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FINANCIAL MANAGEMENT

STUDY PAPERS

AS PER

SCIENCE COLLEGE AUTONOMOUS, HINJILICUT

SYLLABUS

(2021)

PRESENTED BY: PRITAM KUMAR JENA

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CONTENTS
S.L NO. CHAPTER PAGE
NO.

1 UNIT-I Meaning And Nature Of Finance 3-34

& Capital Budgeting

2 UNIT-II Operating And Financial 35-70

Leverage & Capital Structure Theories

3 UNIT-III Dividend Policies 71-85

4 UNIT-IV-Management Of Working Capital 86-101

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Unit-1
Meaning of finance
finance, the process of raising funds or capital for any kind of
expenditure. Consumers, business firms, and governments often do not
have the funds available to make expenditures, pay their debts, or
complete other transactions and must borrow or sell equity to obtain
the money they need to conduct their operations. Savers and investors, on
the other hand, accumulate funds which could earn interest or dividends
if put to productive use. These savings may accumulate in the form of
savings deposits, savings and loan shares, or pension
and insurance claims; when loaned out at interest or invested in equity
shares, they provide a source of investment funds. Finance is the process
of channelling these funds in the form of credit, loans, or invested capital
to those economic entities that most need them or can put them to the
most productive use. The institutions that channel funds from savers to
users are called financial intermediaries. They include commercial banks,
savings banks, savings and loan associations, and such nonbank
institutions as credit unions, insurance companies, pension funds,
investment companies, and finance companies.
Nature of Financial Management
Finance management is a long term decision making process which
involves lot of planning, allocation of funds, discipline and much more.
Let us understand the nature of financial management with reference of
this discipline.

Risk and Returns Evaluation

Nature of financial management basically involves decision where risk and
return are linked with investment. Generally high risk investment yield
high returns on investments. So, role of financial manager is to effectively
calculate the level of risk company is involve and take the appropriate
decision which can satisfy shareholders, investors or founder of the
company.

Capital Requirement Estimation

Using financial management to forecast working capital and fixed capital
requirements for conducting business operations, it is possible to plan
ahead of time for money. It is necessary to have a proper balance between
debt and equity in order to keep the cost of capital as low as possible.
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Financial management determines the appropriate allocation of various
securities (common equity, preferred equity and debt).

Wealth Management
The finance manager keeps track of all cash movements (both inflow and
outflow) and guarantees that the company does not experience a cash
shortage or surplus.

Valuation of Company
Primary nature of financial management focus towards valuation of
company. That is the reason where all the financial decisions is directly
linked with optimizing / maximization the value of a company. Finance
functionality like investment, distribution of profit earnings, rising of
capital, etc. are the part of management activities.

Improve Company’s Stock / Shareholder Value

Increase the amount of return to shareholders by lowering the cost of
operations and increasing earnings, according to the company’s mission
statement. The finance manager’s primary focus should be to increase
revenue by obtaining cash from a variety of sources and investing.

Source of Funds
In every organization, the source of funding is a critical decision to make.
There are long-term, medium-term and short-term source of funds. Every
organization should thoroughly research and evaluate various sources of
money (e.g., stocks, bonds, debentures, and so on) before selecting the
most appropriate sources of funds with the least amount of risk.

Selective Investment
Before committing the funds, it is necessary to thoroughly examine and
assess the investment proposal’s risk and return characteristics.
Appropriate decision need to be made for selecting right type of
investment options.

Control Management
The implementation of financial controls assists the firm in maintaining
its real costs of operation within reasonable bounds and generating the
projected profits.
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Scope of financial management

Estimates Capital Requirements

Financial management helps in anticipation of funds required for running
the business. It estimates working and fixed capital requirements for
carrying out all business activities. The finance manager prepares a budget
of all expenses and revenues for a particular time period on the basis of
which capital requirements are determined.

Decides Capital Structure

Deciding optimum capital structure for an organization is a must for
attaining efficiency and earning better profits. It involves deciding the
proper portion of different securities like common equity, preferred
equity, and debt. The proper balance between debt and equity should be
attained which minimizes the cost of capital.

Select Sources Of Fund

Choosing the source of funds is one of the crucial decisions for every
organization. There are various sources available for raising funds like
shares, bonds, debentures, venture capital, financial institutions, retained
earnings, owner investment, etc. Every business should properly analyze
different sources of funds available and choose one which is cheapest and
involves minimal risk.

Selects Investment Pattern

Once funds are procured it is important to allocate them among profitable
investment avenues. The investment proposal should be properly
analyzed regarding its safety, profitability, and liquidity. Before investing
any amount in it all risk and return associated with it should be properly
evaluated.

Raises Shareholders Value

Financial management works towards raising the overall value of
shareholders. It aims at increasing the amount of return to shareholders
by reducing the cost of operations and increasing the profits. The finance
manager focuses on raising cheap funds from different sources and invest
them in the most profitable avenues.
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Management Of Cash
Financial management monitors all funds movement in an organization.
Finance managers supervise all cash movements through proper
accounting of all cash inflows and outflows. They ensure that there is no
situation like deficiency or surplus of cash in an organization.

Apply Financial Controls

Implying financial controls in business is a beneficial role played by
financial management. It helps in keeping the company actual cost of
operation within the limit and earning the expected profits. There are
various processes involved in this like developing certain standards for
business in advance, comparing the actual cost or performance with pre-
established standards, and taking all required remedial measures.

Profit maximisation
Profit maximisation is a process business firms undergo to ensure the best
output and price levels are achieved in order to maximise its returns.

Influential factors such as sale price, production cost and output levels
are adjusted by the firm as a way of realising its profit goals.

In business, profit maximisation is a good thing, but it can be a bad thing

for the client if, for example, lower-quality materials and labour are used
or if the business decides to raise the prices for executing projects, all in
pursuit of profit maximisation.

Arguments in Favour of Profit Maximization

• Profit is essential for survival of a business: The survival of all

the profit oriented firms in the long run depends on their ability to
make a reasonable profit depending on the business conditions and
the level of competitor. Profit is the biggest incentive for work. It is
the driving force behind the business enterprise. It encourages a man
to work to do the best of his ability and capacity. Making a profit is a
necessary condition for the survival of the firm. Once the firms are
able to make profit, they try to maximize it.
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• Achieving other objectives depends on the ability of a business to
make profit: Many other objectives of business are maximization of
managerial utility function, maximization of long-run
growth, maximization of sales revenue. The achievement of such
alternative objectives depends wholly or partly on the primary
objective of making profit.
• Profit maximization objective has a greater predicting
power: As compared to other business objectives,
profit maximization assumption has been found to be good in
predicting certain aspects related to a business. Milton Friedman
supports this by saying that the profit maximization is considered
to be good only if it predicts the business behavior and the business
trends correctly.
• Profit is a more reliable measure of efficiency of a
business: Thought not perfect, profit is the most efficient and
reliable measure of the efficiency of a firm. It is also the source of
internal finance. The recent trend shows a growing dependence
on the internal finance in the industrially advanced countries. In
fact, in developed countries, internal sources of finance contribute
more than three-fourths of total finance. Keeping this in mind, it can
be said that profit maximization is a more valid business objective.

Objections Against Profit Maximisation:

Though profit earning by a business is essential but profit maximisation
is not desirable. Maximising profits without caring for anything else will
amount to exploitation.

Profit maximisation is opposed due to the following reasons:

(i) Exploitation:
A business trying to earn more and more profits will start exploiting
workers and consumers. In free competition a business may not be able to
increase prices of products. A businessman will try to exploit workers by
paying them less and low quality goods will be provided to consumers for
increasing profits.
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(ii) Social Inequalities:
Profit maximisation objective may lead to social inequalities. The rich will
become more rich at the cost of economically weaker sections of society.
Social inequalities will widen with the passage of time. After all, profits
will be increased by exploiting some section or the other.

(iii) Corrupt Practices:

Profit maximisation aim may lead to a number of corrupt practices.
Businessmen will try to be friend government employees for getting
favours in procuring industrial inputs and raising prices of products.

(iv) Lowers Human Values:

The increased emphasis on high profits will lead to materialistic society
where money is considered everything. It will lower the importance of
human values which are an essential part of an ideal social system.

Wealth Maximisation

Wealth maximization is the concept of increasing the value of a business

in order to increase the value of the shares held by its stockholders. The
concept requires a company's management team to continually search
for the highest possible returns on funds invested in the business, while
mitigating any associated risk of loss. This calls for a detailed analysis
of the cash flows associated with each prospective investment, as well
as constant attention to the strategic direction of the organization.

The most direct evidence of wealth maximization is changes in the price

of a company's shares. For example, if a company spends funds to
develop valuable new intellectual property, the investment community
is likely to recognize the future positive cash flows associated with this
new property by bidding up the price of the company's shares. Similar
reactions may occur if a business reports continuing increases in cash
flow or profits.
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Arguments in favour of Wealth Maximization objective

1. It is superior: This objective is superior to profit maximization as its

main aim is to maximise shareholder’s wealth.
2. It is precise and unambiguous: It is based on the concept of cash flows
rather than profit. The concept of profit in the profit maximization
objective is vague and ambiguous.
3. Considers time value of money: Wealth maximization objective takes
into account the time value of money as it considers timing of cash
inflows. The cash flows occurring at different period of time are
discounted with appropriate discount rate.
4. Considers risk: This objective also considers future risk associated
with occurrence of cash flows. This is done with the help of discounting
rate. Higher the discount rate, higher the risk and vice-versa.
5. Ensures efficient allocation of resources: Resources are allocated
wisely to increase shareholder’s wealth.
6. Ensures economic interest of society: When wealth of shareholder is
maximized, it ultimately upholds economic interest of society.

Unfavourable arguments for Wealth Maximization objective

1. Creates owner-management problem: The concept of wealth

maximization creates owner-management problem as owners want to
maximize their profits and management want to maximize
shareholder’s wealth.
2. Ignores other stakeholders: This objective has been criticized on the
ground that it is inclined towards wealth maximization of shareholders
only and ignores other stakeholders such as creditors, suppliers,
employees etc.
3. Criteria of market value is not fair: The criteria of wealth
maximization is based on market value of shares which is not a correct
measure. Because value of shares could increase or decrease due to
other economic factors which are beyond the control of the firm.
4. It is just another form of profit maximization: Ultimate aim is to earn
maximum profits. Without earning profits wealth cannot be maximized.
5. Management alone enjoy certain benefits.
6. It is not suitable for present-day businesses.
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Finance Functions
Investment Decision

One of the most important finance functions is to intelligently allocate

capital to long term assets. This activity is also known as capital
budgeting. It is important to allocate capital in those long term assets so
as to get maximum yield in future. Following are the two aspects of
investment decision

1. Evaluation of new investment in terms of profitability

2. Comparison of cut off rate against new investment and prevailing
investment.

Since the future is uncertain therefore there are difficulties in calculation

of expected return. Along with uncertainty comes the risk factor which
has to be taken into consideration. This risk factor plays a very significant
role in calculating the expected return of the prospective investment.
Therefore while considering investment proposal it is important to take
into consideration both expected return and the risk involved.
Investment decision not only involves allocating capital to long term
assets but also involves decisions of using funds which are obtained by
selling those assets which become less profitable and less productive. It
wise decisions to decompose depreciated assets which are not adding
value and utilize those funds in securing other beneficial assets. An
opportunity cost of capital needs to be calculating while dissolving such
assets. The correct cut off rate is calculated by using this opportunity
cost of the required rate of return (RRR)
Financial Decision

Financial decision is yet another important function which a financial

manger must perform. It is important to make wise decisions about when,
where and how should a business acquire funds. Funds can be acquired
through many ways and channels. Broadly speaking a correct ratio of an
equity and debt has to be maintained. This mix of equity capital and debt
is known as a firm’s capital structure.
A firm tends to benefit most when the market value of a company’s share
maximizes this not only is a sign of growth for the firm but also
maximizes shareholders wealth. On the other hand the use of debt affects
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the risk and return of a shareholder. It is more risky though it may
increase the return on equity funds.
A sound financial structure is said to be one which aims at maximizing
shareholders return with minimum risk. In such a scenario the market
value of the firm will maximize and hence an optimum capital structure
would be achieved. Other than equity and debt there are several other
tools which are used in deciding a firm capital structure.
Dividend Decision

Earning profit or a positive return is a common aim of all the businesses.

But the key function a financial manger performs in case of profitability
is to decide whether to distribute all the profits to the shareholder or
retain all the profits or distribute part of the profits to the shareholder
and retain the other half in the business.
It’s the financial manager’s responsibility to decide a optimum dividend
policy which maximizes the market value of the firm. Hence an optimum
dividend pay out ratio is calculated. It is a common practice to pay regular
dividends in case of profitability Another way is to issue bonus shares to
existing shareholders.
Liquidity Decision

It is very important to maintain a liquidity position of a firm to avoid

insolvency. Firm’s profitability, liquidity and risk all are associated with
the investment in current assets. In order to maintain a trade-off between
profitability and liquidity it is important to invest sufficient funds in
current assets. But since current assets do not earn anything for business
therefore a proper calculation must be done before investing in current
assets.
Current assets should properly be valued and disposed of from time to
time once they become non profitable. Currents assets must be used in
times of liquidity problems and times of insolvency.
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Capital Budgeting
Capital budgeting is the process a business undertakes to evaluate
potential major projects or investments. Construction of a new plant or a
big investment in an outside venture are examples of projects that would
require capital budgeting before they are approved or rejected.

