adequate inventories allows a firm in making long production runs and reducing
the set-up costs associated with each run.
Production variations can also be avoided through proper control over inventories.

It helps in Maintaining Buffer Against Fluctuations in Demand: For example;

80
When actual sales are less than forecasted, inventories of finished goods are allowed to
accumulate.
Thus, inventory control is sought to provide safeguards against fluctuations in demand
and avail the opportunities of earning maximum profits.
Minimizing the Wastages: It helps in Minimizing wastage of materials in the course of
purchasing, storing and production. Any abnormal wastage of materials by leakage, theft,
embezzlement and spoilage due to rust, dust or din, will be strictly controlled.
Efficient Service to Customers: maintaining adequate stock of finished goods to meet the
expectations of customers for prompt execution of their orders is one main objective of
inventory management.
Quick deliveries to customers depend upon the availability of inventories of finished goods.
Efficient inventory management enables a firm to execute the customers' orders promptly and
hence avoid loss of sales in case of non-supply of goods in time.
Efficient Use of Capital; the capital available to the firm will be put into effective and efficient
use. For example, It is the responsibility of financial manager to set-up the maximum and
minimum levels of stocks to avoid deficiency or surplus of stock position so that the capital
available to the firm could be put to effective use for financing the cycle of purchase, production,
sale and collection.
Minimizing the Carrying Costs: One of the main objectives of inventory management
is minimize the carrying costs which comprise of the expenses for storing, insurance, storage,
and cost of funds tied up in inventories.
Economies in Purchasing: There will be availability of the economies in purchasing raw
materials, supplies, etc. For example, a firm will take advantage of quantity discounts offered
by the suppliers of raw materials, keeping in view that the savings resulting from lower
purchase price and ordering costs are more than the costs of carrying these inventories.
Will be able to identify obsolete and surplus materials
It will be able to provide accurate information for financial control
Minimizing Risk of Loss: The firm will be able to minimize risks of loss due to price decline,
product deterioration and obsolescence between the time of purchase and the time of sale is also
an important objective of inventory control.
Loss from product deterioration may be due to improper storage or holding a product for too
long a period.
Loss from obsolescence may result from change in customers' tastes : new production
techniques, improvement in product design, etc.

OBJECTIVES OF INVENTORY MANAGEMENT

The basic managerial objective of inventory management is two- fold, i.e.,
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Below is summary of Objectives and Importance of Inventory management
Objectives and Importance of Inventory Control:
(1) Ensuring continuous supply of materials;
(2) Efficient utilization of production facilities;
3) Controlling production and purchase levels;
(4) Maintaining buffer stock against fluctuations in demand;
(5) Minimizing the wastages;
(6) Efficient service to customers;
(7) Effective use of capital;
(.8) Minimizing the carrying costs;
(9) Economies in purchasing;
(10) Minimizing Risk of Loss.
11) Ability to identify obsolete and surplus materials
12) Provide accurate information for financial control
13) Point out the cases of unused items purchased against purchase requisitions received from
various departments.

Q. 3. What do you understand by inventory control? What are the essentials of a good inventory
control system?
Ans;
The meaning of inventory control
Inventory control refers to the management functions relating to acquisition, storage, handling
and use of inventories so as to minimise wastage and losses, achieve maximum economy
and establish responsibility for various operations through physical checks, record
keeping accounting and other devices.