As part of capital budgeting, a company might assess a prospective

project's lifetime cash inflows and outflows to determine whether the
potential returns that would be generated meet a sufficient target
benchmark. The capital budgeting process is also known as investment
appraisal.

Investment Criteria of Capital Budgeting:

# 1.Accounting or Average Rate of Return Method:
The Average Rate of Return (ARR) method is used in order to measure the
profit-abilities of the investment proposals. This is practically an
accounting method and it incorporates the expected return which may be
obtained from the project. Under this method average annual profit (after
tax) is expressed as percentage of investment.

There are a number of alternatives for calculating ARR. Although, there is

no unanimity regarding its definition, the most common usage of the ARR
which is found out by dividing the average annual profit / income after
tax by the average investment.

In this connection, it may be noted that the average investment must be

equal to the original investment plus salvage value, if any, divided by two.
Moreover, the ARR can also be found out by dividing the total book value
of investment (after depreciation) by the life of the project.

Therefore, this is nothing but an average rate which is expressed as a

percentage and can be determined with the help of the following:
ARR = (Average Annual Profit after Tax/Average Investment) × 100

Under this method, the investment which will give the highest rate of
return will be accepted. Sometimes, a firm may fix a standard rate or cut-
off rate of return and as such, investments which will not produce this
rate will be excluded.
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Illustration:
A Ltd. wants to purchase a machine. Two machines, viz. X and Y, are
available in the market. The cost of each machine is Rs. 1,00,000. Their
expected lives are 5 years.

Net profits before tax during the expected life of the machines are
given below:

Note: The average rate of tax is 50 %.

From the above information, ascertain which one is more profitable.

Solution:

Hence, Machine Y is more profitable since it gives the higher return.

Alternative approach:
Instead of taking the average cost of the project, the original cost is
considered

In that case, the ARR, in case of both machines, will be {Rs. 7,375/Rs
56.125× 100} 13.14%
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Advantages of ARR:
(i) It is very simple and easy to calculate

(ii) It supplies the readily available accounting information.

Disadvantages of ARR:
(i) The significant demerits of this method is that it does not recognise the
timings of cash inflows and outflows since it is based on accounting
income instead of cash flows.

(ii) Moreover, competing projects generally have a varying length of life.

In order to find out the average earnings, additional years’ earnings of a
project which has a longer life are compared with the earnings of a project
which has a comparatively short life. This is unfair. As such, that system
will be taken into consideration which will satisfy both the factors, viz.
timing of income and varying length of life.

Additional Rate of Return:

It is the average additional profit expressed as percentage of investment.
Under the circumstances, if it is found that the return is satisfactory in
comparison with what is available, the replacement may be made. Before
discussing the principles, it becomes necessary to explain the related
terms in this respect, viz. (a) Investment, and (b) Average Additional profit.

(a) Investment:
(i) The original cost of investment;

(ii) Average Investment.

We know that the original cost of an asset gradually diminishes from year
to year over its effective life since the capital cost is recovered by way of
depreciation charges. As such, if the straight line method of depreciation
is followed, the average investment will be the half of the depreciable part
plus the whole of the non-depreciable (remaining) part of the cost of the
investment.

It should be mentioned that the depreciation portion is divided by two

since the uncovered investment declines from the original cost of the asset
to zero.
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(b) Average additional profit:
It is simply the difference between the profit which arises out of the sales
proceeds of output produced by the new machine and those which are
produced by the machine which is proposed to be replaced. It may be
taken (for the purpose of calculating return on investment) as the profit
either before-tax or after-tax.

Evaluation of ARR:
Before evaluating ARR, its merits and drawbacks should carefully be
considered. Its advantages are given below:
(i) The most significant attribute of ARR is that it is very simple to
understand and easy to calculate.

(ii) It can be easily computed on the basis of accounting data which are
furnished by the financial statements.

(iii) It recognises the entire stream of income while calculating the

accounting rate.

The ARR is not even free from snags. They are discussed below:
(i) The principal shortcoming of ARR is that it recognises only the
accounting income instead of cash flows.

(ii) It does not recognise the time value of money.

(iii) It does not take into consideration the length of lives of the projects.

(iv) It does not consider the fact that the profits may be re-invested.

# 2.Pay Back Period:

The Pay Back Period Method is the second unsophisticated method of
capital budgeting and is widely employed in order to overcome some of
the shortcomings of ARR method It recognises that recovery of the original
investment is an important element while appraising capital expenditure
decisions.

It may be stated that it is simply an application of ‘break-even’ concept to

investment. Practically, this method gives the answer about the question,
‘How many years will it take for the cash benefits to pay the original cost
of an investment?
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It is defined as the number of years required to cover the original cash
outlay which are invested in a project. In other words, Pay Back Period is
the period required for the savings in costs or net cash flow after tax but
before depreciation, to recover the cost of investment.’

Thus, Pay Back Period is computed when:

(i) Cash flow accrues at even rate, i.e. where there is equal cash inflow:

Pay Back Period (P.B P.) = Cost of the investment Cash outlay/ Annual Vet
Cash Inflow

(ii) Where there is unequal cash inflow:

The P B P. can be found out by adding up the cash inflows until the total
is equal to the initial cash investment.

Illustration:
(Where there is equal cash inflow):
A project requires an investment of Rs. 1.00.000 with a life of 10 years
which yield an expected annual net cash inflow of Rs. 25.000 Compute the
pay-back period.

Solution:
Pay Back Period (P.B P.) = Cost of the investment (projects)/ Annual Net
Cash Inflow

= Rs. 1,00,000 / Rs. 25,000 = 4 years.

Advantages:
1. It is simple to operate and easy to understand. Since it is very easy the
same is used in many advanced countries, viz. U.K., U. S.A etc.

2. It shows how soon the cost of purchasing an asset will be recovered. In

other words, it considers the liquidity aspect of working on the ground
that a project with short-pay-off period is better than those with long pay-
off period.

3. Short-term approach reduces the loss through obsolescence particularly

when there is any rapid technological development.
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4. It considers risks as well which may arise due to the following:
(i) Political instability;

(ii) Nature of the product; and

(iii) Introduction of a new product.

5. It acts as a yardstick in comparing the profitability of two projects

6. In some cases. Pay Back Period is closely related to ARR and as such,
enjoys the benefit of ARR. This is particularly applicable where the
projects have substantially longer lives than their pay back periods and
annual savings on cash inflows are comparatively uniform.

Disadvantages:
1. It recognises only the recovery of purchase costs, not profits earned
during the working life of the asset.

2. It gives much stress on converting capital into cash, which is not

important in case of those assets which have longer working life.

3. It does not recognise the time value of money.

4. It does not take into consideration that profits from different projects
may assume at an uneven rate.

5. It ignores the basic fact that actual profitability depends on the number
of years it will continue to operate after the pay-back period Thus,
Profitability = Net cash flow or Saving × (Expected life of the project – Pay
Back Period).

Pay Back Profitability:

This is a modified version of Pay Back Period Method. It recognises the
fact that the total cash flow remains after recovering the cost of
investment. Therefore, project will be selected on the basis of profitability
after pay-off period.

Profitability is calculated as under:

Profitability = Net cash flow or Savings Earning × (Expected life of the
project – Pay Back Period)
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# 3.Net Present Value Method (NPV):
The Net Present Value Method (NPV) is the time value of money approach
to evaluate the return from an investment proposal. Under this method,
we discount a project using the required return as the discount factor In
other words, a stipulated compound interest rate is given and by the use
of this percentage net cash flows are discounted to present values.

The present value of the cost of the project is subtracted from the sum of
present values of various cash inflows. The surplus is the net present
value. If the NPV is positive, the proposal’s forecast return exceeds the
required return, hence, the proposals are acceptable.

But if the NPV is negative, the forecast return is less than the required
return, the proposals is not acceptable. Thus, the decision rule for a
project under NPV is to accept the project if the NPV is positive.

and reject if it is negative. Or,

(1) NPV > zero = Accept.

(2) NPV < zero = Reject.

Conversion of Net Cash Flow (NCF) into Present Value (PV):

a. By the use of Logarithms:

In case of uneven Net Cash Flows (NCF), the present value of a future sum
may be computed with the help of the following formula:
V = A/(1 + i)n
Where,

V = Present Value

A = Annual Net Cash Flow (after tax but before depreciation)

i = Rate of Interest

n = Number of years,
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where there are a number of years annual net cash flows, the above
formula may be to:

However, if there is uneven net cash flows, the PV of various NCF must be
computed separately which will result in tedious calculation. But, if there
is an even rate, the following annuity formula may be used:

Therefore, any of the above three forms may be accepted. The following
illustration will make the principle clear:

Illustration:
The management of a firm desires to purchase a machine. Two machines
are available in the market — Machine A and Machine B You is asked to
advise the management which of the two alternatives will be more
profitable under the NPV method from the following particulars:
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Solution:
Before taking decisions it is necessary to find out the present value of net
cash flows from the alternative investments with the help of the following
annuity formula:

It is evident from the above that Machine B will be the more profitable
investment since the NPV of earnings in Machine B is greater than that of
Machine A

b. By the use of Discount Tables:

Sometimes net cash flows (NCF) can be converted into NPV with the help
of the discount table which reveals the present value of Re. 1 receivable at
different intervals of time together with wide range of interest rates.

It should be noted in this respect that when there is expected uneven cash
flows, each year’s NCF will have to be discounted separately in order to
find out the NPV. But if there is even NCF, a general Present Value table is
sufficient for the purpose.
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Illustration:
Calculate the NPV for project ‘A’ which initially cost Rs 3,000 and
generates annual cash inflow of Rs. 1,000, Rs. 900, Rs. 800, Rs. 700 and
Rs. 600 in five years. The discount rate is assumed to be @10%.

Solution:
Net Present Value of Project A

Thus, it is possible to calculate the NPV for any series of future cash flows
with help of the above procedure.It is needless to mention that if NCF
accrues at even rate, the procedure is quite simple. For example, the future
cash flow id Rs. 400 in a series which is to be received at the end of the
next three years.

The above procedure may be neglected but the dame is computed as

under:

This discount factor, i.e., 2,486 can be applied directly. Therefore, the P.V
of Rs. 400 to be received annually for 3 years would be –

Rs. 400 x 2.486 = Rs. 994 (approx.).

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Evaluation of NPV method:

Advantages of the NPV method are:

(i) It recognises time value of money.

(ii) It also recognises all cash flows throughout the life of the project.

(iii) It helps to satisfy the objectives for maximising firm’s values.

Disadvantages:
The NPV method has the following drawbacks:
(i) It is really difficult.

(ii) It does not present a satisfactory answer when there is different

amounts of investments for the purpose of comparison.

(iii) It does not also present a correct picture in case of alternative projects
or
where there is unequal lives of the project with limited funds.

(iv) The NPV method of calculation is based on discount state which again
depends on the firm’s cost of capital. The latter is to some extent difficult
to understand as well as difficult to measure in actual practice.

# 4.Internal Rate of Return or Yield Method:

The Internal Rate of Return (IRR) method is the second discounted
cash flow or time adjusted method for appraising capital investment
decisions. It was first introduced by Joel Dean. It is also known as
yield on investment, marginal efficiency of capital, rate of return over
cost, time-adjusted rate of return and so on.

Internal rate of return is a rate which actually equates the present

value of cash inflows with the present value of cash outflows.

It is actually the rate of return which is earned by a project, i.e. it is

a rate at which the NPV of investment is zero. This method also
recognises the time value of money like NPV method by discounting
the cash streams.
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Since it exclusively depends on the initial outlay and cash proceeds
of the projects, and not by any rate determined outside the
investment, it is appropriately called as Internal Rate of Return Under
this method, the IRR should be compared with a required rate of
return which is as the cut-off or hurdle rate.

A project is profitable only when the IRR is not less than the required
rate, i.e. undertake any project whose internal rate of return exceeds
required rate. In the opposite case, it is rejected.

In other words, where there are a number of alternative proposals,

the acceptances criterion can be considered after analysing the
following:
(i) IRR is to be found out in each alternatives cases;

(ii) Compare the IRR with cut-off rate and those projects are rejected
whose IRR is less than the cut-off rate.

(iii) Compare the IRR of each alternative and select that one which
produces the highest rate and most profitable one.

IRR can be found out by solving the following equation

(mathematically), it is represent by the rate, r, such that:

where, C = Initial cash outlay;

P , P , P , = Stream of future net cash flows.

1 2 3

The main shortcoming of this method is to ascertain the IRR which

equates P. V. of NCF with that of initial cash outlay. In most cases, the
rate is chosen at the first attempt and consequently one has to resort
to trial and error (that is why this method is sometimes called ‘Trial
and Error’ method).
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Here, C, P, and n are all known and as such r can be found out by
solving the
equations. But the difficulties arises since the value of log (1 + r)-

n
cannot be determined.
Naturally, after applying three or four trials runs, an area can be
noticed, where the actual rate lies and simple interpolation or graph
may be used in order to approximate the actual rate.

The above principles may be explained with the help of the

following illustration under two conditions:
(a) Where there is even series of net cash flows:
Under the circumstances, initial cash outlay should be divided by the
NCF per annum and locate the nearest discount factors. And choose
that discount rate which corresponds to the approximate rate of
return. For this purpose, simple interpolation may be used for
accuracy. The following illustration will, however, make the principle
clear.

Illustration:
Initial Outlay Rs. 40,000.

Annual Net Cash Flow (NCF) Rs. 12.,000

Estimated life 5 years.

Calculate the Internal Rate of Return (r) of the projects.

 25:
Solution:
In order to find out IRR, we are to calculate the rate which will actually
equate the original investment (Rs. 40,000) with the present value of
Rs. 12,000 received annually for five years.

Suppose, we start with 14% rate of interest. The present value of Re.
1 received annually for 5 years at 14% is 3.4331 which is the discount
factor. At the same time, the total present value of Rs. 12,000 received
annually for 5 years becomes Rs. 60,000 (Rs. 12,000 x 5) which
actually comes to Rs. 41,197.2.

The present value of future cash streams exceeds the initial

investment (i.e., Rs. 40,000). Alternatively it can be stated that the
NPV> zero. As such, this rate is naturally not the IRR. As the NPV>
zero we are to search for a higher rate of interest in order to have a
lower NPV.

Let us try again on the assumption that the discount rate is 16%. Thus,
the discount factor is 3.2743 which is multiplied by Rs 12,000
presents a total present value of Rs. 39,291.6. As a result, the present
value of cash streams falls short of the outlay (by Rs. 708 4) and as
such, the NPV < zero.

Therefore, the IRR lies between 14% and 16%. If we consider again 15%
rate of interest which is 3.3522. In that case, the present value of Rs.
12,000 after five years will be Rs. 40,226.4, i.e. slightly more than the
original outlay.

So, the IRR will be slightly more than 15% but not more than 16%.
 26:
However, the exact figure can be received by the application of the
following interpolation formula:

Therefore, the IRR is 15.24%.

From the above, it is evident that the said principle is particularly

applicable if there is a constant annual cash flow. But in actual
practice, that is not always possible. The calculation in such a case is
more difficult. This principle is explained below.

(b) Where there is uneven series of net cash flows:

It has already been stated above that if there is any uneven series of net
cash flows, calculation is comparatively difficult In this case, in order to
reduce the number of trial runs the first trial rate should be carefully
selected It should be remembered that if net cash flow is not too uneven,
selection of first rate may be considered as under:
 27:
When the first trial rate is applied for converting net cash flows to
present values, the next trial rates can be selected on the basis of the
following:
(i) When the present value of NCF is < the cost of the project = the second
trial rate will be less than the first trial rate;

(ii) When the present value of NCF is > the cost of the projects = the second
trial rate will be more than the first one.

In this manner, there will be a place where the exact discount rate will lie
and the same can be ascertained with the help of simple interpolation.

The Internal Rate of Return Method has the following advantages:

(a) It recognises the time value of money like Net Present Value Method;

(b) It also takes into account the cash flows throughout the life of the
project;

(c) This method also reveals the maximum rate of return and presents a
fairly good idea about the profitability of the project even if the firm’s cost
of capital is absent since the latter is not a precondition for use of it;

(d) The percentage which is calculated under the method is more

meaningful and justified and that is why it is acceptable to the users since
it satisfies them in relation to cost of capital.

# 5.Profitability Index (PI) or Benefit Cost Ratio (B/C Ratio):

Another time-adjusted techniques for evaluating investment proposals is
the Profitability Index (PI) or Benefit Cost Ratio (B/C Ratio). It is the relation
between present value of future net cash flows and the initial cash outlay,
i.e. this ratio is computed by dividing the present value of net cash flows
by the initial cash outlay.

It is computed as under:
 28:
It is similar to the NPV approach. It measures the present value of return
per rupee invested. Whereas NPV depends 011 the difference between PV
of NCF and PV of cash outflow. This is actually a drawback of NPV method
which has been mentioned above since it is an absolute measure, PI, on
the other hand, is a relative measure.

Illustration:

Calculate the NPV and PI of the project assuming that the discount factor
is 10%.

Solution:

Under this method, it should be remembered that an investment proposal

may be accepted when the Profitability Index (PI) is greater than one.
However, in case of mutually exclusive proposals, the acceptance criterion
will be: the higher the index, the more profitable is the proposals and vice-
versa.
 29:
Example:
(Data are taken from the previous illustration):

Thus, Investment in Machine B will be more profitable. It may also be done

with the help of ranking. That is, highest rank will be given to that project
which has highest PI.

Acceptance Rule (i.e., Accept-Reject Decision):

That an investment proposal is accepted when the PI is greater than one.
When PI equals to I, the firm is indifferent to the project. Similarly, where
PI is greater than, less than or equal to 1, the NPV is greater than, less than
or equal to O respectively, i.e.

ADV.FM. 19

NPV will be positive = PI>1

NPV will be negative = PI<1

Therefore, NPV and PI present the same result about the investment
proposals.

# 6.Capital Rationing:
From the foregoing discussion it may be recalled that the profitability of
a project can be measured by any one of the DCF techniques, (viz., IRR,
NPV and PI) particularly the two theoretically sound methods IRR and NPV.

Practically, the firm may accept all those projects which give a rate of
return higher than the cost of capital or, which have a positive NPV. And
in case of mutually exclusive projects, the projects having the highest NPV
or giving the highest rate of return may be accepted In other words, a firm
should accept that investment proposal which increases by maximizing
firm’s value.
 30:
In actual practice, however, every firm prepares its annual capital
expenditure budget which depends on the availability of funds with the
firms or other considerations. In that case, a firm has to select not only
the profitable investment opportunities, but also it has to rank the
projects from the highest to lowest priority, i.e., a cut-off point is selected.

Naturally, the proposals which are above the cut-off point, will be funded
and which is below the cut-off point will be rejected. It should be
remembered that this cut-off point is determined on the basis of the
number of projects, funds available for financing capital expenditure and
the objectives of the firm.

That is, in other words, question of capital rationing appears before us. It
is normally applied to situations where the supply of funds to firm is
limited in some way. It, actually, encompasses many different situations
ranging from that where the borrowing and lending rates faced by the
firms differ to that where the funds available for investment by the firm
are strictly limited.

In short, it refers to a situation where the firm is constrained for external,

or self-imposed, reasons to obtain necessary funds to invest in all
profitable investment projects, i.e., a situation where a constraint is placed
on the total size of capital investment during a particular period.

In the circumstances the firm has to select a combination of investment

proposals which provides the highest NPV subject to the budget
constraint.

Selection Process under Capital Rationing:

Needless to mention that under capital rationing a firm cannot accept all
the projects even if all of them are profitable. In order to select or reject
the projects, a comparison must be made among them.
 31:
Selection of project actually depends on the following two steps:

(i) Ranking the projects according to the Profitability Index (PI) or Net Present Value
(NPV) method;

(ii) Selecting projects in descending order of profitability (until the funds are
exhausted).

The projects can be ranked by any one of the DCF techniques, viz. IRR, NPV and PI. But
PI method is found to be more suitable and reliable measure of profitability since it
determines the relative profitability while NPV method is an absolute measure of
profitability.

Illustration:
Funds available for capital expenditure in a year are estimated at Rs.
2,50,000 in a firm. The profitability index (PI) together with mutually
exclusive investment proposals.

Which of the above projects should be accepted?

 32:
Solution:
The projects should be selected on the basis of profitability under PI
method and rank is assigned accordingly, subject to maximum utilization
of available funds.

These are shown below:

From the above, it becomes clear that the first projects should be selected
as the optimum mix since they will completely utilise the available funds
amounting to Rs. 2,50,000. Projects P6 and PB are not included in above as
their PI is less than unity (1) and hence, these are to be rejected.

#7.Cost of capital
Cost of capital refers to the return a company expects on a specific
investment to make it worth the expenditure of resources. In other words,
the cost of capital determines the rate of return required to persuade
investors to finance a capital budgeting project.
The cost of capital is heavily dependent on the type of financing used in
the business. A business can be financed through debt or through equity.
However, most companies employ a mixture of equity and debt financing.
Therefore, the cost of capital comes from the weighted average cost of all
capital sources.
 33:
How to calculate cost of capital
To calculate the weighted average cost of capital (WACC), you must first
calculate the cost of debt and the cost of equity, which are represented by
these formulas:
1. Cost of debt
The cost of debt refers to interest rates paid on any debt, such as
mortgages and bonds. Interest expense is the interest paid on current
debt.

2. Cost of equity
Cost of equity refers to the return a company requires to determine if
capital requirements are met in an investment. Cost of equity also
represents the amount the market demands in exchange for owning the
asset and therefore holding the risk of ownership.
Cost of equity is approximated by the capital asset pricing model (CAPM):

In this formula:
• Rf= risk-free rate of return
• Rm= market rate of return
• Beta = risk estimate
3. Weighted average cost of capital
Cost of capital is based on the weighted average of the cost of debt and
the cost of equity.
 34:
In this formula:
a. E = the market value of the firm's equity
b. D = the market value of the firm's debt
c. V = the sum of E and D
d. Re = the cost of equity
e. Rd = the cost of debt
f. Tc = the income tax rate
Example 2
Newly formed Gold Company needs to raise $1.5 million in capital in order
for it to buy an office and the necessary equipment to run its business.
The company raises the first $800,000 by selling stocks. Shareholders
demand a 5% return on their investment, so the cost of equity is 5%.
Gold Company then sells 700 bonds for $1,000 each to raise the remaining
$700,000 in capital. The individuals who purchase those bonds expect a
10% return, so Gold Company's cost of debt is 10%.
Gold Company's total market value is $1.5 million, and its corporate tax
rate is 25%. The weighted average cost of capital can be calculated as:

Gold Company's weighted average cost of capital is 6.1%.

 35:
UNIT-2
Leverage
The word ‘leverage’, borrowed from physics, is frequently used in
financial management.

The object of application of which is made to gain higher financial benefits

compared to the fixed charges payable, as it happens in physics i.e.,
gaining larger benefits by using lesser amount of force.

In short, the term ‘leverage’ is used to describe the ability of a firm to use
fixed cost assets or funds to increase the return to its equity shareholders.
In other words, leverage is the employment of fixed assets or funds for
which a firm has to meet fixed costs or fixed rate of interest obligation—
irrespective of the level of activities attained, or the level of operating
profit earned.

Leverage occurs in varying degrees. The higher the degree of leverage, the
higher is the risk involved in meeting fixed payment obligations i.e.,
operating fixed costs and cost of debt capital. But, at the same time, higher
risk profile increases the possibility of higher rate of return to the
shareholders.

Types of Leverage:
Leverage are the three types:
(i) Operating leverage

(ii) Financial leverage and

(iii) Combined leverage

 36:
1. Operating Leverage:
Operating leverage refers to the use of fixed operating costs such as
depreciation, insurance of assets, repairs and maintenance, property taxes
etc. in the operations of a firm. But it does not include interest on debt
capital. Higher the proportion of fixed operating cost as compared to
variable cost, higher is the operating leverage, and vice versa.

Operating leverage may be defined as the “firm’s ability to use fixed

operating cost to magnify effects of changes in sales on its earnings before
interest and taxes.”

In practice, a firm will have three types of cost viz:

(i) Variable cost that tends to vary in direct proportion to the change in the
volume of activity,

(ii) Fixed costs which tend to remain fixed irrespective of variations in the
volume of activity within a relevant range and during a defined period of
time,

(iii) Semi-variable or Semi-fixed costs which are partly fixed and partly
variable. They can be segregated into variable and fixed elements and
included in the respective group of costs.

Operating leverage occurs when a firm incurs fixed costs which are to be
recovered out of sales revenue irrespective of the volume of business in a
period. In a firm having fixed costs in the total cost structure, a given
change in sales will result in a disproportionate change in the operating
profit or EBIT of the firm.
 37:
If there is no fixed cost in the total cost structure, then the firm will not
have an operating leverage. In that case, the operating profit or EBIT varies
in direct proportion to the changes in sales volume.

Operating leverage is associated with operating risk or business risk. The

higher the fixed operating costs, the higher the firm’s operating leverage
and its operating risk. Operating risk is the degree of uncertainty that the
firm has faced in meeting its fixed operating cost where there is variability
of EBIT.

It arises when there is volatility in earnings of a firm due to changes in

demand, supply, economic environment, business conditions etc. The
larger the magnitude of operating leverage, the larger is the volume of
sales required to cover all fixed costs.

Illustration 1:
A firm sells its product for Rs. 5 per unit, has variable operating cost of
Rs. 3 per unit and fixed operating costs of Rs. 10,000 per year. Its current
level of sales is 20,000 units. What will be the impact on profit if (a) Sales
increase by 25% and (b) decrease by 25%?
 38:
(a) A 25% increase in sales (from 20,000 units to 25,000 units) results in
a 33 1/3% increase in EBIT (from Rs. 30,000 to Rs. 40,000).

(b) A 25% decrease in sales (from 20,000 units to 15,000 units) results in a
33 1/3% decrease in EBIT (from Rs. 30,000 to Rs. 20,000).

The above illustration clearly shows that when a firm has fixed operating
costs an increase in sales volume results in a more than proportionate
increase in EBIT. Similarly, a decrease in the level of sales has an exactly
opposite effect. The former operating leverage is known as favourable
leverage, while the latter is known as unfavorable.

Degree of Operating Leverage:

The earnings before interest and taxes (i.e., EBIT) changes with increase or
decrease in the sales volume. Operating leverage is used to measure the
effect of variation in sales volume on the level of EBIT.