The term inventory control refers to a systematic control over the purchasing, storing and using
of inventories so as to have the minimum possible cost of inventories.
FACTORS THAT DETERMINE (ESSENTIALS OF) A GOOD INVENTORY CONTROL
SYSTEM
An effective inventory control system should possess the following essentials:
1. Centralized Purchasing:
In order to avoid reckless buying, make continuous availability of materials for uninterrupted
production. All purchases should be made by a separately established purchasing department.
The purchase department decides what to purchase? When to purchase? Where to purchase?
How much to purchase? At, what price to purchase, and procures all types of materials to the
firm.
2. Classification and Codification of Inventories: An efficient and effective stores control is
also essential for a good inventory control system. The investment in materials constitutes a
major portion of current assets and represents an equivalent amount of cash. It is, therefore

82
desirable to exercise an effective material control through an efficient and well-equipped stores
department scientific classification and codification of various items of stores.
3. Standardization and Simplification: Standardization and simplification of materials is an
important consideration of an efficient inventory system. Standardization refers to the fixation of
standards of various kinds of inventories, whereas simplification refers to the elimination of
excessive types and sizes of inventories.
Standardization aims at clear specifications of different items of inventory so that the items
of only requisite quality may be purchased,
Whereas simplification aims at reducing the number of items carried in the store.
4. Adequate Storage and Handling Facilities: Adequate storage and handling facilities
constitute an important factor for an effective inventory control system. Well planned storage
and handling of inventories avoid losses from theft, carelessness, damage, deterioration,
evaporation pilferage, loading and unloading, leakage, inefficient handling, fire, etc.
5. Adequate Inventory Records and Control Levels: Information about availability of
various inventories should be adequate enough to meet the needs of purchasing,
production, sales and financial departments of the firm. Information required about any kind of
inventory may relate to its quantity in hand, location, unit cost, quantity in transit, amount set.
6. Efficient Staff: Trained, qualified, experienced and devoted personnel should be entrusted
with the task of operating the system of inventory control. It is rightly observed, “Improperly
trained and unqualified personnel, as well as improper organization are at the root of less
effective inventory control in many business concerns."

Summary
Essentials of a Good inventory Control System
(1) Centralized purchasing;
(2) Classification and Codification of inventories;
(3) Standardization and Simplification;
(4) Adequate storage and handling facilities;
(5) Adequate inventory records and reports;
(6) Trained, qualified and experienced personnel.

Q. 4. What is Inventory Control? Explain the Techniques of Inventory Control. Or Write short
notes on:
(i) Economic Order Quantity (ii) Reorder Level (iii) ABC Analysis
Or what do you understand by Inventory Control? Discuss the techniques that are commonly
used in determining' the optimum level of investment in inventories, Ans.

INVENTORY CONTROL TECHNIQUES/APPROACHES

The various inventory control techniques used in determining the optimum size of investment in
inventories include the following:

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The principal focus of stock control is on the re-order quantities or re-orders levels which
determine the level of stock when a new order is placed.

An essential part of this is economic order quantity (EOQ). This attempts to calculate/determine
the level of stock when a new order is placed so as to which minimize the costs.

[A] Determination of Economic Order Quantity:

Determination of the quantity for which the order should be placed is one of the important
problems relating to efficient inventory control.

Definition of EOQ
Economic Order Quantity (EOQ) refers to the size of materials to be ordered at one time
which gives maximum economy.
Sometimes, the EOQ is also called 'Re-ordering Quantity' or Economic Lot Size'. The EOQ is
determined in such a way as to minimize the cost of ordering and carrying costs. Thus, it is fixed
after taking into consideration the following costs:

What EOQ considers

The costs of holding stock
The fact that the more stock which is held the higher the costs
The average cost of ordering
The fact that larger orders mean that unit costs and delivery costs are reduced
Costs involved.

Buffer stock
This is the desired minimum level of stock which will be held by a business.The more efficient
the organization, the lower the buffer stock.

Reasons for holding buffer stock

Buffer stock is held in order to account for the problems in production or, perhaps, being let
down by its supplies.
Some suppliers may deliver substandard materials
Demand may unexpectedly rise.

The costs involved in a inventory ordering systems are as follows:

The purchase cost
The re-order cost
The inventory –holding cost
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Purchase cost
This is the cost of actually purchasing the goods. Over a year the total cost will remain constant
regardless of how we decide to have the items delivered and is therefore irrelevant to our
decision.
Ordering Costs: This is the cost of actually placing an order and securing the supplies. It
includes cost such as administrative time included in placing an order and the delivery cost
charged for each order posted in the purchasing department, inspection section and payment
department.
For example.
Cost of stationary,
Postage and telephone charges,
Thus, this type of costs comprises
Cost of floating tenders,
Cost of comparative -valuation of quotations,
Cost of paper work and postage involved in placing an order,
Cost of inspecting the inventories to be purchased, rust, of accounting and making payments.
Ordering cost varies from time to time depending upon the number of orders placed.
Carrying Cost/Inventory holding cost: It is cost of holding items in inventories. Includes;
The cost of storage,
Cost of handling and transportation,
Cost of investment blocked in inventories,
Cost of spoilage, cost of obsolescence cost of insurance, etc.
The larger the volume of inventory, the higher will be the carrying cost and vice versa.
The 'ordering costs' decreases while the 'carrying cost increases with every increase in the
quantity of purchase-lot. The economic size of inventory would, thus, depend on trade-off
between carrying costs and ordering costs.
The economic order quantity is determined at a level for which aggregate of two costs is the
minimum. The EOQ may be determined with the help of the following formula

The EOQ formula

This is a more accurate and time saving way to find the EOQ.
The formula is:

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 2 COD
EOQ=
√ CH

Where,
EOQ = Economic Order Quantity
D = Annual Usage or demand in Units
CO = Cost of Placing an Order
CH = Cost of Storage or holding Stock of one unit in inventory per year.
Illustration: A refrigerator manufacturer purchases a certain component from outside suppliers
worth shs, 5,000,000 per unit. The annual usage or demand is 800 units. The order placing cost is
shs. 100000 and cost of carrying one unit for one year is $ 4, calculate the Economic Ordering
Quantity.
2 COD
Solution: EOQ=
2 x 800 x 100000
√ CH
=
4
= √ 40,000000 = 2000units

Assumptions of EOQ:
The EOQ model of inventory control is based on the following assumptions:
The firm knows with certainty the annual usage or demand of a certain item of inventory. This
assumption is not true because there is a likelihood of a discrepancy between actual and
anticipated demand for a particular item of inventory.
The rate at which the firm uses inventories or makes sales is constant throughout the year. This
assumption is also not valid.
The lead time is known and fixed
All prices are constant and certain
Each quantity is ordered each time an order is made
The cost of placing an order is independent on the size and volume.
The receipt of the order occurs in a single instant /orders arrive in one batch
Quantity discounts are not calculated as part of the model
Shortages or stakeouts do not occur.
The orders for replenishment of inventory are placed exactly when inventories reach the zero
level; this assumption is also of doubtful validity.

Determining Different Controlling Levels

In order to avoid stock outs and overstocking of materials, it i S necessary to fix the minimum and
maximum limits of inventory along with re-ordering level.

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(a) Re-ordering Level along with the determination of economic order quantity or
optimum order level, is also important to decide when to order for new stock.
This quantity level is known as 'Re-ordering Level' or 'Ordering Level
Re-order level may be determined as follows:
Reorder level = Maximum Usage x Maximum Reorder Period Or
Reorder Level - Minimum Level
+ (Normal Usage x Normal Delivery Time)
(b)Minimum inventory/Quantity of an item is that quantity or number which the firm wants to
keep in stock at all times.
The minimum inventory is the same thing as safety stock. When the inventory reaches its
minimum limit, order is placed for acquiring the fresh supplies of the material which will bring
the stock back to its maximum level.
The minimum limit is fixed so that production may not be held up for want of materials.
The minimum stock level of a certain item is fixed on the basis of the reorder level, the normal
rate of consumption and the normal delivery time. Minimum limit of a particular item of
inventory may be computed by using the following formula:
Minimum Stock Level = Reorder Level - (Normal Usage) x Normal Delivery Time
(c)Maximum Inventory level represents the maximum limit beyond which the quantity of any
item should not rise at any time.
This limit is fixed in advance to avoid overstocking of any material.
However, if it is in the interest of the firm, the stocks may be held above maximum, limit. Since
overstocking of inventories involves unnecessary blockage of working capital, loss due to
obsolescence, deterioration in quality, depreciation in market value, etc., it is always desirable to
avoid overstocking.
Maximum inventory level is fixed on the basis of the reorder level, the reorder quantity, the
minimum rate of consumption and the minimum delivery time. It may be computed with the help
of the following formula