The formula used to compute operating leverage is:

A high degree of operating leverage is welcome when sales are rising i.e.,
favourable market conditions, and it is undesirable when sales are falling.
Because, higher degree of operating leverage means a relatively high
operating fixed cost for recovering which a larger volume of sales is
required.
 39:
The degree of operating leverage is also obtained by using the
following formula:
Degree of operating leverage (DOL) = Percentage change in EBIT /
Percentage Change in Units Sold

The value of degree of operating leverage must be greater than 1. If the

value is equal to 1 then there is no operating leverage.

Importance of Operating Leverage:

1. It gives an idea about the impact of changes in sales on the operating income
of the firm.

2. High degree of operating leverage magnifies the effect on EBIT for a small
change in the sales volume.

3. High degree of operating leverage indicates increase in operating profit or

EBIT.

4. High operating leverage results from the existence of a higher amount of fixed
costs in the total cost structure of a firm which makes the margin of safety low.

5. High operating leverage indicates higher amount of sales required to reach

break-even point.

6. Higher fixed operating cost in the total cost structure of a firm promotes
higher operating leverage and its operating risk.

7. A lower operating leverage gives enough cushion to the firm by providing a

high margin of safety against variation in sales.

8. Proper analysis of operating leverage of a firm is useful to the finance

manager.
 40:
What Effect Does Operating Leverage Have on a Company's
Profits?

Understanding Cost Structures

The more operating leverage a company has, the more it has to sell before
it can make a profit. In other words, a company with a high operating
leverage must generate a high number of sales to cover high fixed costs,
and as these sales increase, so does the profitability of the company.
Conversely, a company with a lower operating leverage will not see a
dramatic improvement in profitability with higher volume, because
variable costs, or costs that are based on the number of units sold,
increase with volume.

Operating Leverage and Its Implications

Operating leverage defines a company's break-even point,

reports Accounting Tools. The break-even point is the point at which
costs are equal to sales; the company "breaks even" when the cost to
produce a product equals the price customers pay for it.

The importance of operating leverage is that it drives a company's pricing

strategy. To make a profit, the price must be higher than the break-even
point. A company with a high operating leverage, or a higher ratio of fixed
costs to variable costs, always has a higher break-even point than a
company with a low operating leverage. The company with a high
operating leverage, all other things being equal, must raise prices to make
a profit.

Benefits to High Fixed Costs

It may seem as though a low operating leverage is beneficial to profits,

but a high fixed cost leverage structure also has some benefits. The
principal advantage is that companies with a high operating leverage
have more to gain from each additional sale because they don't have to
increase costs to generate more sales. As a result, profit margins increase
at a faster pace than sales. For example, most software and
pharmaceutical companies invest a large amount in upfront development
and marketing. It doesn't matter if Microsoft or Pfizer sell one unit or 100
units, as their fixed costs will not change much.
 41:
2.Financial Leverage:
Financial leverage is primarily concerned with the financial activities
which involve raising of funds from the sources for which a firm has to
bear fixed charges such as interest expenses, loan fees etc. These sources
include long-term debt (i.e., debentures, bonds etc.) and preference share
capital.

Long term debt capital carries a contractual fixed rate of interest and its
payment is obligatory irrespective of the fact whether the firm earns a
profit or not.

As debt providers have prior claim on income and assets of a firm over
equity shareholders, their rate of interest is generally lower than the
expected return in equity shareholders. Further, interest on debt capital is
a tax deductible expense.

These two facts lead to the magnification of the rate of return on equity
share capital and hence earnings per share. Thus, the effect of changes in
operating profits or EBIT on the earnings per share is shown by the
financial leverage.

According to Gitman financial leverage is “the ability of a firm to use fixed

financial charges to magnify the effects of changes in EBIT on firm’s
earnings per share”. In other words, financial leverage involves the use of
funds obtained at a fixed cost in the hope of increasing the return to the
equity shareholders.

Favourable or positive financial leverage occurs when a firm earns more

on the assets/ investment purchased with the funds, than the fixed cost
 42:
of their use. Unfavorable or negative leverage occurs when the firm does
not earn as much as the funds cost.

Thus shareholders gain where the firm earns a higher rate of return and
pays a lower rate of return to the supplier of long-term funds. The
difference between the earnings from the assets and the fixed cost on the
use of funds goes to the equity shareholders. Financial leverage is also,
therefore, called as ‘trading on equity’.

Financial leverage is associated with financial risk. Financial risk refers to

risk of the firm not being able to cover its fixed financial costs due to
variation in EBIT. With the increase in financial charges, the firm is also
required to raise the level of EBIT necessary to meet financial charges. If
the firm cannot cover these financial payments it can be technically forced
into liquidation.

Illustration 2:
One-up Ltd. has Equity Share Capital of Rs. 5,00,000 divided into shares
of Rs. 100 each. It wishes to raise further Rs. 3,00,000 for expansion-cum-
modernisation scheme.

The company plans the following financing alternatives:

(i) By issuing Equity Shares only.

(ii) Rs. 1,00,000 by issuing Equity Shares and Rs. 2,00,000 through
Debentures @ 10% per annum.

(iii) By issuing Debentures only at 10% per annum.

(iv) Rs. 1,00,000 by issuing Equity Shares and Rs. 2,00,000 by issuing 8%
Preference Shares.
 43:
You are required to suggest the best alternative giving your comment
assuming that the estimated earnings before interest and taxes (EBIT) after
expansion is Rs. 1,50,000 and corporate rate of tax is 35%.

In the above example, we have taken operating profit (EBIT = Rs. 1,50,000)
constant for alternative financing plans. It shows that earnings per share
(EPS) increases with the increase in the proportion of debt capital
(debenture) to total capital employed by the firm, the firm’s EBIT level
taken as constant.

Financing Plan I does not use debt capital and, hence, Earning per share is
low. Financing Plan III, which involves 62.5% ordinary shares and 37.5%
debenture, is the most favourable with respect to EPS (Rs. 15.60). The
difference in Financing Plans II and IV is due to the fact that the interest
on debt is tax-deductible while the dividend on preference shares is not.

Hence, financing alternative III should be accepted as the most profitable

mix of debt and equity by One-up Ltd. Company.
 44:
Degree of Financing Leverage:
Financing leverage is a measure of changes in operating profit or EBIT on
the levels of earning per share.

It is computed as:
Financial leverage = Percentage change in EPS / Percentage change in EBIT
= Increase in EPS / EPS / Increase in EBIT/EBIT

The financial leverage at any level of EBIT is called its degree. It is

computed as ratio of EBIT to the profit before tax (EBT).

Degree of Financial leverage (DFL) = EBIT / EBT

The value of degree of financial leverage must be greater than 1. If the

value of degree of financial leverage is 1, then there will be no financial
leverage. The higher the proportion of debt capital to the total capital
employed by a firm, the higher is the degree of financial leverage and vice
versa.

Again, the higher the degree of financial leverage, the greater is the
financial risk associated, and vice versa. Under favourable market
conditions (when EBIT may increase) a firm having high degree of financial
leverage will be in a better position to increase the return on equity or
earning per share.

Importance of Financial Leverage:

The financial leverage shows the effect of changes in EBIT on the earnings
per share. So it plays a vital role in financing decision of a firm with the
objective of maximising the owner’s wealth.
 45:
The importance of financial leverage:
1. It helps the financial manager to design an optimum capital structure.
The optimum capital structure implies that combination of debt and
equity at which overall cost of capital is minimum and value of the firm is
maximum.

2. It increases earning per share (EPS) as well as financial risk.

3. A high financial leverage indicates existence of high financial fixed costs

and high financial risk.

4. It helps to bring balance between financial risk and return in the capital
structure.

5. It shows the excess on return on investment over the fixed cost on the
use of the funds.

6. It is an important tool in the hands of the finance manager while

determining the amount of debt in the capital structure of the firm.

How Financial Leverage Affects Profits

Interest Impact

One of the most direct ways leverage negatively affects ongoing profit is
payment of interest. When you owe money, you pay the lender interest
over time. Every dollar in interest reduces your profit by the same
amount. If you get a low interest rate on a particular loan, the cost of the
interest may make a reasonable investment. Trade buyers often purchase
inventory on account and pay interest to carry the debt. The inventory
flexibility is a positive trade-off.
 46:
Growth and Development

To launch or grow a business, you have two basic ways to finance the
move. You can seek out investment money or get a loan. If you prefer to
maintain greater control with debt financing, you accept the repayment
obligations as part of the deal. In the long run, a business may generate
greater profit through business expansion. Plus, each owner gets a
greater share of the profit in that scenario if you borrowed money instead
of inviting more owner-investors.

Cash Flow Limitations

Leverage inhibits future cash flow because you must set aside a certain
amount of ongoing profit for principal and interest payments. Limited
cash flow often causes companies to avoid taking new risks or making
additional investments. While this approach may not affect current
profit, it can prohibit growth in profitability over time. A high degree of
leverage is very stifling for this reason. If competitors aggressively go
after new opportunities, you could also miss out on needed revenue
streams and capital resources for future profit development.

Asset Sale Implications

A minor way that leverage affects net profit relates to asset sales. When
you borrow money to pay for a building or piece of equipment, the value
of the item is an asset and the debt is a liability. If you sell an asset, the
money you receive is recorded as one-time unusual revenue. This boosts
your net profit. However, the money received is mitigated by amounts
that you have to use to pay down debt at the time of the sale.

3. Combined Leverage:
Operating leverage shows the operating risk and is measured by the percentage change

in EBIT due to percentage change in sales. The financial leverage shows the financial

risk and is measured by the percentage change in EPS due to percentage change in

EBIT. Both operating and financial leverages are closely concerned with ascertaining

the firm’s ability to cover fixed costs or fixed rate of interest obligation, if we combine

them, the result is total leverage and the risk associated with combined leverage is
known as total risk. It measures the effect of a percentage change in sales on

percentage change in EPS.

 47:
Degree of Combined Leverage:
The combined leverage can be measured with the help of the following
formula:
Combined Leverage = Operating leverage x Financial leverage

The combined leverage may be favourable or unfavorable. It will be

favourable if sales increase and unfavorable when sales decrease. This is
because changes in sales will result in more than proportional returns in
the form of EPS. As a general rule, a firm having a high degree of operating
leverage should have low financial leverage by preferring equity financing,
and vice versa by preferring debt financing.

If a firm has both the leverages at a high level, it will be very risky
proposition. Therefore, if a firm has a high degree of operating leverage
the financial leverage should be kept low as proper balancing between the
two leverages is essential in order to keep the risk profile within a
reasonable limit and maximum return to shareholders.
 48:
Importance of Combined Leverage:
1.It indicates the effect that changes in sales will have on EPS.

2. It shows the combined effect of operating leverage and financial

leverage.

3. A combination of high operating leverage and a high financial leverage

is very risky situation because the combined effect of the two leverages is
a multiple of these two leverages.

4. A combination of high operating leverage and a low financial leverage

indicates that the management should be careful as the high risk involved
in the former is balanced by the later.

5. A combination of low operating leverage and a high financial leverage

gives a better situation for maximising return and minimising risk factor,
because keeping the operating leverage at low rate full advantage of debt
financing can be taken to maximise return. In this situation the firm
reaches its BEP at a low level of sales with minimum business risk.

6. A combination of low operating leverage and low financial leverage

indicates that the firm losses profitable opportunities.

Capital Structure Theories

# 1. Net Income (NI) Approach:

According to NI approach a firm may increase the total value of the firm
by lowering its cost of capital.

When cost of capital is lowest and the value of the firm is greatest, we call
it the optimum capital structure for the firm and, at this point, the market
price per share is maximised.
 49:
The same is possible continuously by lowering its cost of capital by the
use of debt capital. In other words, using more debt capital with a
corresponding reduction in cost of capital, the value of the firm will
increase.

The same is possible only when:

(i) Cost of Debt (Kd) is less than Cost of Equity (Ke);
(ii) There are no taxes; and

(iii) The use of debt does not change the risk perception of the investors
since the degree of leverage is increased to that extent.

Since the amount of debt in the capital structure increases, weighted

average cost of capital decreases which leads to increase the total value of
the firm. So, the increased amount of debt with constant amount of cost
of equity and cost of debt will highlight the earnings of the shareholders.

Illustration 1:
X Ltd. presents the following particulars:
EBIT (i.e., Net Operating income) is Rs. 30,000;

The equity capitalisation ratio (i.e., cost of equity) is 15% (Ke);

Cost of debt is 10% (Kd);
Total Capital amounted to Rs. 2,00,000.

Calculate the cost of capital and the value of the firm for each of the
following alternative leverage after applying the NI approach.

Leverage (Debt to total Capital) 0%, 20%, 50%, 70% and 100%.
 50:

From the above table it is quite clear that the value of the firm (V) will be
increased if there is a proportionate increase in debt capital but there will
be a reduction in overall cost of capital. So, Cost of Capital is increased
and the value of the firm is maximum if a firm uses 100% debt capital.
 51:
# 2. Net Operating Income (NOI) Approach:
Now we want to highlight the Net Operating Income (NOI) Approach which
was advocated by David Durand based on certain assumptions.

They are:
(i) The overall capitalisation rate of the firm Kw is constant for all degree
of leverages;
(ii) Net operating income is capitalised at an overall capitalisation rate in
order to have the total market value of the firm.

Thus, the value of the firm, V, is ascertained at overall cost of capital

(Kw):
V = EBIT/Kw (since both are constant and independent of leverage)
(iii) The market value of the debt is then subtracted from the total market
value in order to get the market value of equity.

S–V–T

(iv) As the Cost of Debt is constant, the cost of equity will be

Ke = EBIT – I/S
 52:
Illustration 2:

Assume:
Net Operating Income or EBIT Rs. 30,000

Total Value of Capital Structure Rs. 2,00,000.

Cost of Debt Capital Kd 10%

Average Cost of Capital Kw 12%
Calculate Cost of Equity, Ke: value of the firm V applying NOI approach
under each of the following alternative leverages:

Leverage (debt to total capital) 0%, 20%, 50%, 70%, and 100%

Although the value of the firm, Rs. 2,50,000 is constant at all levels, the
cost of equity is increased with the corresponding increase in leverage.
Thus, if the cheaper debt capital is used, that will be offset by the increase
in the total cost of equity Ke, and, as such, both Ke and Kd remain
unchanged for all degrees of leverage, i.e. if cheaper debt capital is propor-
tionately increased and used, the same will offset the increase of cost of
equity.
 53:
# 3. Traditional Theory Approach:
It is accepted by all that the judicious use of debt will increase the value
of the firm and reduce the cost of capital. So, the optimum capital
structure is the point at which the value of the firm is highest and the cost
of capital is at its lowest point. Practically, this approach encompasses all
the ground between the Net Income Approach and the Net Operating
Income Approach, i.e., it may be called Intermediate Approach.

The traditional approach explains that up to a certain point, debt-equity

mix will cause the market value of the firm to rise and the cost of capital
to decline. But after attaining the optimum level, any additional debt will
cause to decrease the market value and to increase the cost of capital.

In other words, after attaining the optimum level, any additional debt
taken will offset the use of cheaper debt capital since the average cost of
capital will increase along with a corresponding increase in the average
cost of debt capital.

Thus, the basic proposition of this approach are:

(a) The cost of debt capital, K , remains constant more or less up to a
d

certain level and thereafter rises.

(b) The cost of equity capital K , remains constant more or less or rises
e

gradually up to a certain level and thereafter increases rapidly.

(c) The average cost of capital, K , decreases up to a certain level
w

remains unchanged more or less and thereafter rises after attaining a

certain level.
 54:
Illustration 3:

Calculate the cost of capital and the value of the firm under each of the
following alternative degrees of leverage and comment on them:
 55:
Thus, from the above table, it becomes quite clear the cost of capital is
lowest (at 25%) and the value of the firm is the highest (at Rs. 2,33,333)
when debt-equity mix is (1,00,000 : 1,00,000 or 1: 1). Hence, optimum
capital structure in this case is considered as Equity Capital (Rs. 1,00,000)
and Debt Capital (Rs. 1,00,000) which bring the lowest overall cost of
capital followed by the highest value of the firm.

# 4. Modigliani-Miller (M-M) Approach:

Modigliani-Miller’ (MM) advocated that the relationship between the cost
of capital, capital structure and the valuation of the firm should be
explained by NOI (Net Operating Income Approach) by making an attack
on the Traditional Approach.

The Net Operating Income Approach, supplies proper justification for the
irrelevance of the capital structure. In Income Approach, supplies proper
justification for the irrelevance of the capital structure.

In this context, MM support the NOI approach on the principle that the
cost of capital is not dependent on the degree of leverage irrespective of
the debt-equity mix. In the words, according to their thesis, the total
market value of the firm and the cost of capital are independent of the
capital structure.

They advocated that the weighted average cost of capital does not make
any change with a proportionate change in debt-equity mix in the total
capital structure of the firm.
 56:
Proposition:
The following propositions outline the MM argument about the
relationship between cost of capital, capital structure and the total
value of the firm:
(i) The cost of capital and the total market value of the firm are
independent of its capital structure. The cost of capital is equal to the
capitalisation rate of equity stream of operating earnings for its class, and
the market is determined by capitalising its expected return at an
appropriate rate of discount for its risk class.

(ii) The second proposition includes that the expected yield on a share is
equal to the appropriate capitalisation rate of a pure equity stream for that
class, together with a premium for financial risk equal to the difference
between the pure-equity capitalisation rate (Ke) and yield on debt (Kd). In
short, increased Ke is offset exactly by the use of cheaper debt.
(iii) The cut-off point for investment is always the capitalisation rate which
is completely independent and unaffected by the securities that are
invested.

Assumptions:
The MM proposition is based on the following assumptions:
(a) Existence of Perfect Capital Market It includes:
(i) There is no transaction cost;

(ii) Flotation costs are neglected;

(iii) No investor can affect the market price of shares;

(iv) Information is available to all without cost;

(v) Investors are free to purchase and sale securities.

 57:
(b) Homogeneous Risk Class/Equivalent Risk Class:
It means that the expected yield/return have the identical risk factor i.e.,
business risk is equal among all firms having equivalent operational
condition.

(c) Homogeneous Expectation:

All the investors should have identical estimate about the future rate of
earnings of each firm.

(d) The Dividend pay-out Ratio is 100%:

It means that the firm must distribute all its earnings in the form of
dividend among the shareholders/investors, and

(e) Taxes do not exist:

That is, there will be no corporate tax effect (although this was removed
at a subsequent date).

Interpretation of MM Hypothesis:
The MM Hypothesis reveals that if more debt is included in the capital
structure of a firm, the same will not increase its value as the benefits of
cheaper debt capital are exactly set-off by the corresponding increase in
the cost of equity, although debt capital is less expensive than the equity
capital. So, according to MM, the total value of a firm is absolutely
unaffected by the capital structure (debt-equity mix) when corporate tax
is ignored.
 58:
Proof of MM Hypothesis—The Arbitrage Mechanism:
MM have suggested an arbitrage mechanism in order to prove their
argument. They argued that if two firms differ only in two points viz. (i)
the process of financing, and (ii) their total market value, the
shareholders/investors will dispose-off share of the over-valued firm and
will purchase the share of under-valued firms.

Naturally, this process will be going on till both attain the same market
value. As such, as soon as the firms will reach the identical position, the
average cost of capital and the value of the firm will be equal. So, total
value of the firm (V) and Average Cost of Capital, (Kw) are independent.
It can be explained with the help of the following illustration:
Let there be two firms, Firm ‘A’ and Firm ‘B’. They are similar in all respects
except in the composition of capital structure. Assume that Firm ‘A’ is
financed only by equity whereas Firm ‘B’ is financed by a debt-equity mix.

The following particulars are presented:

From the table presented above, it is learnt that value of the levered firm
‘B’ is higher than the unlevered firm ‘A’. According to MM, such situation
 59:
cannot persist long as the investors will dispose-off their holding of firm
‘B’ and purchase the equity from the firm ‘A’ with personal leverage. This
process will be continued till both the firms have same market value.

Suppose Ram, an equity shareholder, has 1% equity of firm ‘B’. He will

do the following:
(i) At first, he will dispose-off his equity of firm ‘B’ for Rs. 3,333.

(ii) He will take a loan of Rs. 2,000 at 5% interest from personal account.

(iii) He will purchase by having Rs. 5,333 (i.e. Rs. 3,333 + Rs. 2,000) 1.007%
of equity from the firm ‘A’.

By this, his net income will be increased as:

Obviously, this net income of Rs. 433 is higher than that of the firm ‘B’ by
disposing-off 1% holding.

It is needless to say that when the investors will sell the shares of the firm
‘B’ and will purchase the shares from the firm ‘A’ with personal leverage,
this market value of the share of firm ‘A’ will decline and, consequently,
the market value of the share of firm ‘B’ will rise and this will be continued
till both of them attain the same market value.

We know that the value of the levered firm cannot be higher than that of
the unlevered firm (other things being equal) due to that arbitrage process.
We will now highlight the reverse direction of the arbitrage process.
 60:
Consider the following illustration:

In the above circumstances, equity shareholder of the firm ‘A’ will sell his
holdings and by the proceeds he will purchase some equity from the firm
‘B’ and invest a part of the proceeds in debt of the firm ‘B’.

For instance, an equity shareholder holding 1% equity in the firm ‘A’ will do the

following:

(i) He will dispose-off his 1% equity of firm ‘A’ for Rs. 6,250.

(ii) He will buy 1 % of equity and debt of the firm ‘B’ for the like amount.

(iii) As a result, he will have an additional income of Rs. 86.

Thus, if the investors prefer such a change, the market value of the equity of the firm

‘A’ will decline and, consequently, the market value of the shares of the firm ‘B’ will
tend to rise and this process will be continued till both the firms attain the same market

value, i.e., the arbitrage process can be said to operate in the opposite direction.

Criticisms of the MM Hypothesis:

We have seen (while discussing MM Hypothesis) that MM Hypothesis is based on some

assumptions. There are some authorities who do not recognise such assumptions as

they are quite unrealistic, viz. the assumption of perfect capital market.

We also know that most significant element in this approach is the arbitrage process

forming the behavioural foundation of the MM Hypothesis. As the imperfect market

exists, the arbitrage process will be of no use and as such, the discrepancy will arise
between the market value of the unlevered and levered firms.
 61:
The shortcomings for which arbitrage process fails to bring the
equilibrium condition are:
(i) Existence of Transaction Cost:
The arbitrage process is affected by the transaction cost. While buying
securities, this cost is involved in the form of brokerage or commission
etc. for which extra amount is to be paid which increases the cost price of
the shares and requires a greater amount although the return is same. As
such, the levered firm will enjoy a higher market value than the unlevered
firm.

(ii) Assumption of borrowing and lending by the firms and the

individual at the same rate of interest:
The above proposition that the firms and the individuals can borrow or
lend at the same rate of interest, does not hold good in reality. Since a firm
holds more assets and credit reputation in the open market in comparison
with an individual, the former will always enjoy a better position than the
latter.

As such, cost of borrowing will be higher in case of an individual than a

firm. As a result, the market value of both the firms will not be equal.

(iii) Institutional Restriction:

The arbitrage process is retarded by the institutional investors e.g., Life
Insurance Corporation of India, Commercial Banks; Unit Trust of India etc.,
i.e., they do not encourage personal leverage. At present these
institutional investors dominate the capital market.
 62:
(iv) “Personal or home-made leverage” is not the prefect substitute for
“corporate leverage.”:
MM hypothesis assumes that “personal leverage” is a perfect substitute for
“corporate leverage” which is not true as we know that a firm may have a
limited liability whereas there is unlimited liability in case of individuals.
For this purpose, both of them have different footing in the capital market.

(v) Incorporation of Corporate Taxes:

If corporate taxes are considered (which should be taken into
consideration) the MM approach will be unable to discuss the relationship
between the value of the firm and the financing decision. For example, we
know that interest charges are deducted from profit available for dividend,
i.e., it is tax deductible.

In other words, the cost of borrowing funds is comparatively less than the
contractual rate of interest which allows the firm regarding tax advantage.
Ultimately, the benefit is being enjoyed by the equity-holders and debt-
holders.

According to some critics the arguments which were advocated by MM, are
not valued in the practical world. We know that cost of capital and the
value of the firm are practically the product of financial leverage.
 63:
MM Hypothesis with Corporate Taxes and Capital Structure:
The MM Hypothesis is valid if there is perfect market condition. But, in the
real world capital market, imperfection arises in the capital structure of a
firm which affects the valuation. Because, presence of taxes invites
imperfection.

We are, now, going to examine the effect of corporate taxes in the capital
structure of a firm along with the MM Hypothesis. We also know that when
taxes are levied on income, debt financing is more advantageous as
interest paid on debt is a tax-deductible item whereas retained earning or
dividend so paid in equity shares are not tax-deductible.

Thus, if debt capital is used in the total capital structure, the total income
available for equity shareholders and/or debt holders will be more. In
other words, the levered firm will have a higher value than the unlevered
firm for this purpose, or, it can alternatively be stated that the value of
the levered firm will exceed the unlevered firm by an amount equal to debt
multiplied by the rate of tax.

The same can be explained in the form of the following equation:

 64:
Illustration 4:
Assume:
Two firms—Firm ‘A’ and Firm ‘B’ (identical in all respects except capital
structure)

Firm ‘A’ has financed a 6% debt of Rs. 1,50,000

Firm ‘B’ Levered

EBIT (for both the firm) Rs. 60,000

Cost of Capital is @ 10%

Corporate rate of tax is @ 60%

Compute market value of the two firms.

Thus, a firm can lower its cost of capital continuously due to the tax
deductibility of interest charges. So, a firm must use the maximum amount
of leverage in order to attain the optimum capital structure although the
experience that we realise is contrary to the opinion.
 65:
In real-world situation, however, firms do not take a larger amount of debt
and creditors/lenders also are not interested to supply loan to highly
levered firms due to the risk involved in it.

Thus, due to the market imperfection, after tax cost of capital function
will be U-shaped. In answer to this criticism, MM suggested that the firm
would adopt a target debt ratio so as not to violate the limits of level of
debt imposed by creditors. This is an indirect way of stating that the cost
of capital will increase sharply with leverage beyond some safe limit of
debt.

#5. Determinants of capital structure decisions

The capital structure of a firm depends on a number of factors and these

factors are of different importance. Moreover, the influence of individual
factors of a firm changes over a period of time. Generally, the following
factors should be considered while determining the capital structure of a
company.

1.Trading on equity and EBIT - EPS analysis..