Maximum Stock Level = Reorder Level + Reorder Quantity

- (Minimum Usage or Consumption)
x Minimum Delivery Time

(d) Average Stock Level, the average stock level may also be calculated using the following
formula :
Minimum + Maximum
Level Level
Average Stock Level =
2

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 1
OR, Minimum Level+ (Reorder Qty)
2
Illustration: In manufacturing its product, a company uses raw material Z, in respect of which
the following apply
Normal Usage 600 units weekly
Minimum Usage 300 units weekly
Maximum Usage 900 units weekly
Reorder Quantity 4,800 twits
Reorder Period 4 to 6 weeks
Required:
Calculate: (a) Minimum Level, (b) Maximum Level, (c) Reorder Level and (d) Average Stock
Level.
Solution:
(1) Reorder Level = Maximum Usage
Maximum Reorder Period
900 x 6 = 5,400 Units
(2) Minimum Level Reorder Level - (Normal Usage x Normal Reorder Period)
4 +6
(
= 5,400 – 600 x
2)
= 5,400 - 3,000 = 2,400 Units
(3) Maximum Level = Recorder Level
+ Reorder Quantity - (Min. Usage x Min. Reorder Period)
= 5,400 + 4,800 - (300 x 4)
= 10,200 ~ 1,200 = 9,000 Units
Maz. Level+ Min Level
Level Average Stock Level=
2
9000+2400
=
2
11,400
= =5700 units
2
B) JUST IN TIME TECHNIQUE (JIT).
This is an inventory control method whose goal is to maintain just enough material in just the
right time to make just the right amount of the product.
JIT is an inventory strategy implemented to improve the return on investment of a business by
reducing in progress inventory and its assisted goals.
New stock is ordered when stock reaches the re-order level. This saves warehouse space and
costs. Precise timing and reliable suppliers are essential for this technique to work effectively.

Goals of JIT system

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The aim of JIT is to produce the required items, at the required quality and in the required
quantities, at the precise time they are required. In particular , JIT seeks to achieve the following
goals.
Elimination of non-valued added activities
Zero inventories
Zero defects
Batch sizes of one
Zero break downs
A 100% on time delivery service

Assumptions under the JIT system

Price guarantees being in place (Fixed)
Technical competence on both sides of bottlenecks
Both the supplier and the procurement entity must be within realistic geographical distance
JIT must be beneficial to both the supplier and procuring entity.
It is usually on long term arrangement for it to make meaningful advantages to both parties.
Pre-requisites for JIT
Limited number of suppliers to encourage partnerships
Reliable transport and communication means. For quick delivery to both production points and
consumer/buyer points
Short lead times
Quality assurance and control measures to enable high quality inputs
Production in small lots i.e. batch production, produce when the orders come
Advantages of JIT method
There is reduction in stock holding costs
Identification and elimination of bottlenecks
Better relationship with the supplier
There are better and higher chances of cutting down on machine and other process failures.
Increase productivity, less scrap or rework through zero tolerance.
Lower working capital costs because of exact investments (inventory only required)
Improved quality through quicker fault tracking; fast detection and corrections of unsatisfactory
quality.
Minimum time wastage
Less resource wastage

Disadvantages of JIT
Guarantee of competence on both sides could be challenging
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Dangers associated with single sourcing
It can bring the entire organization to a standstill once deliveries are delayed or not made
It is restricted for batch production not continuous production
It is prone to errors in forecasting and communication breakdown.
Benefits of holding inventories are limited
High transport and delivery costs i.e. high ordering costs