The use of long - term debt and preference share capital, which are fixed
income - bearing securities, along with equity share capital is called
financial Leverage or trading on equity. The use of long -' term debt capital
increases the earnings per share (EPS) as long as the return on investment
(ROI) is greater than the cost of debt. Preference share capital will also
result in increasing EPS. But the leverage effect is more pronounced in case
of debt because of two reasons : i) cost of debt is usually lower than the
cost of preference share capital, and ii) the interest paid on debt is tax
deductible.
 66:
Because of its effects on the earnings per share, financial leverage is one
of the important considerations in planning the capital structure of a
company. The companies with high level of Earnings Before Interest and
Taxes (EBIT) can make profitable use of the high degree of leverage to
increase the return on the shareholders' equity. The EBIT – EPS analysis is
one important tool in the hands of the financial manager to get an insight
into the firm's capital structure planning. He can analyse the possible
fluctuations in EBIT and their impact on EPS under different financing
plans.

Under favourable conditions, financial leverage increases EPS, however it

can also increase financial risk to shareholders. Therefore, the firm should
employ debt to such an extent that financial risk does not spoil the
leverage effect.

ii) Growth and stability of sales

This is another important factor which influences the capital structure of

a firm. Stability of sales ensures stable earnings, so that the firm will not
face any difficulty in meeting its fixed commitments of interest payment
and repayment of debt. So the firm can raise a higher level of debt. Jn the
same way, the rate of growth in sales also affects the capital structure
decision. Usually, greater the rate of growth of sales, greater can be the
use of debt in the financing of a firm. On the other hand, the firm- should
be very careful in employing debt capital if its sales are highly fluctuating
and declining.
 67:
iii)Cost of capital

Cost of capital is another important factor that should be kept in mind

while designing the capital structure of a firm. The capital structure
should be designed in such a way that the firm's overall cost of capital is
the minimum. Cost of capital is the minimum return expected by its
suppliers. Of all the sources of capital, equity capital is the costliest as the
equity shareholders bear the highest risk. On the other hand, debt capital
is the cheapest source because the interest is paid on it by the firm
whether it makes profits or not. Moreover, interest on debt capital is tax
deductible, which makes it further cheaper. Preference share capital is also
cheaper than equity capital as the dividends are paid at a fixed rate on
preference shares. So, the overall cost of capital depends on the
proportion in which the capital is mobilised from different sources of
finance. Hence, capital structure should be designed carefully so treat over
all cost of capital is minimised.

iv) Cash flow ability

A firm which has the ability of generating larger and stable cash inflows
will be able to employ more debt capital. The firm has to meet fixed
charges in the form of interest on debt capital, fixed preference dividend
and the principal amount, when it becomes due. The firm can meet these
fixed obligations only when it has adequate cash inflows. Whenever a firm
wants to raise additional funds, it should estimate the future cash inflows
to ensure the coverage of fixed charges. Fixed charges coverage ratio and
interest coverage ratio are relevant for this purpose. Here, one important
point to be considered is that it is the cash flow ability of the firm and not
the earning capacity alone (as indicated by EBIT) that should be taken into
 68:
view while designing the capital structure. A firm may have adequate
profits (EBIT) but it may not have adequate cash inflows to meet its fixed
charges, obligation. Some times, inadequacy of cash inflows may lead the
firm to the point of .insolvency, when it fails to meet its payment
obligations in time. Therefore debt capacity of the firm is determined by
its cash flow ability.

v) Control

Some times, the designing of capital structure of a firm is influenced by

the desire of the existing management to retain the control over the firm.
Whenever additional funds are required, the management of the firm
wants to raise the funds without any loss of control over the firm. If equity
shares are issued for raising funds, the. control of the existing
shareholders is diluted. Because of this, they may raise the funds by
issuing fixed charge bearing debt and preference share capital, as
preference shareholders and debtholders do not have any voting right.
The Debt financing is advisable from the point of view of control. But
overdependence on debt capital may result in heavy burden of interest
and fixed changes and may lead to liquidation of the company.

vi) Flexibility

Flexibility means the firm's ability to adapt its capital structure to the needs of
the changing conditions. Capital structure should be flexible enough to raise
additional funds whenever required, without much delay and cost. The capital
structure of the firm must be designed in such a way that it is possible to
substitute one form of financing for another to economise the use of funds.
Preference shares and debentures offer the highest flexibility in the capital
structure, as they can be redeemed at the discretion of the firm.
 69:
vii) Size of the firm

The size of the firm influences the capital structure design of a firm. Small
companies find it very difficult to mobilise long - term debt, as they have
to face higher rate of interest and inconvenient terms. Hence, small firms
make their capital structure very inflexible and depend on share capital
and retained earnings for their long - term funds . Since their capital
structure is small, small firms cannot go to the capital market frequently
for the issue of equity shares, as it carries a greater danger Of loss of
control over the firm to others. Hence, the small firms sometimes limit the
growth of their business and any additional fund requirements met
through retained earnings only. However, a large firm has relative
flexibility in capital structure designing. It has the facility of obtaining
long - term debt at relatively lower rate of interest and convenient terms.
Moreover, the large firms have relatively an easy access to the capital
market.

viii) Marketability and timing

Capital market conditions may change from time to time. Sometimes there maybe

depression and at other times there may be boom condition in the market. The firm

should decide whether to go for equity issue or debt capital by taking market

sentiments into consideration. In the case of depressed conditions in the share market,

the firm should not issue equity shares but go for debt capital. On the other hand,

under boom conditions, it becomes easy for the firm to mobilise funds by issuing

equity shares. The internal conditions of a firm may also determine the marketability

of securities. For example, a highly levered firm may find it difficult to raise additional

debt. In the same way, a firm may find it very difficult to mobilise funds by issuing
any kind of security in the market merely because of its small size.
 70:
ix) Floatation costs

Floatation costs are not a very significant factor in the determination of

capital structure. These costs are incurred when the funds are raised
externally. They include cost of the issue of prospectus, brokerage,
commissions, etc. Generally, the cost of floatation for debt is less than for
equity. So, there may be a temptation for debt capital -There will be no
floatation cost for retained earnings. As is said earlier, floatation costs are
not a significant factor except for small companies.

Floatation costs can be an important consideration in deciding the size of

the issue of securities, because these costs as a percentage of funds raised
will decline with the size of the issue. Hence, greater the size of the issue,
more will be the savings in terms of floatation costs. However, a large issue
affects the firms's financial flexibility.

x) Purpose of financing

The purpose for which funds are raised should also be considered while
determining the sources of capital structure. If funds are raised for
productive purpose, debt capital is appropriate as the interest can be paid
out of profits generated from the investment. But, if it is for unproductive
purpose, equity should be preferred.

xi) Legal requirements

The various guidelines. issued by the Government from time to time

regarding. the issue of shards and debentures should be kept in mind
while determining the capital structure of a firm. These legal' restrictions
are very significant as they give a framework within which capital
structure decisions should be made.
 71:
UNIT-3
Dividend Policy
A dividend policy is the policy a company uses to structure its dividend
pay out to shareholders. Some researchers suggest the dividend policy is
irrelevant, in theory, because investors can sell a portion of their shares
or portfolio if they need funds. This is the dividend irrelevance theory,
which infers that dividend pay-outs minimally affect a stock's price.

Types of Dividend Policies

Stable Dividend Policy

A stable dividend policy is the easiest and most commonly used. The goal
of the policy is a steady and predictable dividend payout each year, which
is what most investors seek. Whether earnings are up or down, investors
receive a dividend.

The goal is to align the dividend policy with the long-term growth of the
company rather than with quarterly earnings volatility. This approach
gives the shareholder more certainty concerning the amount and timing
of the dividend.

Constant Dividend Policy

The primary drawback of the stable dividend policy is that investors may
not see a dividend increase in boom years. Under the constant dividend
policy, a company pays a percentage of its earnings as dividends every
year. In this way, investors experience the full volatility of company
earnings.

If earnings are up, investors get a larger dividend; if earnings are down,
investors may not receive a dividend. The primary drawback to the
method is the volatility of earnings and dividends. It is difficult to plan
financially when dividend income is highly volatile.
 72:
Residual Dividend Policy

Residual dividend policy is also highly volatile, but some investors see it
as the only acceptable dividend policy. With a residual dividend policy,
the company pays out what dividends remain after the company has paid
for capital expenditures (CAPEX) and working capital.

This approach is volatile, but it makes the most sense in terms of business
operations. Investors do not want to invest in a company that justifies its
increased debt with the need to pay dividends.

Essentials of a Sound Dividend Policy

Following are the essentials of a sound dividend policy of a company:

1. Stability:
Stability in dividend distribution implies regularity in payment of
dividend. If a company pays a high dividend in a year but fails to pay any
dividend next year, then it cannot be said as good. On the other hand, if a
company pays a dividend each year even though at a medium rate, its
shareholders will remain satisfied and its shares will not be subjected to
high speculation.

2. Gradually Rising Dividends:

The management of the company should always try to make some increase
in the dividend rate each year, though this increase will depend on the
increase in income of the company. If there are huge profits in any year
than in that year the company should distribute additional or special
dividends.

3. Distribution of Cash Dividend:

Dividends should be paid in cash. But, if the amounts of reserves and
funds in the company become very high, then stock dividend may also be
declared. But the distribution of stock dividend should remain within
reasonable limits otherwise the company may become victim of over-
capitalization.
 73:
4. Moderate Start:
In the beginning years of a company’s incorporation, dividends should be
declared at lower rates for some years so that the company’s financial
position may become sound. Afterwards with the growth and progress of
the company, dividend rates may be increased gradually.

5. Other Factors:
Dividends should be paid out of earned profits only. If there is carry
forward of past losses, then dividend should not be declared till these are
set off. Though, the dividend is usually paid only once in a year in order
to keep the shareholders in high spirits, interim dividends should also be
declared.

Factors Determining Dividend Policy

The major factors affecting the dividend policy of a firm are listed
below:
1. Company’s Own Policy:
The Company’s own dividend policy regarding the stability of dividend
affects the dividend decisions.

Where the earnings are more stable the company may decide to pay a
constant dividend. Where the earnings are not stable i.e., fluctuating, then,
the company may decide to pay a huge amount of dividend when earnings
are more or no dividend in case of less earnings.

2. Availability of Divisible Profits:

The dividend policy of a concern depends upon the divisible profits
available. If there are no divisible profits, there is no question of
declaration of dividend. If there are large divisible profits, there can be
more dividend distribution and more retention of funds.

3. Liquidity of the Company:

Liquidity of the company also affects the dividend decisions. Liquidity
indicates the cash available to make the payment of dividend.

If a company has sufficient liquidity to pay a dividend, it can declare a

higher dividend.
 74:
4. Effect of Current Market Prices:
Dividend decisions affect the market price of the shares. As per Walter’s
model, dividend is relevant while determining the market price of a share.

5. Past Dividend Rates:

Every company takes past dividends as a base and takes decisions to
enhance the dividend in the future. If a company pays 60% dividend in the
last year, should maintain the same rate or enhance the rate during the
current year.

6. Contractual Restrictions:
The term lending financial institutions impose restrictions on dividend
decisions. They fix the maximum ceiling on the rate of dividend or the
amount of dividend and also on the retained earnings.

7. Legal Restrictions:
The Companies Act specifies that every company is required to transfer a
certain amount to general reserve based on the rate of dividend declared.
If any shortage after declaration of dividend will impose restriction on
their companies for declaration of dividend.

8. Equity Capitalisation Rate:

Cost of capital is an important factor to decide the dividend payment. If a
company is raising capital at a cheaper rate of interest, then the company
can declare a higher rate of dividend.

9. Composition of Shareholders:
The composition of shareholders also determines dividend policy. The
shareholders of closely held company may be interested in capital gains
rather than on dividends. Hence, a low dividend should be paid. But
shareholders of widely held companies may be interested in higher
dividends. Such companies may decide to pay a higher rate of dividend.

10. Availability of External Sources of Fund:

The availability of external sources of funds are needed for capitalisation purposes.
The companies with greater accessibility to external sources may decide to pay higher
dividends because they can retain less earnings for reinvestment. In case of new
companies having less access to the external market may declare and pay lesser
dividends and to retain more earnings.
 75:
11. Re-Investment Opportunities of the Company:
Availability of profitable investment opportunities to the company also
decides the payment of dividend, if a company has more profitable re-
investing opportunity, then it can declare a lower rate of dividend. In other
words, if a company cannot reinvest its earnings, then it can declare a
higher rate of dividend.

12. Taxation:
The dividend tax has a greater impact on the dividend policy. If the
dividend is taxable in the hands of individual shareholders, then the
companies declare bonus issues, rather than cash dividend. At present the
dividend distribution tax on a dividend is taxable in the hands of the
company.

13. Bonus Issue:

The bonus issue in the past years increases the capital base in the current
year, hence dividend policy determined on the basis of bonus issue. A
company has to pay a dividend compulsorily in the year of bonus issue
because a bonus issue cannot be in lieu of cash dividend.

14. Future Plan for Growth and Expansion:

A Company which will plan for future growth and expansion requires a
huge fund. As merger and acquisition need a huge outflow of cash, a
moderate dividend can be expected from such a company.