C) Inventory Control through ABC Analysis

It is a selective inventory control technique. This technique is based on the assumption that all
inventory items do not require the same degree of control.
Since a large number of manufacturing firms keep thousands of items of inventory, it is neither
possible nor necessary to exercise the same degree of control on all the items.
It is always desirable to exercise a greater degree of control on costly items as compared to those
items which are less costly. According to this approach, all inventory items are divided into
three categories A, B and C.
A-category items represent a large value for a few items. e.g. they are basic and account for the
bulk of expenditure
B-category items are more in number but represent smaller value and
C-category items are too numerous but represent the minimum value. Such an analysis of
inventories is known as ABC analysis.
The ABC classification process is an analysis of a range of items, such as finished products or
customers into three categories;
Outstandingly important
-Of average importance
Relatively unimportant
ABC control application- The ABC classification system is to grouping items according to
annual sales volume in an attempt to identify the small number of items that will account for
most of the sales volume and that are the most important ones to control for effective inventory
management.
While exercising control over inventories, greatest attention should be paid to A-category
inventory items and least attention to the bulk of inventories comprising C-category,B-category
inventory items are subject to routine control.
Class
A-Very critical
B-Medium
C-.Less critical

Areas where ABC analysis could be of use /importance

Security of stock
Ordering of stock
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Stock stating
Serving of customers
Stores layout
Staff allocation
Advantages of ABC method
Saves time
Fastens planning
Better stores lay out
Better management of stores
Disadvantages
It could be misleading
It does not address the issue of stock control properly
It requires technical competence on the side of the stores staff. This at times may be missing.
Q. 5. Discuss the factors determining Optimum Investment in Inventory.
Ans.
FACTORS DETERMINING OPTIMUM INVESTMENT IN INVENTORY
The various internal and external factors determining the optimum level of investment in
inventories are as follows
1. Seasonal Nature of Input and Output: If certain raw materials are available only during a
particular season, whereas they are continuously required throughout the year for running the
production operations of the firm, the investment in such inventories would be larger and vice
versa.
2. Length of Operating Cycle: Investment in inventories depends on the length of its
operating cycle. The shorter the lime-lag between the purchase of materials and manufacture
of finished products and between the sales and production of goods, lesser will be the investment
in inventories and vice versa. Thus, a firm can reduce investment in inventories by shortening
its operating cycle.
3. Nature of Product and Production Technology: The size of investment in inventories is
also influence by the nature of product and production technology. Manufacturing process
always involves a time-lag between the feeding of raw materials in the manufacturing line and
turning out of the finished product.
The length of this period depends on the nature of products and production technology. For
example, ship-building industry will require larger investment inventories because the nature of
product is such which needs much time in its completion

4. Nature of Business: Investment in inventories is also determined by the nature of a firm's

business. Trading firms have to invest huge funds in inventories. On the other hand, service
industries such as insurance, banking, transport, etc., need relatively much less inventories and
hence much less investment in inventories.

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5. Economies of Size: The size of investment in inventories is also influenced by the firm's
desire to avail the economies of scale. If raw materials are available on long credit, favorable
terms and attractive quantity discount, the firm may have larger investment in inventories.
6. Supply Conditions: A firm’s success depends on its ability to meet customers' demand as
and when it exists. Quick deliveries depend on inventories as well as flexibility in
manufacturing.
7. Price Level Changes: Price level changes also influence the size of investment in
inventories.
If price rise is expected in near future, there will be more investment in inventories so as to avail
the benefit of lower prices in a bid to minimize the cost of production, conversely, if the price
level is expected to go down, a firm will make the minimum investment in inventories by
resorting to open market purchases of materials as per its requirements.
8. Production Policies: If management decides for long production runs, the investment in
inventories of raw "materials and semi-finished goods will be higher and vice versa.
9. Credit Facilities: The size of investment in inventories also depends on the availability of
credit facilities. If the cost of borrowed funds or terms of credit are such which do not give rise to
the cost of inventories, the investment in inventories will be higher. However, where cost of
credit facilities is more, the investment in inventories will be less.
10. Other Factors: Other factors such as stock out costs, deterioration and obsolescence
costs, storage, insurance and depreciation costs, also effect the decision in respect of investment
in inventories.

Revision questions;
Write short notes on the following;
Reasons for holding cash

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ABC analysis technique
Benefits and limitations of holding ordinary shares and debentures
With examples, distinguish between debit cards and financial cards

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 UNIT 10
DIVIDEND POLICIES
What will you study in this chapter?
I. Meaning of Dividend Policy,
2. Factors Affecting Dividend Policy,
3. Essentials of a Sound Dividend Policy.
4. Types of Dividend Policies,
"Dividend Policy is a financing decision, as such the payment of cash dividend is a passive
factor. "
Q. I. What is Dividend Policy? Explain the various factors determining the Dividend Policy by a
corporation.
Or What are the factors which shape the Dividend Policy of a company? Explain briefly.
What factors determine the Dividend Policy of a company?
"Dividend Policy should be guided by certain basic Objectives." What are these Objectives and
how are they achieved?
Ans.
DIVIDEND POLICY
The term Dividend Policy refers to the policy regarding amount of profits to be distributed as
dividend.
Dividend is that part of a company's divisible profits which is distributed among its shareholders
as return on their shareholdings.

The concept of dividend policy implies that companies through their Board of Directors evolve a
pattern of dividend payment which has a bearing on future action.
OBJECTIVES AND IMPORTANCE OF DIVIDEND POLICY
The most important aspect of dividend policy is to determine the amount of profit to be
distributed among shareholders and the amount of profit to be retained in the business for
financing its long-term growth.
Dividend Policy, therefore, affects both the long-term financing and the wealth of shareholders
as there is a reciprocal relationship between the cash dividend and retained earnings. Thus, while
evolving a Dividend Policy, the Corporate Management will be guided by the following three
Objectives:
1. Adequate Provision of Funds: the first objective of its dividend policy should be to ensure
that retained earnings are sufficient enough to finance (he investment requirements of the
company.
2. Return to Shareholders: The second objective of dividend policy should be to ensure a
reasonable rate of return to shareholders on their shareholdings in the form of dividend in order
to satisfy their desire for current income and develop their confidence in the company's
successful operations,

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3. Maximization of Shareholders Wealth: The third objective of a company's dividend policy
should be to maximize the shareholder's. Wealth in (lie long-run through retention of earnings
and (heir investment is profitable projects.
FACTORS AFFECTING DIVIDEND POLICY
The management of every company attempts to distribute a reasonable dividend to the
shareholders. But they are not successful in doing so, because a number of factors may restrict
them from regular payment of dividend at a reasonable rate to the shareholders. The various
Internal and External Factors Affecting the Dividend Policy of a company are as follows:
INTERNAL FACTORS
Following are the Internal Factors which affect the Dividend Policy of a company;
1. Nature of Business: Companies with regular and definite earnings such as public utilities can
follow a stable dividend policy. On the other hand, companies with fluctuating/unstable
earnings cannot follow a stable Dividend Policy.
2) Age of Company:.
A newly established company may require much of its earnings for its expansion and
development purposes and cannot distribute reasonable dividend to the shareholders regularly
may follow a rigid dividend policy.
On the other hand, well established old companies may regularly distribute a reasonable dividend
to the shareholders by adopting a stable Dividend Policy,