15. Effect of Inflation:

Inflation affects dividend decisions. During inflation the value of closing
stock and the figures of net profits are overstated. During inflation, it is
necessary to retain earnings so as to enable the company to have sufficient
funds to replace capital assets. Hence, the companies pay lower cash
dividends.
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Walter’s model:

Professor James E. Walterargues that the choice of dividend policies

almost always affects the value of the enterprise. His model shows clearly
the importance of the relationship between the firm’s internal rate of
return (r) and its cost of capital (k) in determining the dividend policy that
will maximise the wealth of shareholders.

Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt
or new equity is not issued;

2. The firm’s internal rate of return (r), and its cost of capital (k) are
constant;

3. All earnings are either distributed as dividend or reinvested internally

immediately.

4. Beginning earnings and dividends never change. The values of the

earnings per share (E), and the divided per share (D) may be changed in
the model to determine results, but any given values of E and D are
assumed to remain constant forever in determining a given value.

5. The firm has a very long or infinite life.

 77:
Walter’s formula to determine the market price per share (P) is as
follows:
P = D/K +r(E-D)/K/K

The above equation clearly reveals that the market price per share is
the sum of the present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and

ii) The present value of the infinite stream of stream gains.

[r (E-D)/K/K]

Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an
all equity firm under different assumptions about the rate of return.
However, the simplified nature of the model can lead to conclusions which
are net true in general, though true for Walter’s model.

The criticisms on the model are as follows:

1. Walter’s model of share valuation mixes dividend policy with
investment policy of the firm. The model assumes that the investment
opportunities of the firm are financed by retained earnings only and no
external financing debt or equity is used for the purpose when such a
situation exists either the firm’s investment or its dividend policy or
both will be sub-optimum. The wealth of the owners will maximise only
when this optimum investment in made.

2. Walter’s model is based on the assumption that r is constant. In fact

decreases as more investment occurs. This reflects the assumption that
the most profitable investments are made first and then the poorer
investments are made.
 78:
The firm should step at a point where r = k. This is clearly an erroneous
policy and fall to optimise the wealth of the owners.

3. A firm’s cost of capital or discount rate, K, does not remain constant; it

changes directly with the firm’s risk. Thus, the present value of the firm’s
income moves inversely with the cost of capital. By assuming that the
discount rate, K is constant, Walter’s model abstracts from the effect of
risk on the value of the firm.

Gordon’s Model:

One very popular model explicitly relating the market value of the firm to
dividend policy is developed by Myron Gordon.

Assumptions:

Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available

3. The internal rate of return (r) of the firm is constant.

4. The appropriate discount rate (K) of the firm remains constant.

5. The firm and its stream of earnings are perpetual

6. The corporate taxes do not exist.

7. The retention ratio (b), once decided upon, is constant. Thus, the growth
rate (g) = br is constant forever.
 79:
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful
value for the share.

According to Gordon’s dividend capitalisation model, the market value of

a share (Pq) is equal to the present value of an infinite stream of dividends
to be received by the share. Thus:

The above equation explicitly shows the relationship of current earnings

(E,), dividend policy, (b), internal profitability (r) and the all-equity firm’s
cost of capital (k), in the determination of the value of the share (P0).

3. Modigliani and Miller’s hypothesis:

According to Modigliani and Miller (M-M), dividend policy of a firm is

irrelevant as it does not affect the wealth of the shareholders. They argue
that the value of the firm depends on the firm’s earnings which result from
its investment policy.

Thus, when investment decision of the firm is given, dividend decision the
split of earnings between dividends and retained earnings is of no
significance in determining the value of the firm. M – M’s hypothesis of
irrelevance is based on the following assumptions.

1. The firm operates in perfect capital market

2. Taxes do not exist

3. The firm has a fixed investment policy

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4. Risk of uncertainty does not exist. That is, investors are able to forecast
future prices and dividends with certainty and one discount rate is
appropriate for all securities and all time periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical
for all shares. As a result, the price of each share must adjust so that the
rate of return, which is composed of the rate of dividends and capital gains,
on every share will be equal to the discount rate and be identical for all
shares.

Thus, the rate of return for a share held for one year may be calculated
as follows:

Where P^ is the market or purchase price per share at time 0, P, is the

market price per share at time 1 and D is dividend per share at time 1. As
hypothesised by M – M, r should be equal for all shares. If it is not so, the
low-return yielding shares will be sold by investors who will purchase the
high-return yielding shares.

This process will tend to reduce the price of the low-return shares and to
increase the prices of the high-return shares. This switching will continue
until the differentials in rates of return are eliminated. This discount rate
will also be equal for all firms under the M-M assumption since there are no
risk differences.
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From the above M-M fundamental principle we can derive their valuation
model as follows:

Multiplying both sides of equation by the number of shares outstanding (n),

we obtain the value of the firm if no new financing exists.

If the firm sells m number of new shares at time 1 at a price of P^, the value
of the firm at time 0 will be

The above equation of M – M valuation allows for the issuance of new

shares, unlike Walter’s and Gordon’s models. Consequently, a firm can pay
dividends and raise funds to undertake the optimum investment policy.
Thus, dividend and investment policies are not confounded in M – M model,
like waiter’s and Gordon’s models.

Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks
practical relevance in the real world situation. Thus, it is being criticised
on the following grounds.

1. The assumption that taxes do not exist is far from reality.

2. M-M argue that the internal and external financing are equivalent. This
cannot be true if the costs of floating new issues exist.
 82:
3. According to M-M’s hypothesis the wealth of a shareholder will be same
whether the firm pays dividends or not. But, because of the transactions
costs and inconvenience associated with the sale of shares to realise
capital gains, shareholders prefer dividends to capital gains.

4. Even under the condition of certainty it is not correct to assume that

the discount rate (k) should be same whether firm uses the external or
internal financing.

If investors have desire to diversify their port folios, the discount rate for
external and internal financing will be different.

5. M-M argues that, even if the assumption of perfect certainty is dropped

and uncertainty is considered, dividend policy continues to be irrelevant.
But according to number of writers, dividends are relevant under
conditions of uncertainty.

Determinants of Dividend Policy

(i) Type of Industry:
Industries that are characterised by stability of earnings may formulate a
more consistent policy as to dividends than those having an uneven flow
of income. For example, public utilities concerns are in a much better
position to adopt a relatively fixed dividend rate than the industrial
concerns.

(ii) Age of Corporation:

Newly established enterprises require most of their earning for plant
improvement and expansion, while old companies which have attained a
longer earning experience, can formulate clear cut dividend policies and
may even be liberal in the distribution of dividends.
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(iii) Extent of share distribution:
A closely held company is likely to get consent of the shareholders for the
suspension of dividends or for following a conservative dividend policy.
But a company with a large number of shareholders widely scattered
would face a great difficulty in securing such assent. Reduction in
dividends can be affected but not without the co-operation of
shareholders.

(iv) Need for additional Capital:

The extent to which the profits are ploughed back into the business has
got a considerable influence on the dividend policy. The income may be
conserved for meeting the increased requirements of working capital or
future expansion.

(v) Business Cycles:

During the boom, prudent corporate management creates good reserves
for facing the crisis which follows the inflationary period. Higher rates of
dividend are used as a tool for marketing the securities in an otherwise
depressed market.

(vi) Changes in Government Policies:

Sometimes government limits the rate of dividend declared by companies
in a particular industry or in all spheres of business activity. The
Government put temporary restrictions on payment of dividends by
companies in July 1974 by making amendment in the Indian Companies
Act, 1956. The restrictions were removed in 1975.

(vii) Trends of profits:

The past trend of the company’s profit should be thoroughly examined to
find out the average earning position of the company. The average
earnings should be subjected to the trends of general economic
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conditions. If depression is approaching, only a conservative dividend
policy can be regarded as prudent.

(viii) Taxation policy:

Corporate taxes affect dividends directly and indirectly— directly, in as
much as they reduce the residual profits after tax available for
shareholders and indirectly, as the distribution of dividends beyond a
certain limit is itself subject to tax. At present, the amount of dividend
declared is tax free in the hands of shareholders.

(ix) Future Requirements:

Accumulation of profits becomes necessary to provide against
contingencies (or hazards) of the business, to finance future- expansion of
the business and to modernise or replace equipments of the enterprise.
The conflicting claims of dividends and accumulations should be
equitably settled by the management.

(x) Cash Balance:

If the working capital of the company is small liberal policy of cash
dividend cannot be adopted. Dividend has to take the form of bonus
shares issued to the members in lieu of cash payment.

The regularity of dividend payment and the stability of its rate are the two
main objectives aimed at by the corporate management. They are accepted
as desirable for the corporation’s credit standing and for the welfare of
shareholders.

High earnings may be used to pay extra dividends but such dividend
distributions should be designed as “Extra” and care should be taken to
avoid the impression that the regular dividend is being increased.
 85:
A stable dividend policy should not be taken to mean an inflexible or rigid
policy. On the other hand, it entails the payment of a fair rate of return,
taking into account the normal growth of business and the gradual impact
of external events.

A stable dividend record makes future financing easier. It not only

enhances the credit- standing of the company but also stabilises market
values of the securities outstanding. The confidence of shareholders in the
corporate management is also strengthened.
 86:
UNIT-4

Working Capital

Working capital, also known as net working capital (NWC), is the

difference between a company’s current assets—such as cash, accounts
receivable/customers’ unpaid bills, and inventories of raw materials and
finished goods—and its current liabilities, such as accounts payable and
debts.

NWC is a measure of a company’s liquidity, operational efficiency, and

short-term financial health. If a company has substantial positive NWC,
then it should have the potential to invest and grow. If a company’s
current assets do not exceed its current liabilities, then it may have
trouble growing or paying back creditors. It might even go bankrupt.

Types of working capital

The types of working capital are mainly divided into different parts:
• Gross Working Capital
Gross working capital is the total value of the company’s current assets.
Current assets include cash, receivables, short-term investments, and
especially market securities.
The Gross working capital does not showcase the current liabilities.
Gross working capital can be executed by calculating the difference
between the existing assets and current liabilities.
The difference remaining is the actual working capital that the company
has to meet its obligations.
• Net Working Capital
Networking capital is the difference between the current assets and
current liabilities of the company. If the company’s assets are more than
current liabilities, it indicates a positive working capital, and the
company is in a financial position to meet its obligations.
However, if the company’s assets are less than current liabilities, it
indicates a negative working capital, and the company is facing financial
distress.
 87:
The key difference between gross and net working capital is that gross
working capital will always be a positive value. In contrast, networking
capital can either be a negative or positive value.
• Permanent Working Capital
Permanent working capital is the minimum amount of capital required to
carry on the operations without interruption or difficulty.
For example, a company will need minimum cash to keep the operations
smooth and running; here, the minimum amount of money required will
act as permanent working capital.
• Regular Working Capital
Regular working capital is the amount of funds businesses require to
fund its day to day operations. For example, cash needed for making
payment of wages, raw materials, salaries comes under regular working
capital.
• Reserve Margin Working Capital
Apart from conducting day-to-day activities, a business may need some
amount of capital to face unforeseen circumstances. Reserve margin
working capital is nothing, but the money kept aside apart from the
regular working capital. These funds are held separately against
unexpected events like floods, natural calamities, storms, etc.
• Variable Working Capital
Variable working capital can be defined as the capital invested for a
temporary period in the business. Variable working capital is also called
fluctuating working capital.
Such capital differs with respect to changes in the business assets or the
size of the business. Furthermore, variable capital is subdivided into two
parts:
1) Seasonable Variable Working Capital
Seasonable variable working capital is the amount of capital kept aside to
meet the seasonal demand if the business is running seasonally.
2) Special Variable Working Capital
Special variable working capital is the temporary rise in the working
capital due to any unforeseen or occurrence of a special event.
 88:
Significance

Gross working capital concept focuses attention on the two aspect of

current asset management. They are:

1). Optimum investment in current assets:

Investment in current asset must be just adequate to the needs of the firm.
On the other hand excessive investment in current asset should be
avoided.

2). Financing of current asset:

Need for working capital arise due to the increasing level of business
activity. Therefore, there is a need to provide it quickly. If there is surplus
fund arise that should be invested in short term securities.

Net Working Capital Concept

As per this concept the excess of current asst over current liabilities
represents net working capital. Similar view is expressed by Guthmann,
Gerstenberg, Goel Etc.

Net Working Capital represents the amount of current asset which remain
after all the current liabilities were paid. It may be either positive or
negative. It will be positive if current asset exceed current liabilities and
vice versa.

To quote Roy Chowdry, “Net Working Capital indicates the liquidity of the
liquidity of business whilst gross working capital denotes the quantum of
working capital with which business has to operate.
 89:
Significance

Net Working Capital Concept focuses on two aspects. They are:

1). Maintaining liquidity position:

Excess current assets help in meeting its financial obligation within the
operating cycle of the firm. Negative and excess working capitals both are
bad to the firm.

2). To decide upon the extent of long term capital in financing current
asset:

Net working capital means the portion of current asst that should be
financed by long term funds. This concept helps to decide the extent of
long term fund required in finance current assets.