3) Liquidity Position;.
Companies with insufficient cash resources and unsatisfactory overall liquidity position cannot
pay dividend in cash or at a higher rate.
Conversely, companies with sufficient cash resources and strong liquidity position can pay
dividend to the shareholders at a reasonable rate.
4) Need for Additional Capital: Financial Needs of the company also affect its dividend policy
because a part of its divisible profits may be retained for stretching the financial position of the
company.
The Companies requiring more additional working capital for expansion and development
programmes will be adopting a rigid dividend policy.
Small and new companies find it difficult to raise additional working capital, and so they retain a
big part of their profits and distribute dividends at low rates.
5) Desire of Shareholders: Shareholders' desire influence the Dividend Policy
Although the Directors have considerable liberty in respect of the disposal of the company's
divisible profits for various purposes, but they cannot overlook the desire of shareholders while
deciding about the dividend policy
The shareholders expect a reasonable return on investment regularly and an increase in the
market value of shares held by them.

95
If the management does not distribute dividends to respect the desire of shareholders, it will be
difficult for the company to raise additional capital in future.
6) Nature of Ownership: The Nature of Ownership also influences the dividend decisions.
A closely held company with ownership in the hands of a limited number of persons may
adopt a conservative dividend policy with the assent of the shareholders because ploughing back
of a large part of profits will ultimately increase the benefits of the existing shareholders only.
When the number of shareholders of a company is very large and widely scattered, the
company will have to adopt a liberal Dividend Policy. This is because; the company will face a
great difficulty in securing such assent as they may insist on the distribution of higher dividend
in cash immediately.

8) Desire of Control: Dividend Policy is also affected by the desire of shareholders or the
management to retain control over the company.
Issue of new shares for procuring additional funds will inevitably dilute the control of the
existing shareholders over the company.
But if the shareholders or management wish to retain/hold a strong desire for control, the
additional funds for profitable investment opportunities shall be mobilized by retaining sufficient
earnings, and the company will follow a rigid Dividend Policy.
8. Dividend Policies of Other Companies: Dividend Policy of a Company is also influenced by
the dividend policies of the competing companies. For example, other things being equal a
company would never like to pay dividends at lower rate than that paid by the rival companies.
9) Access of the Capita/ Market:
Well established large firms usually have better access to the capital market for raising additional
funds if it can still want distribute divided and can adopt a liberal and stable dividend policy.
Small and new companies, on the other hand, depend on their internal resource i.e., retained
earnings, as they find it difficult to raise the additional funds from external sources.
10) Investment Opportunities: The dividend policy has the affect of dividing a company's
divisible profits into two parts, namely, retained earnings and dividends.
Retained earnings provide funds for financing the company's long-term growth whereas cash
dividends involve the use of available funds of the company.
Since retaining of divisible profits belonging to the shareholders has cost equal to the external
sources of financing, the management retains a large part of dividend so long as sufficient
profitable investment opportunities are available.
11) Financing Policy of the Company: Dividend Policy is also influenced by the Financing
Policy of the company,
If the company decides to finance the development and expansion programme through retention
of earnings, it will have to pay lower dividend.
However, if the company finds out that external borrowing is cheaper than internal financing, it
may decide to pay higher dividends.

EXTERNAL FACTORS
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Following are the External Factors which affect the Dividend Policy of a Company;
1. General State of Economic condition; the general economic conditions of the economy
affects significantly management’s decision to retain or distribute the company's earnings.
During uncertain economic and business conditions, “the management may retain the whole or
a large part of the company’s profits to build up reserves to absorb shock in future.
During the period of depression, the management may also retain large part of its earnings in
order to preserve the company's liquidity position.
During the period of prosperity the management may also not be liberal in dividend payments
when the earning power of the company warrants it because of availability of larger profitable
investment opportunities.
During the periods of inflation, the management may also withhold dividend payments in order
to retain a large part of the earnings for replacement till worn-out assets.
2) Legal Restrictions: The dividend policy of companies is also conditioned by the provisions
of the Companies Act which puts several introductions regarding payments and declaration of
dividends.
It is provided that dividends can only be paid out of current and accumulated profits of the
company.
Likewise, the Uganda’s Income Tax Act also lays down certain restrictions on payment of
dividends.
The management has (to take into consideration all the legal restrictions while determining the
dividend policy of the company otherwise it may be declared as ultra varies.
3) State of capital Market:
In case of favorable capital market conditions when funds may be raised from different sources
without much difficulty, the management of a company may follow a liberal dividend policy.
However, if capital market conditions are unfavorable for raising funds, the management should
follow a conservative Dividend Policy.