Need for working capital

1. Continuity in Business Operations: Working capital keeps the

business operations going. It is needed to purchase raw materials, to
pay the workers and staff and also to pay for recurring expenses like
electricity and power bills, rent, etc.
2. Dividend Payment: Working capital is needed to pay a dividend to
the shareholders. The payment of dividend takes place on a yearly or
half-yearly basis.
3. Repayment of Long-Term Loans: Working capital is also used to
repay long-term loans and debentures.
4. Increases Creditworthiness: A company that pays its creditors on
time has a positive reputation in the credit market. Such a goodwill
helps a company to obtain raw materials on credit. It can also get
loans and advances from the banks. The dealers will also be willing
to give money to such companies. Hence, working capital increases a
company's creditworthiness.
5. Boosts Efficiency and Productivity: The company that faces no
working capital problems provides better working conditions and
welfare facilities to its workers. It also can maintain its machines in
good condition. It can afford to spend money for training and
 90:
development of its workers. All such steps boost the efficiency and
productivity of the company.
6. Helps to Fight Competition: Working capital helps the company to
fight its competitors. It can be used to advertise and for sales
promotion. The company can also afford to give longer credit terms
to the customers.
7. Helps to Withstand Seasonal Fluctuations: Working capital is
required throughout the year. But sales may be seasonal in nature. If
the sales are low, the money inflow is less. Therefore, liquid cash is
required to pay wages to workers and to meet other expenses. So, it
helps the company withstand seasonal fluctuations.
8. Increases Goodwill: The company that meets the needs of its
working capital without any difficulty earns a good reputation in the
labour and capital markets. This happens because the company pays
wages and salaries to the employees and the suppliers of raw
materials, etc., on time. Thus, it also helps increase the goodwill of
the company.

Concept of operating cycle

Working capital is the life blood of any business, without which the fixed
assets are inoperative. Working capital circulates in the business, and the
current assets change from one form to the other. Cash is used for
procurement of raw materials and stores items and for payment of
operating expenses, then converted into work-in-progress, then to
finished goods.

When the finished goods are sold on credit terms receivables balances will
be formed. When the receivables are collected, it is again converted into
cash. The need for working capital arises because of time gap between
production of goods and their actual realization after sales. This time gap
is called technically called as ‘operating cycle’ or ‘working capital cycle’.

The operating cycle of a company consists of time period between the

procurement of inventory and the collection of cash from receivables. The
operating cycle is the length of time between the company’s outlay on raw
materials, wages and other expenses and inflow of cash from sale of
 91:
goods. Operating cycle is an important concept in management of cash
and management of working capital.

The operating cycle reveals the time that elapses between outlay of cash
and inflow of cash. Quicker the operating cycle less amount of investment
in working capital is needed and it improves the profitability. The duration
of the operating cycle depends on the nature of industry and the efficiency
in working capital management.

The above said periods are ascertained as follows:

(a) Raw Material Holding Period:

(b) Work-In-Process Period:

(c) Finished Goods Holding Period:

(d) Receivables Collection Period:

(e) Creditors Payment Period:

The knowledge of operating cycle is essential for smooth running of the

business without shortage of working capital. The working capital
requirement can be estimated with the help of duration of operating cycle.
The longer the operating cycle, the larger the working capital
requirements. If depreciation is excluded from expenses in the operating
cycle, the net operating cycle represents ‘cash conversion cycle’.

The length of operating cycle is the indicator of efficiency in management

of short-term funds and working capital. The operating cycle calls for
proper monitoring of external environment of the business. Changes in
government policies like taxation, import restrictions, credit policy of
central bank etc. will have impact on the length of operating cycle.
 92:
It is the task of Finance manager to manage the operating cycle effectively
and efficiently. Based on the length of operating cycle, the working capital
finance is done by the commercial banks. The reduction in operating cycle
will improve the cash conversion cycle and ultimately improve the
profitability of the firm.
 93:
Reasons for Prolonged Operating Cycle:
The following could be the reasons for longer operating cycle period:
(a) Purchase of materials in excess/short of requirements.

(b) Buying inferior, defective materials.

(c) Failure to get trade discount, cash discount.

(d) Inability to purchase during seasons.

(e) Defective inventory policy.

(f) Use of protracted manufacturing cycle.

(g) Lack of production planning, coordination and control.

(h) Mismatch between production policy and demand.

(i) Use of outdated machinery, technology,

(j) Poor maintenance and upkeep of plant, equipment and infrastructure

facilities,

(k) Defective credit policy and slack collection policy.

(l) Inability to get credit from suppliers, employees,

(m) Lack of proper monitoring of external environment etc.

How to Reduce Operating Cycle?

The aim of every management should be to reduce the length of operating
cycle or the number of operating cycles in a year, only then the need for
working capital decreases. The following remedies may be used in
contrasting the length of operation cycle period.
 94:
i. Purchase Management:
The purchase manager owes a responsibility in ensuring availability of
right type of materials in right quantity of right quality at right price on
right time and at right place. These six R’s contribute greatly in the
improvement of length of operating cycle. Further, streamlining of credit
from supplier and inventory policy also help the management.

ii. Production Management:

The Production manager affects the length of operating cycle by managing
and controlling manufacturing cycle, which is a part of operating cycle
and influences directly. Longer the manufacturing cycle, longer will be the
operating cycle and higher will be the firm’s working capital requirements.

The following measures may be taken like:

(a) Proper maintenance of plant, machinery and other infrastructure
facilities,

(b) Proper planning and coordination at all levels of activity,

(c) Up-gradation of manufacturing system, technology, and

(d) Selection of the shortest manufacturing cycle out of various

alternatives etc.

iii. Marketing Management:

The sale and production policies should be synchronized as far as
possible. Lack of matching increases the operating cycle period.
Production of qualitative products at lower costs enhances sales of the
firm and reduces finished goods storage period. Effective advertisement,
sales promotion activities, efficient salesmanship, use of appropriate
distribution channel etc., reduce the storage period of the finished
products.
 95:
iv. Credit Collection Policies:
Sound credit and collection policies enable the Finance manager in
minimizing investment in working capital in the form of book debts. The
firm should be discretionary in granting credit terms to its customers.

In order to see that the receivable conversion period is not increased, the
firm should follow a rationalized credit policy based on the credit standing
of customers and other relevant facts. The firm should be prompt in
making collections. Slack collection policies will tie-up funds for long
period, increasing length of operating cycle.

v. External Environment:
The length of operating cycle is equally influenced by external
environment. Abrupt changes in basic conditions would affect the length
of operating cycle. Fluctuations in demand, competitors, production and
sales policies, government fiscal and monetary policies, changes on
import and export front, price fluctuations, etc., should be evaluated
carefully by the management to minimize their adverse impact on the
length of operating cycle.

vi. Personnel Management:

The Personnel manager by framing sound recruitment, selection, training,
placement, promotion, transfer, wages, incentives and appraisal policies
can contrast the length of operating cycle.

Use of Human Resources Development technique in the organization

enhances the morale and zeal of employees thereby reduces the length of
operating cycle. Proper maintenance of plant, machinery, infrastructure
facilities, timely replacement, renewals, overhauling etc., will contribute
towards the control of operating cycle.

These measures, if adhered properly, would go a long way in minimizing

not only the length of operating cycle period but also the firm’s working
capital requirements.
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METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENT

The following methods are used to calculate the amount of working capital
requirement in a business

1. Operating cycle concept: In this method, the estimates of working

capital requirements on the basis of average holding period of current
assets and relating them to costs based on company’s expectations and
experiences. This value of total current assets is known as gross
working capital. From gross working capital, the expected current
liabilities like sundry creditors for raw materials, expenses, etc are
deducted to find net working capital. This is the most appropriate
method of calculating working capital

2. Current assets holding period Method: This method is based on

operating cycle period. Here, the working capital requirement equals to
gross working capital requirement.

3. Ratio to sales method: The working capital requirements are estimated

as a ratio of sales for each component of working capital.

4. Ratio of fixed investment method: The working capital is estimated as

a percentage of fixed investment.

Working Capital Financing

Working Capital Financing is when a business borrows money to cover

day-to-day operations and payroll rather than purchasing equipment or
investment.
Working capital financing is a common practice for businesses with an
inconsistent cash flow.
Companies from every industry use working capital financing to expand
and scale up.
For example, a large business with steady cash flow may apply for a
working capital loan to finance the expansion of operations into a new
region.
 97:
In this instance, the loan will act as a buffer until the new region becomes
self-sufficient.
Similarly, a small business may require working capital finance to bridge
the gap between cash inflows and outflows while the business grows.

Importance of Working Capital Finance for Businesses

Whether your business is facing cash flow issues or not, having extra cash
in reserves is always good to secure yourself during unexpected
circumstances.
Working capital financing lets firms fulfil their short-term or urgent cash
flow shortfalls.

Benefits of Working Capital Financing

This financing option is beneficial for different business types and

purposes. Below are key benefits of working capital financing:
Cover Expenditure Gaps
Working capital financing helps keep a business afloat by financing its
payment gaps and fulfilling its working capital requirement.
Small and growing businesses solely relying on accounts payables to fuel
their working capital can support their everyday operations without the
need for an equity transaction.
Zero Collateral Requirement
Firms with good credit ratings are granted unsecured working capital
finance. They do not need to forfeit any collateralised assets in the event
of default.
The ability to access zero collateralised financing enhance the business’s
credibility.
Faster and Flexible
Since businesses usually seek working capital financing to meet their
immediate cash flow needs, lending institutions need to process it quickly.
Financiers must understand:
• The significance of quick financing and the need for businesses to revive their
operations quickly.
• Flexible repayment terms.
• Interest rates may vary depending on the risk associated with the industry and the
business model.
 98:
Positive impact on the turnover ratio
To fully understand the benefits of working capital financing, one needs
to be familiar with working capital turnover ratio first.
Working capital ratio indicates how well the business meets its current
obligations. It also shows how much working capital financing it will need
moving forward.
However, this is not the financing option to go for if you do not have the
cash flow to meet periodic payments.
If your business has an unproven track record, pursuing a collateralised
contract may still be the dominant strategy until your credit rating
improves.

Types of Working Capital Finance

There are several ways of financing working capital. The most common
are:
• Working Capital loans
• Overdrafts
• Lines of credit
• Invoice Discounting
Each have their advantages and disadvantages.
However, some are easier to get approval than others as banks can ask for
huge collateral coverage depending on your businesses’ credit status.

Working capital loan

Very simply, a loan taken to finance the daily operations of a business.

For example, a business applies for a loan to cover the rental cost of the
premises. Renting a premise would indirectly generate enough yield to pay
the loan by maturity.
One of the drawbacks of a working capital loan is that it must be taken out
again each time.
For this reason, a working capital loan makes it a poor long term working
capital financing solution compared to alternatives.
Hence, not effective for businesses experiencing frequent cash flow
shortage.
The size can vary wildly – generally between $2,000 to $5 million.
 99:
Line of Credit

This is a loaning facility granted by a lending institution allowing a

business to borrow and repay as often as needed within a set limit.
It is a long term and flexible working capital financing solution.
For example, a business is granted a line of credit for the year. The
company borrows and repays 60% of the allotted amount monthly.
Let’s assume the business picks up in the summer and needs to borrow a
higher amount from its line of credit.
A credit line allows the business to:
• Use credit facility when is needed
• Have a lower interest rate compared to one off bank loans
This is because a line of credit only accrues interest when debt is taken
out on it.

Overdraft

An overdraft is always offered by the institution providing the corporate

bank account. Alternatively, any third-party institution can provide a
revolving credit facility.
For the bank account holder, an overdraft behaves the same way as a line
of credit.
If your account balance dips below zero, the bank provides you overdraft
protection up to a certain amount. This prevents your purchase from being
declined and your cheque from being bounced.
Overdraft protection can be linked to a business account but is typically
utilised by individuals. This is because revolving credit facilities are only
offered to businesses.
While personal bank accounts will come pre-equipped with an overdraft
facility, businesses must apply for overdrafts on commercial accounts.
Overdraft very similar to a line of credit but this is a non-revolving form
of credit.
 100:
Invoice Discounting

Invoice discounting is the process by which a business sells its account

receivables to a third party institution.
This working capital financing solution for small and medium-sized
businesses is easier to get compared to other financing methods.
Why? Because it is backed by an asset, the invoice.
For example, if a business has an invoice that is not payable yet, invoice
discounting can help bridge the gap and make the funds immediately
available.
Gain a deeper understanding of how invoice discounting works through
our conceptual article that expands on the concept.
Three Working Capital Financing Strategies
Just as there are different types of working capital financing, different
strategies and approaches can be used to manage the working capital of a
business.
The most applicable approach will depend on the specific circumstances
surrounding your business.
Below are three working capital strategies businesses should adapt based
on their credit score, industry, business size, working capital turnover
ratio, and financial goals:
Conservative Approach – As the name speaks for itself, this strategy
finances working capital with low risk and profitability.
Working capital financing will primarily be secured through long term
solutions in these instances. For example, equity funding, term loans or
long-term securities like debentures.
This strategy also finances a portion of your temporary working capital.
Temporary working capital is the net working capital variation curve above
permanent working capital.
Companies with high cyclical variances such as tourism or farming may
adopt this approach.
This methodology helps buffer against insolvency risks.
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Aggressive Approach – Conversely, an aggressive approach involves
extensive utilisation of short-term financing options.
An aggressive approach aims to speed up your business cycle and reduce
idle assets that generate unnecessary costs.
Although there are efficiency advantages associated with this approach, it
is incredibly high risk compared to a conservative strategy.
Hedging Approach – Perhaps the most sensible, utilitarian and most
frequently adopted approach.
This involves using long term financing methods to account for fixed
assets and permanent working capital.
The graphical representation below, gives you a better understanding of
how the three working capital strategies work.
Long- and short-term strategies are used to overcome temporary and
permanent working capital needs.
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