4) Change in Government Policies:

The profit earning capacity of companies are widely affected by the change in fiscal, industrial,
labor, control and the Government Policies.
Sometimes, Government restricts the distribution of dividend beyond a certain percentage in a
particular Industry.
5) Taxation Policy: The tax policy followed by the Government also affects the dividend,
policy.
High taxation reduces the earnings of companies as a result of which the rate of dividend is
lowered down. Sometimes, Government levies dividend tax on distribution of dividend beyond a
certain limit.
In such a case, management may be inclined to retain a larger pan of profit and follow a
conservative Dividend Policy.
6) Contractual Responsibility: Sometimes dividend policy is also influenced by the contractual
liability of the company in respect of loans taken from financial agencies.
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The loan agreement may restrict the company from declaring dividend until a certain level of
earnings has been achieved or,
Paying cash dividends beyond a certain amount or percentage of profits until the centre amount
of loan is refunded.
7) Public Opinion: The management has also to consider the public opinion while determining
the dividend policy of the company
Companies which distribute dividends at a very high rate are generally criticized in all of the
society.
Consumers demand for curtailment in price of goods produced by the company and employees
of the company demand for increased wages and salaries.
2. What are the Essentials of a Sound Dividend Policy of a Corporation..

Ans
ESSENTIALS OF SOFT DIVIDEND POLICY
Since Dividend Policy has a direct bearing on long-term financing and wealth of shareholders of
an enterprise, it influences the company's goodwill and future progress. Thus, formulation of a
round dividend policy by the financial manager is of great significance in maximizing the value
of the company to the shareholders.
While developing a Sound Dividend Policy, the following factors need to be considered
carefully:
1. Stability of Dividend: Regular payment of a certain amount of dividend for a long period,
irrespective of fluctuations in the company's earnings, constitutes the main characteristic feature
of a Sound Dividend Policy.
2. Gradual Increases in Dividends: In order to attract the Potential investors and satisfying the
existing shareholders, the management should gradually increase the rate of dividend with the
increase in earnings of the company.
3. Moderate Dividend during Initial Years:During Initial Years of a company, the shareholders
should be distributed dividend at a low rate so that the liquidity position of the company may be
strengthened.
4. Distribution of Cash Dividend: For avoiding the uncertainty of the future and for meeting
their current living expenses, the shareholders totally prefer cash dividends than capital gains
accruing as a result of plough link of profits in the business. Hence, dividends should be
distributed, when the company's liquidity position is not sound.
5) Other Considerations: In case the losses of previous years are still pending, the company
should pay dividends at a lower rate until such losses are fully written off.

TYPES OF DIVIDEND POLICY

Three types of Dividend Policies are usually followed by companies—
Liberal Dividend Policy;
98
Conservative or restricted Dividend Policy
Stable or Sound Dividend Policy.
1) Liberal Dividend Policy;
Under Liberal Dividend Policy, a large part of profits is distributed as dividend among the
shareholders.
The dividend payout ratio under this policy exceeds 80%. Adoption of this policy increases the
goodwill of the company and income of the shareholders, but the financial soundness of the
company is adversely affected in the long run.
Liberal Dividend Policy also encourages speculation in shares and provides opportunities to the
directors and their officers of the company to fulfill their vested interests.
2. Conservative or Strict Dividend Policy: Under this policy companies retain a large part
of profits financing their expansion and development programmes and distribute minimum
dividend to the shareholders.
3. Stable or Sound Dividend Policy: Stable Dividend Policy refers to a dividend policy which
ensures regular payment of a certain minimum amount as dividend irrespective of fluctuation in
earnings from year to year.

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